From a Lender's Perspective, Is A Loan Modification The Best Choice?

Recently it has been reported that foreclosure numbers are down in Sacramento. This may be due to the fact that many lending institutions are choosing to modify loans that they before would have foreclosed upon.  Typically, a paying customer is better than no customer at all.  However, when modifying a loan, a lender must be concerned with maintaining the priority of the recorded deed over other encumbrances on the collateral property.

The principals of priority that are applicable to each type of modification vary depending on the specific type of modification – extension of time, change in interest rate, advance of further funds (construction loans), adjustment to principal, etc.  A modification will affect priority if the senior note alteration is considered a material change when it prejudices the position of the junior lien holder.  Essentially, the senior loan affects the junior loan, thus threatening its priority, when a modification of the senior loan increases the risk of default or makes protection of the junior lienor’s position more burdensome. Such situations can cause a senior lien holder to lose priority subsequent to a modification which is considered to be material.

Generally a modification of time to a promissory note (extension) is not considered a material alteration.  In fact, it is considered beneficial to a junior lien holder in that it protects the security of the junior lien as well. 

However, if the result of the modification to the senior note results in an extension of time past the statute of limitation when the junior lien could claim to hold its interests free of the senior lien, the extension is not binding upon the junior creditor. Moreover, note priority may be affected in such a situation if it can be found that the extension burdens the junior lienor by effectively denying a defense to the junior lienor by precluding the junior’s ability to bring a law suit. The statute of limitation pertinent to this issue is codified under C.C.P. § 337(1), which allows 4 years to bring an action on breach of written contract – i.e., a promissory note.

There are alternative legal theories that dictate by the very nature of being a junior lien holder, said junior lien holder inherently assumes the risk of the modification of a senior lien holder. A senior lienor owes no express or implied contractual duties to a party who extends credit in a junior position. In fact, some courts have held that establishing a rule that protects junior creditors from a material change in a senior loan would upset the California policy of “first in time, first in right” system of lien priority. Friery v. Sutter Butte Savings Bank, 61 Cal. App. 4th 869, 877-879 (1998).  Moreover, the Friery case eluded that even a material change in a senior lien holder’s promissory note will not affect the priority if either a subordination agreement or “special relationship” between the senior and junior lien holder exist. Friery at 877-879.

It is ultimately a lender’s choice if modification or foreclosure provides for a better fiscal recovery of a bad debt.  However, when a lender chooses the former, the lender must show special consideration to any potential affects to any existing junior lien holders.


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