Price Waterhouse Ltd. v. Decca Design Build, Inc.

SUPREME COURT OF ARIZONA
En Banc

In re: Petition of Price )
Waterhouse Limited as Judicial )
Trustee and Receiver of, inter ) Supreme Court
alia, Eron Mortgage Corporation, ) No. CV-01-0074-CQ
Eron Financial Services, Ltd., )
and as Judicial Trustee of 494597 )
BC Ltd.; 519722 BC Ltd.; 530884 )
BC Ltd.; 534172 BC Ltd.; 494043 )
BC Ltd.; Maxim Resources, Ltd.; )
533373 BC Ltd.; 545054 BC Ltd.; ) United States
533175 BC Ltd.; 729720 Alberta ) Bankruptcy Court
Ltd.; and 532285 BC Ltd., each a ) Southern District of
company incorporated under the ) California
laws of the Province of Canada, ) Case No. 97-16013-PB
in a foreign proceeding by ) (In a Case Ancillary
appointment of the Supreme Court ) to a Foreign Proceeding
of British Columbia, ) Under 11 U.S.C. §304)
)
Debtor. ) Adversary No. 99-90066B
___________________________________)
)
PricewaterhouseCoopers, Inc. as )
Foreign Representative herein, and )
Judicial Trustee of, inter alia, )
Eron Mortgage Corporation and )
494597 B.C. Ltd. by Appointment )
of the Supreme Court of British )
Columbia, )
Plaintiff, )
)
v. )
) O P I N I O N
Decca Design Build, Inc., an )
Arizona corporation, )
Defendant. )
___________________________________)

CERTIFIED QUESTION ANSWERED
_________________________________________________________________

PERKINS COIE LLP Santa Monica
by Steven G. F. Polard
and
SQUIRE, SANDERS & DEMPSEY LLP Phoenix
by Donald A. Wall
Debora L. Verdier
Attorneys for PriceWaterhouseCoopers, Inc. as
Judicial Trustee and Foreign Representative
of Eron Mortgage Corporation, Eron Arrowhead
Ltd., and 494597 BC Ltd., et al.

ALHADEFF & SOLAR LLP San Diego
by Robert K. Edmunds
S. Douglas Kerner
and
SACKS TIERNEY Scottsdale
by Sharon Shively
Isabel M. Humphrey
James W. Armstrong
Attorneys for Decca Design Build, Inc.

_________________________________________________________________

J O N E S, Chief Justice

This case involves a certified question from a bankruptcy

court in California. We address first the jurisdictional issue.

The Arizona Constitution confers jurisdiction on the state supreme

court as “provided by law.” Article VI, § 5(6). By statute, this

court has jurisdiction over questions certified to it by other

courts, including the Supreme Court of the United States, a court

of appeals of the United States, a United States district court, or

a tribal court. Arizona Revised Statutes § 12-1861 (1994)

(A.R.S.). Section 12-1861 is based on the 1967 version of the

Uniform Certification of Questions of Law Act. That act was

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modified in 1995 specifically to include bankruptcy courts.1 While

Arizona has not directly amended its version of that law to include

any federal court, the intent of the statute as it currently

exists, coupled with our own supreme court rule allowing

certification of questions from federal and tribal courts,

sufficiently provides this court with the discretionary authority

to answer the bankruptcy court’s certified question. Ariz. S. Ct.

R. 27(a)(1); see also 28 U.S.C.A. § 151 (1993) (bankruptcy judges

constitute “a unit of the district court.”).

The Honorable Peter Bowie of the United States Bankruptcy

Court for the Southern District of California has certified the

following question to this court upon stipulation of the parties:

Where real property is subject to a first priority deed
of trust, a second priority mechanic’s lien, and a third
priority deed of trust, where the holder of the first
priority deed of trust and the holder of the third
priority deed of trust enter into a written subordination
agreement pursuant to which the holder of the first
priority deed of trust agrees that the third priority
deed of trust shall constitute a lien or charge upon said
land which is unconditionally prior to and superior to
the lien or charge of the first priority deed of trust,
and where the holder of the second priority mechanic’s
lien is not a party to the subordination agreement, what
effect, if any, does the subordination agreement have on

1
Unif. Certif. Questions of Law Act § 3, 12 U.L.A. 73 (1996).
“The [Supreme Court] of this State may answer a question of law
certified to it by a court of the United States . . . .” The
comment notes that “[t]his section has been revised to replace the
previous list of federal courts with the term ‘a court of the
United States.’ This is intended to permit a court in a State
adopting the section to answer questions certified by any United
States court including bankruptcy courts.”

