An intercreditor is a written agreement between two creditors intended to memorialize in advance how their competing security interests are to be handled when each possess liens (a claim or money charging interest), in a common borrower and secured property. This agreement is used between senior/junior lenders to establish rights and responsibilities between the lenders. In most cases, the actual agreement is referred to as a “subordination and intercreditor agreement.” The agreement typically provides that one lender’s lien is senior to the other regardless of when and which order the liens were recorded.
Why is this beneficial to all parties? The first lien holder gains benefit in knowing that someone other than the borrower is responsible to make payments and keep the property current. The first lien holder can be confident that if there is perceived protective equity that the junior lien holder will suffer the stress related to protecting their junior lien position and equity. The second lien holder will have comfort that adequate notice will be given if there is a problem with the payments. The second lien holder will assume that there is a mutual and reciprocal beneficial agreement to protect both parties, which has been negotiated. It is advisable to obtain an “intercreditor agreement” when possible. In many cases the burden will fall on the lender to convince all parties of the benefits.
California law provides for what is referred to as a request for notice of default which may be recorded by interested parties under civil code section 2924b. Other states may or may not provide for request for notice by interested parties. Most states require junior lien holders to be noticed pursuant to a statutory procedure when the senior lien holder declares and files a notice of default of its lien. A junior lien holder is covered under 2924b and is required to be notified within 30 days after the filing a notice of default. If an actual request for a notice document has been filed, then requester will receive notice within 10 days. An intercreditor agreement expands the provisions and allows the junior lien holder to better protect their interest.
The senior lender may be prohibited from taking any action to enforce the senior debt, including declaring a default, accelerating the debt, making demands for payoff, or taking legal action without notice to the junior lien holder. The junior lien holder may be extended the opportunity to cure the borrower’s default and proceed its own declaration of default.
Responsibility of the junior lien holder in the event of default under the junior lien by the borrower will be to notify the senior lender of the default. The agreement may address which lender may proceed with the notice of default and foreclosure sale. Should the junior lien holder proceed with the notice of default and foreclosure sale, the agreement will typically provide for a reasonable period time to bring the debt service on the senior lien current. The junior lender will be typically required to maintain the payment of the senior lien.
A lien is a claim or money charge recorded at the county or municipal recorder’s office, creating a public record, clouding the title of the security property and provides for constructive notice of indebtedness.
An encumbrance is something that clouds the title, which may or may not be a money charge against the property.
You may want to a review my article about the recording sequence that affects the title and creates a cloud on title, that must be dealt with by all related or participating parties. Please review my article entitled, “Liens and Encumbrances Affecting Real Property Transaction” on www.danharkey.com in the real estate section.
I am not going to address whether this is a consumer purpose loan or a commercial/business purpose loan, because each type of loan comes with different licensing, state and federal oversite standards, and different underwriting standards. I am going to assume that this loan is a commercial/business purpose loan.
When the lender/mortgage broker receives the loan inquiry, they will ask a series of obvious questions that are necessary to process, underwrite, and find a suitable investor to invest their capital. The investor will invest in the trust deed for the purpose of enjoying the cash flow during the life of the loan.
Those questions include:
1. What is the property type, address, geographic location, and description of the collateral?
2. Does the property have a rental income stream, including gross rents, vacancy, expenses to determine the net operating income; this is often referred to as “NOI”. They will want to know what the anticipated value conclusion is represented by the borrower. This is subject to obtaining an appraisal report by a licensed, certified appraiser, who has familiarity with the property type, location, and related appraisal techniques.
3. Describe the first lien collateral, principal balance, interest rate, due date, payment amount, and payment history.
4. Does the first lien have a provision in the trust deed; referred to an “alienation” clause or what some call “due on further encumbrance clause”. In other words, does the borrower have to contact the first trust deed lender and obtain written approval to place a junior lien on the property?
