Subrogated guarantors should get all the fruits of underlying obligations

Subrogation is commonly described as a legal device that allows one person to "step into the shoes" of another in relation to a debt or claim. This depiction leaves open the question: Exactly how far can a subrogated person walk wearing the shoes of another?

California law does not provide a clear answer, despite the major implications for the recovery of guarantors who have paid the debts of their primary borrowers. While some authorities provide that subrogated guarantors only have a right to enforce the underlying obligation against the primary borrower to the extent of obtaining a reimbursement of the funds the subrogated guarantor expended, more recent authorities argue persuasively that subrogated guarantors should be able to obtain all remedies available to the satisfied creditor -- such as default interest -- even if the subrogated guarantor ultimately recovers a higher dollar amount than originally paid to satisfy the primary borrower's obligations.

California Civil Code Section 2848 provides that a guarantor (otherwise known as a surety), upon satisfying the obligation of the primary borrower, is entitled to enforce "every remedy which the creditor then has against the principal." The subrogated guarantor "steps into the shoes" of the creditor that has been paid by taking the satisfied creditor's place in pursuing all remedies provided for by the guaranteed obligation against the primary borrower as if the obligation had not been satisfied. Subrogation is often referred to as "equitable assignment" because the subrogated party inherits the same rights, the same level of priority, and the same defenses as the party whose place has been taken.

In apparent contravention of the idea that a subrogated guarantor is effectively an assignee of the loan, Section 2848 contains a caveat to a guarantor's subrogation rights: It provides that the guarantor is entitled to enforce the remedies of the creditor "to the extent of reimbursing what he has expended." This limitation was enshrined in a 1901 California Supreme Court decision, Yule v. Bishop, 133 Cal. 574. The court in Yule reasoned that the underlying obligation is "extinguished" upon the guarantor's payment of the debt, and "[s]ince the [primary] obligation is thus extinguished, it cannot be ... that the original obligation is kept alive and passes to the surety." Instead, "new rights and liabilities" arise upon the guarantor's payment of the debt, including a liability of the primary borrower "to reimburse the surety for the moneys expended, with legal interest, though not according to the terms of the primary obligation."

However, Yule's idea that the underlying obligation is extinguished upon the guarantor's payment -- and therefore the guarantor can only collect based on an action for reimbursement of the amount expended plus legal interest -- is now acknowledged as discredited. In Collection Control Bureau v. Weiss, the California Court of Appeal held that "the doctrine of Yule was recast" by California's adoption of the Uniform Commercial Code in 1963. Collection Control Bureau v. Weiss, 50 Cal. App. 3d 865, 869 (1975). The court held that the adoption of Section 3415 of the California Commercial Code, which provides that a guarantor who "pays the instrument has a right of recourse on the instrument against such party," is intended to ensure "the right of the guarantor to collect on a note he has paid."

If a subrogated guarantor is to inherit the rights available to the creditor according to the underlying loan rather than a mere right to reimbursement, then it should follow that the subrogated guarantor can collect all amounts due under the loan from the borrower, including interest at the contractual, rather than legal, rate. Default interest compensates lenders for the time and expense associated with enforcing the obligation -- costs that the guarantor shoulders when it is subrogated to the rights of the lender. Denying recovery of default interest places guarantors in a lesser economic position than the satisfied lenders whose rights they have inherited -- an outcome that frustrates the very idea of "stepping into the shoes" of the lender.

This was the holding by the Court of Appeal in Flojo Internat., Inc. v. Lassleben, 4 Cal. App. 4th 713 (1992). In Flojo, the guarantor paid the debt of the primary borrower immediately upon learning of the borrower's default and therefore became subrogated to the rights of the lender. In a lawsuit to enforce the obligation, the trial court awarded the guarantor the principal amount of the debt and interest at California's 10 % legal rate but denied the guarantor's claim to an additional 4% default interest rate and attorney fees as provided for by the note. The Court of Appeal reversed this calculation of interest and denial of attorney fees, concluding that "[w]hen a surety satisfies the obligations of the principal he is subrogated to the rights of the creditor, and is entitled to enforce every remedy which the creditor then has against the principal. ... The concept of subrogation puts the surety in the shoes of the creditor whose claim he has paid -- according to the surety all the creditor's collection rights." The court cited Collection Control Bureau's interpretation of the Uniform Commercial Code and also held that the "general law of suretyship" provided the same result: The guarantor was entitled to enforce the obligation against the borrower in accordance with the terms of the underlying note, even though those terms provided the guarantor with a greater recovery than a reimbursement of the amount it had expended plus legal interest.

The California Supreme Court has not reversed its position in Yule, and Section 2848 has not been amended since its adoption in 1872. Whether the rule in Flojo will become widely adopted remains to be seen, but it is in accord with the core concept of subrogation: A subrogated guarantor should obtain rights that are coextensive with those of the creditor. 