Bofinger v Kingsway Group Pty Ltd

[2008] NSWCA 332

New South Wales

Court of Appeal

CITATION:	BOFINGER & Anor v KINGSWAY GROUP PTY LTD & Ors [2008] NSWCA 332 This decision has been amended. Please see the end of the judgment for a list of the amendments.
HEARING DATE(S):	7 October 2008
JUDGMENT DATE:	3 December 2008
JUDGMENT OF:	Giles JA at 1; Handley AJA at 19; Sackville AJA at 60
DECISION:	Appeal dismissed with costs.
CATCHWORDS:	EQUITY - rule in Otter v Vaux - extended to guarantors - prevents guarantor keeping first mortgage alive against second mortgage he has guaranteed. - EQUITY - subrogation - unconscionable conduct - guarantor paying off first mortgage - first morgagee holding surplus - not unconscionable for first mortgagee to transfer surplus to second mortgagee where second mortgage also guaranteed. - GUARANTEE - subrogation - guarantor paying off first mortgage - not entitled to subrogation in priority to second morgage guaranteed by himself. - MORTGAGE - rule in Otter v Vaux - guarantor pays off first mortgage - rule extended to prevent guarantor keeping first mortgage alive against second mortgage guaranteed by himself.
LEGISLATION CITED:	Law Reform (Miscellaneous Provisions) Act 1965
CATEGORY:	Principal judgment
CASES CITED:	Aldrich v Cooper (1803 8 Ves Jun 382 at 389; 32 ER 402 Alwyn v Witty (1861) 30 LJ Ch 860 Aquilina Holdings Pty Ltd v Lynndell Pty Ltd [2008] QSC 57 Austin v Royal (Giles J, 14 May 1988, unreported; BC 9801770 at 12) Australasian Conference Association Ltd v Mainline Constructions Pty Ltd (in liquidation) (1978) 141 CLR 335 Australian Broadcasting Corporation v Lenah Game Meats Pty Ltd (2001) 208 CLR 199 Banque Financiere de la Cité v Parc (Battersea) Ltd [1999] 1 AC 221 Barnes v Addy (1874) LR 9 Ch App 244 Challenger Managed Investments Ltd v Direct Money Corporation Pty Ltd (2003) 12 BPR 22,257 Cochrane v Cochrane (1985) 3 NSWLR 403 Dawson v Bank of Whitehaven (1877) 4 Ch D 639 Drew v Lockett (1863) 32 Beav 499; 55 ER 196 Duncan Fox & Co. v North and South Wales Bank (1880) 6 App Cas 1 Forbes v Jackson (1882) 19 Ch D 615 Gedye v Matson (1858) 25 Beav 310 Highland v Exception Holdings Pty Ltd (in liq) [2006] NSWCA 318; 60 ACSR 223 Liquidation Estates Purchase Co. v Willoughby [1898] AC 321 McColl’s Wholesale Pty Ltd v State Bank of New South Wales (1984) 3 NSWLR 365 Mercantile Law Amendment Act 1856 (UK) O’Dey v Commercial Bank of Australia Ltd (1933) 50 CLR 200 Otter v Lord Vaux (1856) 2 K & J 650; 69 ER 943 Platt v Mendel (1884) 27 Ch D 246 re W Tasker & Sons Ltd [1905] 2 Ch 587 Registrar-General v Gill (Court of Appeal, 16 August 1994, unreported) Silk v Eyre (1875) 9 IR Eq 393 Sussman v AGC Advances Ltd (1995) 37 NSWLR 37 CA Tanwar Enterprises Pty Ltd v Cauchi (2003) 217 CLR 315 Thorne v Cann [1895] AC 11 Toulmin v Steere (1805) 3 Mer 210 Whiteley v Delaney [1914] AC 132
TEXTS CITED:	Meagher, Gummow and Lehane’s equity: doctrines and remedies, 4th ed (2002) Butterworths LexisNexis
PARTIES:	Ronald John BOFINGER (1st Appellant) Sandra Anne BOFINGER (2nd Appellant) KINGSWAY GROUP PTY LTD (1st Respondent) RECKLEY PTY LTD (2nd Respondent) John Edward SKEHAN (3rd Respondent) David John LEVI & John Maxwell MORGAN (Joint Liquidators B & B Holdings Pty Ltd) (4th Respondents) Ron TOSOLINI (5th Respondent) Adrian MATTIUSSI (6th Respondent) Lou POLITO (7th Respondent) Peter HATHELIER (8th Respondent)
FILE NUMBER(S):	CA 40782/07; 40909/07
COUNSEL:	G McVay (1st & 2nd Appellants) D R Sibtain (1st & 8th Respondents) C Harris SC (2nd & 3rd Respondents) J Hubbard (Sol) 4th Respondent) R Darke SC (5th, 6th & 7th Respondents)
SOLICITORS:	Warren McKeon Dickson (Appellants) Watson Mangioni Lawyers (1st & 8th Respondents) Bransgroves Lawyers (2nd & 3rd Respondents) McLachlan Chilton (4th Respondent) Middletons (5th, 6th & 7th Respondents)
LOWER COURT JURISDICTION:	Supreme Court - Equity Division
LOWER COURT FILE NUMBER(S):	SC 2451/06
LOWER COURT JUDICIAL OFFICER:	Young CJ in Eq
LOWER COURT DATE OF DECISION:	15 October 2007
LOWER COURT MEDIUM NEUTRAL CITATION:	[2007] NSWSC 1138

CA 40782/07
CA 40909/07

GILES JA
HANDLEY AJA
SACKVILLE AJA

Wednesday 3 December 2008

BOFINGER & ORS v KINGSWAY GROUP PTY LTD & ORS

The plaintiffs were guarantors of loans to a developer which were secured by first, second and third mortgages over the development property, supported by first, second and third mortgages over their home and a private investment property. The guarantors sold their home and the investment property and the net proceeds were paid to the first mortgagee. The three mortgages over their own properties were discharged on settlement although the second and third mortgagees received nothing.

