                    IN THE COURT OF APPEALS OF TENNESSEE
                                AT NASHVILLE
                                       October 11, 2000 Session

                    ASSOCIATES HOME EQUITY SERVICES, INC.
                         v. FRANKLIN NATIONAL BANK

                       Appeal from the Chancery Court for Davidson County
                        No. 99-3037-I   Irvin H. Kilcrease, Jr., Chancellor



                       No. M2000-00516-COA-R3-CV - Filed March 26, 2002


        In this appeal Associates, a mortgage company, appeals the trial court’s holding that it was
not entitled to equitable subrogation to the rights and priority of earlier mortgagees whose loans it
paid off. Franklin, another mortgage company, made a loan to the same property owners one day
before Associates made its loan and recorded its deed of trust three days before Associates recorded
its deed of trust to the same real property. Associates claims that, although Franklin recorded first,
Associates is entitled to priority pursuant to the doctrine of equitable subrogation. Franklin filed a
Motion for Judgment on the Pleadings, which the trial court granted. We find that because the
remedy of equitable subrogation is an equitable one dependent upon the facts and circumstances of
the situation and the equities between the parties, judgment on the pleadings was inappropriate.

             Tenn. R. App. P. 3 Appeal as of Right; Judgment of the Chancery Court
                                   Reversed and Remanded.

PATRICIA J. COTTRELL, J., delivered the opinion of the court, in which BEN H. CANTRELL, P.J., M.S.,
and WILLIAM C. KOCH, JR., J., joined.

Stephen C. Small, C. Dewees Berry, IV, Nashville, Tennessee, for the appellant, Associates Home
Equity Services, Inc.

J. Timothy Street, Franklin, Tennessee, for the appellee, Franklin National Bank.

                                                  OPINION

       On two consecutive days, two different lending institutions, Franklin National Bank and
Associates Home Equity Services,1 loaned money to Ronnie R. Lampley and wife Debra A.
Lampley, each loan to be secured by the same real property at 400 Achievement Drive in Nashville,

       1
           Associates’ predecessor, Ford Consumer Finance Company, actually made the loan.
Tennessee. The first of these two loans was made by Franklin in the amount of $75,500 on July 24,
1997. Associates made its loan the next day, July 25, 1997, in the amount of $102,886.72.

       The Associates’ loan was closed on July 25, 1997, and funded on July 31. The deed of trust
securing the loan was recorded August 7, three days after Franklin recorded its deed of trust on the
same property.

        Franklin declared the Lampleys in default under the Franklin Mortgage, and published a
notice of foreclosure sale for October 22, 1999. Associates filed this action and sought a temporary
restraining order to prevent the sale. The temporary restraining order was denied, and the
foreclosure sale went forward. After reading the Notice of Foreclosure at the sale, the substitute
trustee announced that the property might be sold subject to, among other matters, the Associates’
deed of trust. The property was then sold to JMC Properties, but JMC Properties never closed on
the property. Franklin submitted the only other bid at the foreclosure sale; therefore, the property
was conveyed to it. Franklin sold the property to a third party and the proceeds of that sale were
tendered to the Clerk and Master.

        Associates’ lawsuit claimed that, while Franklin’s mortgage was recorded first, Associates
still had priority under the doctrine of equitable subrogation because the monies that Associates
loaned to the Lampleys paid off two earlier mortgages.2 Franklin filed a Motion for Judgment on
the Pleadings pursuant to Tenn. R. Civ. P. 12.03. The trial court granted judgment on the pleadings
and dismissed Associates’ lawsuit. Associates appeals from that order of the trial court.

                                                           I.

         In this case the trial court granted Franklin’s motion for judgment on the pleadings pursuant
to Tenn. R. Civ. P. 12.03. When a motion for judgment on the pleadings is made by the defendant,
it is in effect a motion to dismiss for failure to state a claim upon which relief can be granted.
Waldron v. Delffs, 988 S.W.2d 182, 184 (Tenn. Ct. App. 1998). Such a motion admits all of the
relevant facts alleged in the complaint as true but asserts that such facts cannot constitute a cause of
action. Id.; see also Lavin v. Jordon, 16 S.W.3d 362, 364 (Tenn. 2000); McClenahan v. Cooley, 806
S.W.2d 767, 768 (Tenn. 1991); Lewis v. Allen, 698 S.W.2d 58, 59 (Tenn. 1985); Gray v.
McDonald’s Corp., 874 S.W.2d 44, 45 (Tenn. Ct. App. 1993).

