by Norma J. Williams, Esq., Williams & Associates
Part 2: Subordination Agreements
Part 1 of this article, published in the Fall 2018 Issue, contained an overview of the general California rules of lien priority and some common priority disputes involving deeds of trust. This Part 2 discusses parties’ voluntary alteration of their priorities using Subordination Agreements and is focused on subordinations in loan transactions only.
As stated in Part 1, California’s “first in time, first in right” rule, combined with the effect of the recording laws, results in a document having priority based on the time of its recording, subject to compliance with other rules regarding notice. Subordination is the act by which a beneficiary that has a senior lien based on the general priority rules, voluntarily agrees, for consideration, that its lien would be junior to a lien that is subsequently recorded.
Common Scenarios/Other Relationships Distinguished
Subordination Agreements can arise in a variety of contexts in the financing of commercial real estate and present a number of issues. Subordination Agreements are used in many situations including those among leases and as between loans and leases. In the loan scenario, there are three main transactions in which subordinations take place.
- The first is seller financing in which the seller agrees that its loan will be subordinated to a construction loan to be later obtained by the buyer/borrower. In these situations, the law is highly protective of the subordinating seller.
- The second is seller financing in which the seller agrees that its loan will be subordinated to any type of loan to be later obtained by the buyer/borrower.
- The last is when any lender agrees that its loan will later become subordinate to another loan. An example of the this would be an agreement by a HELOC that it will later subordinate to a refinance loan.
There are several other transactions that have characteristics similar to Subordination Agreements but differ from them. In a payment subordination, the parties agree that one (or more) creditor(s) will be paid prior to any payment being made to another creditor(s). Unlike the loan subordination scenario that is the subject of this article, it is the debt claim and not the lien on a particular asset that is being subordinated. Both types of subordinations, as well as other aspects of relationships among creditors, may be addressed in a more complex agreements such as an Intercreditor Agreement.
General Classification of Subordination Agreements
Subordination Agreements are generally classified as either executory or executed. Subordinations may also be “automatic.”
Executory Subordination Agreement/Financing Seller Subordinating to Construction Loan
An executory subordination is a promise by the senior lender that it will subordinate its lien to a later created lien. The promise may be in a separate agreement, a clause in a senior lender’s deed of trust, or, in the case of seller financing, a clause in the purchase and sale agreement. In order for the executory agreement to be specifically enforceable, it must be sufficiently specific, certain and reasonable so that a court can compel the senior lender to execute the later Agreement if it does not do so.
The Executory Subordination Agreement is subject to general contract law and must be reasonable and certain. At a minimum, the agreement must specify the maximum principal amount, interest rate, term, and the mode of repayment of the subordinating loan. As stated above, there must be consideration for the agreement. In order to be certain and reasonable, the Agreement should also include the payment terms, the purpose of the loan, and the allowable amount of fees and other charges. The agreement is subject to the covenant of good faith and fair dealing implied in every contract in California.
When a seller who provides financing agrees to subordinate to a later construction loan, the requirements for certainty are even more stringent. Absent sufficient specificity, courts may not specifically enforce an executory agreement of the seller to later subordinate. The reasons for this relate to the risk to which the seller’s lien is exposed. Prior to completion of construction, the property is over-encumbered since its value without improvements will be less than the total amount of the loans. If the borrower defaults on its construction obligations, sellers generally cannot take over and complete construction or make payments on the construction loan in order to avoid foreclosure of the construction loan. Also, although a seller financier who subordinates to a construction loan can pursue a borrower post-foreclosure (an exception to the purchase money loan antideficiency restriction), the borrower may not have sufficient assets to make pursuit of the deficiency worthwhile. Thus, the courts have required more specificity for specific performance of a seller’s executory agreement to subordinate to a construction loan, especially as against unsophisticated sellers. In general, the courts have looked to the entire circumstances of the financing, the seller’s risk and the seller’s understanding of the risk. Thus cases, considering different circumstance have required 1) even greater specificity as to loan terms, e.g. minimum and maximum repayment term; 2) maximum loan to value or construction cost ratios; 3) a requirement that the construction loan funds only be used for construction purposes or for other specific uses; 4) a description of the improvements to be built on the property; 5) a requirement that the construction lender be obligated to give the seller notice and opportunity to cure all defaults on the construction loan; and 6) a firm commitment for permanent financing as a condition precedent to subordinating and the terms of that permanent financing. The seller may also want to require that the buyer/borrower post a completion bond.
