SUBORDINATION AGREEMENTS

An expensive claims problem in recent years has been with respect to Subordination Agreements. The title insurance industry has experienced a significant number of claims on mortgagee's policies which involve these agreements.

A subordination agreement is an agreement between an existing mortgage holder and a new lender whereby it agrees to give up its senior mortgage priority and become junior in priority to the new lender. The existing mortgage holder subordinates its mortgage to the new lender. With a proper subordination agreement, we are able to insure the new lender that it is now the senior lienholder.

Subordination agreements are frequently given by previous landowners who sell the property and take back mortgages. Such an arrangement is needed in order to permit additional financing for the development of the land and the construction of the improvements. People who give these agreements are often unsophisticated and inexperienced. When something goes wrong, they frequently claim that they did not really understand the true nature of the transaction.

A proper subordination agreement should be dated, recite the names of the existing mortgage holder, the new lender, and specifically describe the existing mortgage and the new loan documents. It must recite consideration. This might be the mutual benefits that accrue to each party or some other form of consideration. Finally, it should contain language that unconditionally subjects the existing mortgage to the new loan. The document must be executed, acknowledged and recorded.

Be careful! If the new loan calls for future advances, renewals or extensions, be sure that the subordination agreement mentions these so that the existing loan is subordinate to those provisions also. If the new loan is modified after the original transaction, it may be necessary to secure an amended or new subordination agreement to accommodate the changes.

Also, be aware that subordination agreements are common targets for forgers. Since the former landowner/mortgagee seldom appears at the subsequent construction loan closing, it is a simple matter for a developer/landowner to bring in a purported subordination agreement which will permit the closing of the new construction mortgage he or she is anxious to make.

If you are asked to insure a new loan and it is determined that the existing mortgage is properly subordinated, the existing mortgage and subordination agreement should be shown under Schedule B-II of the mortgage policy as a subordinate matter. They should be listed as exceptions on Schedule B of the owner's policy.

Subordination Agreements

You must carefully examine the terms and provisions of each particular subordination agreement. Many have specific limitations. Some examples are as follows:

1. The subordination contains a time limit. Example: the mortgage is subordinated for only one year; or, the existing mortgage is subordinated until construction of improvements is completed.
2. The subordination requires that the new loan be used for a particular purpose. Example: the proceeds of the new loan may be used only for construction purposes; or, the existing mortgage is subordinate only to the extent that proceeds of the new loan are used to construct a shopping center.
3. The subordination is limited to a certain dollar amount. Example: the existing mortgage is subordinated to a new loan not exceeding $200,000.00.

If you are asked to insure a new loan where an existing mortgage has been subordinated by a subordination agreement that contains a limitation, you must show the existing mortgage as an exception on Schedule B of both the loan and owner's policies· An exception to the "limited" subordination agreement should also be included on Schedule B. The mortgage and this subordination agreement must not be put on Schedule B - Part II.

All of the foregoing suggests that extreme caution should be exercised in dealing with subordination agreements. Extra care must be taken to see that a proper exception is taken to the effect of any limiting provisions in the agreement. Since subordination agreement problems do not typically arise until a project goes "belly up," you should always be particularly wary of a transaction that appears to be too "thin" or does not seem to make economic sense. You cannot heal a broken leg with a band-aid.