       In other words “In considering a Rule 12.03 TRCP motion, all of the facts alleged in the
complaint must be taken as true and then the issue is whether those facts state a cause of action that
should be decided by a [court].” Gray, 874 S.W.2d at 45; see also McClenahan, 806 S.W.2d at 768.


         2
           The Lam pleys had given a m ortgage to Pinnacle Mortgage Company on November 1, 1993, on the
Achievement Drive property for a loan of $76,168. Later, on Novem ber 2, 1995, the Lampleys gave a second mortgage
to Chisolm & Associates for a loan of $5,500. Associates alleges that the proceeds from its loan w ere used, in part, to
pay off these prior mortgages. Attached to its complaint are an affidavit of the closing attorney and the closing
statemen t reflecting that checks for $ 75,13 3.69 and $3,526 were d elivered to the holde rs of the prior mo rtgages.

                                                          -2-
When deciding on such a motion the court is to “construe the complaint liberally in favor of the
plaintiff . . . and deny the motion unless it appears that the plaintiff can prove no set of facts in
support of the claim that would entitle him to relief.” Waller v. Bryan, 16 S.W.3d 770, 773 (Tenn.
Ct. App. 1999).

                                                          II.

         Franklin’s position rests upon the fact that its deed of trust was filed first and that its
instrument is entitled to priority by virtue of Tenn. Code Ann. § 66-26-105,3 which provides that a
first-registered instrument, including a mortgage or deed of trust, has preference over later-filed
instruments unless the holder of the first-filed had notice of the pre-existing but later-filed
instrument. This statute is part of Tennessee’s recording system, and along with Tenn. Code Ann.
§§ 66-26-102 and 103, establish the basic principles of that system, whose operation has been
described as follows:

         It is perceived there are five leading propositions embraced in the [recording
         statutes]: (1) That, as between the parties themselves and their heirs and
         representatives, such instruments take effect and are good without regard to
         registration; (2) that they also take effect and are equally good as to all persons who
         have actual notice of them from the date of such notice, except creditors; (3) that as
         to creditors (that is, of the vendor) they are inoperative, ineffective, and practically
         nonexistent until so noted for registration . . .; (5) that upon being so “noted for
         registration” they become at once “notice to all the world,” and so effective as to all
         the world.

Wilkins v. McCorkle, 112 Tenn. 688, 697-98, 80 S.W. 834, 835 (1904).

       Under Tenn. Code Ann. § 66-26-105, a first-filed instrument has preference over a later-filed
document, even one which was executed first. Harris v. Buchignani, 199 Tenn. 105, 113, 285
S.W.2d 108 (1955). This preference is not available where the party claiming under the subsequent
instrument had “full notice” of the prior unrecorded one. Tenn. Code Ann. § 66-26-105.4


         3
           Courts have described the purpose or intent of T.C.A. § 66-26-105 as “to resolve the situation created by a
dishon est landowner who know ingly or negligently conveys the same land more than once” and stated that this “statute
[is] designed to avoid inequity, not to create or promote it.” Watson v. Watson, 658 S.W.2d 132, 134 (Tenn. Ct. App.
1983).


         4
                  Notice may be imparted in several ways. There may be actual notice, which is the
                  equivalent of personal knowledge on the part of the purchaser, or there may be
                  record notice (sometimes called ‘constructive’ notice), deriving from the
                  recordation of the prior instrument or something making reference to is. Finally,
                  there is a form com mo nly re ferred to as inq uiry notice, wh ich ex ists wh en the
                                                                                                         (con tinued...)

                                                          -3-
         Yet, the statute limits the effect of a race to the courthouse by providing that a party
         claiming a priority status under a subsequent mortgage who has notice of the prior
         mortgage, will not gain priority status. Thus, priority of registered instruments is
         governed by a race-notice statute in Tennessee. However, it has been held that
         priority may be affected by provisions in the mortgage.