The first mortgagee then realised its security over the development property and after it had been paid in full it retained in its hands surplus proceeds of sale and the certificates of title to two unsold properties which were then paid and delivered to the second mortgagee. The guarantors claimed to be subrogated in equity and under s3 of the Law Reform (Miscellaneous Provisions) Act 1965 to the rights of the first mortgagee over the surplus proceeds and unsold properties in priority to the second mortgagee. The Chief Judge in Equity held that the guarantors’ right of subrogation protected them from unconscionable conduct by the first mortgagee but the latter had not acted unconscionably in transferring the surplus proceeds and the certificates of title to the unsold lots to the second mortgagee and the guarantors’ proceedings were dismissed.

On appeal:

HELD:

(1) A guarantor of a first mortgage who pays it off can normally keep it alive for his own benefit against the mortgagor and a second mortgagee: Drew v Lockett (1863) 32 Beav 499, 505 and other cases applied;

(2) By Giles JA and Handley AJA: the rule in Otter v Vaux (1856) 2 K & J 650, (1856) 6 Be G M & G which prevents a mortgagor who has paid off the first mortgage keeping it alive against the later mortgage created by himself applied in principle and should be extended to prevent a guarantor who pays off a mortgage that he has guaranteed keeping it alive against the later mortgage that he has also guaranteed:

(3) By the whole Court: The guarantors were not entitled to be subrogated to the surplus assets in priority to the second mortgagee because it would not be unconscionable for the first mortgagee to hold those assets for the benefit of the second mortgagee or for the second mortgagee to claim them in priority to the guarantors;

(4) The guarantors’ appeal should be dismissed.

ORDERS

Appeal dismissed with costs.

CA 40782/07
CA 40909/07

GILES JA
HANDLEY AJA
SACKVILLE AJA

Wednesday 3 December 2008

BOFINGER & ORS v KINGSWAY GROUP PTY LTD & ORS

JUDGMENT

1 GILES JA: The principal question in the appeal is whether guarantors (the Bofingers) are entitled on principles of subrogation to the benefit of the first mortgage given by the debtor (B & B) to one creditor (Kingsway) in priority to the rights as second and third mortgages of two other creditors (Reckley and Skehan) over the property mortgaged by B & B. The facts are described in the reasons of Handley AJA: I will not repeat them, but it is important that the Bofingers also gave guarantees to Reckley and Skehan and gave first, second and third mortgages over their own properties to the respective mortgagees as security for their guarantees.

2 The available funds leave nothing for Skehan, and it is sufficient to refer only to the Bofingers’ entitlement as against Reckley.

3 In Registrar General v Gill (CA, 16 August 1994, unreported) Gleeson CJ and Priestley JA said:

“The equitable principles relating to subrogation aim to adjust the interest of three parties, such as a creditor, a debtor and an insurer or surety, in such a way as to avoid the unconscionable result of double recovery by the creditor or inequitable discharge of the liability of the debtor.”

4 Subrogation in relation to securities was said by Lord Eldon, in Aldrich v Cooper (1803 8 Ves Jun 382 at 389; 32 ER 402 at 405, to arise by force of “that equity upon which it is considered against conscience that the holder of the securities should use them to the prejudice of the surety; and therefore there is nothing hard in the act of the Court, placing the surety exactly in the situation of the creditor”. In Australasian Conference Association Ltd v Mainline Constructions Pty Ltd(in liquidation) (1978) 141 CLR 335 at 348 Gibbs ACJ said, after referring to this passage, that the principle underlying the subrogation is “that it would be inequitable for a creditor, by choosing not to resort to remedies in his power, to cast the whole of the obligation on the surety.”

5 As appears from these passages, the subrogation has commonly been given the doctrinal basis of unconscionability or inequity. This is open to debate, see Highland v Exception Holdings Pty Ltd (in liquidation) (2006) NSWCA 318; 60 ACSR 223 at [94]-[110]. In England it is now founded on unjust enrichment, see Banque Financière de la Cité v Parc (Battersea) Ltd (1999) 1 AC 221.

6 The general entitlement of a guarantor who has discharged the debtor’s obligation to the benefit of a mortgage given by the debtor to the creditor is, however, well established. It has statutory expression, with some modification, in s 3 of the Law Reform (Miscellaneous Provisions) Act 1965 (“the Act”), which provides in subs (1) -

“(1) A person who, being surety for the debt or duty of another, or being liable with another for a debt or duty, pays that debt, or performs that duty, is entitled:


(a) to have assigned to that person, or to a trustee for that person, every judgment, specialty or other security held by the creditor in respect of that debt or duty, whether or not that judgment, specialty or other security is taken at law to have been satisfied by the payment of the debt or the performance of the duty, and

(b) to stand in the place of the creditor and to use all the remedies, and, if necessary, and on a proper indemnity, to use the name of the creditor in any proceedings to obtain from the principal debtor or any co-surety, co-contractor or co-debtor (as the case requires) indemnity for the advances made and loss sustained by the person who paid the debt or performed the duty.”

