This article discusses the typical modifications of a note and reviews the use of a note modification agreement and the modification of note forms.
Later changes in note provisions
A promissory note is written evidence of a promise made to repay a loan or pay a carryback installment debt. The provisions in the note determine a borrower’s or buyer’s debt payment schedule and interest obligations.
During the term of a promissory note, a lender or carryback seller and the owner of the secured real estate may agree to modify, add or rescind one or more of the note’s provisions. Any modification of a note requires mutual agreement between the debtor (borrower or buyer) and the creditor (lender or carryback seller) and consideration given in exchange for allowing the modification. [See Form 426 accompanying this article]
Modifications of a note secured by a trust deed usually arise out of a financial necessity experienced by the owner of the secured property.
The modification of a promissory note is a transaction controlled by rules of contract law. Thus, a written contract, in this example a note, can be modified by:
· a written agreement; or
· an oral agreement. [Calif. Civil Code §1698]
However, for an oral modification to be enforceable, both the lender and the borrower must put the oral modification into effect by taking action on it, called execution. To be certain of the modified terms, the lender and the borrower must memorialize the modification in a writing.
On a modification, the note itself should not be canceled or rewritten, especially if it is secured by a trust deed. The dates of the note and trust deed will differ if the note is redrafted, even though the secured debt remains the same. The different dates will cause difficulty on foreclosure or reconveyance of the trust deed since the trust deed refers to the secured debt as that evidenced by a note “of same date” as the identification date on the trust deed.
Once the modification agreement has been negotiated and entered into to set the new terms for payment, a Modification of the Promissory Note form is used to change the terms of the existing debt from those originally stated in the note. [See Form 425 accompanying this article]
The modification identifies the promissory note which it modifies, names the parties to the note and identifies the trust deed and the property involved in the transaction.
The modification agreement is attached to the promissory note as an allonge which contains mutually agreed-to provisions that become part of the original note.
Common modifications of a trust deed note include:
· a due date extension;
· interest rate changes;
· installment payments rescheduled or changed in amount;
· cash advances or accrued interest added to principal; and
· the addition of special provisions.
Owners of encumbered real estate and lenders or carryback sellers agree to the modification of a note for many reasons:
A buyer of real estate is willing to cash out a seller’s equity in real estate and assume the existing recourse loan which encumbers the property, called a cash-to-loan (CTL) transaction.
However, the seller is unwilling to remain liable for the recourse loan, even though the buyer will assume the loan. Due to the listing agent’s negotiations, the lender, buyer and seller agree to the buyer’s assumption of the loan and a release of the seller from further liability on the loan, called a novation.
The novation agreement is accompanied by a modification of the note which provides consideration for the lender’s release of the seller’s liability in the form of:
· an increase in the note’s interest rate and monthly payments; and
· payment of an assumption fee to the lender.
An owner of real estate has property which is located on an earthquake fault line. The existing trust deed loan encumbering the property is recourse paper.
The owner is concerned about his future liability exposure should an earthquake render the property valueless. If an earthquake reduces the property’s value below the amount owed on the loan, the owner would be personally liable for the deficiency should the lender need to foreclose, a risk of loss he wishes to eliminate.
The trust deed on the property calls for the owner to carry earthquake insurance which would shift the risk of loss from the owner to the carrier. However, the premium for the insurance policy has become too expensive.
The owner seeks a loan modification with the lender, increasing the interest rate in exchange for:
· elimination of the earthquake insurance provision; and
· a release of the owner’s liability should the security become impaired due to natural causes, called an exculpatory clause.
A seller carries back a note and first trust deed on the sale of an unimproved parcel of real estate. Later, the buyer asks the seller to subordinate his carryback trust deed to a construction loan, an event which would increase the seller’s risk of loss and convert the carryback note to recourse paper.
