American College of Mortgage Attorneys

Aspen, Colorado

October 5, 2007

 

 

A Critical Analysis of Recent Cases

Speaker’s Outline

Roger Bernhardt

Patrick Randolph

Dale Whitman


1. Lender's Attempt to Undo $2000 foreclosure sale of $6 million property fails.

Amalgamated Bank v Superior Court, 149 CA4th 1003, 57 Cal. Rptr. 3d 686 (2007)

As judgment creditor on real property owned by Winncrest, Pension Trust Fund for Operating Engineers and its corporate co-trustee, Amalgamated Bank (collectively, PTF), requested the county sheriff to issue a writ of sale to execute on the property and sell it to the highest bidder (subject to the mortgagor's right of redemption). The property was worth approximately $6.5 million. PTF intended to bid at the public auction but did not do so because its designated bidders, delayed in traffic, did not arrive until after the property was sold to Palmbaum for $2000. Winncrest did not exercise its right of redemption within the one-year redemption period.

PTF sued to set aside the foreclosure sale for irregularities and recorded a notice of lis pendens. The trial court granted Palmbaum summary judgment, concluding that PTF was barred from setting aside the sale. While PTF's appeal was pending, Palmbaum successfully moved to expunge the lis pendens. PTF petitioned for writ of mandate to stay the expungement order. The court of appeal granted an alternative writ and stayed the expungement order pending resolution of the petition.

The court of appeal denied the writ. It first concluded that its stay of the expungement order was superfluous because, under CCP §405.35, a stay upon filing a petition for writ of mandate is automatic; the expungement order is not effective until the writ proceeding is finally adjudicated.

Code of Civil Procedure §405.32 requires a court to order the expungement of a notice of lis pendens if it finds "that the claimant has not established by a preponderance of the evidence the probable validity of the real property claim." Code of Civil Procedure §405.3 defines "probable validity" as "more likely than not" that the claimant will prevail against the defendant in the action. The code comment to §405.32 states that it was intended to disapprove cases that held that the court on a motion to expunge may not conduct a mini-trial on the merits of the case, and to change the law to require judicial evaluation of the merits.

The language of §405.32 is plainly targeted at motions to expunge before trial, not expungement motions made after judgment has been entered and while an appeal is pending. In Mix v Superior Court (2004) 124 CA4th 987, 21 CR3d 826, the court held that a trial court presented with an expungement motion after judgment against the claimant must apply the probable validity standard and may deny the motion only if the court believes that its own decision will be reversed on appeal. The trial court did not err in granting the expungement motion.

In deciding a writ petition under CCP §405.39, after judgment and pending appeal, an appellate court must also assess whether the underlying real property claim has probable validity, i.e., whether it is more likely than not the real property claim will prevail at the end of the appellate process. The appellate court will conduct a prima facie review of the probable success of the underlying appeal, a mini-review that is not equivalent to a full-scale resolution of the underlying appeal. Summary denial of a writ petition does not constitute law of the case requiring the appellate court to decide the appeal against the real property claimant.

PTF had no standing to bring an action to rescind the judicial foreclosure sale. Under CCP §701.680(c)(1), which applies to judicial foreclosure sales, including those subject to a right of redemption, only the judgment debtor can set aside the sale for irregularity and only if the purchaser was the judgment creditor. Here, the property was sold to Palmbaum, a third party; he became the fee owner, subject only to the right of redemption. Because Winncrest did not bring an action to set aside the sale or exercise its right of redemption within the statutory time frames, Palmbaum's title to the property was perfected.

(From CEB California Real Property Law Reporter)

2. Another test of the Restatement, will a refinancing lender with actual knowledge of an intervening lien enjoy subrogation to the refinanced mortgage?

Bank of America v. Prestance Corp., 160 P. 3d 17  (Wn., 6/7/07)

The question before the Washington Supreme Court was whether a refinancing mortgagor must be precluded from equitable subrogation to a first-priority lien if it has actual or constructive notice of a junior lienholder. The court held that that answer was "no."

The court cited and distinguished Kim v. Lee, 145 Wn.2d 79 (2001), where the refinancing mortgagee's title insurer had constructive and actual knowledge of an intervening judgment lien and the court ruled that the title insurer could not avoid liability through equitable subrogation because it had actual knowledge of the lien and refused to disclose it to the insured prior to issuing the title policy) The facts in this case are somewhat complicated. In 1994, Sakae and Yuko Sugihara ("Borrowers") received a 30-year home loan of $543,000 from Washington Mutual, secured by a deed of trust on their home. In 1999, Bank of America ("B of A") made a loan of $400,000 to Prestance Corporation ("Prestance"), a corporation owned by the borrowers, secured in part by a loan on the borrowers' home. B of A later gave Prestance Corporation an additional line of credit for $1 million, secured by Mr. Sughihara's personal guarantee and an amendment to the deed of trust.

