Rock, Paper, Scissors: Virginia Supreme Court Adopts Partial Subordination Rule to Interpret Subordination Agreements

Everyone is familiar with the “Rock, Paper, Scissors” method of resolving disputes where scissors cut paper, paper covers rock, and rock breaks scissors.  In Futuri Real Estate, Inc. v. Atlantic Trustee Services, the Virginia Supreme Court had to decide whether a Subordination Agreement in which the first lienholder agreed to subordinate its lien to the lien of the third lienholder resulted in the holder of the second lien moving into first position.  In deciding that the answer was no, the Virginia Supreme Court adopted the “partial subordination rule,” which it characterized as the majority rule.

Wells Fargo Bank held a 2005 deed of trust on property owned by Milton and Armida Cortez.  SunTrust Bank held a second priority deed of trust on the property, recorded one week after Wells Fargo’s first priority deed of trust.

In 2006, Mr. and Mrs. Cortez obtained an additional loan from Wells Fargo.  In connection with that loan, Wells Fargo executed a Subordination Agreement in which it agreed to subordinate its 2005 deed of trust to its new 2006 deed of trust. 

Following default by the borrowers under the SunTrust loan, the holder of the debt foreclosed SunTrust’s 2005 deed of trust.  The foreclosure trustee distributed the proceeds of sale first to pay off the SunTrust loan and proposed to distribute the remaining proceeds to Wells Fargo.  Litigation then ensued in which: (a) Wells Fargo asserted that its 2005 deed of trust remained a lien on the property that it could foreclose because foreclosure of a subordinate lien does not extinguish a senior lien; and (b) SunTrust’s assignee asserted that when Wells Fargo subordinated its otherwise senior lien to its own third priority lien, the end result was that SunTrust’s deed of trust moved into first priority position so that the foreclosure of the SunTrust deed of trust extinguished both Wells Fargo deeds of trust.  The Fairfax County Circuit Court sided with Wells Fargo.  SunTrust’s assignee appealed to the Virginia Supreme Court.

The Supreme Court noted that the issue was an issue of first impression in Virginia.  It recognized that there is a split of authority between states that follow the “complete subordination rule,” which it characterized as the “minority rule,” and the majority “partial subordination rule.” 

The courts that follow the complete subordination rule rely on a definition of “subordination” “which contemplates a reduction, not an elevation in priority.”  In the absence of express language in the subordination agreement to the contrary, a lienholder who agrees to subordinate a “first” lien to a “third lien” moves down in priority subordinate to the third lien and anything senior in priority to the third lien.

The partial subordination rule “begins with the basic rule of contract construction that a contract is to be interpreted to enforce the intent of the parties.”  A partial subordination “exists if the terms of the subordination agreement clearly intend to affect only the priority of the liens held by the parties to the agreement and if it does not affect the priority status of any intervening or other lienholders.” 

The Virginia Supreme Court concluded that the partial subordination rule is the better rule.  The Court acknowledged that the partial subordination rule “results in a circuity of liens in which each lien is simultaneously prior and subordinate to the other” while the complete subordination rule is “simpler and more straightforward.”  However, the Court said that the complete subordination rule “results in raising the priority of intervening lienholders, thereby making them third-party beneficiaries to an agreement in which they are not even mentioned, giving them a windfall…”  The intervening lienholder is not prejudiced by application of the partial subordination rule “because the intervening lienholder was always subject to the amount of the senior lien.  As Wells Fargo’s subordination agreement mentioned only its own liens, the Virginia Supreme Court determined that Wells Fargo’s 2005 deed of trust retained its priority over the SunTrust deed of trust even though Wells Fargo had agreed to subordinate the 2005 deed of trust to its own 2006 deed of trust.

While Wells Fargo did not inadvertently move itself to the back of the line, Futuri Real Estate, Inc. is nevertheless a cautionary tale for lenders.  While the complete subordination rule may be the minority rule, the Virginia Supreme Court identified several states that follow it.  As banks expand their footprints and lending activity increasingly crosses state lines, assumptions as to what the law is based on prior experience may prove to be wrong to the lender’s detriment.