Lenders should be careful not to impair their mortgage lien priority when modifying mortgage loans or entering into forbearance agreements.
By Valentino F. DiGiorgio III
With an increase in loan workout activity, commercial mortgages are routinely being modified by lenders. Modifications include changes in interest rates, reset of principal repayments, waivers of defaults, extensions of maturity dates and requiring the pledge of additional collateral. In connection with such modifications, a senior lender must take care to avoid losing its lien priority over a junior mortgage.
Material Prejudice. While states may differ in their approaches to determining whether a modified first mortgage loses its priority, the general doctrine is that a junior mortgagee may be entitled to protection from a senior loan modification to which it has not agreed, where such modification materially prejudices the security of the junior mortgage. Most courts, however, have only reluctantly agreed to a total divestiture of the priority of a modified senior mortgage, stating that this drastic remedy should be employed only when the modification has substantially impaired the junior lienholder’s security interest or effectively destroyed its equity. Where prejudice to an intervening lienholder is found, a court may declare a portion of a senior mortgage to be subordinated, as opposed to subordinating the whole mortgage.
Extension of Additional Funds. One instance where a junior mortgagee could argue that it has been prejudiced occurs where the senior lender extends additional funds to the borrower. Junior lienholders in this type of case have argued that the modification of the senior loan and the extension of additional funds materially prejudices the lien of the subordinate mortgage by impairing the value of its collateral and, therefore, the priorities of the mortgages should be reversed. In some cases, courts have found material loss to the intervening lienholder and have determined to subordinate only the portion of the modified mortgage representing the additional funds.
Extending Repayment. Modifications that merely extend the time period in which to pay off the senior loan should not result in a loss of priority of the senior mortgage. The junior lienholder may argue that the extension of the maturity allowed the value of the real estate to fall below existing mortgage balances. It also might contend that if the senior lender had taken action against the borrower on the unmodified due date, everybody might have been paid. A court should reject such arguments, since they are entirely speculative and because a lender has no duty to take legal action on default or exercise any other remedies under its mortgage.
Frequently, in connection with loan workouts, lenders defer principal repayments and maturity dates. Generally, courts deem a junior lender to assume the risk of a deferral of the date of repayment. In fact, such a deferral can often be to the advantage of a junior lender.
A senior lender’s acceleration of principal repayments or maturity dates, however, could pose a problem for a senior lender. A shorter maturity may make it harder for the borrower to repay, increasing the risk of a subsequent default. Also, a modification that accelerates the maturity date could precipitate a foreclosure at a time when the property value is at rock bottom.
Where a maturity date and/or principal repayments are substantially accelerated (not including a situation where an event of default has been declared by the senior lender), a court might be inclined to declare a portion of the senior mortgage subordinate, assuming it can reasonably determine the amount of prejudice to the junior lender or possibly take the more drastic step of declaring the entire senior mortgage subordinate.
Interest Rate Modifications. Interest rate changes pose another risk for senior lenders. An increase in the interest rate of a senior loan will allow an intervening lienholder to argue prejudice or loss in value of its lien/mortgage, since the borrower, presumably, will have fewer funds available for principal reduction of the senior mortgage. Courts will also be more likely to side with a junior lienholder where a modification increases the likelihood of a second default by a borrower, resulting in an increased possibility that the borrower will then have to cure at the higher rate of interest.
Other Modifications. Consideration should also be given as to whether adding cross-default provisions and releasing collateral and/or guarantors or other modifications might prejudice a junior lienholder’s rights.
Recommendations. Some recommendations for senior lenders when entering into mortgage modifications follow:
- Review Title. Know who the subordinate lenders are and the amounts of their mortgages. If it could be reasonably argued that the modification materially prejudices the junior lienholder, consider requiring an update to the title insurance policy.
- Consent of Junior Lienors. Consider getting the approval of all junior lienholders before modifying the mortgage. If the junior mortgage was subordinated pursuant to the terms of a subordination/intercreditor agreement, review that document carefully to determine under what terms and conditions the senior mortgage may be modified.
- Modification Agreement Provisions. Add a clause to the modification agreement providing that the modification should not be construed as affecting, and is not intended to affect, the lien priority of the mortgage or to impair the security of another lienholder. Also, add language stating that if a court finds an adverse effect on another lien, the offending provision shall be invalid as to that lien.
- Reserve Right to Modify Original Mortgage. Consider adding language into original mortgage forms permitting mortgage modifications. Such language should permit the modification of the loan to accelerate the maturity date and principal payments or increase interest rates, as well as permit other specified changes, without notice to or consent from a junior lienholder. While this type of clause may not defeat the argument of a junior lender, it will allow the senior lender to argue that the junior lienholder had record notice of a possible mortgage modification.
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