In 2001, the Borrowers approached Wells Fargo Bank West ("WFB West"), for a loan in the amount of $1 million, which was to be secured by a mortgage on the Borrowers' property. The court stated, at par. 4, that:

"           One purpose of the loan was to pay off the first-position Washington Mutual [home] loan [in the amount of approximately $500,000]. WFB expected it would then have priority over the other loans for the amount used to pay Washington Mutual. A preliminary title commitment showed the Bank of America loans, secured by the Bank of America deed of trust and its amendment . . . [I]t was WFB West's understanding [when its loan closed] that Bank of America's deed of trust had been (or was being) reconveyed to Wells Fargo Bank ("WFB") and that WFB (a bank related to WFB West) would subordinate its $500,000 loan, putting the WFB West deed of trust in first position."

(In November 2001, Mr. Sugihara received a $500,000 home equity loan from WFB. Part of that loan was used to pay B of A for its original $400,000 loan to Prestance Corporation. Bank of America cashed the check but never reconveyed the deed of trust to WFB.) Bank of America sued the Borrowers, Prestance, WFB and WFB West, seeking a money judgment and foreclosure of the defaulted B of A loan. The trial court, relying on the Restatement (Third) of Property: Mortgages sec. 7.6 Subrogation (1997) ("Restatement"), ruled that WFB West should be equitably subrogated to the first-priority position of Washington Mutual in the payoff amount of $499,477, which would leave B of A (according to the trial court judge) "in no worse position than it would have been [in] had had [WFB West] never made its . . . loan." Id. at par. 5. The appellate court reversed, holding that under the Kim v. Lee decision [see discussion above], "WFB West's actual knowledge of Bank of America's lien barred the application of equitable subrogation." Id. at par 5.

Describing the origins and purpose of the doctrine of equitable subrogation, the Washington Supreme Court stated that, "Borrowed from English courts of equity, equitable subrogation simply seeks to maintain the status quo . . . Equitable subrogation preserves the proper priorities by keeping the first mortgage first and the second mortgage second. Id. at par. 9. The court then adopted the Restatement position, which means subrogation would occur even if the refinancing lender had actual or constructive notice of the intervening lien. Restatement (Third) of Property: Mortgages sec. 7.6 Subrogation 1997. The court also stated that "Despite an initial resistance to equitable subrogation, many courts now apply it liberally" (citations omitted)). Id. at par. 9-10. The court then discussed the three different jurisdictional approaches to equitable subrogation; 1) the Restatement approach (i.e., actual or constructive knowledge is irrelevant); 2) the "minority" approach that says a plaintiff with either actual or constructive knowledge cannot seek equitable subrogation; and 3) the "majority" approach that says a plaintiff with actual knowledge cannot seek equitable subrogation, while one with constructive notice can.

In its discussion of the majority rule, the court dismissed the argument that applying the Restatement approach would "obstruct the predictability and stability of recording act and the rule "first in time, first in right"; the court stated that "while the recording act provides stability and notice to lenders (both vital elements to any successful real estate lending scheme), we cannot rigidly adhere to its strictures where it works an injustice." Id. at par. 18. The court also dismissed the minority rule, stating that while the rationale for that rule is that a party should not profit from its own negligence by failing to check the public records, "[f]or practical purposes, this rule swallows the doctrine and is widely criticized." Id. at par. 14-15. The court reasoned that if all such persons who confer a benefit on others due to their negligence would be disqualified from equitable relief even where no other party is harmed, "then the law of restitution, which was conceived in order to prevent unjust enrichment, would be of little or no value" (citations omitted)." Id. at par. 15. The court cited with approval a recent law review article by Grant S. Nelson and Dale A. Whitman, Adopting Restatement Mortgage Subrogation Principles: Saving Billions of Dollars for Refinancing Homeowners, 2006 B.Y.U. L. Rev 305, 315-16, in particular the following:

"We have vigorously criticized this approach [the minority rule] and find it impossible to understand in light of the fact that subrogation in this situation harms no one, leaving the intervening lien exactly where it started. In contrast, refusal to grant subrogation gives the intervening lienor an unexpected, unearned, and unwarranted promotion in priority. (footnote omitted)."

The court also justified its decision (allowing WFB West's refinancing mortgage to be equitably subrogated to the first-position Washington Mutual loan even though West knew of the existence of the intervening B of A loan) based on economic considerations, including alleged savings on title insurance premiums and costs. The court stated that "a liberal equitable subrogation doctrine can save billions of dollars by reducing title insurance premiums. Title insurance primarily insures there are no intervening liens, and when a jurisdiction adopts the liberal view of equitable subrogation, the insurance premium is greatly reduced. . . We have demonstrated that title insurance costs in residential mortgage refinancings represent billions of dollars annually – costs that are now borne overwhelmingly by homeowners." Id. at par.33. The court further stated that "A liberal approach is in line with the [equitable subrogation] doctrine's equitable rationale and is becoming the more acceptable rule, in no small part because of the immense benefits it holds for homeowners." Id. at par. 34. The court concludes, after examining the existing case law, that "[t]his trend is clearly toward the more liberal [Restatement] approach, and we would be wise to follow it." Id. at par. 27. Also the court, in discussing the "history of equitable subrogation," stated at par. 24:

The rule requiring a subrogee have no knowledge of intervening interests is left over from an early mistrust of equitable subrogation and was borrowed from courts applying subrogation as a restitution remedy. We abandon this rule since this early mistrust has abated, and we are concerned with refinancing mortgages, not restitution.

