Daily Development for
Wednesday, February 24, 1999

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

Thanks to Jack Murphy for suggesting this case.

The case is very complex, so the DD is a little longer than usual, but any "old hand" real estate professional will recognize the issues here and, I believe, find the case and its resolution interesting.

 ESCROW; ESCROW AGENT'S DUTY TO DISCLOSE: An escrow agent is agent for all parties to an escrow for purposes or imputed knowledge with regard to information received by the agent pursuant to its carrying out the duties of that escrow (but not otherwise); it has a duty to disclose such information; and the principles all are treated as if they had such information.

Triple A Management Co., Inc. v. Frisone, 81 Cal Rptr. 3d 669 (Cal.App. 1999).

This case is discussed under the heading "Mortgages; Assignments forSecurity; Subordination."

MORTGAGES; ASSIGNMENTS FOR SECURITY;SUBORDINATION: A collateral assignee of a mortgage note has no power to subordinate the note to another secured party, but is not liable for the warranty of title contained in such subordination if it attempts to do so.

Triple A Management Co., Inc. v. Frisone, 81 Cal Rptr. 3d 669 (Cal.App. 1999)

Farms acquired a 140 acre tract from Western, giving a purchase money mortgage of $540,000.  Four years later, some of the property apparently became valuable for development purposes, and Farms agreed to sell 20 acres of the property to Greenwood, for cash and a new purchase money mortgage in the amount of $425,000.  The terms of the Greenwood sale included Farms agreement to subordinate its purchase money mortgage to a "development loan" not to exceed $1.6 million.  Western agreed to release the 20 acres from its mortgage on the larger tract if Farms assigned this new purchase money note and mortgage to Western.  (All the mortgages in involved are deed of trust mortgages).

The parties opened an escrow with Stewart, and Stewart was instructed to draft the necessary assignment to Western.

 While this escrow was pending, Greenwood "flipped" the property to Sullivan.  The purchase price was almost double what Greenwood was paying for the property.  Sullivan agreed to assume the mortgage note to Farms, gave a note secured by a third deed of trust, and in addition agreed to pay $350,000 cash.  Greenwood planned to obtain the case by borrowing a new loan from Frisones and giving them a senior deed of trust on the property.

 The parties to Greenwood/Sullivan transfer opened a second and independent escrow with Stewart Title.  The instructions in this escrow stated (and the language is important) that title would vest in Sullivan subject to "Deed of Trust to be of record at close of escrow in favor of [Farms] and collaterally assigned to [Western] securing a note in the amount of $425,000 [which] shall be subordinated to the loan in favor of [Frisones]."   Frisones instructed Stewart to release their funds only when the circumstances were clear that Frisones' lien would be a first lien on the property that Stewart would insure as a title insurer.

The same closing agent was assigned to both escrows.

 In carrying out the first escrow, Greenwood executed its note and deed of trust and Farms then executed a document entitled "CollateralAssignment" on a form provided by Stewart.  Aside from the title, the form was worded as an absolute assignment.  Apparently after these instruments were deposited in escrow, but prior to closing, Greenwood revealed that it desired that Farms subordinate its interest in theGreenwood/Farms mortgage to a proposed mortgage to Frisones (the one that was funding the second sale from Greenwood to Sullivan).  Farms adamantly refused, giving as its reason that it did not want to go back into negotiations with Western concerning the release of the property and assignment of the Greenwood/Farms mortgage.

Although Farms refused to subordinate, Greenwood arranged for Stewart to draft a subordination agreement for Western to sign.  That subordination agreement stated on its face that some of the proceeds of the loan to which Western would subordinate would not be invested in the property (contrary to the condition of the original deal  which requred that this be a "development loan.")  A Greenwood principal (since disappeared) assured Western, and also Stewart,  that Farms had agreed to the subordination.  Further, Western's officer testified that the Stewart escrow agent had told him that this subordination was what was required by the original deal.  This officer read the documents only cursorily and did not notice that the subordination agreement was not consistent with the terms of the Farms/Greenwood deal, but he testified that he believed that Farms was also executing a separate subordination and would be very cautious in examining the documents.  (Remember that Western was well secured by the other 120 acres in addition to this assignment.)

 The transaction closed, Frisones got their title insurance, and Sullivan even made one payment on the Greenwood/Farms/Western loan (which it had assumed)  before the whole house of cards collapsed.  Note that, as this was a California purchase money mortgage, no deficiency was possible, and Sullivan's assumption didn't mean much.  Everything depended on the land security.

 Western, as collateral assignee of the Greenwood note,  sent notice of default and substituted trustees on the Greenwood  deed of trust mortgage, but before it got too far into foreclosure, Farms paid off the original note for which the Greenwood note had been assigned as collateral and Western reassigned the note and mortgage and stepped aside.

Farms then filed an action for a declaration that its mortgage was superior to Frisones' mortgage, notwithstanding the subordination agreement executed by Western while Western was a collateral assignee.

 The trial court ruled in favor of Farms.  It held that Frisones knew nothing of the subordination agreement, and did not rely upon it.  Its agent, Stewart, did rely on the subordination agreement, the court stated,  but Stewart was unreasonable in doing so in light of what it knew about the interest of Farms.  Implicitly, the court was concluding that Farms was not bound Western's unilateral subordination and that Stewart should have understood that.

