Most title underwriters, title agents and escrow companies require that all Subordination Agreements be approved by management or counsel before recording in a transaction. Clearly, it would be best if they went through the approval process before they were signed, but since they are often prepared by a lender or attorney outside of escrow, that "luxury" is not always possible. Black's Law Dictionary defines subordination as "the...process by which a person's rights are ranked below the rights of others." We hear the term used frequently in the title and escrow business, but since an example is much better than a cold definition, the following will serve as an illustration.
Subordination Agreements are most often used to subordinate one deed of trust to another. A few years ago there were some cases known in the title industry as the BURKONS/MANLEY vs. TICOR cases in Arizona. These cases centered around some people who sold their commercial properties and took carryback deeds of trust for a good portion of the sale price. Shortly thereafter they were asked to subordinate their "carryback" interest to new loans which seemed to be loans for improvements on the properties, but which did not specifically so state. It ended up that they did subordinate their loans, that the new loans, plus their carrybacks (now second deeds of trust), were for substantially more than the unimproved properties were worth. This was to be a precarious position for the sellers, because as it turned out, the buyers took the money from the new loans and defaulted on both loans. This caused the now "first" lenders to foreclose and subsequently "wipe out" or eliminate the interests of the subordinate or second deeds of trust.
Even had the original sellers been able to protect their positions in the properties by paying the first deeds of trust off, it was no longer practical to do so since the properties had not been improved and were not worth the amounts of the new loans. It was what we often term "over-encumbered" property. TICOR suffered substantial losses due to these lawsuits, and the findings of the court ("case law") set a new standard of care for the industry in Arizona.
A number of years ago an owner's policy was issued to a developer covering a tract of land and an easement for roadway purposes leading to the tract. We called attention to the fact on our title insurance policy that the easement strip was encumbered by a deed of trust. Subsequently, the developer filed a subdivision plat on the tract showing the easement strip as access to the subdivision. The Subdivision Title Report was prepared to accompany the plat in the application package to the Real Estate Department, and again we had to mention that the easement strip leading to the subdivision was subject to a deed of trust.
This had to be done because in being asked to insure against lack of a right of access to and from the lot, we could not, since a subsequent foreclosure of the deed of trust in question would have "cut out" or eliminated the easement, thus land-locking the subdivision. To remedy this situation, we required that the easement strip be either partially released from the lien of said deed of trust, or subordinated to the instrument creating the easement. A Subordination Agreement was prepared by an attorney for the developer and delivered to the holder of the note and deed of trust for signing and subsequent recordation. Once this had been accomplished, we could issue our policies insuring access to the subdivision without further exception. Although it is not something we would normally insure, as "experts" in title matters, we would be wise to give notice to our client that unless the easement was specifically acquired to serve a subdivision, the owner of the servient parcel(s) may claim that the easement would be overburdened if used for a number of parcels. Also, the subdivision laws of cities and counties usually require roads of a certain width.
Subdividers should determine before major investment that the easement is wide enough to accommodate the subdivision. In looking at a Subordination Agreement, the following questions are asked by management, counsel, or an underwriter: (1) Has the subordinating party been made fully aware of the possible consequences of subordinating their lien or interest? (2) Does the Subordination Agreement clearly state what is being done - which lien is subordinate and which is superior? and (3) Has the subordinating party been given all the information about the amount, interest, and any balloon payments of the lien to be made superior?
This last question was brought up in a case a few years ago, and the Subordination Agreement in question was found invalid by the court since this did not happen. For equity's sake the subordinating person has to be given the financial status of the new loan in order to evaluate their ability or desire to take over the loan in case of a default on the part of the borrower.
There are certainly times when a subordination of interest is to the benefit of all parties. However, it is something that should be done with complete understanding of the process, since it could mean that a foreclosure on the deed of trust being given a superior interest could override the interest of the subordinated lien, especially if the person subordinating is not in a financial position to pay off the other lien. We should always recommend that our customers seek the advice of someone competent in real estate law if they are unsure of the exact situation created should they subordinate any interest in real property.
Mark F. Cheney is President and Senior Trust Officer for Yavapai Title
Agency, Inc. in Prescott, AZ. He can be reached at email@example.com or 520-445-2528.