Note also footnote 19, which states that: "Lest anyone fear for the future of the title insurance industry, Professors Nelson and Whitman assure us "the title insurance industry can endure a significant reduction in refinance premiums (citation omitted). Additionally, Nelson and Whitman spoke with a variety of executives representing major title insurance companies and mortgage lenders from all geographic areas of the country . . . Their comments were unanimous in one important respect – they supported either judicial or legislative adoption of the Restatement subrogation rule (citation omitted)." Id. at fn.19.

Finally, the court listed two "policy considerations" that it alleges support its position that the Restatement approach should prevail: "First, by facilitating more refinancing, equitable subrogation helps stem the threat of foreclosure . . . Second the Restatement approach affords enormous financial benefits for many homeowners." Id. at par. 32-33.

The dissent in this case argues that the refinancing mortgagee should be protected only if it has actual knowledge of the intervening lien. The dissent reasons that "in my view a commercial lender who undertakes no title search will be unable to demonstrate, as the Restatement (Third) requires, that it 'reasonably expected' to receive a security interest in the real estate with the priority of the mortgage being discharged" (citation omitted) (emphasis in text). Id. at par. 41.

For recent cases rejecting the Restatement, see Ethridge v. Tierone Bank, 226 S.W. 3d 127 Countrywide Home Loans, Inc. v. First Nat'l Bank of Steamboat Springs, N.A., 2006 Wyo. 132, 144 P.3d 1224 (Wyo.2006)., the DIRT DD for 11/8/06. (Wyoming holds that institutional lender is not entitled to benefit of equitable mortgage doctrine where State has explicit "filing date priority" or "first in time" statute and lender has actual and constructive notice of intervening mortgage.)

The Reporter for this item was Jack Murray of the First American Title Insurance Company's Chicago office.

3 .What parties are entitled to protected by equitable subrogation?

Gibson v. Neu, 867 N.E.2d 188 (Ind., 2007).

Nowak gave Gibson a note for $350,000 to cover the price of stocks purchased from him. The note was secured by a mortgage on Nowak's Indianapolis residence, as well as by a mortgage on other property Nowak owned in Michigan. With regard to the residence, the mortgage Gibson took was junior to a $506,000 first mortgage that was held by Irwin.

Nowak sold his residence to the Neus for $600,000, which proceeds were used to retire the Irwin first mortgage and to give Nowak $55,000 in cash, because Gibson's mortgage had not been picked up by the title company. The Neus financed their purchase with a $200,000 mortgage loan from Washington Mutual and apparently provided the balance themselves.

Nowak paid approximately $41,000 of his note to Gibson (leaving an apparent balance of $309,000), but then defaulted and Gibson brought this action to foreclose, claiming the status of a senior lienor because his mortgage had been recorded before WAMU's. The trial court entered summary judgment against Gibson, interpreting his loan agreement to obligate him to release the residence from the mortgage when Nowak sold it. The court of appeal rejected that position, holding that a release was required only if the loan was not in default at the time of transfer, whereas Nowak was in default at that point. But the court also held that the trial court has correctly ruled that both WAMU and Neus were entitled to equitable subrogation priority over Gibson's mortgage.

The court of appeals reached this conclusion because in 2005, the Indiana Supreme Court had endorsed the position taken in Restatement of Mortgages §7.6 that neither constructive nor actual notice bars a refinancing lender who pays off a prior lien from being equitably subrogated to its priority over another existing junior lienor who was inadvertently not paid off, since that junior suffers no harm by the replacement of the original lender with the new lender. Bank of New York v. Nally, 820 NE2d 644.

The court held that the reasoning of Nally is not limited to refinancing lenders, that neither Neus nor WAMU were volunteers, and there is no requirement that Neus have had an expectation of obtaining a security interest in the property to qualify for equitable subrogation. Indeed, the Restatement itself gives as an example a purchaser who pays off a prior lien:

21. Mortgagor holds Blackacre subject to two mortgages, held respectively by Mortgagee-1 and Mortgagee-2. Mortgagor sells Blackacre to Grantee, falsely stating to Grantee that Blackacre is subject only to the first mortgage and promising that Mortgagor will pay and satisfy that mortgage obligation with the proceeds of the sale. Grantee, believing this statement, makes no title examination and is unaware of the existence of the second mortgage. Grantee completes the purchase. Mortgagor uses the proceeds of the sale to satisfy the first mortgage but does not satisfy the second. Grantee is entitled to be subrogated to the rights of Mortgagee-1 as against Mortgagee-2 and may enforce the first mortgage against Mortgagee-2.  Therefore, WAMU as well as the Neus were both entitled to priority over Gibson to the extent of Irwin's former $506,000 mortgage.

Comment: . It is easy to understand how equitable subrogation works for WAMU the new lender: its $200,000 mortgage has the status of Irwin's old first mortgage, since it fits comfortably within the $506,000 that was previously prior to Gibson. But giving equitable subrogation priority to the Neus as well complicates the situation considerably.

