Daily Development for
Friday, October 10, 1997
by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
MORTGAGES; SUBORDINATION; PURCHASE MONEY CONTRACTS: Purchase contract unenforceable when seller's agreement to accept part of purchase price in form of note secured by subordinated purchase money mortgage is not set forth with terms that sufficiently "define and minimize" the subordinated purchase money lender's risk.
Linderkamp v. Hoffman, 562 N.W. 2d 734 (N.D. 1997)
Seller and Buyer contracted for the sale of an apartment building for a price of $87,500. The proposed contract contained the following language relating to financing:
"Buyer to obtain loan in the amount of $63,500 from lending institution of their choice. Seller to carry $24,000 at 8.69% interest amortized over 30 years to balloon in 5 years. Seller may pay off Contract early without penalty."
This apparently was the entire statement of the agreement on the issue. No further language is supplied by the court.
Buyer later contended that the parties understood this language to state that the seller would be secured by a mortgage with respect to its interest, but that this mortgage would be subordinate to the institutional mortgage loan. (Note that there is not only no mention of subordination in the provisions quoted - there is not even mention of a mortgage.) Buyer arranged the outside loan. Seller did not show up at the closing, and Buyer sued for specific performance.
The trial court concluded that Seller had "unjustifiably refused to convey the property" and ordered specific performance.
On appeal to the North Dakota Supreme Court, held: Reversed.
The appeals court relied upon a line of cases described in an annotation at 26 A.L.R.3d 855 (1970) to the effect that a court will not order specific enforcement of a sale contract that contains a subordination agreement that is too open ended. Most of the cases are California cases, with a few supporting cases in other jurisdictions. There are a number of out-of-California cases that refuse to follow the California authority as well.
The seminal case in California is Justice Traynor's opinion in Handy v. Gordon, 65 Cal.2d 578, 55 Cal.Rptr. 769, 770-71, 422 P.2d 329, 330-31 (1967), which held:
"[A]n enforceable subordination clause must contain terms that will define and minimize the risk that the subordinating liens will impair or destroy the seller's security. ... Without some such terms ... the seller is forced to rely entirely on the buyer's good faith and ability as a developer to insure that he will not lose both his land and the purchase price.... The personal liability alone of the vendee would not constitute sufficient protection to the vendor to permit specific performance."
Handy, in fact, suggests that the court must be satisfied overall that the contract is fair, which of course means that no buyer, short of a lawsuit, can ever be confident that it has an enforceable subordination agreement. Subsequent courts have moderated this position somewhat. The A.L.R. reporter states that courts rejecting the claim of indefiniteness and upholding the contract "have tended ... to be satisfied with contract terms which have fixed at least the maximum limits of the obligation to which the seller's interest was to be subordinated and the most important terms as to interest and terms of the loan, or at least made some provision for fixing such loan terms other than by future agreement of the buyer and seller." Anno., 26 A.L.R.3d at 868.
But many California cases reject the notion that the buyer can define the terms of acceptable financing. They require explicit limits on the terms of the priming loan in addition to the gross amount of that loan.
Comment 1: In the instant case, of course, the provisions of the agreement were nowhere close to an explicit agreement to subordinate, much less an agreement to the terms of subordination. In fact the financing terms in the agreement didn't even indicate an expectation that either the seller's loan or the bank's loan would be secured by mortgages. But the seller's loan, at least in many jurisdictions, would have enjoyed the protection of a vendor's lien if there had been no agreement for a mortgage. Further, absent specific language in the contract, the seller's lien would have been prior to the bank's mortgage under the purchase money priority doctrine. (Most courts find that the seller gets ahead of an outside purchase money lender under the doctrine.) Consequently, this case is not really a very good one for the court to embrace and apply Handy v. Gordon. By the terms of the contract, the seller already was getting a good deal, and it appears that the buyer was trying to get specific enforcement of unwritten understandings that were not in the written agreement at all.
Comment 2: In any event, is the California theory correct? Neither California nor other courts have gone out of their way to protect other parties who agree to be subjected to risks associated with prior mortgage liens. For instance, tenants routinely subordinate their rights in open ended clauses to any and all mortgages that might be placed upon the property. There is no "defining or limiting risk" in such deals, but the courts enforce them anyway. Why the special protection for sellers in these deals? Note that this was a straight commercial transaction - no widows or orphans here.
In many of the precedent cases, including Handy, the subordination is to be to a construction loan that will far exceed the value of the property. The subordination will not occur until some time after the inital closing. The parties anticipate that the buyer will close on the property and then go to get funds to carry out some improvements. If the subordination provision in such cases doesn't at least require that the proceeds of the prime loan be used to improve the property, then the buyer clearly is trading on equity produced by the seller's loan. Consequently, there is some merit to requiring at least a provision for investment of the prime loan proceeds in improvements to the property such cases. But the California cases, and this case, go beyond such requirements, and instead require further clarity about loan terms.
An agreement to subordinate to a loan with no stated maximum principal amount obviously has a certain level of ambiguity and might be said to be suspect (although such subordinations occur all the time in leases). But to go beyond this simple requirement and to require specificity as to other terms of the mortgage is to indulge in the presumption that the parties know far more than they are likely to know about what terms will and will not create undue risk for the seller. It not only is unlikely that the seller will know at the time of contracting what terms fit this description, it even is unlikely that the buyer will know. To force the parties to stipulate such terms at the time they agree to subordination is not to provide for greater clarity, but rather to give the seller a "second chance" at the negotiation, because it is quite likely the buyer will have to return to the seller to ask for modification of the stipulated terms once it has negotiated with a lender.
In the instant case, where the buyer intends to use the outside loan to help finance the initial purchase, it can be said that the parties are more likely to know soon what the terms of the outside loan will be. But why is it vital to enforceability that the parties stipulate these loan terms at the time of contracting? In a commercial setting, the parties ought to be free to make a deal that does not set specific loan terms for the priming loan, at least beyond the maximum loan amount.
Comment 3: California, and the handful of the other jurisdictions that have taken seriously this limitation on subordination provisions in sale agreements, seem to be caught up with "judicial stereotyping" of these transactions. They have a view of a sharpy buyer who is able to take advantage of an unsophisticated seller by throwing up high numbers for the purchase price but providing for subordinated purchase money financing. Then they envision a buyer's motive to strip the equity in the form of mortgage loan proceeds and then to default on all loans, leaving the seller a "sold out junior." (Such sellers, on the basis of this reasoning, are not subjected to California purchase money anti-deficiency limitations, but still have to find "Sharpy" and Sharpy's assets in order to be made whole.
The editor questions the prevalence of this situation. At least, the editor does not understand why the stereotype is any more true of purchase money contracts than of a myriad of other deals. There are crooks everywhere. That's no reason to restrict parties to a commercial real estate transaction from making deals.
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