This article has been written by Ashwin Balachandran pursuing the Diploma in US Intellectual Property Law and Paralegal Studies from LawSikho. This article has been edited by Zigishu Singh (Associate, Lawsikho) and Prashant Baviskar (Associate, Lawsikho).
Table of Contents
Introduction
This article intends to briefly delve into the fundamentals aspect of subordination and subordinated mortgage contracts. The article shall focus on the concepts of the subordination and factors that need to be focused on while drafting a subordinated contract.
Individuals and legal entities turn to lending institutions when they are in need of funds. It is known that the lending institutions keep their business afloat through the interest that they accrue on the loaned amount, unless the borrower defaults on the payment. The process of taking loans is universal; however with regard to the lending institutions of the US, they have separate legal arrangements of ‘Subordination’ for protecting their interests. The US banking institutions for safeguarding its interest, tends to execute a contract wherein it places additional liens against the secured property if the lender is to take on an additional loan. A contract of subordination is a legal document which prioritises the precedence of one debt over the other. The priority of debt becomes essential when the debtor defaults on making payment or when the debtor declares bankruptcy. A subordination contract fundamentally makes the creditor with a higher claim or lien to that of another creditor in the event the borrower’s assets are to be liquidated for the repayment of debts. Thus, in essence, by virtue of the subordination agreement, it is established that one party’s claim is prioritised over that of another party in the event the borrower’s assets are to be liquidated. The subordination provisions are most commonly seen in the domains of mortgage contracts, mortgage refinancing contracts, real estate and bond issue Agreements.
Purpose of subordination contract
The Purpose of the Subordination Contract is as follows,
- Subordinate Contract within the realm of mortgage is for setting the lender’s priority in exercising its rights and recourse over the security asset/collateral.
- By executing a Subordinate Contract, the lender renders other claims as subordinate.
- Essentially Subordinate Contracts are legal protection afforded to the lender.
UCC and Subordination
Article 9, of The Uniform Commercial Code Secured Transactions, provides for provisions for governing rules for any transactions that combine a debt with a creditor’s interest in debtor’s personal property. Basically, Article 9 of the UCC enumerates steps to legally protect a debt by staking a claim in the debtor’s property. That is, a creditor with a perfected security interest has recourse to collateral and in the event two or more secured creditors are there, then the general rule under UCC is to perfect the priority whether competing security interests are consensual or not. This is not applicable in most scenarios as the possession is trumped by earlier filing.
Operation of subordinated mortgage contract
When a person takes out a mortgage loan, the lending institution will most likely make him execute a contract of subordination with it and wherein the wordings of the contract would accentuate the lending institution’s lien and its precedence over other liens placed on the security property. If a default of repayment of loan were to happen, the lending institution would have the legal standing to repossess the security property and cover its outstanding balance. In a scenario wherein there are other subordinate mortgages present, the secondary liens would only be recouped after the costs of the primary lender has been seen through. There are instances wherein the value of the security property might not be enough to cover all liens, in those situations subordinate lenders would be in a riskier position than the primary mortgage.
Identifying and drafting subordination clauses
- Recital Clause: The Recital Clause of the Subordination Agreement should contain mention of the indenture/mortgage executed to secure the loan amount and also should provide a description of the property. A model recital clause is drafted hereunder:
The Owner has executed a Mortgage, date 16.11.2021 to secure a loan in the sum of $125,000 in favour of AAA Bank as collateral/security. The Property recorded on in the record of ______ County, California as Deed No. 919/1985 recorded in Book No.1, Pages 425-430 is provided herewith as Security and is described as hereunder.
- Terms and Conditions: The Terms and Conditions of the Subordinate Agreement should contain the following particulars. That the Lender has primary lien over the collateral property over other debts, that anything contained in the agreement should not be construed as the right to alter the priority of the lender with regard to the interest in the property. That all proceeds should satisfy the primary debt in case of liquidation of assets. A model terms and conditions are drafted hereunder,
- The Bank shall have primary lien over the security/collateral property in the instance of other debts and liquidation of assets.