Restatement Illustration 21 says a paying purchaser is entitled to the same equitable subrogation rights as are given to a refinancing lender. The Illustration, however, does not say how this is to work, but the Reporters' Note declares that it is based on Dixon v. Morgan, 285 S.W. 558 (Tenn. 1926), which does show how the principal operates. Dixon describes it as an "equitable assignment" of the old mortgage to the purchaser of the property, "and equity treats him as the assignee of the original senior mortgage, and will revive and enforce it for his benefit." In other words, it is like the fearsome Dracula mortgage situation where a senior lender forecloses without including the junior lender in the action (making the junior mortgage both dead (because of a valid foreclosure on the title) and alive (because the junior mortgage was not included) at the same time. When this occurs, the foreclosure purchaser is treated as having purchased both the title (with the right to pay the junior lien off) and as assignee of the old senior lien (with the right to now foreclose out the junior), depending on how the numbers work.

In this case, the Neus should be treated as assignee of the remaining Irwin mortgage priority. Although they paid $400,000 of their own funds to purchase the property (if the court's numbers tell the complete story), there was only $306,000 of priority left in the Irwin mortgage after $200,000 of it was given to WAMU. And below them is Gibson with his approximately $309,000 "third.

If the property is worth only the $600,000 the Neus paid for it, it will not support the combined burden of these three obligations, which total $815,000. If WAMU foreclosed, it would take the first $200,000, the next $306,000 would go to the Neus, and the final $94,000 would go to Gibson. The remainder of Gibson's debt ($309,000 less $94,000), would no longer be secured by this property, but would still burden Nowak's Michigan land. The Neus would suffer the most, since they would get back only $306,000 of the $400,000 they had originally paid, and they dare not overbid, since any extra they add over the $600,000 would go to Gibson before it would come to them.

If Gibson foreclosed, he would sell the property subject to $506,000 of senior liens, and might receive a bid of $94,000. Again, the Neus would lose the property unless they bid more, but that would only put more money into Gibson's pocket. The remaining $94,000 cash that they had paid for the property would go to Gibson.

There is probably no way around this for the Neus. As titleholders, they can redeem from Gibson, but it might cost them $309,000 since that is the amount of his lien. Alternatively, as equitable assignees, they can foreclose on Gibson. A strict foreclosure might be possible, since Gibson has no title at stake, and Gibson would have to redeem from them to protect himself, but it would cost him only $306,000, the amount the Neus have priority for. If the Neus foreclose by sale (selling the property subject to the WAMU first), they could credit bid, but bids in excess of the $306,000 that they have equitable priority for will go next to Gibson. Indeed, Gibson would probably bid at least $94,000 over a Neus' $306,000 credit bid, since those funds will all come back to him. For the Neus to then reenter the bidding would only be to put more funds into Gibson's pocket until his lien was paid in full.

The Neus may benefit from equitable subrogation, but it does not totally.

(From Bernhardt's Mortgage Law Newsletter)


4. Court enforces recourse of "bad boy" carveouts in a nonrecourse securitized loan.

Blue Hills Office Park, LLC v. J.P. Morgan Chase Bank, 477 F. Supp.2d 366 (D. Mass. 2007)

The borrower settled a dispute with a neighboring landowner concerning the neighbor's attempt to get zoning that would permit it to erect a parking garage on its property. The borrower withdrew its appeal of a zoning ruling in return for a cash payment of $2 million. It pocketed the money and provided no notice the lender. The court ruled that the settlement was part of the "mortgaged property," which, as described in the loan documents, included "[a]wards or payments . . . with respect to the Premises . . . for any . . . injury to or decrease in value of the Premises."

The nonrecourse provision in the mortgage (which obviously was carefully negotiated) specifically provided that if the borrower diverted funds from the mortgaged property that belonged to the lender, the borrower's and guarantors' liability would become recourse for the entire loan balance of the loan (certain other borrower acts and defaults, such as fraud, intentional physical waste, or removal and disposal of mortgaged property after default, would result only in limited liability of the mortgagor and guarantors for actual damages).

The court held that when the borrower settled a zoning appeal against the adjoining landowner (in this case for $2 million) and failed to disclose the settlement to the lender or seek its consent (as required by the mortgage loan documents) and diverted the funds to itself, the borrower (and the guarantors) lost their nonrecourse protection and became liable for the full amount of the deficiency and other costs (upwards of $20 million), and not simply the restitution amount of $2 million. (The high bidder at the lender's foreclosure sale, instituted after the borrower defaulted on its loan payments, was a single-purpose entity created by the lender, which later sold the property to a third party.)

The court castigated the attorneys for the borrower and the guarantors. Apparently these attorneys assumed that since litigation in this area is so rare, they could assume a very aggressive litigation posture and the matter would be worked out later to their satisfaction. But the moral of the Blue Hills case is that carveouts to nonrecourse loans mean what they say and will be strictly enforced (even if the borrower and guarantors rely on advice to the contrary from their counsel)! (See John C. Murray, "Carveouts to Nonrecourse Loans: They Mean What They Say!" http://www.firstam.com/listReference.cfm?id=5574.)