In Re Total Care, Inc., 102 B.R. 646, 650 (Bankr. W.D. Tenn. 1989).

        Courts recognize, however, exceptions to the first-filed rule which are based upon facts not
disclosed by a search of recorded instruments. Among those are subrogation or equitable
assignment. For example, in Third Nat’l Bank v. Highlands Ins. Co., 603 S.W.2d 730 (Tenn. 1980),
our Supreme Court held that a surety on a contractor’s performance bond is subrogated to the rights
of the contractor to monies earned before default. The court held that the surety is essentially
“secured” by its right of subrogation and that such “right of subrogation, being created by operation
of law and not by written instrument, is not subject to recordation. . . .” Id. at 733. Consequently,
the surety’s unrecorded right of subrogation defeated, or took priority over, intervening creditors,
in that case a bank with a security interest in the contractor’s inventory, accounts receivable and
contract rights and proceeds. The financing statement evidencing the security interest was filed after
the performance bond was issued.

        It is this subrogation exception to the first-filed rule that forms the basis of Associates’ claim.
Associates takes the position that the priority apparently given Franklin by the first-filed rule is
irrelevant because Associates took the priority of the older mortgages its loan paid off. Based upon
the doctrine of equitable subrogation, Associates argues that it was subrogated to the rights of the
prior creditors and, consequently, it is entitled to priority to the extent its loan was used to pay the
senior loans.

                                                               III.

        Subrogation is defined as “the substitution of another person in the place of a creditor, so that
the person in whose favor it is exercised succeeds to the rights of the creditor in relation to the debt.”
Blakenship v. Estate of Bain, 5 S.W.3d 647, 650 (Tenn. 1999) (citing Castleman Constr. Co. v.
Pennington, 222 Tenn. 82, 92, 432 S.W.2d 669, 674 (1968)). In its most basic form, subrogation
means that Party A is substituted for Party B and is allowed to assert the rights and claims that Party
B had against Party C. Id.



         4
             (...continued)
                      purchaser is in possession of informa tion o r facts sufficient to cau se a rea sonable
                      person to m ake further inq uiry as to the existence and content of the unregistered
                      doc um ent.

Toxey H. Sewell, The Tennessee Recording System, 50 T E N N . L. R E V . 1, 43-44 (1982 ).

                                                               -4-
        Our Supreme Court has explained the sources of a right to subrogation, stating such right
“may arise by contract” (‘conventional subrogation’) by application of equitable principles of law
(‘legal subrogation’), or by application of statute (‘statutory subrogation’).” Blakenship, 5 S.W.3d
at 650. The doctrine of equitable, or legal, subrogation allows a person who pays the debt of another
to assume the creditor’s place with respect to the debt. Castleman Constr. Co., 222 Tenn. at 93, 432
S.W.2d at 674. Parties entitled to subrogation on equitable principles include parties who pay off
a debt, with the intent of keeping the debt alive, to protect their own interest. Harrison v. Harrison,
149 Tenn. 601, 606, 259 S.W. 906, 907 (1923). This includes “subsequent encumbrancers paying
off a prior encumbrance.” Id.

        The distinctions in the types of subrogation relate to the source of the right and the
determination of whether a right to claim subrogation exists. Castleman Constr. Co., 222 Tenn. at
95, 432 S.W.2d at 675. Such distinctions do not enter into the separate question of enforcement of
the right or application of the remedy of subrogation. The question of whether subrogation will be
afforded is answered by equitable principles. Id. 222 Tenn. at 97, 432 S.W.2d at 676. Subrogation
is a remedy whose application depends upon the balancing of the equities involved. See Lawyers
Title Ins. Corp. v. United Am. Bank, 21 F. Supp. 2d 785, 792 (W.D. Tenn. 1998). Subrogation “will
not be enforced when it would work injustice to the rights of those having equities.” Castleman
Constr. Co, 222 Tenn. at 94, 432 S.W.2d at 674.