The carryback seller will subordinate the carryback trust deed to a construction loan if the buyer modifies the note to increase the interest rate and monthly payments, and record a Request for Notice of Delinquency (NODq) and serve a copy on the senior lienholder. [See first tuesday Form 412]
Editor’s note — The modification of the interest rate on a carryback note is not subject to usury laws. [DCM Partners v. Smith (1991) 228 CA3d 729]
If a modification or replacement note restructures the debt created by a carry back credit sale and the debt remains secured solely by the property sold, the debt remains outside the interest rate limitation imposed by the usury laws. The debt retains its original purchase-money anti-deficiency characteristics since the modified or replacement note evidences a continuation or rollover of the original carryback debt. [Ghirardo v. Antonioli (1994) 8 C4th 791]
A buyer and carryback seller get into a dispute after the close of escrow about the seller’s representations concerning the property’s condition.
The carryback seller offers to modify the note by reducing the note balance and the monthly payments to compensate the buyer for an overvaluation of the property in exchange for the buyer releasing the seller from any further claims concerning the condition of the property and the purchase transaction.
The buyer agrees to modify the note and enter into a release and waive of any future claims as offered by the seller. [See first tuesday Form 540]
An owner of real estate executes a trust deed note with a five-year due date. Later, with the due date of the final/balloon payment approaching, the owner realizes he will be unable to meet a demand for the final payoff of the note.
The owner contacts the noteholder to negotiate a due date extension for the payoff of the note.
The noteholder offers to extend the payoff date if the owner agrees to:
· a higher interest rate and increased monthly payments; and
· allow the noteholder to run a credit check for any change in the owner’s financial status since originally entering into the note.
A seller carried back a note containing a five-year due date. By its terms, the note will soon be due.
However, the seller does not want the note paid off now since capital gains taxes will be due on the profit in the final/balloon payment. Payment of the taxes will reduce his working capital. Also, the current market interest rate is much lower than the interest rate on the carryback note.
The seller wants to negotiate an extension of the due date and include a prepayment penalty in the note. The seller will lower the interest rate — possibly below market rates — in exchange for the buyer agreeing to an extension of the due date and a prepayment penalty.
Junior lienholder is subordinated
Most debts relating to real estate are secured by a lien on title to the real estate, typically a recorded trust deed which describes the property involved and is insured by a title company.
Since the trust deed is insured, an agreement to modify a trust deed note should always be conditioned on reinsuring the trust deed by obtaining a title insurance policy or an endorsement to the existing policy held by the lender or carryback seller.
Title insurance is needed to assure a lender or carryback seller of the continued priority of his trust deed as against the interest of others on title to the real estate.
For example, consider a property which is encumbered by first, second and third trust deed liens. The terms for payment of the second trust deed note are modified.
However, the modification of the interest rate, payments or due date, or a combination of these, cannot result in a substantial economic change in the debt which would put the third trust deed holder at a significantly greater risk of loss than already exists, unless a greater risk of loss is agreed to by the third trust deed holder, called subordination.
Consider a holder of a first trust deed lien on a parcel of real estate who agrees to modify the trust deed note. The modification agreement entered into shortens the note’s due date, raises the interest rate and increases the amount of principal due.
The holder of a second trust deed claims the first trust deed lien lost its priority to his trust deed since the modification of the first trust deed note significantly reduced the value of the second trust deed holder’s security interest in the property.
The first trust deed holder claims only the modifications in the note do not have priority to the second trust deed since only the modified portions of the note would impair the secured position of the second trust deed.
Here, the agreement which modified the original note does not have priority to the second trust deed, but the terms of the original note do retain their priority. Thus, the second trust deed lien remains unimpaired by the modified first trust deed and in the same financial and legal position as when it was first recorded. [Lennar Northeast Partners v. Buice (1996) 49 CA4th 1576]
Now consider a seller who carries back a second trust deed on the sale of property which is subject to a first trust deed containing a due-on clause. The holder of the first trust deed note is not advised of the sale.
Later, the first trust deed lender learns of the sale and calls the loan. To avoid the call, the buyer assumes the first trust deed loan and modifies the note to shorten its due date.
On discovering the modifications, the carryback seller claims his second trust deed now has priority over the first trust deed since the modification on the note secured by the first trust deed substantially impairs his security by increasing the potential for default.