After the court's judgment, the guarantors fired their attorneys and put them on notice of a malpractice claim. The borrowers and guarantors subsequently appealed from the judgment, but the appeal was dismissed and $17.25 million (98.5% of the judgment) was paid to the lender to settle the case. (Blue Hills Settlement and Release Agreement.) As Judge Young so succinctly stated during the trial, "don't mess around with the collateral. . . . "[I]f you mess around with the collateral, that's when you'll be liable for the entire amount of the deficiency." 10/13/06 Blue Hills Case Trial Transcript at 47.

The court also found a second violation of the nonrecourse carveouts – the borrower had violated single-member and single-purpose-entity requirements in the loan documents by commingling the $2 million settlement payment with monies of its member and by failing to maintain a participating independent director. Although the borrower had named as the "independent director" an individual who once worked as a paralegal or secretary at the borrower's law firm, the court stated that "it is clear that she did not participate in the management of Blue Hills in that capacity," Id. at 383, and that she "was not involved in the discussions concerning the $2,000,000 settlement payment." Id. Therefore, the court held, the borrower had violated a specific mortgage covenant because it had failed to "cause there to be" an independent director and had failed to maintain its status as a single-purpose entity. See In re Kingston Square Associates, 214 B.R. 713, 721 (Bankr. S.D.N.Y. 1997) (finding for plaintiffs partially on basis that "[the "independent director"] seems not to have taken any interest at all in the properties. He testified that as a director he never reviewed any documents regarding any of the Debtors including rent rolls, judgments, or state court decisions").

Editor's Comment: The editor believes that the lesson here is that "bad boy" clauses may mean what they say, and that therefore lawyers counseling borrowers and guarantees should so assume. But the editor is not convinced that the courts have totally abandoned the notion that provisions creating a penalty for default are not enforceable.

Consider, for instance, if the sole violation in this case had been the appointment of the paralegal as the independent director. Assume that, after the lender complained about this appointment (which of course was a callous disregard of the spirit of the independent director requirement), but before any ill consequences had occurred, the borrower agreed to appoint a true independent director. Later, if a default occurs, would the court conclude that the "bad boy" clause operated to destroy the nonrecourse protection? The editor believes that in such cases - harmless or relatively harmless violations or cured violations - even deliberate and callous - the courts may view the loss of nonrecourse protection as a penalty. He's certainly not willing to assume otherwise after just one case.

The Reporter for this case was Jack Murray of the Chicago office of First American Title Insurance Company.

5.  Even though a foreclosing mortgagee may already have obtained a judgment for collection of the note, it may still seek to recover additional fees and charges in a subsequent foreclosure action provided those fees and charges do not arise out of the same circumstances as were litigated in the collection action.

First Union National Bank v. Penn Salem Marina, Inc., 190 N.J. 342, 921 A.2d 417 (2007)

Mortgagors on a commercial loan defaulted and, as a result, the mortgagee sued on the note and also initiated foreclosure proceedings. The note was partially secured by a first mortgage. The note also laid out the terms under which the mortgagee could recover the debt in the event of a default.

In the action on the note, the mortgagee sought the principal due at the time of default, plus late charges, insurance, escrowed taxes, and interest accrued from the time of default through the date of judgment. The mortgagor failed to respond, and the mortgagee was awarded the amount it sought along with attorneys' fees on its claim against the promissory note.

Although both the suit on the note and the foreclosure suit were filed about the same day, they were heard in different divisions. The foreclosure action, in the equity division, ultimately proceeded to judgment about a year and a half after the judgment in the suit on the note in the law division. In the foreclosure action, the lower court in the foreclosure proceedings awarded, over the objection of the mortgagors, an amount that was nearly two hundred thousand dollars more than what had been awarded by the lower court that had heard the note collection matter. The foreclosure award included the same unpaid principal as owned at the time of the default on the loan, but included a larger amount of interest and taxes because they had accrued over a longer period of time. The mortgagees also sought a prepayment penalty and default interest, items that had not been part of their earlier claim.

The mortgagors appealed the foreclosure decision, arguing that the foreclosure award should not have exceeded the amount of the decision that enforced the note. Applying issue preclusion priniciples of collateral estoppel, The Appellate Division affirmed the lower court's decision and had found that the foreclosure ruling was not precluded by the ruling on the note enforcement. The Appellate Division also found that principles disallowing a matter that has been resolved from being re-litigated did not apply because legal actions and remedies to enforce the terms of a note were different than legal actions and remedies for adjudicating a foreclosure. The mortgagors appealed the Appellate Division's decision.

Before the New Jersey Supreme Court, the mortgagors argued that the amount awarded to the mortgagee in the note enforcement action fixed the amount to be awarded in the foreclosure proceedings. First, the Court noted that the relief sought in the foreclosure was more extensive than the relief sought in the enforcement of the note, but that the underlying claim for relief was largely the same. It concluded that the lender was limited to the recovery already granted as to matters that had in fact been litigated in the earlier action. For instance, in the earlier action, the court had established a certain figure for per diem interest. The foreclosure court, studying the same documents, came up with a different conclusion. But the Supreme Court held that the foreclosure court was precluded from reexamining that issue, and rolled back the per diem interest to that determined by the original court in the suit on the note. That issue had been resolved, albeit by default judgment.

