In Citizens Business Bank v. Gevorgian (2013) 218 Cal.App.4th 602, the Court declined to enforce a subordination agreement, where modifications to the underlying loan accomplished through a “side letter” to the construction loan agreement were not disclosed or agreed to by the subordinating seller.

The seller carried back a note of $1.4 million in connection with the sale of property to be developed with 15 residential homes.  The seller agreed to subordinate its carryback loan to a new $6.6 million construction loan to be obtained by the buyers from Citizens Business Bank.  The unsigned construction loan agreement was provided to and approved by the seller.  However, a side “letter of understanding” between the buyer/borrower and the Bank relative to the loan was not provided to the seller.

The side letter differed from the construction loan agreement in important ways.  For one thing, the side letter provided for an immediate loan disbursement of $2.2 million to pay off existing loans, with the result that the buyers would not have to contribute money of their own into the project.  The side letter also stated that the development was to be in three phases, with further loan disbursements contingent on completion of the phases.

After the purchase, the buyer/developer defaulted on the loan, and the Bank sought to judicially foreclose.  The subordinating seller filed a cross-complaint, seeking a declaration of relative priorities of the liens against the property.

The seller testified he had not seen, and was not informed of, the side letter.  While the Bank said a side letter was used due to technical limitations in the software used to prepare form construction loan documents, banking experts testified that “custom and practice” in the industry is to include all relevant terms regarding the structure of the construction loan in the construction loan agreement.  The seller testified that had he known of the construction phasing and the immediate disbursement provisions of the side letter, he would not have agreed to subordinate because he believed those provisions put his loan at higher risk of default.

The Court agreed, concluding that the undisclosed provisions in the side letter did indeed place the seller’s subordinated lien at greater risk of default.  Specifically, because the side letter allowed for an immediate disbursement of $2.2 million, there was an obligation to make interest payments from the beginning of the loan.  Moreover, that disbursement meant that the sellers had no money of their own in the project and therefore less “skin in the game.”  The Court also found that the phasing of the project, because of its relatively small size, was inefficient and increased both the time and cost necessary to complete the project.  The Court rejected arguments that the seller was negligent in failing to inquire as to the existence of the side letter, since the seller had no reason to expect that there was such a side letter.

Citing earlier decisions dealing with subordination agreements, the Court held that a lender and a borrower may not bilaterally make a material modification to a loan to which the seller has subordinated, without the consent or knowledge of the seller.  The Court rejected the Bank’s argument that these requirements only apply to modifications made after the subordination agreement is signed.  The important question is whether there is an unconsented-to modification which materially affects the rights of the subordinated seller, regardless of when that modification occurs.  Moreover, the Court stated its conclusions were based on public policy to protect subordinated sellers, and therefore not mooted by contractual provisions in the construction loan agreement purporting to shift the risk of the Bank’s loan administration to the subordinated seller.

This case is a reminder to lenders that if they accept a seller’s subordination agreement, they also agree not to create additional risk to the subordinated lien through unconsented-to modifications of the senior lien.  If such modifications are made, the lender risks losing its contractual priority.  While this case may be unusual in terms of the existence of an undisclosed side agreement containing material terms of the loan, the Court made clear that there is no requirement of “culpability” on the part of the subordinating lender in this context.  The only question is whether the subordinating lender modified its loan without the consent of the subordinated seller in a manner that creates greater risk for the subordinated security.  Title insurers should also be aware of the potential loss of priority, including from unconsented-to modifications occurring pre-policy, and undertake their underwriting accordingly.

This case starkly highlights the special protections afforded to sellers who agree to subordinate their carryback loans based on public policy, and contrasts with other, recent case law which appears to give subordinated “hard money” lenders fewer protections.  (See, e.g., R.E. Loans LLC v. Investors Warranty of Americas, Inc. (2013) 212 Cal.App.4th 1432 .)