Rockhill v. United States

Rodowsky, J., delivered the opinion of the Court. This matter comes to us from the United States District Court for the District of Maryland under the Maryland Uniform Certification of Questions of Law Act. 1 It arises on a motion to dismiss a complaint. In essence we are asked whether, under Maryland law, a mortgage lender whose loan is for construction or repair purposes and who obtains lien priority by subordination, thereby owes a duty to the subordinating lienor to exercise care that the borrower applies the loan proceeds to the intended purposes of the loan. On the facts alleged, our answer is "no.” ²³⁹ Eunice L. Rockhill and The Flag Harbor Corporation (Sellers), who have been designated as appellants, in November 1975 respectively conveyed two adjoining pieces of property in Calvert County to Neal E. Beachem and Mary E. Beachem (Borrowers).

Sellers took back deeds of trust to secure payment of the unpaid balances of the purchase prices. The properties conveyed by Sellers included some frontage on the Chesapeake Bay and contained a small marina. In January 1977 the marina suffered extensive damage from ice and the area was subsequently declared a disaster area. Borrowers applied for and were granted a disaster loan from appellee, Small Business Administration (SBA).

Sellers subordinated their purchase money deeds of trust to the lien securing the SBA loan by agreements with Borrowers dated November 4, 1977. On November 14, 1977 Borrowers executed deeds of trust upon the properties in favor of SBA to secure repayment of the disaster loan. Appropriate recording was effected. Thereafter Borrowers defaulted on the SBA loan.

A petition to foreclose was filed on April 11, 1979. Sellers intervened as defendants in the foreclosure proceedings and counterclaimed for a declaration that their purchase money deeds of trust were entitled to first lien status. When SBA moved to dismiss Sellers’ counterclaim for failure to state a claim upon which relief could be granted, Sellers requested certification of that issue to this Court. In an opinion dated November 2, 1979 the United States District Court reviewed the allegations, determined that Maryland law governs 2 and concluded that certification should be granted.

The certified question is: Whether the allegations contained in the counterclaim of [Sellers], as reprinted in the statement of facts set out in the Court’s opinion dated November 2, 1979 state a cause of action under Maryland law which, if proven, would entitle ²⁴⁰ them to have the subordination agreement dated November 4,1977, set aside and the priority of their liens restored? The allegations set out in the opinion are that in August 1977 Borrowers approached Sellers, indicated that they were in the process of applying for an SBA disaster loan and stated that one of the loan requirements was that Sellers subordinate their liens on the properties to the deeds of trust to be executed for the benefit of SBA. Sellers executed the requested subordination agreements with Borrowers in reliance on the fact that Borrowers would use the loan funds to improve the properties and thereby increase their value. The terms of the loan authorization issued by SBA required Borrowers to use the loan proceeds for repairs and improvements on the properties and obligated SBA to distribute the funds as the work was completed.

SBA did not properly inspect the progress of the work being performed, properly administer its loan, or properly disburse funds as the repairs were performed. As a result Borrowers used all the loan funds for their own benefit and not for the benefit of the properties. The opinion determining to certify the question, in order precisely to delineate the issues, also states: Rockhill and Flag Harbor have not alleged: 1) that the SBA expressly agreed or represented to [Sellers] that it would disburse the funds only as improvements or repairs were completed; 2) that [Sellers] signed or are a party to the SBA-Beachem loan arrangement; 3) that the SBA signed or is a party to the subordination agreement; 4) that the subordination agreement contains language which conditions its enforceability upon the SBA overseeing the use of the funds or distributing the funds only as the work progressed; or 5) that the subordination agreement contains language which limits [Sellers’] waiver of priority only ²⁴¹ to the amount of the loan which was actually used to repair or improve the property. The general problem presented here has been addressed in a number of decisions.

Typically the subordinating party is the owner of land who sells it, or makes a long term lease of it, to a developer who will require financing. An increase in the value of the property upon completion of the contemplated improvements is anticipated, so that the owner may be offered an attractive purchase price or rental. The owner, in turn, assumes some of the risk of the venture by agreeing to an arrangement under which those who will more substantially finance the development obtain priority over a take-back purchase money mortgage, or obtain a lien on the lessor’s reversionary interest. The term "subordination” is used in at least two general senses in the cases of the type presented here.

One aspect refers to the executory promise to subordinate to financing of a described type (hereinafter sometimes called a "subordination clause”). The term is also applied to the declaration or agreement which expressly manifests assent to the priority of a specific lien (hereinafter sometimes called a "subordination agreement”). Some subordination clauses contemplate the execution by the subordinator of a subordination agreement. Others are drafted with the object of effecting subordination without further documentation when a given loan falls within the description of the subordination clause ("automatic subordination”).