But the Court held that a foreclosure action adjudicated following the adjudication of note enforcement is bound by the first decision only as to damages that are similar to those claimed in the second action. Damages of a different type, not sought in the first proceeding, could still be awarded in a subsequent adjudication. In the case at hand, the mortgagee had not asked for a prepayment penalty or default in interest in its claim for relief in the law court action on the note., and they were not "essential" to recovery of the amounts that the trial court in that action did award. So the mortgagee was free to raise these issues in the foreclosure action.

Further the Court held that issue preclusion does not bar a lender from recovering monies in excess of the first judgment where further charges are later accrued such as for interest, costs, and attorneys' fees.

The Court reversed the Appellate Division's decision that the foreclosure action was not precluded at all by the note enforcement action, and held that the foreclosure was precluded only as to those issues that were the same in both proceedings.

Note: The court does not mention in any detail the question of late charges. The mortgagee had included an item for late charge in the first proceeding, but there was a much large item for late charges in the foreclosure award. The court notes in a footnote that the appeals court had lowered the amount, but still it does not appear to have lowered the amount back to what had been in the first award. So far as the editor understands the case, there should be no additional award for late charges, as a late charge can only be imposed once, and the amount of that charge had been resolved in the suit on the note. The editor is concerned that the court doesn't explain the apparent discrepancy in the two claims on this score, but it does indicate that on remand the principles it dictates may result in further changes.

Comment: Of course, the question of procedure for judicial recovery on notes secured by mortgages varies dramatically from one jurisdiction to another. Some courts would permit only one lawsuit to run at a time. It may be that some courts would require that all actions that reasonably could be included in a suit between the parties on basically the same facts should be included or be forever barred. In is interesting that New Jersey, apparently because a foreclosure suit is for different relief in a different court, takes such a generous view toward the mortgagee on the question of issue preclusion.

6. Lender could not recover percentage late fee on promissory note's final balloon payment when fee provision applied only to interim installment payments.

Poseidon Dev., Inc. v Woodland Lane Estates, LLC 152 CA4th 1106, ___ CR3d ____(2007)

Woodland executed a promissory note (Note) and deed of trust in favor of Poseidon which provided for monthly interest-only payments and a final payment of principal and unpaid interest. If any installment was not paid on time, the Note provided for a late charge of 10 percent of the overdue amount, described as processing and accounting charges.

Woodland failed to make the final payment of principal and interest on the due date. Poseidon recorded a notice of default and then began collection proceedings, incurring attorney fees and costs. Although Woodland eventually made the final payment of principal and interest, it refused to pay a late charge or the expenses of collection.

Poseidon sued Woodland for breach of contract, seeking to recover a late charge of 10 percent of the final balloon payment, its collection expenses and damages for lost business opportunities, costs and attorney fees. The trial court sustained Woodland's demurrer without leave to amend, concluding that the Note's late charge provision applied only to the interest payments, not the final balloon payment, that Poseidon was not entitled to costs of collection because it was not authorized to initiate foreclosure proceedings, and that Poseidon could not recover damages for lost business opportunities. The trial court granted Woodland's motion for costs and attorney fees.

The court of appeal reversed. Although the trial court correctly determined Poseidon was not entitled to the relief sought in the complaint, it erred in sustaining Woodland's demurrer without leave to amend because Poseidon was entitled to recover actual damages suffered by reason of the late payment.

Poseidon was not entitled to a late charge on the balloon payment as an element of damages. Although a final, balloon payment may be considered an installment within the common meaning of that term, the parties did not so intend here, as indicated by the plain language of the Note read as a whole, in accordance with CC §§1638, 1641, 1643, and 1644. Moreover, the trial court's interpretation saved the late charge provision from being an unlawful penalty under CC §1671(b). The Note provided that the purpose of the late charge provision was to compensate Poseidon for administrative expenses, which would not vary appreciably depending on the amount of the overdue payment. If the late charge provision was intended to apply to both interim installments and the final payment, it would be an unenforceable penalty provision because it could not possibly be considered a reasonable estimate of the damages contemplated by a breach. The only interpretation of the late charge provision that would make it lawful, operative, definite, reasonable, and capable of being carried out, as required by CC §1643, is one that would make it inapplicable to the final payment.

The trial court properly took judicial notice of a recorded assignment of the Note and deed of trust whose clear legal effect was that Poseidon no longer held the beneficial interest under the deed of trust. Because Poseidon gave up its right to replace the trustee and initiate foreclosure when it assigned the Note and deed of trust, it had no power to initiate foreclosure proceedings and was not entitled to recover the cost of doing so from Woodland.

The demurrer should not have been sustained without leave to amend. It was undisputed that Poseidon was entitled to interest from the date final payment was due until it was paid and might also be entitled to other damages in the nature of administrative expenses. Although Poseidon had been given one opportunity to amend the complaint to state a claim for unpaid interest and failed to do so, it was appropriate to give Poseidon one more chance.

(From CEB, California Real Property Law Reporter)

7. Non-assuming grantee can reinstate home mortgage in face of default, but can it be done in face of "due on sale" acceleration?

In re Ramos, 357 B.R. 669 (Bankr. S.D. Fla. 2006)

One day after securing a mortgage on a residence, the mortgagor transferred to a third party, Ramos, who took subject to the mortgage, but did not assume it. The mortgage contained a due on sale clause, and there appears to be no dispute that the transferred triggered an acceleration right under that clause. Of course, no one bothered to tell the mortgagee of the transfer.

