The following is a case update written by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.), a member of the ad hoc group and the Insolvency Law Committee of the Business Law Section., analyzing a recent decision of interest:
The Supreme Court of Virginia, in a case of first impression, joined the majority of states in ruling that the contractual subordination of a first priority lien to a third priority lien was a partial subordination and did not elevate the second priority lien to first position. Futuri Real Estate, Inc. v. Atlantic Trustee Services, LLC, 835 S.E. 2d 75 (Va. Nov. 27, 2019).
Milton and Armida Cortez owned real property encumbered by three separate lines of credit: (1) Wells Fargo Bank, N.A. in the amount of $415,000, recorded on September 23, 2005 (2005 Wells Fargo lien); (2) SunTrust Bank in the amount of $220,000, recorded on September 30, 2005 (SunTrust lien); and (3) Wells Fargo in the amount of $252,007, recorded on October 25, 2006 (2006 Wells Fargo lien). On October 26, 2006, a Subordination Agreement was recorded which subordinated the 2005 Wells Fargo lien to the 2006 Wells Fargo lien.
In 2016 the Cortezes defaulted on the SunTrust lien and SunTrust completed a foreclosure in January 2017. Futuri Real Estate bought the property at a public auction conducted by Atlantic Trustee Services for $468,000. From that sum, Atlantic paid about $44,000 in real property taxes and foreclosure costs and $224,579 to SunTrust Bank in full satisfaction of its lien. When advised of a dispute between Futuri and Wells Fargo, Atlantic interpled the balance of the funds to the Clerk of Court. Futuri filed a cross-claim against Wells Fargo for a declaratory judgment that the Subordination Agreement ousted the 2005 Wells Fargo lien from first priority and moved the SunTrust lien into the first position. That would cause the SunTrust foreclosure to wipe out both Wells Fargo liens such that the balance of the purchase price belonged to Futuri.
Ruling on Wells Fargo’s motion to dismiss the cross-claim and finding no issues of fact in dispute, the circuit court was tasked with determining whether the Subordination Agreement was a complete or partial subordination. A complete subordination, adopted by a minority of states, would cause the 2005 Wells Fargo lien to be subordinated to both the second and the third priority liens, whereas a partial subordination, embraced by a majority of states, would have no effect on the second priority position of the SunTrust lien. Concluding that the plain language of the Subordination Agreement demonstrated that Wells Fargo intended to only impact the two liens referenced, the circuit court ruled it was a partial subordination and granted the motion to dismiss.
After denying a motion for reconsideration, the circuit court entered judgment for Wells Fargo, which Futuri timely appealed. The Supreme Court of Virginia affirmed the partial subordination ruling.
The crux of the tussle between partial and complete subordination was whether the second priority lien was entitled to be a third-party beneficiary of the Subordination Agreement. The Virginia Supreme Court determined that according SunTrust and its successors (i.e. Futuri) third-party beneficiary status, which would give them a windfall by being elevated to the first priority position, was inconsistent with Virginia jurisprudence, which requires a contract to state clearly its intent to affect a third-party beneficiary. Here, there was no intent to elevate the second lien.
The court used simple examples to explain the difference between partial and complete subordination. Complete subordination relies primarily on the definition of the term “subordination” which contemplates a reduction, not an elevation in priority. Under complete subordination, where A is the senior lienholder, B the second lienholder, and C the third, and A subordinates its lien to C, B moves into first position. Partial subordination, on the other hand, results in a circuity of liens where each is both prior and subordinate to the other. For the same A, B, and C lienholders, A subordinates its lien to C, limited to the amount of A’s lien. C then 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.
The distribution scheme for funds from a foreclosure sale is as follows: (a) set aside from the fund the amount of A’s claim; (b) out of the set aside funds, pay C the amount of its claim and if any balance remains, pay A up to the value of its lien; (c) pay B the amount of the fund remaining after A’s claim has been set aside up to its lien’s value; and (d) distribute any remaining balance to C, then A. This scheme does not penalize B, for it is junior only to the amount of A’s claim, but also preserves the shared priority of A and C over the second lien by not treating B as a third-party beneficiary. The intent of the parties is carried out. Using this scheme, the Virginia Supreme Court affirmed the judgment for Wells Fargo.
This result seems so “right” that it is almost hard to believe there are states which have adopted the minority position favoring complete subordination. The argument for complete subordination is that it is a simpler and more straightforward interpretation of recorded instruments, thereby enhancing the reliability of such instruments. However, the tradeoff for the arguably more-difficult-to-apply partial subordination – but not really so difficult as the A, B, and C scenarios above demonstrate – is it carries out the intent of the contracting parties and leaves the non-contracting party in exactly the priority position it bargained for when it accepted its junior position.
If lienholders are thinking of subordination where there is an intervening lien, practitioners should become aware of their state’s stance, if it has adopted one, on partial versus complete subordination. From the discussion in Futuri, it is possible even clear and specific drafting might not be sufficient to overcome precedent if the state has adopted complete subordination. If a state has so adopted, parties should try some other tool to accomplish their subordination wish unless they are prepared to undertake a big risk.
My independent research shows that Alabama, Georgia, and Idaho have reported cases adopting complete subordination; Utah, Arizona, California, Texas, Nevada and Colorado have reported cases adopting partial subordination.
These materials were written by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.), a member of the ad hoc group and the Insolvency Law Committee of the Business Law Section. Editorial contributions were provided by Corey R. Weber, a partner at Brutzkus Gubner Rozansky Seror Weber LLP, a member of the ad hoc group and the Chair of the Business Law Section. Thomas Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomas Reuters.