California laws governing lien priority generally follow the “first in time, first in right” rule, which states that whichever lien has been recorded first holds a higher priority than recorded liens that follow. However, there are some exceptions to this rule, and when a lender modifies a loan where there is a junior lien holder, the senior lender needs to be careful to make sure the modification does not affect lien priority.
Lenders frequently need to modify their loans before maturity or even at the time of maturity. The lender may modify the interest rate, term, loan amount, or various other terms depending on the circumstances. If a junior lien is placed on a property, the junior lender agrees to lend taking into account the terms of the senior loan at the time of the junior loan closing. Once a junior lien is placed on the property, the senior lender will need to take that into account when modifying its loan. Case law has held that a modification of the senior loan that is detrimental to the junior lender and that is made without the junior lender’s consent may result in the modified portion of the senior loan or the full amount of the senior loan losing priority to the junior, depending on the facts.
Is the modification detrimental to the junior lender?
Of course, the trick is to determine whether a specific modification would be found detrimental to the junior lender. Advancing additional funds, shortening the term of the loan, or increasing the interest rate are all clearly in the “detrimental” category. If a lender is making these types of modifications, then it will need to get a new subordination agreement from the junior lender to maintain lien priority. However, it should be noted that if a senior lender is advancing additional funds (and there are no other detrimental modifications), only the new funds would typically be of lower priority than the existing second lien. Generally speaking, any modification that makes the senior loan more burdensome to the borrower (and therefore uses more resources which could have been used to repay the junior lien) may be considered detrimental and therefore jeopardize lien priority.
On the other hand, some modifications may not be detrimental to the interests of the junior lender. Courts have generally found that merely extending the maturity date of the senior loan, without any other changes, is not detrimental to the interests of the junior lender. If you have questions about whether your modification may impact lien priority, you should consult with an attorney before making the modification.
A prudent lender should always make sure that their modification will not affect lien priority, or if they need to make such a modification, that they take the appropriate steps to address the potential problem. Specifically, if a senior lender needs to make an additional advance, they will need to obtain a subordination from the junior lender in order to maintain full lien priority.
Prior to the effectiveness of the modification, diligence on the part of senior lenders contemplating modifications includes obtaining the consent of the junior lender, consent of (or reaffirmations from) any guarantors (even if the Guaranty states that it is not affected by modifications) and obtaining appropriate modification endorsements to the lender’s title insurance policy.