In this example, the modification of the note secured by a first trust deed without the consent of the junior carryback seller does not result in a change in trust deed priorities. The secured property was sold (and the seller accepted a second trust deed) without first obtaining the lender’s prior written consent. Thus, the seller breached the due-on clause in the lender’s trust deed. Due to the breach, no duty is imposed on the first trust deed lender to avoid impairment of the owner’s second trust deed lien. [Friery v. Sutter Buttes Savings Bank (1998) 61 CA4th 869]
The modification of an existing trust deed note does not trigger the due-on clause in other trust deeds of record on title to a property. Only the initial act of creating or transferring a security interest such as recording a trust deed, not the later altering of the secured note, triggers the due- on clause.
A policy of title insurance on the modification of a trust deed note is obtained to assure the trust deed holder that any junior trust deed liens of record will remain junior after the note modification. An owner seeking the modification of the trust deed note usually pays the premium charged for the title insurance policy.
The junior trust deed holder, even if he has previously entered into a future subordination agreement allowing for a later modification of the senior trust deed note, will be required by the title company to sign a specific subordination agreement on title company forms before the trust deed securing the modified note will be reinsured.
Analyzing the Agreement to Modify a Promissory Note
The Agreement to Modify a Promissory Note, first tuesday Form 426, is used by brokers to prepare a written document to formalize the negotiation between the owner of property and the beneficiary of a trust deed note encumbering the owner’s property regarding a change in the terms of the note.
Generally, the offer to modify the note will be made by the property owner in an attempt to accommodate a financial objective, such as an extension of the due date, an advance of additional loan funds, the substitution of property as security, the subordination of a trust deed or a partial release of the security. For the beneficiary, Form 426 acts as a checklist of provisions to consider when agreeing to a modification of the note or trust deed.
Form 426 sets forth all the necessary elements for an agreement to modify a note, including:
· Facts — identifies the note being modified and all junior and senior liens encumbering the property;
· Terms — sets forth the changes in the note’s term and the consideration the lender or owner is to receive on modification; and
· Provisions — addresses title insurance and the subordination of junior liens.
Preparing the Agreement to Modify a Promissory Note
The following instructions are for the preparation and use of first tuesday Form 426, the Agreement to Modify a Promissory Note.
The numbers on the instructions correspond to the numbers given provisions in the form.
Editor’s Note — Check and enter items in the boxes and blanks throughout the agreement in each provision, unless the provision is not intended to be included as part of the final agreement, in which case it is left unchecked or blank.
Enter the date and the name of the city where the offer is prepared. This date is used when referencing this purchase agreement.
1. The note: Enter the date and face amount of the note, the name of the person who signed the note, and the name of the payee.
1.1 Enter the dollar amount of the remaining principal balance on the note and the day, month and year through which the interest has been paid.
1.2 Enter the dollar amount of any late charges which have been properly noticed and remain unpaid.
1.3 Enter the dollar amount of any advances which have been made by the Lender.
Editor’s note — Advances are made to cure defaults which impair the lender’s position, such as delinquent taxes, senior loans, insurance premiums, and assessments.
2. Trust deed identification: Enter the date the trust deed was recorded, the recorder’s instrument number, and the county of record. Enter the names of the Trustors and Beneficiaries stated on the trust deed.
2.1 Enter the legal or common description of the property. Enter the assessor’s parcel number.
2.2 Enter the description of any additional property securing the note.
2.3 Enter the dollar amount of the balance in any impound account held by the Lender.
3. Senior financing: Enter the appropriate information in §§3.1 and 3.2 if the trust deed securing the note is junior to existing senior encumbrances.
4. Junior encumbrances: Enter the appropriate information in §§4.1 and 4.2 if the trust deed securing the note is senior to any junior trust deeds.
5. Note modification: Enter the terms offered in the appropriate blanks to indicate the modifications applicable to the note.
5.1 Interest rate changes: Enter the new interest rate and the date interest is to begin accruing at the new rate.
5.2 Payment amount change: Enter the new dollar amount of the payment and the date the change is to take effect.
5.3 Due date change: Enter the new due date.
5.4 Impound added: Check the box to indicate the property owner is to begin making impound account payments. Enter the dollar amount of the advance deposit for the impound account due on modification.