7 Where s 3 applies, debate over the doctrinal basis for subrogation in relation to securities is truncated, as it must be applied according to its proper construction; also truncated is modification of the entitlement to subrogation according to perceived unconscionability or inequity in the particular case.

8 The guarantor’s entitlement to the benefit of the mortgage adjusts interests as between creditor, debtor and guarantor. The creditor holds the mortgage for the benefit of the guarantor, instead of its own benefit, and the debtor and guarantor come into the relationship of mortgagor and mortgagee.

9 If there is a second mortgage over the security property, however, the interests of a fourth party arise. It is a further question whether the guarantor entitled to the benefit of the first mortgage can assert its entitlement in priority to the rights of the second mortgagee, and similarly as to any subsequent mortgagee. Unconscionability, inequity or unjust enrichment as between creditor, debtor and guarantor does not mean unconscionability, inequity or unjust enrichment as against the second mortgagee.

10 In Drew v Lockett (1863) 32 Beav 499; 55 ER 196 it was said that the guarantor’s entitlement carried with it the priority afforded to the first mortgage. The reason for this was (at 505; 198) -

“It is to be observed, that the second and any subsequent mortgagee is in no respect prejudiced by the enforcement of this equity; when he advances his money he knows perfectly well that there is a prior charge on the property, and if he thinks fit to advance his money on such security, it is his own affair, and he cannot afterwards with justice complain. The amount being limited, it is a matter of indifference to him whether the first mortgagee or the surety is the prior claimant for the amount, and it would be, in my opinion a violation of all principle if, when the surety pays off the debt, he were not to be entitled, as against the principal debtor and those who claim under him, to be paid the full amount due to him.”

11 This might be thought questionable. A second mortgagee can expect that when the first mortgagee is paid out, it will stand first in line, and it will not be indifferent to the substitution of the guarantor as first mortgagee. The reason rather begs the question of substitution so as to maintain for the guarantor the first mortgagee’s priority. Be that as it may, it leaves open that in the particular case the second mortgagee can with justice complain. It may be that in the adjustment of interests as between the guarantor and the second mortgagee, the guarantor cannot assert its entitlement in priority to the rights of the second mortgagee.

12 This is consistent with the flexibility by which a guarantor can give up equitable or statutory subrogation rights, see O’Day v Commercial Bank of Australia Ltd (1933) 50 CLR 200 and other cases noted in Austin v Royal (Giles J, 14 May 1988, unreported; BC 9801770 at 12). Equity and s 3 of the Act place the guarantor in the shoes of the first mortgagee, to use the traditional phrase, but do not demand that the guarantor retain the first mortgagee’s priority.

13 Reckley advanced its money with knowledge of the first mortgage, and presumably with knowledge of the Bofingers’ guarantee given to Kingsway. But as well as its second mortgage from B & B, Reckley took a guarantee from the Bofingers and a mortgage of the Bofingers’ properties as security for their guarantee. As between the Bofingers and Reckley the plain intention was that Reckley was to have resort to the property mortgaged by B & B after Kingsway and prior to any entitlement the Bofingers might have with respect to that property. Put another way, the obligations undertaken by the Bofingers towards Reckley were inconsistent with the Bofingers having prior resort to the property mortgaged by B & B.

14 As between creditor, debtor and guarantor the guarantor will not be put in the shoes of the creditor for all purposes. In McColl’s Wholesale Pty Ltd v State Bank of New South Wales (1984) 3 NSWLR 365 Powell J pointed out that the guarantor will not necessarily obtain the benefit of all covenants in the security instrument, such as interest at the covenanted rate, because “the ultimate purpose of subrogation is not to put the surety in the identical position in which the creditor formerly stood, but to enable the surety to enforce his right to an indemnity by resort to the securities formerly held by the creditor” (at 379). To the same effect, in Banque Financière de la Cité v Parc (Battersea) Ltd Lord Hoffmann said at 236 that the plaintiff’s legal relations with a defendant “are regulated as if the benefit of the charge had been assigned to him”, and that “it does not by any means follow that the plaintiff must for all purposes be treated as the actual assignee of the benefit of the charge”. Although his Lordship regarded subrogation as founded in unjust enrichment, the point is good whatever its doctrinal basis.

15 Equally, in my opinion, where the interests of a second mortgagee arise the guarantor cannot necessarily assert its entitlement under principles of subrogation in priority over the rights of the second mortgagee. Mitchell and Watterson, Subrogation: Law and Practice (OUP, 2007), also treat subrogation as founded on unjust enrichment, including the question of priority. The priority ordinarily afforded to the guarantor is described at paras 4.17-4.23, 4.25-4.26 as reversing the enrichment of the “junior secured creditor” whose position has been improved by the discharge of the prior-ranking security, and as open to defences including change of position, estoppel and agreement that the junior secured creditor should have priority over the guarantor. The learned authors later say -

“8.26 Although the claimant’s new rights generally replicate the characteristics and content of the discharged creditor’s old rights, it must be kept in mind that the claimant is not an actual assignee of the creditor’s rights, and that the claimant’s new rights are awarded for a particular purpose, namely reversing an unjust enrichment at his expense. Hence the claimant does not inevitably acquire new rights which share every characteristic of the rights which were formerly held by the creditor. Sometimes their quality may vary, for a number of different reasons.
8.27 First, the court may think it appropriate to modify the claimant’s rights where the debtor or a remoter party has successfully invoked a defence. For example, the debtor may have changed his position, or may have repaid the sum due. Alternatively, an existing junior incumbrancer may resist the claimant’s claim to priority vis-à-vis the junior interest on the basis that it has changed its position; or on the basis that giving the claimant such priority would be contrary to public policy.
8.28 Secondly, … .” (footnotes omitted)

