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More Risk for Junior Lienholders – Understanding Subordination Agreements

Litigation, Negotiating Transactions, and Real Estate Law by Peter N. Brewer, Esq.

Junior Lienholders are by their very nature assuming greater risk because they are not in first position.  In the case of R.E. Loans LLC v. Investors Warranty of America, Inc., the junior lenders were at even more risk because the senior loan was actually one of 3 loans cross-collateralized on multiple pieces of property.

The junior lienholders here had a $3M dollar loan that was originally a $6.5M in third position against “Jack’s Ranch” in San Luis Obispo County.  The borrower, Martin Weyrich Winery, LLC, paid off the first and second position lenders, and then paid down R.E. Loans to $3M—leaving significant equity in the property.  Later, the Winery brought in a new loan which would be $4M at first position if R.E. Loans agreed to subordinate.  R.E. Loans agreed to the subordination and specifically stated that they were only subordinating to the $4M ahead of them.  However, apparel R.E. Loans did not know that the Winery was actually taking out 3 total loans, secured or “cross-collateralized” against Jack’s Ranch as well as other properties.

It was clearly a problem that R.E. Loans did not seem to know about the other two loans but further, the loans were “cross-defaulted” as well – which simply means that a default on one loan would be considered a default on all the loans.  (also sometimes referred to as “cross-acceleration”)

The Winery defaulted and the senior lender’s Notice of Default informed the borrower that $26,307,307.93 was required to cure the default.  R.E. Loans did not cure the default and the property went to foreclosure sale, which wiped out R.E. Loans’ junior deed of trust.  R.E. Loans sued for a declaration that it was not a soldout junior lienholder.  R.E. Loans claimed senior lender Transamerica breached the subordination agreement by using its trust deed to secure three loans totaling $21,196,850.  R.E. Loans won its motion for summary judgment but was overturned on appeal.

The appellate court concluded:

“To the extent Investors’ trust deed secured a note in the amount of $4,006,600, it was senior to RE’s trust deed. To the extent Investors’ trust deed secured other notes it is junior to RE’s trust deed. That would be the result had each note been secured by its own trust deed. There is no reason why a different result should pertain because the notes are secured by a single trust deed.”

What the appellate court is referring to is that the different order of priority that lenders enjoy is specific to the property that the deed of trust is recorded against.  Here, Loan 1 was in 1st possession on Jack’s Ranch and RE Loans was in 2nd position.  The court is simply noting that defaults on the other two loans would not affect RE Loans with regard to Jack’s Ranch.

As to the issue about curing the default on the Notice of Default, the Court noted, “The mandatory language of Civil Code section 2924c, subdivision (b)(1) is directed to the property owner, not the holder of a junior trust deed.”

Here’s the confusing part, the Notice of Default expressly said, “to cure the default you must pay all sums due…”  Obviously, R.E. Loans did not want to pay $26,307, 307.93 to cure the default.  But under the Court’s explanation, R.E. Loans was entitled to some kind of apportionment of that number such that they could cure for only the amount that was in default on Jack’s Ranch.

The Court indicated there was no evidence on the record that R.E. Loans had attempted to obtain or pay a lesser default amount.  That is a strange distinction because the loans were cross-defaulted, therefore, the senior lender should have been entitled to foreclose due to a default on one of the other two loans, even if the amount to cure on Jack’s Ranch was zero.  But, because the loan agreement was only between the borrower and the senior lender—the junior was not bound by the cross-default provision!

The cautionary tale here in the dicta is that had R.E. Loans attempted to cure only its portion, but the senior lender had taken the unreasonable position that all $26M was required to cure, then there might have been a different result, or at a minimum, grounds for an injunction to halt the trustee’s sale on Jack’s Ranch. [R.E. Loans, LLC v. Investors Warranty of America, Inc., 2013 DJDAR 1017]

Takeaway – the Notice of Default’s amount to cure is specific to the borrower—not the junior lienholder.  Additionally, as a junior lienholder agreeing to subordinate to a larger loan, be aware of any language in that agreement that permits the lender and borrower to call a cross-default if it is a cross-collateralized loan.  In the case of the senior lender, had it included the cross-default language in the subordination agreement, then potentially it could have bound the junior the full amount required to cure the default on all the loans.

If you have any further questions regarding this article, feel free to contact the Law Offices of Peter N. Brewer at (650) 327-2900.

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