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 the relative priorities of the liens of the three parties
based on the facts set forth below?

The bankruptcy court then attached a statement of facts. We will

summarize those facts as follows.

Fairway Condominium Development, Inc. (Fairway), a real estate

development company, obtained a loan from a Canadian company known

as 494597 B.C. Ltd. (the Canadian company) for $7.5 million to

develop real property. This $7.5 million loan became the first

lien on the subject property. The Canadian company later went into

bankruptcy in British Columbia, Canada. An ancillary bankruptcy

proceeding is underway in California commenced by Pricewaterhouse

as the Canadian company’s trustee.

Decca Design Build, Inc. (Decca) had a second position

mechanic’s lien on the same property. This mechanic’s lien was for

$350,000. An additional $3 million in funding was sought by

Fairway for the development of the property. First Mortgage Bank

(First Mortgage) supplied that additional funding, taking back the

third priority deed of trust, and the property was then subject to

three liens. The Canadian company and Fairway entered into a

subordination agreement with First Mortgage at the time Fairway

sought the additional $3 million funding. That subordination

agreement specified that the $7.5 million loan would be

subordinated to the $3 million lien of First Mortgage. First

Mortgage’s $3 million lien would then become the first priority

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lien on the property. The foreclosure sale of the property yielded

$5 million.

The Agreement

The subordination agreement was between the Canadian company

that funded the first $7.5 million loan and Fairway, the borrower,

and First Mortgage. First Mortgage agreed to fund the second $3

million loan to the development company in exchange for the

priority of its lien before the Canadian company’s lien. The

agreement did not involve or consider Decca’s intervening second

priority mechanic’s lien.

The language of the agreement reads:

This subordination agreement results in your security
interest in the property becoming subject to and of lower
priority than the lien of some other or later security
instrument . . . it is a condition precedent to obtaining
said [$3 million] loan that said deed of trust last above
mentioned shall unconditionally be and remain at all
times a lien or charge upon the land . . . prior and
superior to the lien or charge of the deed of trust first
above mentioned . . . .

Appendix re Order re Stipulation re Request to Certify State Law

Question to the Arizona Supreme Court, Exhibit C, p. 1 (Appendix,

Ex. C). The Canadian company “intentionally and unconditionally

waives, relinquishes and subordinates the lien . . . first above

mentioned in favor of the lien . . . in favor of [First Mortgage].”

Appendix, Ex. C, p. 3. “[T]his Agreement shall be the whole and

only agreement with regard to the subordination of the lien...and

shall supersede and cancel, but only insofar as would affect the

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priority between the deeds of trust hereinbefore specifically

described, any prior agreements as to such subordination . . . .”

Appendix, Ex. C., p. 2.

Analysis

The issue, requiring that we determine the effect of a

subordination agreement between first and third lienholders,

presents a case of first impression in Arizona. We are aware that

courts from other jurisdictions have approached the same issue in

two different ways. One approach follows the partial subordination

analysis of the Supreme Court of Texas in ITT Diversified Credit

Corp. v. First City Capital Corp., 737 S.W.2d 803 (Tex. 1987). The

other follows the complete subordination analysis of the Supreme

Court of Alabama in Amsouth Bank v. J & D Financial Corp., 679 So.

2d 695 (Ala. 1996). For the reasons stated below, we adopt the

partial subordination analysis.

Partial subordination means that this alteration of the

priority of liens between the first and third lienholders has no

effect on the second priority lienholder. The shift in priority

relates only to the amount of the original third priority lien. If

the third priority lien is larger than the original first priority

lien, then the original first priority lien moves completely to the

third position. The original third priority lien moves into first

position but only to the amount of the original first priority

lien. If the third priority lien is smaller than the original

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first priority lien, then the difference between the two amounts,

up to the total of the original first priority lien, is still in a

priority position relative to the second priority lienholder. The

holder of the second priority lien is neither advantaged nor

disadvantaged by the agreement. The second priority lienholder is

not a party to the agreement and should not be affected by it. His

status remains the same to the extent of any remaining assets

available once the amount of the first priority lien has been

satisfied. The consequence of a subordination agreement is that

the amount of the first lien simply goes toward satisfying in whole

or in part two liens as opposed to one.