If the borrower defaults and the seller is faced with both non-payment of his subordinated obligation and loss of his land, the search begins for a legal theory which will result in a reversal of the priorities. Because part of a seller’s purpose in subordinating is to facilitate development of the property, the quest for relief has included focusing on whether the proceeds of the loan to which the seller subordinated were in fact utilized to enhance the value of the security. Legal theories which have received at least some judicial recognition and by which priority has been wholly or ²⁴² partially restored to the subordinating seller (or lessor) include: 1. A subordination agreement by which lender and seller are in privity and under which the lender expressly assumes a duty to supervise use by the borrower of the loan proceeds or to restrict their use to designated purposes; 2.

Collusion by the lender with the borrower in a diversion of loan proceeds by the borrower from a purpose to which the borrower is obligated to the seller to apply them; 3. An automatic subordination clause under which the seller expressly conditions his subordination on use of the loan proceeds for a designated, limited purpose or on the performance of specified duties by the lender; 4. A condition or limitation which is implied in an otherwise unqualified subordination agreement, whether or not the lender is in privity with the seller under it, based upon a condition or limitation expressed in the subordination clause between seller and borrower; and 5. A judicial determination that the lender owes the seller a duty to exercise a degree of care (variously expressed) over the use of the loan proceeds based upon the relationship of the parties to the project and upon the expectations of the seller.

Theories 1 and 2 present what are considered to be the requirements for relief under the general rule. Here an express agreement between Sellers and SBA is not alleged. Nor is there any allegation that SBA in effect colluded with the Borrowers. Similarly, theory 3 is not presented here.

SBA does not assert an automatic priority based on compliance with an express condition in a subordination clause in the purchase money deeds of trust to Sellers. Sellers, however, press decisions which have departed from the general rule. They begin their attack at the level of theory 4 and rely upon Miller v. Citizens Savings & Loan Ass’n., 248 Cal. App. 2d 655 , 56 Cal.

Rptr. 844 (1967). In that case the $95,000 purchase money deed of trust contained a clause subordinating its lien to one or more deeds of trust ²⁴³ " 'made primarily for the purpose of constructing improvements’ ” and provided that the proceeds of the preferred loan might be disbursed for a number of types of costs including offsite improvements, onsite improvements, escrow charges, insurance, loan costs and advertising. Construction loans totalling $349,500 were obtained to which the seller, without qualification, agreed with the lender to subordinate. The final loan disbursement of $26,341.30 was not utilized for a purpose described in the subordination clause of the purchase money deed of trust.

In the seller’s action challenging the priority of the construction deeds of trust, dismissal at the close of the plaintiffs case was reversed. It was held that the seller had presented a prima facie case for placing the last $26,341.30 of the construction loan advances behind the purchase money lien. The court reasoned that the unqualified subordination between seller and lender must be read together with the limited subordination clause of the purchase money deed of trust of which the lender had knowledge. These were said to be parts of a single agreement so that the limitations on use set forth in the latter were read into the former.

Miller was followed and extended in MiddlebrookAnderson Co. v. Southwest Savings & Loan Ass’n., 18 Cal. App. 3d 1023 , 96 Cal. Rptr. 338 (1971), which is also pressed by Sellers here. In Middlebrook the seller entered into a contract to sell 28 lots to the borrower under an escrow arrangement.

The escrow instructions specified a sale price of $365,000 of which $169,500 was deferred and to be secured by a purchase money deed of trust. "This deed was to be second and junior to a construction loan to be obtained at some later time by the buyers.” Id. at 1026 , 96 Cal. Rptr. at 339 . During the pendency of the escrow the buyer-borrower advised the seller that the construction lender required its deed of trust to be recorded first.

This was done. The construction lender disbursed $1,464,400 of which $300,000 was used for purposes other than construction. When the construction lender threatened foreclosure, the seller filed a complaint which included an allegation that the ²⁴⁴ lender had "knowledge that the seller would subordinate its lien on condition the loan funds were to be used only for construction improvements.” Id. at 1029 , 96 Cal. Rptr. at 341 (Emphasis added).

Dismissal on demurrer was reversed. The court’s analysis was in terms of contract law. [T]he lender’s claim to priority flows from the agreement between the seller and the buyer. It is only as a result of the seller’s waiver of his statutory right to a first lien that the lender achieves priority. Thus, the lender is a third party beneficiary in the seller-buyer agreement, but only to the extent that it abides by the conditions of subordination.

If the lender does not comply with the seller’s conditions it does not achieve priority. Since one condition to priority is the proper use of the construction funds, the priority of the construction loan lien does not vest until such time as the funds are applied to the construction purpose. [Id. at 1033, 96 Cal. Rptr. at 344 .] The court then took a step beyond Miller and equated the priority effected by the order of recording with priority accomplished by a subordination agreement. As we read both Miller and Middlebrook, a condition was implied in the subordination to the lender based upon a condition expressed in the subordination clause of the agreement between the seller and the borrower.

