Posting for

Thursday, July 16, 1998

by: Bert Rush

brush@firstam.com

SUBORDINATION AGREEMENTS/MORTGAGE LENDERS/DUTY TO DEFEND

Jonathan Buss (Salt Lake City, UT) writes:

Bert,

I was recently re-reading your comments on Subordination Agreements in the Summer 1995 Law Report, and I have the following questions. Are you aware of any situations since then where we have had to defend an insured lender against a subordinated lender who is arguing the inadequacy of terms of the subordination agreement? Quite often we have to rely on agreements generated by the lender. Because these rarely recite that the subordinating lender has reviewed the terms of the loan agreement, how risky is it to rely on such an agreement? Can you point me towards any other resources on the matter?

Reply to Jonathan: We've had quite a few claims involving subordination disputes over the years. I don't know how many are "out there" just now--maybe some of the claims folk can "reply" and let us know what they're seeing.

One such case which we recently won is Swiss Property Management Co., Inc. v. The Southern California IBEW-NECA Pension Plan (1997) 60 Cal.App.4^th 839, 70 Cal.Rptr.2d 587. Some may remember a subordination agreement story from Temecula, CA in Claims Chronicles IV--well this is yet a second claim involving many of the same players but slightly different facts.

First, a recap of the Temecula story from CC IV: Several years ago a new airport was constructed on the outskirts of town. A promoter contacted owners of vacant land near the airport about a plan to develop their land as part of a new commercial/industrial park. Four owners of adjacent parcels comprising 30 acres each threw in. Each agreed to sell his parcel for about $2 million--getting $500,000 down and carrying back a purchase money deed of trust for the balance. The buyer would be a new limited partnership consisting of the sellers and others. The buyer would obtain an acquisition and development loan from the Southern California IBEW-NECA Pension Plan for about $4.3 million--which would be a first deed of trust. Sellers would subordinate their carry-back deeds of trust to the IBEW Pension Plan deed of trust--and First American would insure.

As part of our underwriting, we required that each seller/subordinating party execute a standard form CLTA (Calif. Land Title Assn.) Subordination Agreement--which we consider to be unconditional and air-tight. But we got fooled--at the suggestion of one of the promoters, each Subordination Agreement was completed in such a way that on lines where a description of the new loan being subordinated to was to be filled in, instead there were inserted asterisks which in turn refer to "weasel language" at the bottom of the page. So the preprinted form reads, "WHEREAS, Owner has executed, or is about to execute, a deed of trust and note in the sum of $***"--then, at the bottom of the page is written the following:

As I recall, the signed Subordination Agreements came in just before closing and weren't looked at by the title officer--we closed and insured the IBEW Pension Plan in the first position. New loan proceeds were used to pay $500,000 to each of the four sellers, another $700,000 was used for legitimate purposes, and the remaining $1.6 million from the insured loan disappeared.

When the IBEW Pension Plan threatened to foreclose, the subordinating parties brought suit to invalidate the Subordination Agreements and establish priority of their carry-back deeds of trust. They claimed it was their intent to subordinate to a new loan the proceeds of which would be used solely to acquire and improve the property--which wasn't done--so their subordination agreements did not become effective.

First American provided for defense of its insured lender under a reservation of rights (there were, as I recall, allegations of lender misconduct). The case was tried, and we lost. The judge ruled that "weasel language" was so unintelligible we couldn't (or shouldn't) have relied on it for any purpose. Judge wouldn't even grant our lender equitable liens in first priority to the extent new loan proceeds were used to pay down payments to the sellers/subordinating parties (!).

The second of these cases--and the one spawning the reported decision mentioned above--did not involve "weasel language" sneaked into the Subordination Agreements.

In the second case, the same promoter set up a similar project with a similar acquisition and financing scenario. Again there would be carry-back deeds of trust, subordination agreements, and the same new lender being insured in the first position. But this time the Subordination Agreements were properly filled out and signed, with the general terms of the new loan being subordinated to clearly shown. In this second case, though, the subordinating parties inserted language about their intentions and understanding that all new loan proceeds would be used to acquire and improve the property in riders attached to their respective carry-back deeds of trust.

Again there was a lawsuit filed by the subordinating parties to invalidate the subordinations and get priority for the carry-back deeds of trust, and again it was alleged new loan proceeds were misappropriated.

This time we won. The trial court judge declined to read and interpret the Subordination Agreements in light of the riders. Instead, the judge found the Subordination Agreements to be clear and unambiguous--and to provide for unconditional subordination of the carry-back deeds of trust. The case was appealed, and the Court of Appeal whole-heartedly affirmed--rendering the decision cited above.

By the way, the standard form CLTA Subordination Agreements (there are five different versions--with minor variations) are in the Underwriting Library (go to Underwriting Library/look for "Welcome to the Underwriting Library,"/look for "Vol. II Title Insurance Forms,"/look for "First American,"/look for "Subordination Agreements A-E").

Now back to Jonathan's question. I think it's very risky to rely on a subordination agreement prepared by a lender--unless you carefully review it and find it to contain all the essential elements listed in my 1995 article:

If you read the Swiss Property Management decision, I think you'll see how each of these elements came into play to convince the trial court and the Court of Appeal to rule in favor of our insured lender. In particular, the last element (integration language) encouraged the Court of Appeal to find that the Subordination Agreement was intended to supersede the riders. A fine point, maybe--but a winning one.

Likewise, I get nervous reading that your lender-drafted subordination agreements usually don't recite that the subordinating party has reviewed the terms of the loan agreement being subordinated to. If there's a dispute down the line, this failure allows the subordinating party to say that the loan agreement terms were other than as represented to him/her (usually by the borrower)--which is the classic irresistable justification for a court to invalidate a subordination agreement.

And, I wonder why would a new lender leave such an obviously helpful recital out of its subordination agreement? Is it because they don't want the subordinating party to know the terms of the new loan? Is it because they think it allows more leeway for them to later modify the loan agreement, without the subordinating party's knowledge or consent? This is not good.

Now the claims handlers out there are thinking, "Yeah, but a lot of the things that give rise to subordination agreement disputes are post-policy, or created/suffered/assumed/agreed to by the insured--and thus excluded from coverage." This is true, but most of these claims I've seen include both covered and non-covered allegations--which usually means we defend under a reservation of rights and try to settle.

All said and done I think the safest practice is for us to require execution of our own approved form of subordination agreement--and see what they say. We might later decide to rely on a customer's form, but at least we'll have made an informed judgment--which usually puts us in good shape.

Questions, comments, argument? Just press the "reply" button....

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Following last Thursday's posting, Jim Dondero (Grand Rapids, MI) writes:

From an underwriting perspective, I wouldn't have it any other way-and haven't for years! This is an area in which we cannot afford to relax our standards, not even to placate a "good customer".