A year later, Ramos, who had been making payments on the mortgage loan, defaulted. Lender brought sued to foreclose and obtained a foreclosure judgment, but no foreclosure sale had been held before Ramos filed a Chapter 13 bankruptcy proceeding. Lender petitioned for relief from the stay.

In its petition, Lender asked in the alternative that it be granted relief from the stay to complete the pending foreclosure or that it receive adequate protection and that the court reinstate of the Mortgage for that purpose.

The court concluded that, contrary to the Lender's assertions, there was value in the property in excess of Lender's loan amount. But it noted that there were a number of other liens against the property (four mortgages) that more than exhausted any equity in the borrower. Nevertheless, the court concluded, unsurprisingly, that the home was critical to carrying out an effective reorganization.. In fact, the borrower asserted in its brief that the whole purpose of the bankruptcy was to salvage the home and prevent it being lost to foreclosure. The court acknowledged that most probably an evidentiary hearing would be necessary in most cases to resolve any dispute on these issues, but it stated that since the Lender had asked in the alternative for reinstatement of the Mortgage and adequate protection, no evidentiary hearing was necessary.

But Lender pressed the claim that there was an additional basis for relief from the stay - "cause" in the form of what the court characterized as "breach" of the due on sale clause. The court acknowledged that "many cases" appear to support this notion, and indicated that the apparent rationale for these cases was "the reasoning that a debtor who is not a borrower can not cure a default under the relevant Chapter 13 Section - 1322(b)(3).

But the court pointed to another line of cases that deny relief notwithstanding a due on sale acceleration. Prominent in this line of cases was In re Garcia, 276 B.R. 627 (Bankr. Ariz. 2002).It stated that the appropriate interpretation of the Bankruptcy Law is that a party holding property subject to a mortgage is always in a debtor-creditor relationship with the mortgagee and thus entitled to reinstatement, whether or not the debtor has personal liability on the mortgage note.

The court then decided that, despite this reasoning, it would not decide that the sale in the face of a due on sale clause did not constitute "cause" justifying relief from the stay. It did not have to decide because, the court concluded, Lender had waived its right to make such a claim when it asked for alternative relief in the form of reinstatement and adequate protection. We are not told why such a waiver resulted.

The court did hold, however, that Ramos was not entitled to reinstatement of the mortgage by paying off the defaulted back payments over time as part of the plan, but would have to make up defaults upon confirmation of the plan.

Comment : This is not the editor's area of expertise, but he still expresses wonder that the bankruptcy court basically reads the due on sale clause right out of the mortgage. The clause give the lender a right to accelerate. This right, incidentally, is protected by federal law, so one wonders why the Bankruptcy law would be seen as preemptive. The only "default" that could be cured, one would think, would be the failure to pay the lawfully accelerated total loan balance, rather than reinstatement of the loan to the payments. The court seems to be of the view, however, that the borrower can preserve her ownership and simply continue on with the old payment structure. This is not a holding, per se, since the court makes that crazy waiver ruling. But the court certainly has a peculiar view of the situation.

8.  A mortgagee in possession of a condominium unit is personally liable for delinquent condominium common charges which accrue against the property's legal owner for services furnished during the mortgagee's possession and control of the premises.

Woodview Condominium Association, Inc. v. Shanahan, 391 N.J. Super. 170, 917 A.2d 790 (App. Div. 2007)

2. A mortgagee in possession of a condominium unit never paid monthly condominium fees while in possession and control of the premises. Consequently, the condominium association sued the mortgagee in possession for conversion and on a book account. The mortgagee defended the action, alleging that it was not personally liable for the accrued fees because it did not hold legal title to the units. The lower court ruled against the mortgagee, reasoning that the mortgagee could not avoid responsibility for all mandatory condominium fees, but still benefit from the rental value of the unit itself. The mortgagee appealed.

The Appellate Division affirmed, holding that along with the entitlement to profits and rent, mortgagees in possession assume the duties of a provident owner which requires management and preservation of the property. The Court then held that a mortgagee in possession may be liable for services rendered to it in connection with the property during its occupancy on the basis of an express or implied contract. The Court found the mortgagee entered into an implied contract in which it received the benefit of common services and so had to suffer the burden of their cost. Accordingly, the Court remanded to the lower court to answer the narrow question of when the mortgagee took possession of the unit so as to appropriately adjust the amount of the judgment based on that determination.

9. Trustee in securitized lending arrangement is not by that function subject to process in North Carolina in class action involving alleged usurious character of the underlying loan.

Skinner v. Preferred Credit, 638 S.E. 2d 203 (N.Car. 2006)

The case was decided December 20 of last year. The North Carolina Attorney General is aghast at this 4-3 decision and is seeking rehearing. The AG's office views the outcome as contrary to the public policy of North Carolina and has distributed a memo asking that all similar thinking North Carolina attorneys join in the rehearing effort.

