Junior & Senior lien Holders: Are “Inter-Creditor Agreements” Advisable?
?Why should you care about inter-creditor agreements? To avoid disputes between lenders if a borrower defaults.
Real estate brokers, mortgage/ commercial lenders, lawyers, and principal borrowers should know the merits of inter-creditor agreements to solve borrower default-related problems before they occur. ??Fiduciaries of the borrowers can more effectively represent their clients by understanding the usage of the agreement.
1)???What is an inter-creditor agreement (ICA)?
A ?borrower defaults on a first trust deed. The second or junior lien could get foreclosed out and lose their principal. ??If the second lien holder is unaware of the first lien borrower’s default, the foreclosure procedure could be completed with a devastating blow to the junior lien. The junior lien security interest could be lost.
An Inter-creditor agreement is a legal contract that is a signed and acknowledged written document of mutual understanding between two or more lenders (usually two lenders/creditors, a first and second lien holder). The agreement spells out the priority of the liens and how the responsibilities of the party’s competing security interests are covered when they possess separate and unequal lien positions if a borrower defaults. The purpose is to establish a clear framework for resolving disputes fairly between creditors and ensuring their rights are protected.
An inter-creditor agreement defines in writing who is responsible for loan payments, property insurance, ?property taxes, and association dues in the event of borrower default.?The subordinate lender (junior) must usually write checks for all these expenses to protect its interest.?At the same time, the subordinate lender can begin their foreclosure procedure while keeping the first current for a specified period. ?
2) What is ?“lien priority” in real estate lending?
Lien priority is related to the exact date and time of a document recording of the security instruments (usually a trust deed or mortgage) in the municipal public records office.?A document will be date-time stamped and given a sequential recording reference number.
California has adopted the “first in time, first in right” concept of lien priorities. A?conveyance (sale) or lien (loan) of property recorded first generally has priority over any later recorded.
Suppose a borrower or their title company records three liens simultaneously on a single property. In that case, the recording will create a first, second, and third lien, regardless of the dollar amount of each lien. ?A first-recorded lien is considered a senior lien; the second and third are junior or subordinate liens. ?The second lien will be inferior to the first and senior to the third.
3)Liens vs. Encumbrances:
a) A lien is a claim or money charge recorded at the county or municipal recorder’s office, creating a public record clouding the security property’s title and providing constructive notice to the public of indebtedness.
b) An encumbrance is everything else that clouds the title, which may not be a money charge against the property. An inter-creditor agreement is an encumbrance, clouding the title against the property.
c)?An executed inter-creditor agreement will be a recorded document to provide public notice.
4)?Subordinated Liens:
A subordinate lien means a lien is in a lower position, rank, or junior to the senior lienholder(s).?The junior lender is subordinate to the senior lender unless a written agreement states otherwise.
Loan documents are recorded in a “sequential date and time-stamped method.”
Sometimes, it is desirable or necessary to keep a lender lien on the property but to agree to modify or lower its priority.??A subordination agreement is a method.?A lender will prepare the subordination agreement to be signed by the borrower and possibly senior and subordinate lenders.?The trustor (borrower) will agree that the lien priority can change or be transferred to a subordinate (lesser) or junior position.
There are many reasons for the subordination of liens between the parties.
Reasons include:
a)?This is an installment sale in real estate and tax planning. A seller carry-back financing lender (beneficiary) desires to avoid being paid off for tax deferral. The purpose is to extend the payment schedule, including principal reductions and interest, for some time.
b)??During a refinance process, a lender may determine that the property equity is insufficient to refinance and pay off all the underlying liens and encumbrances.?The transaction will only work if one or more existing lien holders (lenders) agree to take a partial principal paydown and subordinate a portion of their loan.
5)?Recording of documents-basics:
If a person were to go to the recorder’s office, stand in line, and have the documents recorded, they could check the recording sequence at the counter.?Generally, a title company’s recording of the documents concerns a sale or loan transaction on behalf of third parties in a sale or loan transaction.
