A secret “side letter agreement” between a buyer of real property and its construction lender causes a court to invalidate a seller subordination agreement, thereby allowing the seller’s contractually subordinated lien to prime the construction lender’s priority lien. In Citizens Business Bank v. Gevorgian, 218 Cal.App.4th 602 (2013), a California state appellate court held that a seller’s subordination agreement in favor of a construction lender was unenforceable, and its subordinated lien on real property was entitled to priority, after the buyer of the property and the construction lender entered into a side letter agreement which materially impaired the seller’s security interest. The seller was never made aware of, nor did it consent to, the side letter agreement between the buyer and the construction lender.
In April 2007, AMG & Associates Retirement Trust (the “Seller”) purchased three lots in the San Fernando Valley for development. In 2006, before it had closed on its purchase of the lots, the Seller entered into a purchase agreement with Haig Engineering and Construction, Inc. (“HEC”) to sell HEC the three lots, which were to be secured by a note and mortgage in favor of the Seller. John Tatoulian was the vice president of HEC and Hank Ghazarian was the owner. In 2007, HEC and Mike Ismail formed Riverton Villas, LLC (the “Buyer”), which ultimately purchased all three lots from the Seller, subject to the seller note and mortgage.
In late 2007, the Buyer obtained a construction loan from Citizens Business Bank (the “Construction Lender”) in order to develop the lots that it had purchased. The loan was initially evidenced by a construction loan agreement dated December 21, 2007 (the “CLA”). Tatoulian told the Seller that the Construction Lender required the Seller to subordinate its note and mortgage to those of the Construction Lender pursuant to a subordination agreement (the “Subordination Agreement”). The Seller asked for the loan documents in order to determine the safety of the subordination. The Seller testified that it wanted to be sure that it was not subordinating to an unacceptable loan that would harm its position in the transaction. Tatoulian provided the CLA along with the note and mortgage to the Seller. The Seller eventually consented to the subordination, which allowed the construction loan to close.
However, the Seller was not told about a separate side letter of understanding (the “Side Letter”) between the Construction Lender, on the one hand, and Ghazarian, Tatoulian and Ismail (the principals of the Buyer), on the other hand, which was dated December 26, 2007. The Side Letter contradicted the CLA in several key areas, and was not referenced in the main CLA. The Seller had no knowledge of its existence, and the Construction Lender acknowledged that it never provided the Side Letter to the Seller.
In February 2009, the Construction Lender informed the Buyer that it was worried about the slow pace of construction and that it would no longer fund any more draw requests. Later, Tatoulian informed the Construction Lender that HEC had filed for bankruptcy and that construction on the lots had stopped. The Construction Lender soon declared the loan in default, and sued the Buyer, Ghazarian, Ismail, Tatoulian and the Seller. The Seller cross-complained against the Construction Lender and the Buyer seeking a declaration of the relative priorities of the Construction Lender’s and the Seller’s mortgages and seeking to enjoin the Construction Lender from foreclosing on the property.
The trial court found that because it was unusual to have a side letter agreement not referenced in a CLA, the Seller had no reason to inquire about its existence. The court also found that the terms in the Sider Letter placed the Seller’s subordinated lien at a greater risk by materially modifying key terms of the underlying CLA. Such modifications included: (a) an immediate disbursement of substantial loan proceeds to allow the Buyer to pay off existing liens on the lots, which the Seller had understood were to be paid off with separate funds invested by the Buyer, (b) requiring the Buyer to undertake construction of the lots in three separate phases rather than simultaneously, (c) the release of subsequent loan proceeds were conditioned upon the sale of units from earlier construction phases, and (d) waiving a requirement that Ismail make certain equity contributions to the Buyer, which were to be applied toward the purchase price of the lots.
The court also credited the Seller’s testimony that had the Seller seen the Side Letter, containing such material modifications to the CLA, it would not have consented to the subordination. Furthermore, because the Side Letter was executed after the CLA, the Construction Lender had an obligation to notify and secure the consent of the Seller because the Side Letter materially affected the Seller’s security interest. Since the Seller was prejudiced through no fault of its own, the trial court abrogated the subordination agreement and held that the Seller’s lien had first priority over the foreclosed property. The Construction Lender appealed.
The appellate court first noted that subordination agreements were commonly used for construction loans when a prior purchase money mortgage exists because construction lenders want their liens to be superior to those of the seller. It cited precedents suggesting that a construction lender may owe duties to the subordinated seller based on public policy grounds when such seller’s rights have been materially affected by subsequent actions of the lender and the borrower. Applying these precedents to the instant case, the court found that the Side Letter materially impaired the Seller’s security without the knowledge or consent of the Seller.
The court considered and rejected several arguments raised by the Construction Lender. The Construction Lender argued that the Side Letter existed before the Subordination Agreement made by the Seller. However, the court stated that what mattered was whether the Seller knew and consented to the Side Letter, which it did not. The Construction Lender also pointed to certain language in the Subordination Agreement suggesting that the Seller had given an implied consent to the Sidr Letter. The court rejected that argument largely because of public policy considerations aimed at protecting sellers from material impairment of their rights, which they do not expressly consent to. Lastly, the court observed that the Construction Lender was not a benign actor in this transaction, and that the balance of equities rested with the Seller. Thus, the appellate court affirmed the judgment of the trial court granting the Seller relief.