In the matter at hand there is no subordination clause between Sellers and Borrowers which is alleged to have been the basis for obtaining the Sellers’ subordination to SBA. 3 ²⁴⁵ Rather, Sellers and Borrowers directly entered into the agreements subordinating specifically to the SBA loan. Those subordination agreements are unconditional and there is no other agreement relied upon from which a conditional or limited subordination can be implied. 4 It is therefore unnecessary for us to determine in this case whether Maryland law recognizes an implied condition as was done in Miller and Middlebrook. Thus the issue resolves to whether there is a duty on the lender, enforceable by the seller, to see to the application of the loan proceeds where the purpose of the loan is to make improvements or repairs. As indicated above, the majority of courts have determined there is no such duty.

The general rule throughout the United States is that where a landowner agrees to subordinate his fee interest to a mortgage lien for the purposes of obtaining a construction loan, without an express covenant from the mortgagee (or lessee-developer) to the landowner, to see to the application of the sums advanced, possible diversion of funds by the mortgagor-developer is a risk assumed by the landowner, unless the latter is able to demonstrate ²⁴⁶ fraud or collusion between the mortgagor-developer and the mortgagee. Grenada Ready-Mix Concrete, Inc. v. Watkins, 453 F. Supp. 1298, 1313 (N.D. Miss. 1978). Accord, Carlsberg Resources Corp. v. Cambria Savings & Loan Ass’n., 413 F. Supp. 880, 886 (W.D. Pa. 1976) (claim against lender by assignee of landowner-borrower), aff'd on other grounds, 554 F.2d 1254 (3d Cir. 1977); Fries v. Broadway Federal Savings & Loan Ass’n., 258 Cal. App. 2d 119 , 65 Cal.

Rptr. 460 (1968) (Miller v. Citizens Savings & Loan Ass’n., supra, distinguished because, inter alia, there was no showing that Broadway Federal knew of an alleged oral agreement between the owner and the borrower that the loan would be used only for clearing and for new construction); Gill v. Mission Savings & Loan Ass’n., 236 Cal. App. 2d 753, 757 , 46 Cal. Rptr. 456,459 (1965) ("The fact [lender] had knowledge of an agreement between [sellers] and the [borrower] that the loans from [lender] would be used for construction purposes, and that this was the reason [sellers] agreed to subordinate their deeds of trust to those executed in favor of [lender] is not a circumstance motivating public policy imposition upon [lender] of a duty to exercise care to effect the agreement between [sellers] and the [borrower].”); Matthews v. Hinton, 234 Cal. App. 2d 736, 742 , 44 Cal.

Rptr. 692, 697 (1965) ("Diamond, the lender, was under no obligation to see that the loan money was used in accordance with a contract to which it was not in privity.”); Pope Heating & Air Conditioning Co. v. Garrett-Bromfield Mortgage Co., 480 P.2d 602 (Colo. App. 1971) (unconditional subordination of mechanics’ lien claim to loan and no collusion); Drobnick v. Western Fed. Savings & Loan Ass’n., 479 P.2d 393 (Colo. App. 1970) (no express condition in subordination agreement and no collusion); First Conn. Small Business Investment Co. v. Arba, Inc., 170 Conn. 168, 177 , 365 A.2d 100, 104 (1976) ("In the absence of such collusion, or an express agreement, the mortgagee given priority is under no obligation to see that moneys it advances are employed by the borrower in the manner contemplated by the subordinated purchase money mortgagee.”); Roberts v. Harkins, 292 So. 2d 603 (Fla.

App.), ²⁴⁷ cert. denied, 302 So. 2d 417 (Fla. 1974); Iowa Loan & Trust Co. v. Plewe, 202 Iowa 79 , 209 N.W. 399 (1926); Hyatt v. Maryland Fed. Savings & Loan Ass’n., 42 Md. App. 623 , 402 A.2d 118 (1979) (invoking and applying general rule); Kennedy v. Betts, 33 Md. App. 258 , 364 A.2d 74 (1976) (applying general rule as an alternate ground of decision); Cambridge Acceptance Corp. v. Hockstein, 102 N.J. Super. 435 , 246 A.2d 138 (App. Div. 1968) (discussed infra — recognizing general rule but not applying it); Brooklyn Trust Co. v. Fairfield Gardens, Inc., 260 N.Y. 16 , 182 N.E. 231 (1932); Forest, Inc. of Knoxville v. Guaranty Mortgage Co., 534 S.W.2d 853 (Tenn. App. 1975); Fandel, Inc. v. First of Denver Mortgage Investors, 522 S.W.2d 721 (Tex. Civ. App. 1975); Tuscarora, Inc. v. B.V.A. Credit Corp., 218 Va. 849 , 241 S.E.2d 778 (1978) (expressly approving general rule and expressly rejecting the principle of implied conditional subordination of