        Subrogation is a creature of equity and, as such, its principles are naturally flexible.
Castleman Constr. Co., 222 Tenn. at 95, 432 S.W.2d at 675; Walker v. Walker, 138 Tenn. 679, 682,
200 S.W. 825, 825 (1917). The doctrine of equitable subrogation is one “which will be applied or
not according to the dictates of equity and good conscience, and consideration of public policy, and
will be allowed in all cases where the equities of the case demand it.” Dixon v. Morgan, 154 Tenn.
389, 397-98, 285 S.W. 558, 560 (1926). The doctrine:

        Rests upon the maxim that no one shall be enriched by another’s loss, and may be
        involved wherever justice demands its application . . . . The right to it depends upon
        the facts and circumstances of each particular case, and to which must be applied the
        principles of justice.

Id.

        Subrogation is not a universal remedy for persons who have lost their money, and the court
will not extend the doctrine of equitable subrogation beyond the set of principles on which it rests.
Cole v. Patty, 175 Tenn. 334, 338, 134 S.W.2d 160, 162 (1939); Almany v. Christie, No. 01-A-01-
9608-CH-00376, 1997 Tenn. App. LEXIS 111, at *1 (Tenn. Ct. App. Feb. 21, 1997) (no Tenn. R.
App. P. 11 application filed); 83 C.J.S. Subrogation § 6 (2000). Even a party who establishes a basis
for asserting a right of subrogation must still carry the burden of demonstrating that the equities of
the case entitle it to the remedy. Title Guar. & Trust Co. v. Johnson, 485 S.W.2d 764 (Tenn. Ct.
App. 1972).


                                                 -5-
         In balancing the equities between the parties, the negligence of the party seeking subrogation
is a relevant factor for consideration. In Dixon, the Tennessee Supreme Court thoroughly examined
the degree of negligence which may preclude equitable relief and determined that a party will be
precluded only where he is guilty of culpable negligence. Id. 154 Tenn. at 398, 258 S.W. at 561-63.
In that case, the court granted subrogation to Mr. Dixon who purchased land by paying the
mortgagee of his seller. Mr. Dixon did not search the records and was unaware of the existence of
other deeds of trust at the time of his purchase, assuming from his conversations with the seller, “his
friend, neighbor, and fellow churchman,” that the only encumbrance on the property was the one he
paid off. The court found that Mr. Dixon owed no duty to the bank holding the intervening
encumbrance to search the records, that the bank suffered no injury or loss by his failure to perform
such search, and that he was not guilty of culpable negligence. Id. 154 Tenn. at 406, 258 S.W. 562.
In any event, the degree of negligence and its consequence must depend to a great extent upon the
factual circumstances involved. Castleman Constr. Co., 222 Tenn. at 98, 432 S.W.2d at 677. In
Castleman, the Supreme Court granted the remedy of subrogation to a title company even though
the title company was negligent in failing to discover a prior encumbrance.5 Id.

         The harm suffered by third parties if subrogation is granted is another factor to be considered
as it is part of the weighing of equities. Even clear or culpable negligence will not prevent an
equitable remedy if the other party will not be prejudiced thereby. Dixon, 154 Tenn. at 404, 285
S.W. at 562. “[W]here no one is injured by the mistake other than the party himself, and no one has
changed his position in consequence of what has been done and of the mistake, relief may be
granted, even though a high degree of care has not been exercised.” Id. (quoting 21 Corpus Juris,
88).

       Again, the important principle is that subrogation is an equitable remedy, the grant or denial
of which depends upon weighing the equities between the parties. Nonetheless:

         To entitle one to subrogation, his equity must be strong and his case clear, since it
         will not be enforced where the equities are equal, or the rights are not clear, or where
         it will prejudice the legal or equitable rights of others. Where equities are equal,
         there is no right of subrogation.

Castleman Constr. Co., 222 Tenn. at 94, 432 S.W.2d at 675.

                                                            IV.

        Questions of priorities when a creditor pays off an earlier encumbrance and takes security
in the previously-encumbered property arise in the context of mortgage refinancing, as appears to
be the situation herein. Courts and other authorities have developed principles to be applied in


         5
             Absent mo re inform ation abo ut the facts surro unding each of the loan s, any negligence by Associates appears
to lie in its delay in filing its deed of trust.