16 Priority according to the rationale in Drew v Lockett, rather than on principles of unjust enrichment, also can accommodate the acquisition of ights less than those of a first mortgagee. If the reason for giving the guarantor’s entitlement the priority afforded to the first mortgage does not apply on the facts, a different adjustment of interests will be appropriate as between the guarantor and the second mortgagee. In none of Drew v Lockett or cases to similar effect (Alwyn v Witty (1861) 30 LJ Ch 860; Silk v Eyre (1875) 9 IR Eq 393; Dawson v Bank of Whitehaven (1877) 4 Ch D 639; Forbes v Jackson (1882) 19 Ch 615; and recently Aquilina Holdings Pty Ltd v Lynndell Pty Ltd [2008] QSC 57) did the guarantor give a guarantee and mortgage to subsequent mortgagees as in the serial guarantees and mortgages given by the Bofingers.

17 In my opinion, that the Bofingers undertook obligations to Reckley inconsistent with assertion of their entitlement in priority to the rights of Reckley displaces the priority which would otherwise arise. Handley AJA takes this up as a modest extension of the rule in Otter v Lord Vaux (1856) 2 K & J 650; 69 ER 943, regarding it as a form of estoppel by convention. I respectfully agree that the priority of the Bofingers’ entitlement can in that way be brought within existing principle, but in my view it can also be said more widely that the Bofingers are outside the reason for giving their entitlement to be subrogated to Kingsway’s rights priority over the rights of Reckley, and so that their entitlement should not receive that priority.

18 I agree that the appeal should be dismissed with costs.

19 HANDLEY AJA: This is an appeal as of right by guarantors from the decision of Young CJ in Eq who rejected their claim to be subrogated to the benefit of a security held by the first mortgagee who had been paid in full. The guarantors claim to be entitled to the benefit of that security in priority to the claims of the holders of the second and third mortgages which they had also guaranteed.

20 The first appellant was a director of B&B Holdings Pty Ltd (the Principal Debtor), and the second appellant is his wife. The Principal Debtor, which is now in liquidation, formerly carried on business as a developer. It constructed 17 townhouses and a detached house (the subject properties) on land at Enmore. In order to acquire that land and construct those dwellings, the Principal Debtor borrowed moneys from three separate lenders to whom it gave the relevant mortgages.

21 The first mortgage to Kingsway Group Ltd (the first mortgagee) of 31 January 2003 secured $8,278,000. The second to Reckley Pty Ltd (the second mortgagee) of 14 March 2003 secured $1,400,000, and the third, to John Skehan (the third mortgagee) of 28 April 2005 secured $350,000. The guarantors guaranteed each of these mortgages and supported their guarantees by first, second and third mortgages over their home and an investment unit.

22 The guarantors sold their home and their investment unit and paid the net proceeds of $1,519,234.10 to the first mortgagee between 21 July and 5 October 2005. The three mortgages over those properties were discharged on settlement although neither the second or third mortgagees received any of the net proceeds of sale. There was no evidence that the guarantors had received a formal demand for payment from any of the mortgagees prior to the sale of their home and investment unit.

23 Between November 2005 and February 2006 the first mortgagee sold most of the subject properties in the exercise of its power of sale and applied the net proceeds in further reduction of its mortgage debt. The sale of Lot 13 SP 75069 was completed on 2 February 2006 and, after applying part of the proceeds in paying off the balance of its debt, the first mortgagee held a surplus of $268,307.33 which was paid to the second mortgagee on 7 February 2006.

24 On or about 8 February 2006 the first mortgagee delivered the certificates of title to Lots 1 and 14 SP 75069, the unsold properties, to the second mortgagee together with a discharge of its mortgage, which was registered on 8 February. The first mortgagee had previously sold Lot 5 SP 75069 and on 21 February 2006 it paid $432,712.53, the net proceeds of that sale, to the second mortgagee.

25 The guarantors having, through the sale of their own properties, paid $1,519,234.40 to the first mortgagee in reduction of its debt, claimed to be entitled to the benefit of the security still held by the first mortgagee after its debt had been fully discharged. Their claim was to be subrogated in equity, and under s 3 of the Law Reform (Miscellaneous Provisions) Act 1965, to the first mortgage. The surplus proceeds of sale and the unsold lots, if available to the second mortgagee, will not be enough to pay off its mortgage, and there will be no surplus for payment to the third mortgagee.

26 The guarantors sued the first mortgagee for breach of trust, and the second mortgagee to recover what was alleged to be the guarantors’ trust property. The guarantors also sued the solicitors who acted for both mortgagees on the ground that they were liable under Barnes v Addy (1874) LR 9 Ch App 244. In addition, the guarantors joined the third mortgagee and the Principal Debtor. Young CJ in Eq heard the following separate question that had been stated by Associate Justice Macready on agreed facts:

"In the circumstances of the case were the sums of $286,307.33 and $432,712.53 and the securities over Lots 1 and 14 SP 75069 held by the second defendant [the first mortgagee] in trust for the plaintiffs as at 8 February 2006?"