Editor’s note — A Creditor often collects impounds to pay property taxes and assessments, leasehold payments, hazard insurance premiums, and mortgage insurance premiums. A Creditor’s ability to require an impound account is restricted.
6. Additional modifications: Check the box to indicate an addendum is attached containing other modifications to be made to the note or trust deed, such as adding a late charge, prepayment penalty, or due-on clause to the note or the trust deed. Attach the prepared addendum to this offer.
7. Consideration: Check the appropriate boxes or enter the appropriate information in the blanks to indicate the consideration the Creditor is to receive on modification of the note.
7.1 Assumption agreement: Check the box to indicate a buyer of the owner’s property is to assume the note held by the Creditor and enter into a modification of the note as demanded by the Creditor for waiving any due-on clause.
7.2 Cost of modification: Enter the dollar amount of the Creditor’s out-of-pocket costs to indicate the Property Owner is to pay the costs incurred by the Creditor to modify the note.
7.3 Points and bonuses: Enter the dollar amount the Creditor is to receive due to a bonus or points.
Editor’s note — The payment of a bonus or points does not apply to the principal or costs, but is characterized as prepaid interest.
7.4 Principal reduction: Enter the dollar amount of the principal reduction the Property Owner is to make.
Editor’s note — The Creditor might require a reduction in principal if the trust deed or note modification increases the Creditor’s risk of loss, such as on subordination to a construction loan, or releasing/substituting security.
7.5 Additional security: Check the appropriate box to indicate the Property Owner is to deliver additional security or substitute security for the note. Enter the legal description of the new security. Enter the terms of any senior encumbrance on the new security.
7.6 Notice of delinquency: Check the box to indicate the Property Owner is to sign a Request for Notice of Delinquency (NODq), record it and serve it on the senior lender. [See first tuesday Form 412]
7.7 Other considerations: Check the box to indicate additional consideration is to be given to the Creditor, and attach an addendum such as:
a buyer’s release and waiver on a dispute with a carryback seller [See first tuesday Form 181]; or
the property owner authorizing the Creditor to run a credit check. [See first tuesday Form 302]
8. Acceptance period: Enter the number of days the Property Owner or Creditor has to accept the offer in writing, such as “on presentation” or “three days,” etc.
Editor’s note — The offer will automatically expire if it is not accepted (signed and delivered) within the specified time period.
9. Escrow closing agent: Enter the name of the escrow company which will handle the note modification. Provides for escrow to be opened on acceptance.
10. Closing date: Check the appropriate box and enter the specific date for escrow to close or the number of days anticipated to perform and close escrow. Provides for the property owner to pay the escrow fees and charges.
11. Title insurance: Enter the name of the title insurance company insuring the trust deed.
11.1 Type of policy: Check the appropriate box to indicate the type of title insurance policy desired if a new policy is to be issued.
11.2 Policy endorsement: Check the box to indicate the existing policy held by the Creditor will be endorsed by the title company to insure the Creditor’s title position.
11.3 Encumbrances of record: Provides for the issuance of the title insurance policy or endorsement to show title is subject to current property taxes, recorded covenants, conditions and restrictions (CC&Rs) and the underlying trust deed(s) identified in §3.
11.4 Specific subordination: Provides for any junior lienholders listed in §4 to sign a specific subordination agreement.
Editor’s note — Title insurance companies will require a specific subordination agreement from junior lienholders before insuring the property of an existing trust deed on the modification of its note.
11.5 Policy premium: Provides for the Property Owner to pay the premium for the issuance of the title insurance policy or policy endorsement.
12. Beneficiary statement: Check the box if the Creditor is to be provided a beneficiary statement from each of the underlying trust deed holders so the creditor can confirm the terms and current status of the underlying loans.
13. Costs: Provides for the Property Owner to pay all costs incurred to modify the note.
14. Brokerage fee: Enter the names of the brokers. Enter the total fee due all brokers to be paid by the property owner.
Creditor’s signature: Enter the date the Creditor signs and his name, address and the numbers for his phone and fax. Obtain the Creditor’s signature.
Property Owner’s signature(s): Enter the date the Property Owner signs and his name, address and the numbers for his phone and fax. Obtain the Property Owner’s signature.