5. Is the current property owner/borrowing entity the sole trustor/borrower on the underlying first trust deed? This is important because in many cases the original borrower may have been parents, siblings, possibly deceased, co-trustees of a family trust, ex-spouses. Many purchases are taken “subject to” a lien that some prior owner obtained sometime in the past. The loan will be in the prior owner’s name.
6. Does the current applicant have the sole authority to borrow and encumber the property with a new lien, or is there some other party that claims to have an interest in the property that may object?
7. Are there multiple borrower parties that the lender must include in the application, processing, underwriting, and closing process? Major frustration will occur when the lender discovers that they have been fooled by the unsuspecting and undisclosed party. I can assure you that the title company will not be fooled by an undisclosed borrower party. When the title insurer underwrites their coverage, they will make sure that the correct parties have signed the documents. That is part of their insurance underwriter and approval process.
Here is an example when an intercreditor agreement is advisable. A property has a value of $1 million and has a first trust lien of $400,000 leaving a protective equity position of $600,000. The borrower approaches a lender/mortgage broker and discusses the possibility of borrowing $250,000 and agrees to encumber the property with a second lien; securing the additional $250,000 by the borrower’s real property. In this case the senior lien of $400,000 and the junior lien of $250,000 Would both benefit by agreeing to reasonably negotiated terms of an intercreditor agreement.
Usually the intercreditor agreement will be a recorded document to provide public notice. The borrower should cover the cost to draw the agreement by legal counsel as part of the transaction. In many cases the junior lien lender has the task of convincing the senior to accept and execute the agreement. Then, when the junior lien is paid off and fully satisfied, a release of the intercreditor agreement needs to be drafted and signed by all parties for the title company to remove an encumbrance, or an exception.
Below are more examples of circumstances when an intercreditor agreement is advisable. If the borrower has an institutional loan that is in a senior position, getting the attention of a bank employee who can make a decision may be problematic. A bankers first response is usually to say “no” because the process requires a bit of effort.
a) Knowledgeable lenders will in most cases require intercreditor agreements for competing security interests.
b) Senior lien holder may modify a note for the extension of the loan term and possible additional advances on the capital. It is well advised that the senior lien holder request a subordination and intercreditor agreement for the junior.
c) For both senior and subordinate construction lenders of loans funded for construction projects, given the complexities of a draw schedule and possible default during the construction period, both lenders will require an intercreditor agreement. Funds held by a construction control company for disbursement is considered cash collateral or personal property, that is subject to a security agreement and UCC-1 filing.
d) Pari Passau, or equal in priority instruments are normally recorded at the recorder’s office in a sequential numerical order. The first recording would be senior to the second recorded number. This is referred to as “priority lien position”. There are instances where there are two different lenders, although one is first and other is second, desiring to be what is referred to as Pari Passus; or equal in priority. This can be done in an intercreditor agreement, which will state the intention and the plan for loan servicing, payoff, and for possible default.
e) Mezzanine financing is a hybrid of debt and equity that comes in multiple different structures. The defining characteristics of Mezzanine debt is that is typically not secured by a deed of trust or mortgage, so it will be effectively subordinated to any secured debt. There are loans secured by an assignment of partnership interest or corporate shares. There are loans that will have additional security in the form of a personal guarantee of a third party. Some loans give rights to the lender to convert security interest into equity interest in the event of default. Many junior loans are unsecured. If the loans are not secured by a deed of trust, the lender will rely on a Uniform Commercial Code filing (UCC-1) with the California Secretary of State as a public notice of indebtedness. The regulation provides a framework to follow in the event of default and foreclosure. Mezzanine loans are considered riskier, and demand a higher yield, usually between 10% and 25% including possible profit made from the project. Due to multiple competing lending platforms, intercreditor agreements are advisable for cure rights of any Mezzanine lender. The intercreditor agreement will notice the subordination of claims to secured lenders and provide “right to cure” with the senior secured lenders.
A suggestion to those contemplating the use of a subordination and intercreditor agreement; contact your attorney for assistance in drafting a document that covers all the relevant issues.
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