Summer 1998: Subordination Agreements
By Michael J. Festa
As the sale and development of residential
and commercial properties has heated up again, so has the use of subordination
agreements. What are subordination agreements, and what are their
consequences to the seller, to the buyer and to the lender?
As long as real estate developments require
financing, there will be a need for, and the prevalent use of, subordination
agreements. The reason is that purchasers or lessees intending to
improve real property often do not possess adequate capital to pay
the full purchase price and the cost to construct improvements on
Subordination is the establishment of priority
between existing encumbrances on the same parcel of real property,
by some means other than the basic priority involved in the concept
of "first in time, first in priority".
Since an institutional lender will almost always
require as security a first lien on the property, the seller's security
for any unpaid balance of the purchase price necessarily must be junior
to such institutional lender's lien. Although the seller's lien usually
has priority over later liens created by the buyer, a seller who has
entered into a subordination agreement accomplishes a reversal of
normal priority, causing the seller's lien to become junior to the
subsequent lien of the third party construction lender.
There are unique risks when a seller subordinates
his or her purchase money lien to construction financing. Unlike the
standard seller carry-back transaction in which the purchaser makes
the same or similar use of the property, where the purchaser plans
to develop the property for a different use, the ultimate value of
that property (and of the seller's security) will be determined not
by the original sale price of the property, but instead by the success
of the development venture. Moreover, because construction loans are
relatively large, a seller may be unable to protect his or her security
by raising the sum of money necessary to buy in at the senior lienholder's
There is a bit of a trade-off, however. In
the standard transaction, if the buyer defaults, the seller's only
remedy is to foreclose on the property. In such a situation, the seller
has no right to take any direct action against the buyer. Where the
seller subordinates and the buyer does not make the same or similar
use of the property, however, the seller can proceed directly against
the buyer for breach of contract of the promissory note, for which
the buyer is now personally liable, (even if the now junior lienholder/
seller is wiped out by the institutional lender's foreclosure sale).
In a typical subordination agreement, the seller's
contract or purchase money note provides that the seller promises
to execute a subsequent instrument which will subordinate his or her
lien to the lien of a construction lender, provided certain conditions
and limitations are imposed on that construction loan.
What happens when the seller's original subordination
agreement with the buyer conflicts with the specific recorded subordination
agreement entered into with the construction lender?
In Swiss Property Management Company v. Southern
California IBEW-NECA Pension Plan, the sellers of real property, who
had taken back deeds of trust as part of the purchase financing, brought
an action against the buyer's lender, arguing that their deed of trust
was senior to that of the construction lender, since specific conditions
of subordination that were agreed to by the buyers had not been met.
The Court of Appeal disagreed with the sellers
and held that the California Land Title Association (CLTA) form subordination
agreement between the lender and the sellers was effective to give
the lender's deed of trust priority over the sellers' deed of trust.
The sellers' deed of trust with the buyer had provided that the sellers
would subordinate their deed of trust "consistent with specific
criteria regarding the principal amount of such construction loans,
loan to value ratios, and interest rates." The Court of Appeal
held that the sellers waived these conditions (albeit, unknowingly)
when the sellers signed the CLTA form.
Subordination agreements, although commonly
used, present a myriad of issues and concerns. These agreements must
always be closely reviewed and analyzed by legal counsel prior to
execution, regarding their enforceability as well as their ramifications.