§25.6 - Subordinate Financing

• Jurisdiction: Washington

§25.6 Subordinate Financing

Construction loans generally will not fund more than 80 percent of the project's appraised value upon completion, and for permanent loans, loan-to-value ratios typically are in the range of 60 to 80 percent of the appraised value. When the borrower requires more funds than those advanced by a senior secured lender, it must turn to the subordinate financing market and, subject to the approval of the senior secured lender, obtain junior financing.

Before the emergence of the conduit lending industry, and prior to dramatic rises in interest rates in the 1970s, it was unusual for a senior secured lender's loan documents to restrict the borrower's right to obtain junior financing or otherwise transfer interests in the property. Second mortgages were generally allowed on commercial properties and were the traditional way for borrowers to obtain additional funds. Joseph Philip Forte, Mezzanine Finance: A Legal Background, in Commercial Securitization for Real Estate Lawyers (A.L.I./ABA Course of Study, May 2005), available at SK077 ALI-ABA 419 (Westlaw).

As interest rates began their dramatic rise in the 1970s, senior secured lenders sought to find ways to increase their interest rates whenever the borrower sought to transfer the property or further encumber it. This led to the "due-on-sale" and "due-on-encumbrance" clauses (collectively, "due-on-transfer" clauses), which currently are present in most residential mortgage loan documents and nearly all commercial mortgage loan documents. With the ability to accelerate a below-market loan when the borrower transfers or further encumbers the property, the senior secured lender has an opportunity, in a rising interest rate environment, to either negotiate for a higher rate as a condition of its approval, or obtain full payment of its loan and reinvest its funds.

Initially, the common law rule against "unreasonable restraints on alienation" stood in the way of the enforcement of due-on-transfer clauses. Although different states applied this common-law principle in varying ways, Washington adhered to the prevailing state law principle that due-on-transfer clauses were an unreasonable restraint on alienation unless the lender could prove that enforcement of the clause would be necessary to protect its security. Bellingham First Fed. Sav. & Loan Ass'n v. Garrison, 87 Wn.2d 437, 553 P.2d 1090 (1976). For example, a sale of the property to a party with dubious credit or insufficient expertise to properly manage the property would give the lender a reasonable argument for enforcing a due-on-transfer clause; otherwise, not.

Effective October 15, 1982, the Garn-St. Germain Depository Institutions Act of 1982, Pub. L. No. 97-320, 96 Stat. 1469 (1982), preempted state law restricting enforcement of due-on-transfer clauses. Magney v. Lincoln Mut. Sav. Bank, 34 Wn.App. 45, 56 n.5, 659 P.2d 537, review denied, 99 Wn.2d 1023 (1983). This change in the law made the use of due-on-transfer clauses in commercial real estate loan documents nearly universal. Moreover, after Garn-St. Germain legitimized the senior secured lenders' right to prohibit junior financing without their consent, the senior secured lenders, and particularly the then-emerging conduit lending industry and its rating agencies, became more sensitive to reasons for refusing to consent to subordinate financing altogether.

From the perspective of the senior secured lender, the unfettered rights of a second mortgagee would present many risks, which include the following:

• The senior secured lender may risk losing its priority if its loan is materially modified to the junior lender's prejudice unless the junior consents; thus, a junior lien may constrict a construction lender's flexibility to increase its loan in response to a borrower's request for changes in the project, or a permanent lender's flexibility to increase its interest rate in response to a borrower request for an extension of maturity.
• The presence of additional debt may stress the project's ability to pay all of its obligations in a timely manner, raising the risk of a borrower bankruptcy.
• The presence of additional debt may stress the guarantors' ability to stand behind all of the obligations that they have guarantied.
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