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What is a Subordination Agreement?

If you have ever purchased real property in California using money from a bank or other institutional lender, have obtained a second loan secured by the property, then refinanced the first loan to reduce your payments, you have most likely seen what is known as a “subordination agreement.” Chances are, that document was one of many contained in the mountain of other documents you received and reviewed without much thought, without knowing what it was, and likely without even realizing it existed. So what is a subordination agreement and why is it so important? Without that document, the lender agreeing to “refinance” your property likely would never have agreed to make the loan in the first instance. To understand why the subordination agreement is so important, one must first understand how liens in California are prioritized.

Shortly after California became a state, it adopted a recording system “by which evidence of title or interests in title could be collected . . . in a public place” for the “purpose of establishing a recording system

[] to inform persons planning to purchase or otherwise deal with land about the ownership and condition of the title.” California is known as a “race notice state” Id. which means, in its most simple terms, that the first lien recorded on a piece of real property is the first lien that will be satisfied in the event the borrower fails to repay the loan. Consider the following example:John purchases a home in Encinitas, California, with a value of $650,000.00 in December 2000, and obtains a loan from JP Morgan Chase. In June 2001, John borrows $35,000.00 to improve the property with an in-ground pool from E-Loan. Over the course of the next two years, interest rates drop, and John finds that Wells Fargo Bank would be willing to make a new loan in an amount sufficient to replace the JP Morgan Chase loan that would significantly reduce John’s monthly payments.

In the above example, if Wells Fargo makes the loan to John, the JP Morgan Chase loan will be fully paid; the loan to E-Loan will move into “first position” (effectively replacing the JP Morgan Chase loan); and the loan from Wells Fargo (presumably in a much greater amount than the E-Loan pool loan) moves into “second position.” If John subsequently defaults in the repayment of the E-Loan pool loan, E-Loan will foreclose on its security interest and “wipe-out” Wells Fargo’s lien, making it ineffective and unenforceable. Wells Fargo will then be forced to look to John personally, rather than the property, to recover the amount it is owed, making it less likely that Wells Fargo will ever recover the amount it loaned John.

The solution to this dilemma is the subordination agreement. In the above example, Wells Fargo would likely agree to make the loan to John on the condition that E-Loan agree to subordinate its loan and allow Wells Fargo to assume “first position.” Once recorded, the Wells Fargo loan would be in a superior position to the E-Loan pool loan and would not lose the ability to foreclose on the home and sell it to recover the money it had loaned to John. While the above-example involves a fairly simple and straight-forward situation involving three institutional lenders, the same rules apply to anyone who agrees to make a loan on real property (and in some instances, other types of property) in almost every situation.

Before you loan a substantial amount of money to anyone for any reason, you must understand California’s recording statutes and lien priorities. Failing to do so could result in the loss of your security and money with no hope of ever recovering it.Before loaning any substantial amount to anyone, you need to seek the services of an attorney with a proven track record, like Michael Leonard, Esq., named “Best of the Bar” by the San Diego Business Journal in 2016. If you would like to arrange for a consultation to discuss loaning substantial funds to others, or if you would like to discuss any other business-related matter with a rising star, Michael Leonard, Esq. of San Diego Corporate Law should be your first call. He has the experience and knowledge to ensure all of your business agreements are enforceable in the California Courts. He can be contacted by visiting San Diego Corporate Law or by telephone at (858) 483-9200.

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