Posting for

Friday, July 17, 1998

by: Bert Rush

brush@firstam.com

MODIFICATIONS/MORTGAGE LENDERS/SUBORDINATION AGREEMENTS

Yesterday's discussion of subordination agreements brings to mind another recent decision that has California lenders' counsel buzzing. The case is Friery v. Sutter Buttes Savings Bank (1998) 61 Cal.App.4th 869, 72 Cal.Rptr. 2d 32.

This case concerns commercial property (office building, parking and vacant lots) in Yuba City, CA. In 1986 owners Dennis and Debra Ferraiuolo gave a first deed of trust against the property to Sutter Buttes, securing repayment of $408,100.

The Ferraiuolos later conveyed the property to one Porter, who gave three more deeds of trust--to Jarvis, Marysville Lakeville Apartments, and Summy. When Porter defaulted, Marysville Lakeville foreclosed and became the owner.

In 1988, Friery purchased the property from Marysville Lakeville, subject to the deeds of trust in favor of Sutter Buttes and Jarvis--which were then both in default. Friery cured the arrearages--and apparently paid off Jarvis--but declined to assume the Sutter Buttes loan.

In 1991 Friery sold the property to Herminito and Eloisa Briones, carrying back a note and deed of trust for part of the purchase price--in the amount of $68,000. This loan was due in September 1996.

Soon Sutter Buttes called its loan, pursuant to its due on sale clause, since it considered the Briones uncreditworthy. This led to a "workout agreement," whereby the Briones were permitted to assume the Sutter Buttes loan, and the original loan terms were modified so that the maturity date was advanced (from May 2001 to October 1996--15 days after the Friery note was due), and the Briones were required to pledge to other parcels as additional security. This modification was without Friery's knowledge or consent.

In late 1995 the Briones defaulted and Sutter Buttes filed for judicial foreclosure, naming Friery as a junior lienor. Friery answered and cross-complained seeking priority over the Sutter Buttes deed of trust on the grounds that the "workout agreement" and modification operated to substantially impair her security interest. Friery's case was based on the case of Gluskin v. Atlantic Savings & Loan Assn. (1973) 32 Cal.App.3d 307, 108 Cal. Rptr. 318, which created a duty on the part of senior lenders toward subordinating sellers--holding carry-back mortgages or deeds of trust--not to substantially impair the subordinating party's security without their consent.

Sutter Buttes filed a motion for summary judgment, which was granted. Friery appealed, and the Court of Appeal affirmed.

The Court of Appeal agreed with the trial court holding that the Gluskin case was distinguishable from this case in that Friery did not enjoy the uniquely protected status of the subordinating seller--she (Friery) having acquired the property subject to the Sutter Buttes deed of trust. In so holding, the Court was in sharp disagreement with authors of California's most respected treatise on real estate law and practice, Miller and Starr's "California Real Estate" (2d ed., 1989, sec. 8:83, p. 426)--who have taken the position that Gluskin should be extended to protect virtually any junior lender:

The Court of Appeal wrote that the Gluskin decision was based on principles of contract law, and public policy--but it saw no rationale in either for extending the protection of junior lienors who have not subordinated to their senior lienor. Said the Court,

Because it found no duty, the Court of Appeal did not reach the other issue decided by the trial court--that the modification was not "material" within the meaning of Gluskin. (On the other hand, maybe this is one of those decisions where we should "read between the lines"--Friery really doesn't appear to have been damaged by the modifications.)

Friery did not appeal further, so we don't know whether the California Supreme Court would've agreed to hear the case.

Many of you will recall that the last time we visited the issue of loan modifications and their effect on priorities was in our 1997 Regional Counsel and Underwriter meetings--where the issue arose in two contexts. First, the new EAGLE loan policy coverage includes coverage for priority following a post-policy modification allowing additional advances and/or change in the interest rate charged (see insuring provision 24[b]). This risk is considered insurable since the law of all states allows lenders to make loan modifications without losing priority where the lender lacks actual knowledge of the existence of a junior lienor, without regard to whether a junior's interests are prejudiced by the modification. (You'd think this would cause junior lenders to routinely notify seniors of their junior lien--in writing, but apparently this is seldom done.) The Friery decision can only increase our comfort level in this regard.

The second context was our discussion of the then recent California case titled Lennar Northeast Partners v. Buice (1996) 49 Cal.App.4th 1576, 57 Cal. Rptr.2d 435, in which loan modifications were found to have prejudiced the interests of a subordinating junior lienor, with the result the senior lien lost its priority--but only to the extent of the modification (ie.,prejudicial additional advances). In Lennar, the junior lienor obtained its security interest about one year after the senior lien was created, so the fact the junior signed acknowledgments of its subordinate status would not seem to endow them with equitable standing equal to a subordinating seller. In other words, Friery is in sharp conflict with Lennar--the rationale of Friery could be used to overrule Lennar in a future case.

The Friery decision came as a real surprise to California real estate lawyers and lenders' counsel--myself included. It seems to go too far. Now, who will want to be a second lender--other than someone not intending to rely on the real property as security?

On the DIRT listserv, the Friery decision drew a very interesting comment from "guest editor" Dale Whitman (state unknown). Whitman wrote that the decision is:

I don't know whether Whitman is right about this being the majority view, but he's right about the substance of Restatement of Mortgages (3rd) sec. 7.3(b), the full text of which reads:

There's lots more interesting stuff in the Restatement--such as presumptions as to what kind of modifications are likely to be prejudicial, and what kind are not. But you don't see it cited much in case law and, interestingly, the Restatement doesn't make the distinction between subordinating juniors (much less subordinating sellers) and ordinary juniors--which distinction is at the heart of the Friery decision. Instead, the Restatement appears more in line with the thinking of Miller and Starr--who are dissed by the Friery court.

This issue is likely to be re-visited by some other Court of Appeal, in some other case, and probably sooner rather than later. One to watch.

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

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 Following up on last Friday's posting, Jim Dondero (Grand Rapids, MI) Writes

  I don't know if the case was correctly decided on its facts or not, but I agree with author Whitman and the Restatement that a mortgage modification may not unilaterally and "substantially impair" the rights or security of junior encumbrancers.

Reply to Jim: I think you left a word out before or after "unilaterally" --doesn't matter. Your point is that a senior lender doing a modification has some duty to a known junior lienor...which I take it is your impression of what a court would say in Michigan, and perhaps throughout the mid-west. I'm not aware of another reported decision (other than Friery in CA) where a court went so far as to say the senior has no duty to a known junior. If someone knows of another such case please let me know...