The Colorado Court of Appeals recently decided a question of first impression in Colorado concerning the effect of a subordination agreement on lien priorities. Specifically, the Court had to determine whether to apply the partial subordination approach or the complete subordination approach to this analysis. Ultimately, the Colorado Court of Appeals sided with the majority of Courts that have faced this question and applied the partial subordination approach to lien subordination analysis. See, Tomar Development, Inc. v. Friend, --- P.3d ---, 2015 COA 73, 2015 WL 3503880 (Colo. App. 2015). The impact of this decision is discussed in this article.
Colorado’s Race-Notice system makes the date of recording the default determiner of priority for all liens. See, § 38-35-109(1), C.R.S. 2014; Premier Bank v. Bd. Of. Cnty. Comm'rs, 214 P.3d 574 , 579 (Colo. App. 2009) ("Race-notice is the linchpin of Colorado real estate law. Its purpose is to enable a buyer or mortgagee, by analysis of the chain of title, to determine exactly what it is acquiring." (citation omitted)). Colorado’s race-notice system, however, does not prohibit parties from privately altering these individual seniority rights vis-à-vis each other. See, Co-Alliance, LLP v. Monticello Farm Serv., Inc., 7 N.E.3d 355, 358 (Ind. Ct. App. 2014) (“Subordination agreements are nothing more than contractual modifications of lien priorities.”)
As described by the Tomar Court, "[a] problem arises, however, when the most senior lienholder ("A") agrees to subordinate his interest to the most junior lienholder ("C") without consulting the intermediary lienholders ("B"). The question then becomes, where do those intermediary lienholders fall in the order of priority?" As noted above, there are two generally accepted approaches to dealing with this issue.
The complete subordination approach is followed by a minority of the jurisdictions that have faced this issue. "Under this approach, when A subordinates to C, B simply moves up in priority. So any foreclosure will result in the priority of lien payments to B first, then C, then A." Tomar at ¶ 19. The Colorado Court of Appeals recognized "[t]his approach, however, would affect the rights of those not in privity to the subordination agreement, who were not beneficiaries to the agreement, and who were not entitled to a windfall." Id. In other jurisdictions that have addressed the complete subordination approach it has been noted as a minority view and criticized as an approach that would “add confusion to the law, not clarity.” Co-Alliance, LLP v. Monticello Farm Serv., Inc., 7 N.E.3d 355, 358-360 (Ind. Ct. App. April 23, 2014); see also Metro Bank v. Neilsen, 178 Cal.App.4th 609, 616-617 (Cal. App. 2009); In Re Price Waterhouse Ltd., 46 P.3d 408, 410-411 (Ariz. 2002); Brachter v. Buckner, 90 Cal.App.4th 1177, 109 Cal.Rptr.2d 534 (2001), ITT Diversified Credit v. First City Cap. Corp., 737 S.W.2d 803 (Tex. 1987); Nation, Circuity of Liens Arising From Subordination Agreements: Comforting Unanimity No More, 83 B.U. L.Rev. 591, 597).
Partial subordination, on the other hand, has a neutral effect on third parties. Under the partial subordination approach "when A subordinates to C, C becomes the most senior lienholder, but only to the extent of A's original lien." Tomar at ¶ 16. What this means is that if C's interest is greater than A's, C can only recover prior to B to the extent of A's interest. Any interest C has in excess of A's can only be recovered subsequent to B's interest being satisfied. "Under this partial subordination approach, B is not affected in any manner by the agreement between A and C, to which it was not privy." Id. at ¶ 18. "B remains second in priority to the full amount of A's original lien, neither receiving a windfall nor suffering negative consequences. … In essence, B's interest remains totally unaffected by A and C's subordination agreement." Id. Subordination agreements have no effect on the priority of liens held by third parties that are not parties to any such agreement. This is the critical concept underlying the partial subordination approach.
It is worth noting that the courts that have followed the complete subordination approach have not addressed this issue in over 20 years. Given the logical appeal of partial subordination, it is possible the partial subordination approach could gain overall acceptance in United States courts in the years to come.