                                                            -6-
refinance situations which provide guidance. For example, the Restatement has addressed the issues,
proposing the following:

       § 7.6 Subrogation

       (a)     One who fully performs an obligation of another, secured by a mortgage, becomes
               by subrogation the owner of the obligation and the mortgage to the extent necessary
               to prevent unjust enrichment. Even though the performance would otherwise
               discharge the obligation and the mortgage, they are preserved and the mortgage
               retains its priority in the hands of the subrogee.

       (b)     By way of illustration, subrogation is appropriate to prevent unjust enrichment if the
               person seeking subrogation performs the obligation:

               (1)     in order to protect his or her interest;

               (2)     under a legal duty to do so;

               (3)     on account of misrepresentation, mistake, duress, undue influence, deceit, or
                       other similar imposition; or

               (4)     upon a request from the obligor or the obligor’s successor to do so, if the
                       person performing was promised repayment and reasonably expected to
                       receive a security interest in the real estate with the priority of the mortgage
                       being discharged, and if subrogation will not materially prejudice the holders
                       of intervening interests in the real estate.

RESTATEMENT (THIRD) OF THE LAW OF PROPERTY (MORTGAGES ) § 7.6 (1998). In explaining the
four examples listed, the authors find the last to include a re-finance situation.

              Performance at the request of the debtor. A mortgage debtor may ask
       another person to discharge the debt. In some circumstances, the payor who does so
       is warranted in receiving, by subrogation, the benefit and priority of the mortgage
       paid. The most common context for this sort of subrogation is the “refinancing” of
       a mortgage loan; that is, the payment of a loan with the proceeds of another loan.

                                                 ....

               Perhaps the case occurring most frequently is that in which the payor is
       actually given a mortgage on the real estate, but in the absence of subrogation it
       would be subordinate to some intervening interest, such as a junior lien. Here
       subrogation is entirely appropriate, and by virtue of it the payor has the priority of the
       original mortgage that was discharged. This priority is often of critical importance,


                                                  -7-
         since it will place the payor’s security in a position superior to intervening liens and
         other interests in the real estate. The holders of such intervening interests can hardly
         complain of this result, for it does not harm them; their position is not materially
         prejudiced, but is simply unchanged.

RESTATEMENT, supra, §7.6 comment e, at 519.

         The Restatement incorporates the principles of equity in its “unjust enrichment” language
and in its requirement that subrogation “not materially prejudice the holders of intervening interest.”
The comments explain further:

                 Subrogation will be recognized only if it will not materially prejudice the
         holders of intervening interests. The most obvious illustration is that of a payor who
         lends the mortgagor more money than is necessary to discharge the preexisting
         mortgage. The payor is subrogated only to the extent that the funds disbursed are
         actually applied toward payment of the prior lien. There is no right of subrogation
         with respect to any excess funds.

                 Similarly, if the payor demands a higher interest rate than prevailed under the
         original mortgage loan, the positions of intervening interest holders may be
         jeopardized, since the increased interest may result in the mortgage’s having a higher
         balance at the time it is later foreclosed. Subrogation should be granted only to the
         extent of the debt balance that would have existed if the interest rate had been
         unchanged. This reasoning is inapplicable if the original mortgage provided for
         variable or adjustable interest, and the interest on the refinancing loan falls within the
         parameters thus established.

RESTATEMENT, supra, §7.6 comment e, at 520.

        The Restatement rule places importance on the reasonable expectation of the payor that by
paying off prior encumbrances its mortgage would have first priority. The rule does not include
consideration of knowledge or notice of the intervening encumbrance.6 However, as the Restatement
comments acknowledge, many courts consider knowledge at the time of payment significant and
courts in a number of states have found that such notice, at least actual notice, of a junior or
intervening encumbrance bars subrogation to a prior encumbrance.7 See, e.g., Han v. United States,


         6
          The com me nts to § 7.6 indicate such kno wledge by th e pay or of an intervening or jun ior interest is not
necessarily relevant. Because lenders who provide refinancing ordinarily want an d expect to get security with a priority
equal to that of the mortgages being paid, their know ledge of intervening junio r mortgages doe s not affect their
expectations, according to the reasoning.

