If you’ve been around construction contracts or architects agreements for a while, you’ve heard someone mention “subrogation.” So what exactly is subrogation and how does it work?
Subrogation is pretty simple, yet it defies clear explanation. Here’s one attempt:
Subrogation is a method whereby one who had involuntarily paid a debt of another succeeds to the rights of the other with respect to the debt paid
Hugh?? OK, maybe subrogation is one of those things better explained by example.
- Your own a truck and you buy insurance from the Acme Insurance Company against damage to your vehicle
- As you’re driving to a project site, Mr. Wiley runs a stop sign, smashes into your truck, and causes $5,000 worth of damage. Luckily, no one gets hurt
- You call your insurance agent and submit a claim to Acme for the damage to your truck
- Acme pays your claim for repairs. It comes to $5,000 (we’ll ignore your deductible and the cost of a substitute rental truck here to keep the math simple). So, with full payment from Acme, you have no more quarrel with Mr. Wiley. At least no more quarrel over money. But now Acme does
- By paying your insurance claim, Acme paid off Mr. Wiley’s debt to you – the cost to repair your truck
Here’e where subrogation steps in. Under the principle of subrogation, Acme steps into your shoes (or boots) vis-a-vis Mr. Wiley. By paying $5,000 to repair the damage Mr. Wiley caused, the subrogation transfers the claim you once had against Mr. Wiley over to Acme (up to the $5,000 Acme paid you).
Acme’s happy to take over your $5,000 claim against Mr. Wiley. They just paid $5,000 to clean up the mess he made. And they would like to get some of it back out of Mr. Wiley’s hide. Because Acme is now subrogated to your claim against Mr. Wiley, they can.
Subrogation: It’s Not Just For Insurance Anymore
You can also see subrogation at work among mechanics liens. Often when construction loan proceeds are used to pay a contractor, the lender wants to subrogate to the mechanics lien rights of the contractor they just paid (each a “Lender Paid Contractor”). This becomes especially important when: (a) work by contractors has enhanced project value, and (b) a foreclosure sale of the project doesn’t yield enough money to pay off the lender and all of the contractors who’ve perfected mechanics liens against the project.
The foreclosure sale money must be split up into two buckets. Then, the lender and contractors respectively queue up to draw money from each bucket. They also jockey for the priority position of who gets to stand first in each queue:
- The lender gets the first priority position on the bucket of money representing the project’s pre-work value (the “pre-work value bucket”)
- Contractors with perfected mechanics liens get the first priority position on the bucket of money representing value that the work added to the project (the “added value bucket”)
Wanting to increase their own share of the foreclosure money available, the lender often wants to draw money from both buckets. Sometimes, subrogation not only helps the lender do that, it helps them join contractors in the first priority position on the added value bucket. How? The lender subrogates to the priority position formerly held by the Lender Paid Contractors before they were paid. This arouses controversy between the contractors and the lender:
- The lender usually wants to subrogate up to the full amount of loan proceeds they paid out to each Lender Paid Contractor
- But other contractors drawing from the added value bucket want to maximize their draw. That means minimizing how much others at that bucket draw, including the lender. So, the other contractors may urge limiting how much the lender may subrogate to: limit the amount of the lender’s subrogation to the amount secured by perfected mechanics liens held by the Lender Paid Contractors.For example, if the Lender Paid Contractor had a perfected mechanics lien securing payment of only $1M, but they get paid $2M worth of loan proceeds, then the lender may subrogate to a priority position of only $1M on the added value bucket. The lender steps into the Lender Paid Contractor’s priority shoes, but no more
How much the lender may subrogate to will be our focus in Mechanics Lien Priority: Contractor vs. Lender – Part 5.