27 Young CJ in Eq decided the case on first principles and held that the second mortgagee had not acted unconscionably in retaining the surplus proceeds of sale and the title deeds to Lots 1 and 14, and the guarantors had no right of subrogation. He answered the separate question accordingly and subsequently dismissed the action. The guarantors have appealed to this Court.

28 Although the Judge's reasoning, and his answer to the separate question were both correct, the rule in Otter v Vaux supports a more direct answer. The rule, which had not been referred to by counsel below or in this Court, was drawn to their attention during argument, and further written submissions were received after judgment had been reserved.

29 Mr McVay, counsel for the guarantors, relied on the cases that establish that a guarantor, who has paid off the debt, is entitled to any securities given by the principal debtor to the creditor: Duncan Fox & Co. v North and South Wales Bank (1880) 6 App Cas 1, 12 – 13, 19; Australasian Conference Association Ltd v Mainline Constructions Pty Ltd (1978) 141 CLR 335, 348, Drew v Lockett (1863) 32 Beav 499, 503. In Gedye v Matson (1858) 25 Beav 310, 312 Sir John Romilly MR said that a guarantor who pays the principal creditor:

"is entitled … to have the benefit of or the remedies and advantages which the creditor had against the principal debtor [and] may as against the original debtor enforce payment of his debt … as if the mortgagor had executed a second mortgage … As against the principal debtor the surety is entitled to a charge on the estate."

30 There was no second mortgage in that case and the dispute was between the guarantor and the principal debtor.

31 This right of subrogation arises when the principal has been fully paid, even if the surety has only paid part of the debt: McColl's Wholesale Pty Ltd v State Bank of NSW [1984] 3 NSWLR 365, 378.

32 The guarantor’s right of subrogation to the creditor’s securities binds not only the principal debtor, but also those claiming under him. This was established in Drew v Lockett (1863) 32 Beav 499, 505, where Sir John Romilly MR said:

"… a surety who pays off the debt for which he became surety must be entitled to all the equities which the creditor, whose debts he paid off, could have enforced, not merely against the principal debtor, but also as against all persons claiming under him. It is to be observed, that the second and any subsequent mortgagee is in no respect prejudiced by the enforcement of this equity; when he advances his money he knows perfectly well that there is a prior charge on the property, and if he thinks fit to advance his money on such security, it is his own affair, and he cannot afterwards with justice complain. The amount being limited, it is a matter of indifference to him whether the first mortgagee or the surety is the prior claimant for the amount."

33 This principle has been applied in later cases: Silk v Eyre (1875) 9 IR Eq 393, 396; Dawson v Bank of Whitehaven (1877) 4 Ch D 639, 650; (reversed on other grounds (1877) 6 Ch D 218 CA); Forbes v Jackson (1882) 19 Ch D 615, 621-2.

34 Mr McVay relied upon these cases to support his submission that the guarantors, having contributed to the discharge of the debt secured by the first mortgage, were entitled to be subrogated to the first mortgage over the surplus proceeds and the unsold properties in priority to the rights of the second and third mortgagees. However, in Drew v Lockett and the cases referred to, the surety was under no contractual obligation to the later mortgagees and had not granted mortgages in their favour over the properties that had been sold to reduce the debt secured by the first mortgage.

35 The rule in Otter v Vaux, which is not referred to in the standard works on guarantees, prevents a mortgagor, who has paid off the mortgage debt, keeping that mortgage alive against a later mortgage created by himself. It applies to land under the Real Property Act: Sussman v AGC Advances Ltd (1995) 37 NSWLR 37 CA. There appears to be no reported case in which it has been applied against a guarantor in favour of a second mortgagee he has also guaranteed, perhaps because a claim like the present has not been made before. But in principle the rule applies in such a case.

36 Otter v Vaux (1856) 2 K&J 650 was decided at first instance by Page-Wood VC (later Lord Hatherley). He said at 656-7 that when the mortgagor has paid off the first mortgage:

"… it is impossible for the mortgagor to insist as against the person to whom he has given a second mortgage on his property, that there remains any prior charge on the estate, or that the mortgagor has any right to have the mortgage which he has paid off transferred, so as to keep it alive for his own benefit … The answer to such a claim … would be "you have only discharged your own debt, and you are only doing justice as between yourself and the second mortgagee, by giving the fullest effect to his security that can possibly be given, and you have therefore no claim to set up that prior charge against him … How can he set up a right to the estate so obtained against his own mortgagee, to whom he has by his own act given a charge upon it, … the equity does not depend on the debt being gone by the effect of the payment: if the debt were kept alive … the effect would still be, that the mortgagor would be estopped in consequence of his mortgage from setting up that debt against the second mortgagee."

37 The case went on appeal to Lord Cranworth LC (1856) 6 De G M&G 638 who said at 642-3:

"The general principle, that a mortgagor cannot set up against his own incumbrancer any other incumbrance created by himself, is a proposition that … has never been controverted. … the present case … is strictly the case of the original debtor, the original mortgagor, striving to set up a prior incumbrance created by himself against a subsequent incumbrance also created by himself … The case is therefore to all intents and purposes that of the mortgagor liable to pay a sum of money to his first encumbrancer paying it and getting a transfer; but that transfer is something which upon general principle he cannot set up against the creditor claiming by a title subsequent to that of the person whose charge he has paid off: he pays it off for the benefit of the inheritance; and all persons who are entitled to any portion of the inheritance under him are also entitled to the benefit of his having liquidated a demand prior to their title."