 The trial court also awarded Farms damages based upon Stewart's negligence in the preparation of the original collateral assignment and subordination agreement.  Farms got its attorney's fees in litigating this matter  as damages.

On appeal: held: Affirmed.  Frisones is subordinate.  Stewart was negligent..

Stewart and Frisones argued that Frisones was a bona fide encumbrancer without knowledge of the fact that the subordination agreement, executed by the record and actual assignee of the Greenwood note, might be defective in that it did not bind Farms.

The court pointed out,  however, that a subsequent encumbrancer "is not entitled to view the record through  rose colored glasses' or with blinders on . . . [Further, a] lender is not entitled to ignore warning signs that come to him from outside the recorded chain of title, to the extent such information . . . reasonably brings into question the state of title reflected in the recorded chain of title."

Of course, Frisones itself knew virtually nothing.  But the court ruled that Stewart, acting as escrow agent in the second escrow, had constructive knowledge of the certain information that should have put it on notice thatFarms' consent was necessary in order for Frisones to enjoy the benefits of the subordination agreement.  The court acknowledges that information contained in the first escrow could not be imputed to Frisones, even if theStewart agent had actual knowledge of it, because Stewart did not obtain that information in the scope of its agency.  In this particular, the appeals court departed from the conclusion of the trial court.  Even though the escrow were running simultaneously, and conducted by the same officer, there can be no imputation of knowledge where there is no formal agency.

But the appeals court concluded that there was adequate information in the documentation of the second escrow, where Stewart clearly was acting as an agent for Frisones, that should have triggered an inquiry as to whether Farms ought to execute a subordination.  As indicated above, the escrow instructions in the second escrow referred to the deed of trust as one that Farms would "collaterally assigned to Western securing a note."  Further the title of the document that embodied the assignment to Western stated at the top that it was a "collateral assignment,"

The court notes that the UCC states that a party holding collateral must use reasonable care in the custody and preservation of collateral in his possession.  In the case of instruments (such as notes), the secured party has a duty to take reasonable care to preserve "rights against prior parties."  The court seems to view both aspects of this duty as applicable here, although in fact the issue in questions concerns the collateral assignor's rights as against a subordinate party.  Despite this misreading of the UCC, it does make sense that a collateral  secured party would not have the right to subordinate a the rights in the collateral without the debtor's consent, and indeed the court cites California authority to that effect.  The court concludes that nothing in the UCC changes the common law on this point, at least prior to default by the debtor (as was the case here).

The security agreement that Farms executed provided that Western "had no duty to take any action to preserve any rights of or against any prior or other parties in connection with the Collateral."  The court reads thislanguage as a statement that Western had no duty to take an affirmativeaction to protect the security position, but not as a blanket permssion forWestern to elect to take action that would frustrate the security position.

Finally, as one final nail in the coffin, the court in a footnote held that Frisones had no right against Western under the warranty of title contained in the subordination agreement that Western executed.  The court held that the warranty was ineffective when the party receiving the warranty had reason to know that the warrantor was not claiming title in himself.

Comment 1: There are a number of important points made in this case.Some of them are supported by some authority, but other points have little or no authority.  The editor is uncertain as to whether there is law contrary to the conclusions reached by the court here, but certainly the holdings are significant in any event because the issues are quite starkly drawn.

Comment 2: The notion that any information an escrow agent obtains in the course of an escrow is imputed to the principle is one that may catch many by surprise.  The court admits that the escrow is in fact an agent for both parties.  Nevertheless, the escrow has a duty to divulge any information it receives.  More than that, it must anticipate that representations made to it that appear to be inconsistent with certain details in the documents may be false and need to be further examined.  Note here that one of the parties told the escrow that Farms had agreed to the subordination.  If indeed Farms  had so agreed, then there would be an estoppel and Frisones would be in the clear.

The court's view was that it was the agent's responsbility to inquire further  to disbelieve its own principle  and check with another of its principles, even though there was nothing in the documents that would be inconsistent with Farms consenting to the subordination.  It is unclear whether the reason for this further inquiry is the agent's knowledge that Farms originally opposed subordination or simply the bare statement inthe documents that the assignment of the Sullivan note  was for collateral only.

Comment 3: Although the court minimizes the signficance of the language stating that Western, as assignee, had no duty to take steps to protect the collateral, isn't this language susceptible of the interpretation that Western did have the power to agree to a subordination?  The court states at one point  that the UCC duty to protect collateral is absolute, and cannot be modified by contract, but at other points appears to assume that a contractual power to modify would be honored.   If a contractual duty to modify was possible, would the escrow agent be reasonable in assuming that this language embodied that power?  If so, doesn't that change everything?

Comment 4: What about the warranty holding?  Shouldn't the warranty have been viewed here as an assurance by Western that it was acting with the authority of Farms in agreeing to the subordination?  Even if this representation was incorrect, and not binding upon Farms, shouldn't Western be liable for making it?

Comment 5: Some in other states may be surprised that an escrow company would be engaged in drafting substantive conveyancing documents in a complex commercial real estate deal.  The editor is sorry to report that such activity is common place in California, where many parties to commercial transaction try to avoid lawyer's fees by using the escrow as their drafter.   Sometimes the escrow instructions amount to the only written statement of the parties' understanding.  Escrow companies have been only too willing to oblige in these situations. This case may be a "wake up call" to some of those companies, or at least to their O&E insurers.

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