Partial subordination rule applied in foreclosure case

Where a bank had first- and third-priority liens on real property and recorded an agreement that subordinated the first-priority lien to the third-priority lien, the liens survived when the second-priority lienholder foreclosed after the property owners defaulted.

The agreement was a partial subordination, which did not elevate the second-priority lienholder’s status.

Background

The Cortezes owned real property encumbered by three lines of credit: $415,000 issued by Wells Fargo and secured by a deed of trust dated Sept. 23, 2005 (Wells Fargo 2005 lien); $220,000 issued by SunTrust and secured by a deed of trust dated Sept. 30, 2005 (SunTrust lien); and $252,000 issued by Wells Fargo and secured by a deed of trust dated Oct. 25, 2006 (Wells Fargo 2016 lien).

On Oct. 26, 2016, Wells Fargo recorded an agreement, under which the 2005 lien would be subordinated to the 2006 lien.

The Cortezes defaulted on the SunTrust lien in 2016. Atlantic Trustee Services auctioned the property to Futuri Real Estate in January 2017 for $468,000. After SunTrust’s lien was satisfied, there was a $201,000 surplus. Futuri and Wells Fargo disputed whether the property remained encumbered by the Wells Fargo liens.

Atlantic Trustee filed an interpleader. Futuri filed a cross-claim against Wells Fargo, seeking a declaration that the 2006 subordination agreement put the 2005 Wells Fargo lien behind the 2006 Wells Fargo lien, and that both liens were junior to SunTrust. Futuri argued that upon foreclosure both Wells Fargo liens were extinguished.

Wells Fargo argued that the agreement was for partial subordination that did not change the 2005 lien’s priority. The agreement instead put the 2006 lien first in line for being paid. Wells Fargo asserted that its 2005 lien survived foreclosure and continued to encumber the property.

After acknowledging that this was an issue of first impression, the circuit court looked to other states that have adopted the complete subordination rule (the minority view) and the partial subordination rule (the majority view).

The court determined that the partial subordination rule was the better choice because it does not create a windfall for lienholders who are not parties to the agreement “by elevating their priority positions as the complete subordination rule does[.]”

The court then ruled that because the agreement was for the sole benefit of the parties to the agreement, the agreement was for partial subordination.

Futuri’s cross-claim and its request for a declaratory judgment were dismissed with prejudice. Futuri appealed.

The rules

“The complete subordination rule relies primarily on the definition of the term ‘subordination,’ which contemplates a reduction, not an elevation in priority. It provides that in the absence of any language in the subordination agreement to the contrary, a lienholder ‘who holds a first lien and subordinates it to a third lien makes his lien inferior or subordinate to both the second and third liens.’ …

“The partial subordination rule begins with the basic rule of contract construction that a contract is to be interpreted to enforce the intent of the parties. A partial subordination exists if the terms of the subordination agreement clearly intend to affect only the priority of the liens held by the parties to the agreement and if it does not affect the priority status of any intervening or other lienholders. …

“The partial subordination rule results in a circuity of liens in which each lien is simultaneously prior and subordinate to the other. … For example, where A is the senior lienholder, B the second lienholder and C the third, and A subordinates its lien to C, limited to the amount of A’s lien, C becomes senior to A but remains junior to B and A remains senior to B but becomes junior to C to the amount subordinated not exceeding the amount of A’s lien.”

Partial is better

“[W]e agree with the circuit court that the partial subordination rule is the better rule. … [T]he complete subordination rule results in raising the priority of intervening lienholders, thereby making them third-party beneficiaries to an agreement in which they are not even mentioned, and giving them a windfall of being placed in first priority position to the subordinating lienholders. …

“[I]n construing a subordination agreement, the complete subordination rule incorporates an inference that the contracting parties intended to affect lienholders who are not a party to the agreement, notwithstanding that such intent is not contained in the language of the agreement.

“In contrast, under the partial subordination rule, the intent of the contracting parties is ascertained strictly from the language on the face of their subordination agreement. Thus, where only the subordinating lienholder and the junior lienholder are referenced in the agreement, it demonstrates an intent to affect the priority positions of those lienholders only.”

Ruling

“In this case, the circuit court found that the Agreement on its face addressed only the priority between the two Wells Fargo liens, was not intended to and did not affect the priority of any other lienholder, and therefore was a partial subordination agreement. …

“Following its determination that the partial subordination rule should be used in construing the Agreement, the circuit court proceeded to apply that rule to the disposition of the foreclosure fund remaining in this case. Futuri has not assigned error to the manner in which the circuit court directed distribution of the remaining fund and therefore that disposition has become the law of the case.

Affirmed.

Futuri Real Estate v. Atlantic Trustee Services. Record No. 181501 (Lacy) Nov. 27, 2019 (Fairfax Cir. Ct.). Jonathan Allen Nelson, Melissa Marie Watson Goode. Mariam Wagih Tadros, Jasimine Grace Chalashtori, Chaunacie Louise Wilkerson, Michael Andrew Glasser, Abigail Sue Reigle for the parties. VLW 019-6-086, 8 pp.