6)?Title Insurance and Claims-basics:
After the documents are recorded and added to the computerized public records, the recorder or title company will return the original documents to the lender(s) for safekeeping. A lender should keep the original promissory note, the recorded deed of trust, and the policy of title insurance with other critical papers, usually in a vault.
What ensures the correct order of recording??How do we know that the recorder did not make a mistake and record the documents out of order??A lender will order an insurance policy, referred to as title insurance, to be paid for by the borrower. ?The title policy is supposed to guarantee the lien priority position. ?A miscalculation in the title policy could result in a title claim for reimbursement by a damaged lender. ?That is why the public is willing to pay for what we are told is title insurance. In many cases, title insurance is a misnomer, just as life insurance is death insurance.?
Title insurance companies are profit motivated and do not like to pay out claims for losses. ?They regularly squirm to the maximum to avoid paying claims. Title companies have bottomless financial pockets and use every legal maneuver available to avoid payment in many cases. Usually, the insured party must sue the title company to perfect a rightful claim. The title policy usually only gives you the right to sue the title company when they refuse to pay. Anyone with decades of experience understands the dreadful process of filing a claim only to find that they must sue the title company to get paid. In many cases, title insurance is a false illusion.
7)?Rights and Obligations of lender’s competing security interest:
The agreement will include the rights and obligations of each separate lender party if the borrower/borrowing entity defaults on one or both liens.
a)?The senior lender agrees not to enforce the due on default clause of the borrower’s debt, including declaring a default, accelerating the debt, making demands for payoff, or taking legal action without first noticing the junior lien holder. ?The junior lienholder agrees to cure the borrower’s default and proceed with foreclosure.
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b)??The agreement will often provide the junior holder, upon foreclosure of its lien, with the right to take title to the security property subject to the first lien. Subject to means retaining the first lien and allowing the junior lien to protect their interest, and with the obligation to keep making payments.
c) If a borrower defaults on the junior lien, the junior lien holder will notify the senior lien holder of their intention to begin the foreclosure procedure and willingness to keep the first current. ?The agreement may address which lender may proceed with the notice of default and foreclosure sale. ?Should the junior lienholder move with a notice of default and foreclosure sale, the agreement will typically provide a reasonable period to bring the debt service on the senior lien current. ?A junior lender will usually be required to maintain the payment of the senior lien.
8) Why are inter-creditor agreements beneficial to all property owners, lenders, and borrowers?
A first lien holder benefits from knowing that someone other than the borrower will be responsible for making and keeping the property payments current if the borrower defaults. ?The first lien holder can be confident that if there is perceived protective equity, the junior lienholder will suffer the stress of making payments and protecting their junior lien position and equity.
The second lien holder has the comfort of adequate notice from the first lien holder if there is a payment problem by the borrower. ?
It is advisable to obtain an “inter-creditor agreement” when possible. ?In many cases, the burden will fall on the junior lender to convince all parties of the benefits. ?The junior lender may want to develop a script or provide a copy of this article. ?However, I take no responsibility for the agreement terms, written documentation, or the transaction outcome. ?Consult your attorney or wife.
A prospective borrower usually covers the cost of drawing the agreement by legal counsel as a transaction progresses. ?
When the junior lien is fully satisfied, meaning paid off, a drafted release document of the inter-creditor is completed for the title company to record and removed from public record as an encumbrance. ?Without a termination filing of the inter-creditor agreement, it will remain on the title as an encumbrance. ?
If the borrower has an institutional loan in a senior position, getting the attention of a bank employee or management to allow for an inter-creditor agreement is usually problematic. ?The banker’s first response is usually no; completing the process requires effort and decision-making. Bankers make decisions with strict policies and bank guidelines.?They must follow policies and procedures - defined by their organizations and regulators.?That’s why private money lenders can complete so many loans.
9)??Below are examples of loan transactions when an inter-creditor agreement is advisable.
