Bulletin: ID000003

Dear Associates:

When a developer or builder acquires land to be used to construct homes, it is very common for the prior owner, or in a sale from the developer to the builder, to agree to defer payment of a portion of the purchase price for the lot or parcel. The most common means of documenting the obligation is by means of a note and deed of trust/mortgage. This practice is sometimes commonly referred to as 'subordinating the lot price' or other similar terms. It is also common to see recitals on the face of the deed of trust or mortgage making reference to either

• a present subordination of the deed of trust/mortgage
• a future subordination of the deed of trust/mortgage

It has become apparent that some policy issuing agents are using such language as a justification for insuring a construction loan to be a superior lien to the lien of the loan in favor of the prior owner/developer.

It is a highly dubious practice to rely upon these provisions solely to insure that the construction loan is prior to such other loan. Another practice that falls within the same category would be the practice of holding the deed of trust/mortgage in favor of the prior owner/developer for later recording.

Preferential Rights of a Vendor of Land

In some states statutory authority exists to specifically protect the vendor or seller as to the payment of their sales price. In other states, similar rights generally exist based upon common law. There have been a number of court decisions in various states, as well as in the Bankruptcy Courts thereafter with resulting federal appellate court decisions, where priority was ignored based upon the recording time or instrument number of the documents presented for recording.

One court in particular referred to a 'natural priority' that exists in favor of:

• vendor/seller of land for his purchase price
• a third party purchase money lender
• other loans secured by land
• in the order shown.

In that decision, the court threw out the fact that the third party lender's deed of trust was recorded prior to the deed of trust in favor of the seller. This decision was based upon the rationale that all of the documents were part of the same transaction. When recording, one of those documents had to be presented first for recording. Therefore, the mere fact that the person doing the recording happened to present the third party deed of trust first, that fact alone the court held should not be the basis for the determination of priority. The court then looked at other factors to determine the priority that should be found in the transaction.

Automatic Subordination Provisions of a Deed of Trust/Mortgage

Historically, courts have looked very carefully at the provisions of a subordination agreement to determine the true intent of the parties. It is then common when a default occurs in the third party construction loan, the former owner/developer who has not been paid the balance of their purchase price raises objections to claimed priority of the construction loan.

Even where a specific subordination agreement exists, the former owner/developer commonly may make a challenge based upon the fact that portions of the loan proceeds were not used in the construction of the improvements on the land. Some of the more common disputed uses of the funds are the use of a portion of the funds to finance the purchase of the lot or parcel, use of funds to finance off-site improvements, use of the land as additional security for construction projects on other land, etc.

Provisions on the face of deeds of trust/mortgages that 'this loan will be subordinate to a construction loan&' must be considered suspect. In the first instance, the language on its face may be nothing more than an 'agreement to agree' at some later time and place. The logical construction may be that a later document will in fact evidence the real intent of the parties and thereupon give effect to the subordination of the obligation of the seller of the land/developer. You must also consider that the language may not have been agreed to by the beneficiary in the deed of trust/mortgagee in the mortgage.

This type of general language in the deed of trust/mortgage is usually not sufficient to effectuate a subordination on its face owing to the fact that it is not sufficiently definite as to its terms.

A policy issuing agent should not rely upon recitals that the deed of trust/mortgage is subordinate to a construction loan. You would have no way of knowing that the deed of trust/mortgage being offered is in fact the loan that the prior owner/developer intended to subordinate their obligation to. Some policy issuing agents have offered sellers escrow instructions or letters from counsel for the seller and similar evidence to show the intent to be subordinate to the offered deed of trust/mortgage. All of this evidence is certainly helpful in the event of a claim, but nothing works as well as a specific subordination agreement.

Taking Exception to the Terms and Conditions of the Subordination

Most subordination agreements are predicated upon a specific condition. These conditions as to construction loans usually are that the money will only be used in construction, will only be used on the land offered as security, will have specific notice provisions in the event of default, and similar provisions. The policy issuing agent should always take exception in Schedule B - Part I of the terms and conditions of the subordination agreement. We, of course, have no way of knowing that the disposition of the loan proceeds was strictly in accordance with the intent of the parties.

Further, in most cases, the construction lender knows the intent of the parties and joined in the subordination. The policies provided take as an exclusion from coverage for defects, liens and encumbrances suffered to or agreed to by the insured.

Holding Documents for Later Recording

Whether acting under specific escrow instructions or based upon the generally accepted concepts for closing transactions, documents should not be generally held for later recording. Even if the parties to the closing seemingly want the documents recorded later, the closing agent may still encounter difficulties later arising from claimed lack of understanding of the effect of not immediately recording their deed of trust/mortgage. Prior to insuring a transaction where a policy issuing agent is directed to record a deed of trust/mortgage running in favor of a seller/developer at a time later than the other documents to a transaction, the policy issuing agent should consult with a Regional Underwriter or National Legal Department.

If you have any questions about the subject matter presented, please call.