Summary:

Consider a real-life scenario: a borrower requested a subordination of an existing lien in a seller carry-back transaction…

The borrower and the first lien holder were advised that creating an inter-creditor agreement was the best option…

A seller’s carry-back first lien would be paid off on a refinance, but there was insufficient equity to pay off the first lien. The seller agreed to accept a paydown of the net proceeds of the new first and carry a small second for the remainder.

The turning point in this scenario was the first and subordinate lien holders’ signing and recording of a subordination agreement. This agreement and the inter-creditor agreement clearly defined their rights and responsibilities in the event of a borrower default, thereby playing a pivotal role in the successful transaction.

Article: 

Understanding the Basics: What is the Subordination of a Lien?

Subordinate liens mean a lien is, or will be placed, in a lower lien position, rank, or junior to the senior lienholder(s).  The junior lender is subordinate to the senior lender unless a written agreement states otherwise.

Loan documents are recorded at the municipal recorder’s office using a “sequential date and time-stamped method.” Any lien with an earlier recording date and time stamp is a senior priority unless the parties agree otherwise.  Sometimes, keeping a lender lien on the property is desirable or necessary, but to agree to modify or lower its priority.    A “subordination agreement” is a method.

When a lender prepares the subordination agreement for the borrower and possibly senior and subordinate lenders to sign, it’s a moment of reassurance. This agreement, which clearly outlines the change in lien priority, is a crucial step that ensures a smooth and secure transaction, underscoring its importance in the lending process.

There are many reasons for the subordination of liens between the parties.

Reasons include:

·                  The transaction is an “installment sale” in real estate and tax planning.  A seller’s carry-back financing lender (beneficiary) may choose to defer receiving the principal from the property sale for tax deferral purposes.  The reasoning is to extend the payment schedule, including principal reductions and interest, for some time.  Since a seller pays capital gains on the principal received and ordinary income on the interest earned, a subordinated lien is a vehicle for deferring tax payments if drawn correctly, providing significant benefits in tax planning.

·                  During a refinance process, a lender may find that the property equity is insufficient to refinance and pay off all the underlying liens and encumbrances.  In such cases, the transaction can only proceed if one or more existing lien holders (lenders) agree to take a partial principal paydown and subordinate a portion of their loan. This is where the subordination agreement comes into play, making the transaction feasible.

What is an Inter-creditor agreement (ICA)?

An Inter-creditor agreement is a written legal contract that is a signed and acknowledged document of mutual understanding between two or more lenders (usually two lenders/creditors, a first and second lien holder).  The agreement provides a secure framework for resolving disputes fairly between creditors and ensuring their respective rights are protected.  The contract clearly outlines the priority of the liens and how the responsibilities of the parties’ competing security interests are covered when they possess separate and unequal lien positions if a borrower defaults, ensuring everyone’s rights and obligations are clear and protected.

If a borrower defaults on a first trust deed, the second or junior lien could be foreclosed on and lose all its principal. If the second lien holder is unaware of the first lien borrower’s default, a foreclosure procedure may wipe out the second lien holder’s loan. The entire junior lien could be lost, highlighting the potential risks of not having an explicit inter-creditor agreement and emphasizing the need for caution and awareness in lending situations.

An inter-creditor agreement defines in writing who is responsible for loan payments, property insurance, property taxes, and association dues in the event of borrower default.  The subordinate lender (junior) must write checks for all these expenses to protect its interest.  At the same time, the subordinate lender can begin their foreclosure procedure while keeping the first lien current for a specified period.

The ‘Intercreditor and Subordination Agreement’ is a comprehensive document that combines the terms of both agreements, providing a clear understanding of the rights and obligations of all parties involved.

 THIS INTERCREDITOR AND SUBORDINATION AGREEMENT (this “Agreement”) is made as of __________, by and among __________________, having an address at ____________________________ (such entity, together with any subsequent holder of the First Mortgage Loan Documents (hereinafter defined), the “First Mortgagee”), ________________________________, having an address at _______________ (such entity, together with any subsequent holder of the Subordinate Mortgage Loan Documents (hereinafter defined), the “Subordinate Mortgagee”) and _____________________, having an address at _________________(“Borrower”). 

Then, the definitions, explanation of lien priorities, standstill agreement, turnover of improper payments, cure rights, representations, and miscellaneous are included in the agreement. The first lien holder, the subordinate lien holder, and the borrower will sign the document.

The Loan Broker, acting as a fiduciary of one party and an intermediary between the borrower and the lenders, played a crucial role in advising the parties on the best course of action.

“My client is in the process of refinancing their seller carry-back first lien financing.   The property has gone up only marginally, so the protective equity is insufficient to take the first lien.  The property was appraised at $970,000 with a first lien of $750,000.  The new lender will only loan 70% of the value, or $679,000.  That leaves a shortfall of $71,000, or approximately $100,000, with costs and fees.  The seller’s carry-back principal was reluctant to allow a portion of their lien to be subordinated to a second lien position.  However, the advantages were explained by providing additional protections for an inter-creditor agreement.

The agreement provided that in the event of borrower default, the junior $100,000 lien holder could bring the property currently and begin their foreclosure.  The second was to receive a notice and 30 days to get the first current.

All parties involved in this well-structured arrangement reaped significant benefits. The seller’s carry-back principal received a substantial principal payoff and continued to receive monthly interest payments on the remainder. Simultaneously, the junior lien holder was assured of their rights in case of a default, ensuring a fair and secure transaction for all and highlighting the positive outcomes of a carefully planned agreement.