38 The principle was restated in Platt v Mendel (1884) 27 Ch D 246, 251 by Chitty J:

"… if the mortgagor were to redeem … there being … a second mortgagee such a course would operate for the benefit of the second mortgagee for he would then become, as between himself and the mortgagor, first mortgagee, because a mortgagor redeeming cannot stand in the mortgagee’s place against other incumbrancers. If he has paid off a prior mortgage he can never set it up as against his own mortgage."

39 In re W Tasker & Sons Ltd [1905] 2 Ch 587, 603 Cozens-Hardy LJ referred to the speech of Lord Macnaghten in Liquidation Estates Purchase Co. v Willoughby [1898] AC 321 and continued:

"It will be observed that Lord Macnaghten carefully limits the doctrine of keeping alive to an owner who is not personally liable to pay; and, so far as I am aware, there is no authority for extending it to an owner who is simply paying off his own debt. It is not easy to see how it can be to his interest to keep alive his own debt, which he cannot set up against his own subsequent or pari passu incumbrancers. Nor is it easy to follow the argument that a debtor who has paid off his debt and thus satisfied his legal obligation can keep it, or the security for it, alive for his own purposes."

40 The principle in Otter v Vaux was again considered in Whiteley v Delaney [1914] AC 132, and in the Court of Appeal in that case [1912] 1 Ch 735 (sub nom Manks v Whiteley). Moulton LJ, whose dissenting judgement was upheld on appeal, said at 759, after referring to the two judgments in Otter v Vaux:

"It is evident that in the minds of both these eminent judges the critical fact was that the two incumbrances were created by the mortgagor and embodied obligations on his part to discharge the two debts, and that therefore he could not be allowed to set up the fact that he had fulfilled the one obligation to shield himself in any way from the performance of the other."

41 On appeal Viscount Haldane LC [1914] AC at 144-5 said, after referring to Toulmin v Steere (1805) 3 Mer 210:

"The decision is not an application of what was laid down in Otter v Lord Vaux that a mortgagor purchasing the interest of his first mortgagee cannot derogate from his own bargain by setting up the mortgage so purchased against the second mortgagee. For in Toulmin v Steere it was not the grantor of the second mortgage, but subsequent purchasers of the equity of redemption, whose title was interfered with, and it is far from apparent why the rule should have any application to such a case. Indeed it is now quite plain that a purchaser from a mortgagor and the first mortgagee can always, if he chooses, keep the first mortgage alive, and so protect himself against subsequent incumbrancers … Such authorities as … Thorne v Cann [1895] AC 11 in this House illustrate the distinction between such cases and those where, as in Otter v Lord Vaux , there is a direct relation of contract with the second mortgagee."

42 However, as Viscount Haldane LC said, the rule in Otter v Vaux does not generally apply to a third party who purchases the equity of redemption. The purchaser is not personally liable for the mortgage debt, although the estate remains liable to sale or foreclosure if it is not paid. This principle was considered by Lord Macnaghten in Thorne v Cann [1895] AC 11, 18-19:

"When Searle agreed to buy the equity of redemption … he became the owner of the estate subject to certain charges. The debts which those charges were intended to secure were not his debts, nor was he personally liable to pay them. … Nothing, I think, is better settled than this, that when the owner of an estate pays charges on the estate which he is not personally liable to pay, the question whether those charges are to be considered as extinguished or as kept alive for his benefit is simply a question of intention … you may presume an intention from considering whether it is or is not for his benefit that are charge should be kept on foot."

43 There are therefore three principles of equity to be considered. The first is that the guarantor of a secured debt is subrogated to all securities held by the principal creditor to enable him to recoup himself for his payment. The second is that a mortgagor who pays off an incumbrance he created cannot keep it alive against a subsequent incumbrance created by himself. The third is that the owner of an estate burdened by obligations not created by himself can pay off such an obligation and keep it alive for his own benefit against a subsequent incumbrance.

44 How are these principles to be reconciled where a guarantor pays off a first mortgage he has guaranteed, and attempts to keep it alive for his own benefit against a second mortgage he has guaranteed?

45 In Otter v Vaux the mortgagor had granted a second mortgage which was expressed to be subject to the first. The judges construed the second mortgage as a grant or contract under which the lender would acquire a second mortgage ranking behind the first but in priority to any equity retained by the mortgagor. The first mortgagee was to be paid first, the second next, and the mortgagor last. If the first mortgage was paid off the second mortgage was to become a first mortgage. The rule prevents the mortgagor derogating from his grant and obtaining an advantage from his breach of contract. The mortgagor is estopped by his grant and contract from claiming priority over the second mortgage.

46 It can now be seen that the contract with the second mortgagee created an estoppel by convention which estopped the mortgagor from claiming priority over the second mortgagee. The latter’s priority was the conventional basis of their transaction: Handley “Estoppel by Conduct and Election” pp 115, 116, 118.

47 The position in the present case is substantially the same. The guarantors guaranteed each of the mortgages on the basis that one would be the first, another the second, and the other the third. The Principal Debtor could not have paid off the first and kept it alive for its own benefit. The guarantors, having guaranteed the second mortgage as a second mortgage, agreed in substance with the second mortgage that once the first mortgagee was paid in full the second mortgagee would be paid next from one source or another before the guarantors got anything.

48 In those circumstances the fact that the obligation of the guarantors to the second mortgagee was collateral and secondary, and not primary, does not displace the rule in Otter v Vaux.

