Newsletter:
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 the land.

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 foreclosure sale.

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.