In R.E. Loans LLC v. Investors Warranty of America, Inc. (2013) 212 Cal.App.4th 1432, the court of appeal decided that a subordination agreement was enforceable even though the new deed of trust (“subordinating loan”) to which the existing deed of trust (“subordinated loan”) had been subordinated secured not just the $4 million loan to which the subordinated lender had agreed to subordinate, but two additional loans for a combined total principal balance of $21 million.  In a conclusion that may surprise transactional attorneys, the Court further held that the subordination agreement did not preclude the deed of trust securing the subordinating loan from being used to secure additional loans.  The Court held that a secured lender which has agreed to subordinate to only one of the three secured loans secured by a single deed of trust is junior only to that loan for priority purposes.  Thus the two loans not mentioned in the subordination agreement were inconsequential because their position would be junior to that of the subordinated loan, a “split priority” result that the new loan documents did not expressly dictate.  How a single trust deed containing a single power of sale could effectively secure three separate loans with different priorities was not discussed.

The predecessor of Investors Warranty recorded a deed of trust against property in San Luis Obispo County known as Jack’s Ranch.  The deed of trust secured three separate loans to the owner of Jack’s Ranch in the amount of $4,000,000, $11,000,000 and $6,000.000, for a total amount secured of $21,000,000.  R.E. Loans had an existing deed of trust against the property, which after a partial payoff funded by the Investors Warranty loans, secured an approximately $3,000,000 loan.  Before the Investors Warranty deed of trust was recorded, R.E. Loans signed a subordination agreement by which it agreed that its deed of trust was junior to one of the loans secured by the Investors Warranty deed of trust – the $4,000,000 loan.

The Investors Warranty deed of trust stated that it secured the $4,000,000 note as well as “any and all obligations and covenants of trustor under” a master loan agreement which included the separate $11,000,000 and $6,000,000 loans.  The loan master agreement also states that the three loans are intended to be “cross-defaulted,” that is, default under any of the loans is a default under all of the loans.

A few years later, the trustee under the Investors Warranty deed of trust recorded a notice of default which stated that the $4,000.000 loan was in default, and the amount necessary to cure was approximately $26,000.000, the total secured principal plus accumulated interest and other charges.  R.E. Loans made no effort to cure.  Investors Warranty bid $4,625,000 at the trustee’s sale and received the trustee’s deed to Jack’s Ranch.

After the sale, R.E. Loans sought a declaration from the court that its deed of trust was not affected by the foreclosure sale and remained in first position, because the subordination agreement had been breached and was ineffective.  This was because the Investors Warranty deed of trust secured not only the $4,000.000 loan to which R.E. Loans had agreed to subordinate, but also the additional $11,000,000 and $6,000,000 loan.  The trial court agreed and granted summary judgment to R.E. Loans.

The Court of Appeal reversed.  The Court of Appeal relied solely on a 152 year old California Supreme Court opinion:  Hawker v. Reas (1861) 18Cal. 650, which “illustrates that where a number of notes are secured by a single trust deed, they are treated as separate, secured loans.”  The Court did not reference the substantial body of California law relating to subordination agreements that has developed since 1861.

According to the Court, Investors Warranty’s deed of trust secured three notes, one of which was for $4,000,000.  R.E. Loans had agreed by its subordination agreement to subordinate its deed of trust only to the $4,000,000 loan, not the separate $11,000,000 and $6,000,000 loans also secured by the deed of trust.  Thus, to the extent that Investors Warranty’s deed of trust secured those other notes, it was junior to R.E. Loans’ deed of trust.  This would have been the result had each note been secured by its own trust deed, and there was no reason why a different result should apply simply because the notes are secured by a single trust deed.  Moreover, the fact that the multiple loans were secured by one deed of trust did not breach the subordination agreement because R.E. Loans’ deed of trust was subordinate only to the $4,000,000 loan.  There was nothing in the subordination agreement which prohibited the creation of liens junior to R.E. Loans’ deed of trust.

Transactional lawyers will find this opinion disconcerting.  The case injects uncertainty into the rights and remedies of a subordinating creditor in the case of a “partially” senior deed of trust securing multiple loans.  Ordinarily, a party who breaches the terms of a subordination agreement or fails to obtain one from an existing creditor suffers the loss of priority, either in whole or in part, as a penalty.   In this case the court allowed the “senior” lender to use split priority as a sword, with the result that a partially subordinating lender became a fully sold out junior.  At a minimum, the decision will change the language and terminology of negotiated subordination agreements to explicitly prohibit cross-collateralized and cross-defaulted debts or additional advances.  It will also affect how junior creditors approach trustee’s sales and reinstatements of senior indebtedness given the specter of a deed of trust with split priority.  The court supports its conclusion on the basis the result would be the same if the loans were secured by separate trust deeds, but glosses over the fact that in that case the notices of default specifying amounts required to cure would also be separate, thereby eliminating ambiguity as to amounts required to cure.

By (presumably) credit bidding the amount due on the senior $4,000,000 loan, Investors Warranty was able to obtain a trustee’s deed to the property.  The Court does not discuss whether this credit bid was based solely on the “senior” loan indebtedness, or also included “junior” loan indebtedness.  To the extent it was the latter, the credit bid which “sold out” the subordinated deed of trust included junior indebtedness.  The Court does not discuss to what extent a competing cash bid would have made economic sense from the point of view of R.E. Loans, nor why R.E. Loans made no effort to bid at the sale.  The lesson to be learned by secured lenders who subordinate to only a portion of the amount secured by another deed of trust (whether knowingly or not) is simple:  in order to protect your interest in the event of foreclosure, tender the amounts due under that (senior) portion of the secured debt.  Better yet, explicitly prohibit such cross-collateralization in the subordination agreement.