49 The rule depends on the existence of a legal relationship, by grant or contract, between the party paying off the mortgage and the later incumbrancer. The cases referred to which illustrate the second and third principles (para [25]) emphasised two factors. The first was the mortgagor’s grant of the second mortgage: Otter v Vaux at first instance and on appeal: paras [18], [19]; Platt v Mendel para [20]; re W Tasker & Sons Ltd para [21], Manks v Whiteley para [22]; and Whiteley v Delaney para [23].

50 The second was the personal liability of the mortgagor to the second mortgagee: Otter v Vaux at first instance and on appeal: para [18], [19]; re W Tasker & Sons Ltd para [21]; Manks v Whiteley para [22]; Whiteley v Delaney para [23]; Thorne v Cann para [24].

51 The guarantors were grantors of mortgages over their own properties, but not over the properties of the Principal Debtor. The first of the factors is therefore not directly relevant in the events that happened, although it would have been relevant if the securities granted by the Principal Debtor had been realised first.

52 The second factor, the personal liability of the guarantors to the first and second mortgagees as such, is present in this case. Those guarantees established an agreed order of priorities with the first mortgagee ranking before the second, and the second ranking before the guarantors. The personal liability of the guarantors to both mortgagees, and the agreed order of priorities, prevents the guarantors both by contract and estoppel from setting up a title in themselves in priority to that of the second mortgagee.

53 Thus the priority of the second mortgagee was the conventional basis of the transaction between the guarantors and the second mortgagee, and they are estopped from claiming priority.

54 The guarantors could not have claimed priority over the second mortgagee if the securities granted by the Principal Debtor had been realised first. The first mortgagee would then have resorted to the securities given by the guarantors, and the second mortgagee would clearly have been entitled to any surplus once the first mortgagee had been paid off.

55 It would be remarkable if the order of events, without more, reversed the priority of the second mortgagee over the guarantors. Equity intervened to prevent the order in which a creditor enforced his legal rights against his debtors or his securities from creating inequitable results as between the holders of subordinated securities and the debtor or debtors. This explains, at least in part, the equitable doctrines of marshalling, subrogation, indemnity and contribution. It also explains, at least in part, the rule in Otter v Vaux.

56 The rights of a guarantor to be subrogated to the securities of the principal creditor which were conferred by s 3 of the Mercantile Law Amendment Act 1856 (UK), which has its counterpart in s 3 of the Law Reform (Miscellaneous Provisions) Act 1965, can be surrendered by contract or otherwise: O’Dey v Commercial Bank of Australia Ltd (1933) 50 CLR 200.

57 In view of the conclusion that the guarantors could not acquire rights to the first mortgage security in priority to the second mortgagee it is not necessary to consider whether clauses 6.4 and 7.1 of the guarantee incorporated in the second mortgage operated to surrender such rights.

58 Since writing the above I have had the benefit of reading the reasons for judgment of Sackville AJA in draft. This appeal can be decided on the ground that the conduct of the first mortgagee was not unconscionable. However, I preferred, and still prefer, to apply or perhaps extend the in Otter v Vaux to guarantors. The rule in Otter v Vaux applies to a mortgagor liable under both mortgages. If it does not apply in principle to a guarantor of both mortgages, a decision that it does is a very modest development of equitable principle. I prefer to decide this appeal in that way rather than by starting again from the beginning. In this way the appeal will be decided, in the words of the joint judgment in Tanwar Enterprises Pty Ltd v Cauchi (2003) 217 CLR 315, 325: “by reference to well developed principles … rather than entering into the case at that higher level of abstraction involved in notions of unconscientious conduct in some loose sense where all principles are at large”.

59 In my judgment the appeal fails and should be dismissed with costs.

60 SACKVILLE AJA: I have had the advantage of reading the draft judgment of Handley AJA. I agree with his Honour’s conclusion that the appeal should be dismissed.

61 The principles of subrogation on which the appellants relied have been set out by Handley AJA at [29]-[33]. In my opinion, the appellant cannot establish that these principles apply in the circumstances of the present case.

62 It is important to appreciate that a right to subrogation does not necessarily arise simply because a third party, whether a guarantor or otherwise, pays out the amount due by a mortgagor to a mortgagee. The point is made in a passage in the judgment of Kearney J in Cochrane v Cochrane (1985) 3 NSWLR 403 at 405:

“This principle is based on equity’s concern to prevent one party obtaining an advantage at the expense of another which in the circumstances of the case is unconscionable. Hence, there is a common thread running through the relevant cases to the effect that the conscience of the mortgagor should be affected so as to cause the mortgage to be kept alive. This is illustrated in the text book examples first, of a third party not being entitled to a right by way of subrogation where he simply lends the money on an unsecured basis to the mortgagor who then uses such funds to pay off the mortgage; and secondly, of a third party being so entitled where he advances the money to pay out the mortgage on the understanding that security would be provided for such advance upon the mortgage being paid out.

As a corollary to this basis for the principle, there is no occasion for equity to intervene by way of subrogation where there is available to the third party a remedy at law or in equity sufficient to avoid an unconscionable result.”

This passage has been cited with approval by text writers and by the New South Wales Court of Appeal: Meagher, Heydon and Leeming, Meagher, Gummow and Lehane’s e quity: doctrines and remedies, 4th ed (2002) Butterworths LexisNexis at [9-070]; Highland v Exception Holdings Pty Ltd (in liq) [2006] NSWCA 318; 60 ACSR 223 at [102] per Santow JA (with whom Giles and Hodgson JJA agreed).