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a)?A senior lien holder modifies the promissory note for extension and additional capital advances. The principal loan amount increases, and the term is extended. It is well-advised that the senior lienholder requires an inter-creditor agreement and subordination for any junior liens as a condition to complete the modification.
c)?Senior and sub ordinate lenders of construction loans with draw- schedules need an inter-creditor agreement of any subordinate lien for possible default during construction. ?Funds held by a construction control company for disbursement are considered cash collateral or personal property, subject to a UCC-1 filing with the Secretary of State.
d) ?Pari Passau means equal in lien priority. ?Although one lien was recorded in the first position and the other in the second, there are instances where two different lenders desire equal lien priority, Pari Passus. ?The Pari Passus status is drafted into the inter-creditor agreement to state the intention and plan for loan servicing, payoff, and possible default.
e)?Mezzanine financing is a hybrid of debt and equity that is usually customized into different structures. ?Structures can be creative and dramatically different. ?One size does not fit all.?
The defining characteristic of Mezzanine debt is that it is typically not secured by a deed of trust or mortgage.?It will be effectively subordinated to any secured debt. ?An assignment of a partnership interest or corporate stock shares secures the Mezz debt.
Some lenders will require additional security in the form of a personal guarantee from a third party(s). ?Also, some loan agreements give rights to the lender to convert a security interest into an equity interest in the event of default.
If there is no trust deed to secure the loans, the mezzanine debt lender will rely on a filing with the California Secretary of State, Uniform Commercial Code filing (UCC). ?UCC regulations provide a framework to follow if default and foreclosure occur. ?For personal property, a UCC filing provides public notice of the indebtedness.?
Mezzanine loans are considered riskier and demand higher yields, usually between 10% and 25%, and possibly include project profit participation. ?Due to multiple competing lending platforms, inter-creditor agreements are advisable for the cure rights of any Mezzanine lender. ?The inter-creditor agreement will notice the subordination of claims to secured lenders and provide the “right to cure” with the senior secured lenders.?
10) Real examples-when inter-creditor agreements are beneficial to all parties.
a)??The real estate broker approached the seller about the possibility of a seller-carryback second trust deed. The purchaser would obtain an institutional first loan but needed more capital for the down payment. ?In the discussion, the seller questioned the risk of foreclosure by the first trust deed and getting wiped out in his junior position. ?The answer was to provide an inter-creditor agreement that has protection provisions between the first trust deed lender and the seller carry-back second lender.?
b)?Assume that a commercial property has a value of $1 million and has a first trust lien of $400,000, leaving a protective equity cushion of $600,000. ?The trust deed contains an alienation clause prohibiting the owner from placing a junior lien on the property. ?The property owner/borrower approaches the first lien lender/mortgage broker to request recording a junior and subordinated second lien of $250,000 on the property. ?The first-lien lender agreed to allow the junior lien to provide an inter-creditor agreement that would be structured so that if the borrower defaulted, the second-lien lender is notified and steps in to continue making the payments.?
c)??A borrower wants to purchase a strip center for $2,000,000. ?The borrower only has 15% or $300,000 down—the down needs to be increased to obtain a 65% conventional loan. The question is how to come up with the remaining $400,000 necessary to complete the transaction. The maximum loan available is 65% or $1,300,000.
The seller agreed to carry back a second trust deed of $400,000 to facilitate the closing. An inter-creditor agreement was signed.
The borrower defaulted, and the first trust deed holder notified the second to make the payments. The second lender makes payments to the first, begins their junior trust deed foreclosure procedure, and takes back possession when the foreclosure is completed.
11)?Filing a notice of default will occur if a borrower fails to perform their promised obligations:
According to a statutory procedure, most states require junior lien holders to be noticed when the senior lienholder declares and files a notice of default of its lien. ?California law provides for what is referred to as a request for notice of default which may be recorded by interested parties under civil code section 2924b.???Other states may or may not provide a request-for-notice by interested parties.
?If you find value in this article for you and your associates, please forward it to others that may appreciate its contents. ?I am sure that the reader realizes the importance of competent counsel.
Thank You,
Dan Harkey
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? Dan Harkey. ?This material’s unauthorized use or duplication without express and written permission from this author or owner is strictly prohibited. ?The article may be used in marketing efforts, provided full and clear credit is given to Dan Harkey. ?The credit displayed when you forward any report must include Dan Harkey, Business & Finance consultant. ?You are not authorized to modify the article’s title or content.