The courts are generally not as demanding in the requirements for certainty in Subordination Agreements for other (nonconstruction) purchase assistance loans and specific performance may be granted where there is less specificity.
It is generally advisable that the form of Subordination Agreement that will be later executed be attached to the executory agreement as an exhibit.
Executed Subordination Agreement
Executed subordination refers to the status when both deeds of trust have been recorded. The legal question raised is as to the effect of the terms of the Subordination Agreement previously entered into between the subordinating lienholder and the borrower. If the terms of the loan that acquired priority as a result of the subordination (e.g. the construction loan) do not meet the terms of the Subordination Agreement and those terms are known to the construction lender, the construction lender can lose priority under contract law as stated above or based on lack of bona fide encumbrancer status.
Automatic Subordination Agreement
Another type of subordination, sometimes described as executory and sometimes as executed, is the “automatic subordination.” This may be in a separate agreement, a purchase and sale agreement with seller financing or in a deed of trust. The provision states that the lien of the lender will automatically be subordinate to a later executed deed of trust without any further action on the part of the subordinating lienholder. Automatic Subordination Agreements are disfavored by institutional lenders (who will not rely on them to assure priority of their later-created Deed of Trust) and title companies (who will not rely on them to insure the priority of the later-created Deed of Trust). Those entities will generally require that a separate Subordination Agreement specifically describing the subsequent loan be recorded at the time the subsequent loan is recorded. The form often used for this is the California Land Title Association Subordination Agreement that is found on many title companies’ websites.
It is noted that “fractionalized” notes and deeds of trust issued in private loan transactions involving multiple investors cannot contain automatic subordination clauses. California Business & Professions Code Section 10238(d).
Requirements for Subordination Agreements Involving Loans Under $25,000
California law, in Civil Code Sections 2953.1-2953.5, contain special requirements for Subordination Agreements if either the subordinating lien or the lien acquiring priority is less than $25,000. These requirements go to required language, font sizes and notices. Covered Subordination Agreements that do not meet these requirements are voidable as specified in the statute. While the statutory language is only required for those under $25,000, it is not uncommon to see the statutory language reflected in non-covered Subordination Agreements.
Circuitry of Priorities
Circuity of priorities is an issue faced by lenders that arises when a senior beneficiary subordinates to a junior lien in a situation where there are intervening junior liens. This issue might arise, for example when lenders who make second mortgages or equity lines are asked to subordinate their liens to later refinance liens. The issue is demonstrated when there are three liens on a property, A, the first, B, the second and C, the third. If A subordinates to C, what are the relative priorities among the A, B and C after the subordination? One result could be that A becomes subordinate to B as well as to C (the absolute priority approach). However, California and most jurisdictions follow the partial subordination, approach which would leave B in a neutral position and only subordinate A to the extent it will not result in a windfall to B or penalize B by causing it to be junior to a greater amount of debt. B’s lien would not be affected by the agreement between A and C, to which it was not a party. This determination is important, for example, in the event of a sale that produces an amount that is insufficient to pay off all liens.
Clearly, the prudent thing to do in this situation, prior to entering into the Subordination Agreement, would be for A and C to obtain a Preliminary Report to determine if there are intervening liens and to obtain a Title Policy insuring the priority after the recording. A, the senior lender can then choose not to subordinate or require that any intervening liens be satisfied before it will subordinate. The senior lender can also require that the Subordination Agreement contain language that makes its subordination ineffective if there are intervening liens that would have priority over its lien.
Norma J. Williams, Esq. is a commercial real estate attorney whose practice focuses on finance, purchase and sale and leasing transactions. She is a frequent speaker and author, has drafted major commercial real estate legislation and has held leadership positions in local, state and national real estate bar associations. She received her B.A. degree magna cum laude from Wesleyan University and her J.D. degree from UC Berkeley School of Law. Contact: firstname.lastname@example.org; (213) 996-8464.