63 The approach taken by Kearney J is consistent with the observation of Gleeson CJ and Priestly JA in Registrar-General v Gill (Court of Appeal, 16 August 1994, unreported):

“The equitable principles relating to subrogation aim to adjust the interests of three parties, such as a creditor, a debtor and an insurer or surety, in such a way as to avoid the unconscionable result of double recovery by the creditor or inequitable discharge of the liability of the debtor.”

64 As the Court pointed out in Highland (at [105]), there has been a “doctrinal divergence” between Australia and the United Kingdom in relation to equitable subrogation. In the United Kingdom, the House of Lords has characterised subrogation as an:

“equitable remedy against a party who would otherwise be unjustly enriched. It is a means by which the court regulates the legal relationships between a plaintiff and a defendant or defendants in order to prevent unjust enrichment.”

Banque Financiere de la Cité v Parc (Battersea) Ltd [1999] 1 AC 221 at 236 per Lord Hoffmann (with whom Lords Griffiths and Clyde agreed). In Australia, the precise doctrinal basis is said to be ‘ unsettled ” ( Highland at [94]). However, the authorities emphasise its equitable origins and the need to avoid unconscionable results such as double recovery or inequitable discharge of a liability, although it has also been said that the doctrinal basis is difficult to identify and that “ classification of the mortgagor’s position as unconscionable seems very attenuated ”: Challenger Managed Investments Ltd v Direct Money Corporation Pty Ltd (2003) 12 BPR 22,257 at 22,269-22,270 per Bryson J.

65 In the present case, the appellants rely on the payment by them to the first mortgagee, in consequence of the sale of their home and investment unit, of approximately $1.5 million in reduction of the Principal Debtor’s indebtedness to the first mortgagee (and of their own contingent liability to the first mortgagee). They point out that the first mortgagee exercised its power of sale over the Principal Debtor’s properties, thereby discharging the Principal Debtor’s indebtedness and producing a surplus after the discharge of the first mortgagee’s indebtedness. This, so it is argued, is enough to attract the doctrine of subrogation.

66 But in what way is the doctrine of subrogation needed to avoid an unconscionable result? Or, to put the question another way, what would be unjust or inequitable about the net surplus from the sale of the Principal Debtor’s assets going to the second mortgagee, as envisaged by s 58(3) of the Real Property Act 1900 (NSW) (which deals with the priorities for the application of moneys derived by a mortgagee from the exercise of a power of sale)? The transactions to which the appellants were parties involved the Principal Debtor granting first, second and third mortgages, respectively, to the three mortgagees. The appellants guaranteed the indebtedness of the Principal Debtors and granted first, second and third mortgages to the same three mortgagees in the same priority in order to secure the guarantees. As Mr Harris SC submitted on behalf of the second mortgagee and as the primary Judge held, the parties and any objective observer would have expected that each of the mortgagees would be paid the amounts due to them, if necessary from the sale of the mortgaged assets, subject only to payment of any amounts due to the mortgagee or mortgagees entitled to priority. It is true that until a mortgagee went into possession of the appellants’ properties, the appellants could sell the properties. But in order to give a good title to a purchaser they had to be able to discharge each of the three mortgages on settlement.

67 Mr McVay submitted on behalf of the appellants that the mistake made by the second mortgagee was to consent to the appellants’ selling their properties without insisting that the appellants forego their entitlement to be subrogated to the first mortgagees’ security. The second mortgagee doubtless assumed that it was better for all concerned that the appellants’ properties be sold in an orderly manner, provided the appellants agreed to apply the net proceeds in reduction of the Principal Debtor’s indebtedness. Whether it made a “mistake” depends on whether there is any basis for allowing the appellants to rely on the doctrine of subrogation. In my view, there is no such basis.

68 There is nothing unconscionable or unjust in the first mortgagee, having satisfied its own loan by exercising its power of sale over the Principal Debtor’s properties, applying any surplus proceeds of sale to the second mortgage. This is exactly what the arrangements entered into between the Principal Debtors, the mortgagees and the appellants envisaged. The arrangements were plainly not intended to allow the appellants, by paying out the first mortgagee, to transform the second mortgagee from a secured creditor of the Principal Debtor to an unsecured creditor presumably ranking equally with the other unsecured creditors of the appellants. As Handley AJA has pointed out, it would be remarkable if the result in this case depended on whether the securities granted by the Principal Debtor were or were not realised before realisation of the securities granted by the appellants. That, however, would be the effect of accepting the appellants’ submissions.

69 The appellants rely on a well-defined and well-established principle of equity. They do not seek to invoke the concept of unconscionable behaviour at large: cf Australian Broadcasting Corporation v Lenah Game Meats Pty Ltd (2001) 208 CLR 199 at 245 per Gummow and Hayne JJ; Tanwar Enterprises Pty Ltd v Cauchi (2003) 217 CLR 315 at 324-325 per Gleeson CJ, McHugh, Gummow, Hayne and Heydon JJ. But where the circumstances do not attract the rationale underlying the equitable principle, there is no occasion to apply it. Accordingly, the appellants’ arguments fail in limine and the appeal should be dismissed.

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06/02/2009 - Typographical errors - Paragraph(s) 16 - second line - acquisition "of"45 - last sentence - "mortgagee" should be "mortgagor"61 - first sentence - Handley AJA "[11]-[15]" should be "[29]-[33]"