Without any subordination agreement, the following would be

the distribution of assets:

Canadian company--$7.5 million

Decca--$350,000

First Mortgage--$3 million

With the subordination agreement, the following is the distribution

of assets:

First Mortgage--$3 million

Canadian company--$4.5 million

Decca--$350,000

Canadian company--$3 million

The sum total of liens ahead of Decca remains at $7.5 million both

before and after the subordination agreement.

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 The foreclosure sale of the subject property yielded only $5

million. The first $3 million of that amount goes to First

Mortgage under the subordination agreement. The remaining $2

million goes towards satisfying the $4.5 million lien still owing

to the Canadian company. No additional funds are available to

satisfy Decca’s lien.

This is a fair result under the circumstances as $7.5 million

in liens were in priority ahead of Decca’s second priority lien

prior to the subordination agreement, and the same $7.5 million in

liens is still ahead of Decca after subordination, but it will be

distributed in respective amounts to First Mortgage and to the

Canadian company. Decca’s position has not been altered or

modified in any way by the agreement to which it was not a party.

Decca has not received a windfall nor has it suffered negative

consequences. The agreement between the Canadian company and First

Mortgage has no effect whatever upon Decca’s lien.

Other courts follow this line of reasoning. Grise v. White,

247 N.E.2d 385 (Mass. 1969); ITT, id. at 804; In the Matter of

Cliff’s Ridge Skiing Corp., 123 B.R. 753 (Bankr. W.D. Mich. 1991);

Duraflex Sales & Service Corp. v. W.H.E. Mechanical Contractors,

110 F.3d 927 (2d Cir. 1997); Mid-Ohio Chemical Co., Inc. v. Petry,

140 F. Supp. 2d 828 (S.D. Ohio 2000); Bratcher v. Buckner, 109 Cal.

Rptr. 2d 534, 541 (Cal. Dist. Ct. App. 2001); see also Gilmore,

Security Interests in Personal Property § 39.1 at 1021 (1965).

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 Decca advances the theory that complete, not partial,

subordination occurred here. Under such a reading of the

agreement, the original first priority lienholder would have waived

all priority to the third party lienholder unless some reservation

of first priority status occurred in the language of the agreement.

Decca argues that no such reservation language exists in this

agreement. It would have the result appear as follows after the

subordination agreement:

First Mortgage--$3 million

Decca--$350,000

Canadian company--$7.5 million

Decca reasons that where other liens on the same property exist,

parties to subordination agreements are presumed to know about and

consider them.

Some courts have followed this logic. Shaddix, et al. v.

National Surety Co., 128 So. 220 (Ala. 1930); J.C. McConnell, et

al. v. Mortgage Inv. Co., 292 S.W.2d 636 (Tex. Civ. App. 1955);

Ladner v. Hogue Lumber & Supply Co., Inc., 91 So. 2d 545 (Miss.

1956); Old Stone Mortgage and Realty Trust v. New Georgia Plumbing,

Inc., 236 S.E.2d 592 (Ga. 1977); Amsouth, id. at 695; In re Exec

Tech Partners v. Resolution Trust Corp., 107 F.3d 677 (8th Cir.

1997).

We reject the latter reasoning because it affects the rights

of others not in privity. Decca was not intended to be a

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beneficiary of this agreement and is not entitled to a windfall.

Because Decca’s position is unaffected, a result that appears fully

equitable, we embrace the partial subordination analysis.

Conclusion

We find that a partial subordination occurred from the

subordination agreement in this matter. Decca’s status as second

priority lienholder remains undisturbed by the subordination

agreement between the other parties.

________________________________________
Charles E. Jones
Chief Justice
CONCURRING:

____________________________________
Ruth V. McGregor, Vice Chief Justice

____________________________________
Stanley G. Feldman, Justice

____________________________________
Thomas A. Zlaket, Justice

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