- Nothing in the Agreement is to be construed as the right/claim/interest of the Borrower/Owner to alter the set the primary priority of the bank with respect to the equitable interest in the collateral property.
- In the event of liquidation of assets on non-repayment, the Bank shall have lien over the sale proceeds to balance of repayment.
- Collection and Liquidation: The collection and liquidation clause is pertinent to ascertain sale proceeds in case the loan is declared default. The Bank very well may liquidate or sell the collateral property and the Bank shall accept sale proceeds in any possible means to quench its balance repayment. A model collection and liquidation clause is drafted hereunder,
In the event that the loan is declared in default; the AAA Bank shall liquidate or sell the Collateral Property for securing and satisfying the outstanding balance payment. The AAA Bank shall collect the sale proceeds of such sale and it shall accept cash, certified funds or US treasury cheques in connection with any purchase of the foreclosed or liquidated property.
- No Implied 3rd Party Beneficiary: The Subordinate Agreement should not leave room for any interpretation wherein 3rd party could alter, modify or limit the powers of the Lender or the collateral. A model clause is drafted hereunder.
Nothing stated in the Agreement allows any Third Party to modify or affect the rights of the AAA bank. This Agreement does not confer any right, priority, benefit, interest to anyone or any third party with respect to the Collateral Property as well. Any arrangement in the aforementioned regard shall only be made at the option and interest of the AAA bank and any contravening acts shall stand null and void.
- Successors and Assigns: The Subordinate Agreement should bind the parties and respective heirs, assigns and successors. A model clause successors and assigns is drafted hereunder,
The Bank hereby inure to the benefit of and bind the respective parties to the Agreement, that is the Owner’s heirs, Successors and Assigns including but not limited to party acquiring the AAA Bank’s loan or through the means of sale, assignment or through any other transfer.
- Jurisdiction and Applicable Law: The Subordinate Agreement should clearly specify the jurisdiction and the applicable law so that there arises no room for ambiguity. A model clause Jurisdiction and Applicable law has been drafted hereunder,
The enforceability or interpretation of this Agreement shall be governed by the statutory laws of California State, and the courts of California shall have original jurisdiction in respect of any action to contest the validity, interpretation, enforceability of this Agreement. Notwithstanding the foregoing, the parties agree that prior to initiation of any proceeding, action, law or any such legal remedy in connection with the disputes arising out of this Agreement; the Parties shall first negotiate in good faith with each other regarding such dispute.
Special considerations
In a subordinated Contract for mortgage, the mortgagor is in effect, paying off the first loan when the borrower is taking a refinance or a second loan. It is trite to note that the second loan or the refinance shall move up to be the first loan as the lender would insist on the requirement of entering into a Subordination Contract for the purpose of repositioning the subsequent loan as the apex priority for debt repayment. The priority interests of creditors are thus changed by the contract. From the standpoint of a lender, they would only prefer to issue a loan if their loan is in the primary position and any contravention to that would potentially block any chance of qualifying for a new mortgage. Further, the signed Contract must be notarised and be recorded in the official record of the county to be enforceable.
Conclusion
Thus, it is established that a subordination contract is seen when multiple mortgages exist against one property and the contract prioritizes repayment of debt of one party/creditor over that of others in the event of default of repayment, foreclosure or bankruptcy. The Debt of the second in line creditor shall only be satisfied if the primary or the prioritized debt of the primary creditor has been paid in full. While drafting a subordination contract special consideration with respect to law has to be made. A drafter must be mindful of the past and present laws applicable to the contract.
References
- https://www.rocketmortgage.com/learn/mortgage-subordination
- https://www.investopedia.com/terms/s/subordination-agreement.asp
- https://www.hodgsonruss.com/media/publication/1758_UCC%20Article%209%20Secured%20Party%20Sales%20_w-008-7326_.pdf
- https://www.blankrome.com/sites/default/files/202006/security_interests_and_liens_priorities.pdf
- https://www.law.cornell.edu/ucc/9
- https://www.lawinsider.com/clause/recitals.
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