Secret Lender-Buyer Side Deal Renders Seller Subordination Agreement Unenforceable

by Ballard Spahr LLP

A California Appellate Court ruled recently that a seller’s subordination agreement was unenforceable where the buyer and the lender entered into a side agreement between themselves that the seller knew nothing about and that substantially impaired its security.

In Citizens Business Bank v. Gevorgian et al., the seller sold real property to the buyer subject to seller financing secured by a deed of trust. The buyer then entered into negotiations with the lender for a construction loan to develop 15 single-family residences on the property. Because the lender would not agree to make the loan if its lien were not in first position, the seller agreed to subordinate its security interest.

The lender and buyer entered into a loan agreement, of which the seller was aware, that defined the project as "the construction and completion of all improvements…, including the construction of 15 single family residences" and provided that the loan funds were to be used only for constructing and equipping the project. However, the lender and buyer also entered into a separate letter of understanding modifying the loan agreement by defining the project as "three phases with 5 units in each phase," and providing for immediate disbursement of loan funds to be used to repay existing liens. Neither the lender nor the buyer informed the seller of their letter of understanding.

The court found that the terms of the letter of understanding made material modifications to the loan agreement, about which the seller should have been notified, and these modifications placed the seller’s subordinated lien at greater risk. The court held that, pursuant to public policy, the lender was under a duty to inform the seller of the material modifications to the loan agreement because "public policy… requires protection of subordinating sellers and… a lender and a borrower may not bilaterally make a material modification to a loan to which a seller has subordinated, without the knowledge and consent of the seller to that modification, if that modification materially affects the seller’s rights."

The court also held that such duty was not waived, notwithstanding a provision in the subordination agreement stating that "[l]ender in making disbursements pursuant to any such agreement is under no obligation or duty to, nor has Lender represented that it will see to the application of such proceeds by the person or persons to whom Lender disburses such proceeds and any application or use of such proceeds for purposes other than those provided for in such agreement or agreements shall not defeat the subordination herein…." The court determined that, because public policy rendered the subordination agreement unenforceable, the waiver provision was similarly unenforceable.

The court also rejected the lender’s argument that the seller could not abrogate the subordination agreement because the lender, as a third-party beneficiary, relied on it in making the loan agreement. The court held that, even as a third-party beneficiary of the subordination agreement, the lender was not entitled to enforce it because the buyer had breached it by failing to provide the seller with a copy of the letter of understanding.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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