         7
          “M ost of the cases disqualify the payor who has actual knowledge of the intervening interest, although they
do not consider constructive notice from the public records to impair the payor’s right to subrogation.” R E S T A TE M E N T ,
                                                                                                           (con tinued...)

                                                             -8-
944 F.2d 526 (9th Cir. 1991) (under California law, equitable subrogation is denied to a party who
has actual knowledge of an existing encumbrance); Bankers Trust Co. v. United States of America,
25 P.3d 877, 882 (Kan. 2001) (although not necessarily the majority rule, Kansas law is in accord
with the many jurisdictions which focus on whether a party had actual notice of an intervening
interest before applying equitable subrogation and disagreeing with Restatement’s position that
knowledge is not necessarily relevant); First Fidelity Bank v. Travelers Mortgage Services, 693 A.2d
525 (N.J. Sup. 1997) (where lender had actual knowledge of second mortgage when it paid off senior
mortgage, it was not entitled to be equitably subrogated to the senior mortgagee’s priority even
though second mortgagee would be enriched by denial of subrogation). In G.E. Mortgage Services,
Inc. v. Levenson, 657 A.2d 1170, 1172 (Md. 1995), the Maryland Supreme Court stated:

        Where a lender has advanced money for the purpose of discharging a prior
        encumbrance in reliance upon obtaining security equivalent to the discharged lien,
        and his money is so used, the majority and preferable rule is if he did so in ignorance
        of junior liens or other interests he will be subrogated to the prior lien.

Id. (emphasis added).

         The Tennessee Supreme Court in Dixon noted that some courts hold that a party is precluded
from an equitable subrogation action where he has actual notice and that other courts hold that a
party is precluded when he has constructive notice of a junior lien holder. Instead of following either
of these rules, the court held that a party guilty of culpable negligence would be precluded from
asserting a claim based on equitable subrogation. In Dixon the negligence asserted was the failure
to search the records and the consequent failure to discover a prior recorded encumbrance, and the
court found that under the circumstances, this was not culpable negligence. However, we interpret
Dixon as implying that a party with actual notice may not have a claim for equitable subrogation.
Dixon, 154 Tenn. at 411, 285 S.W. at 564.

        Whether or not actual knowledge is a per se bar to subrogation, we are not persuaded that
a party’s actual knowledge is irrelevant to the question of whether the equitable remedy of
subrogation should be granted. It is a relevant factor in consideration of the negligence to be
attributed to the party seeking subrogation, especially in cases involving a sophisticated institution
in the business of making mortgage loans. But see Castleman Constr. Co., 222 Tenn. at 99, 432
S.W.2d at 677 (holding that a title insurance company was negligent in discovering prior
encumbrances but still entitled to subrogation). Similarly, it is relevant to the reasonableness of a
payor’s expectation that it would take the priority of the mortgages it paid off, particularly in the
absence of an agreement regarding assignment or priorty.




        7
          (...continued)
supra, § 7.6 comment e, at 520.

                                                 -9-
       The record before us is devoid of information regarding the knowledge of either Franklin or
Associates about the other’s loan and any information about the expectations of either or the terms
of Franklin’s arrangement with the property owners. We are not even informed of when filings were
made documenting the release of the 1993 and 1994 mortgages. The record, consisting of only the
pleadings, does not reveal many of the facts which would be relevant to a determination of where
the equities lie.




                                               -10-
                                                 IV.

        Because Associates alleged it paid off the prior encumbrances as part of its loan to the
Lampleys, it has stated a claim for subrogation sufficient to require a balancing of the equities
between the parties to determine if that equitable remedy should be granted. Accordingly, we
reverse the trial court’s grant of judgment on the pleadings and remand for further proceedings to
determine whether subrogation should be granted in view of the facts and circumstances found and
the principles set out herein. Costs of this appeal are taxed to the appellee, Franklin National Bank,
for which execution may issue if necessary.


                                                       ____________________________________
                                                       PATRICIA J. COTTRELL, JUDGE




                                                -11-