The case involves a pretty stinky subprime loan that got sold into a securitized trust. The loan, made in 1997, was for $45,000, and carried over $5000 in up front fees and an interest rate of 14.75% and a term of 180 months. It apparently is the centerpiece of a class action alleging breaches of the North Carolina Deceptive Trade Practices Act and the North Carolina Usury Laws.

The defendant is a Trustee in a securitized loan arrangement. The court noted that less than 3% of the mortgage loans held by the trust originated in North Carolina, and the loan passed into the trust, of course, after it was originated by third parties. A separate loan servicer, Chase Bank, serves as servicer of the loans, and has, the court notes, complete discretion as to how to manage the loan account, including when to foreclose. The servicer pays loan proceeds to the trustee, which distributes the proceeds in accordance with the securitization arrangement to investors in the capital market.

North Carolina loans use the deed of trust device, and the Trustee is acknowledged to be the beneficiary (by assignment) of the Deed of Trust.

In a relatively brief opinion, relying on a prior North Carolina case involving an individual purchase money loan held by an out of state beneficiary and other lower court cases involving securitized lending arrangements in Tennessee, the court ruled not only that the Trust did not fall under any of the three bases for jurisdiction under North Carolina statutes, but that, if the statutes did apply, this outcome would violate the Due Process Clause of the United States Constitution because there were insufficient "minimum contacts" on which to predicate a claim of jurisdiction.

The court ruled that the Trust had undertaken no "substantial activity" in North Carolina, as all the acts by which it became owners of the 114 North Carolina loans that it held occurred outside of the state and after the loans were originated. The Trust had no other activities in North Carolina.

The court then ruled that the case did not involve "goods, documents of title, or other things of value shipped from [North Carolina] by the plaintiff to the defendant at his direction." The payments under the loan were sent to the servicer which, as noted, had complete discretion in managing the account. The fact that the servicer shipped them on to the Trust did not make the Trust the direct recipient of the payments.

Perhaps most significantly, the court ruled that the Trust's status as the beneficiary of the deed of trust securing the loan did not render it the holder of "local property" sufficient to make it subject to North Carolina jurisdiction. The court here relied almost exclusively on precedent in North Carolina and elsewhere, and did not separately analyze the policy ramifications of this decision.

In its discussion of the question of whether Due Process would permit the State to exercise jurisdiction over the Trustee, the court also referred to authority from other jurisdictions, including Kansas, Michigan and Rhode Island, involving similar arrangements. But it distinguished a 9th Circuit decision that did impose jurisdiction in a similar case involving a Washington loan alleged to be usurious. The distinction is important because it tends to narrow the Due Process decision made here. In the Ninth Circuit case, the court noted, the claim was that the trustee benefitted by the receipt of usurious interest payments. Here, the court stated, the claim was that the original fees charged at inception of the loan rendered the loan usurious. Of course, those fees were paid prior to the transfer of the loan to the Trust.

Comment 1: This strikes the editor as an important decision, albeit 4-3, and the editor is not surprised to see the North Carolina Attorney General so exercised about it. Note that the interpretation of the application of the North Carolina statute tends to immunize the Due Process discussion from further appeal. Further, note that the distinguishing of the 9th Circuit decision occurs only in connection with the Due Process analysis. The editor has not studied the 9th Circuit case to determine whether the Washington statute had a broader basis for jurisdiction than the North Carolina case, but the fact that the North Carolina court did not discuss the 9th Circuit case in deciding on its own statute certainly suggests that the court viewed the statutes as different.

Comment 2: The memo from the North Carolina Attorney General notes that the loans in the Trustee's portfolio amount to $4 million in 114 loans emanating from North Carolina, and that the sheer size of the investment renders the case distinguishable from the prior North Carolina case involving a single beneficiary, even though in the other case there was no separation of trustee from servicer. It is interesting that the court in the case chose to note at several points that the total North Carolina investment was less than 3% of the trust portfolio, suggesting, indeed, that size matters. So there is a line somewhere, but the court didn't feel that it was crossed here.

10.  Bank agrees to pay nearly $1 million for environmental conditions at defunct borrower's facility

Cuomo v. HSBC(not a decided case - report of settlement)

HSBC Bank USA, N.A. agreed to pay $850,000 in fines and reimburse environmental agencies for response costs involving a facility that was abandoned by a borrower. The bank also agreed to implement an internal environmental awareness training program for its staff and to adopt revised workout procedures. This case highlights the risks that lenders face during workouts and foreclosure involving manufacturing facilities or contaminated property.

HSBC had extended a $4.1 million loan to Westwood Chemical Corp. After the borrower defaulted, HSBC established a lockbox and directed customers to forward payments to that account. A few months later, HSBC seized Westwood's operating funds and asked the company to prepare a plan for an orderly shutdown. As part of this request, Westwood requested approximately $60,000 to properly dispose of hazardous materials in drums, containers and wastewater tanks as well as raw materials and work in process. HSBC refused this request and also declined to follow the recommendations of its consultants to winterize the facility.

During the winter, pipes from the fire suppression system burst as well as many of the containers storing hazardous materials. The contents of the drums mixed with water when the weather warmed. At some point in early 2005, the local code enforcement officer became aware of the conditions and notified the New York State Department of Environmental Conservation (NYSDEC), which then referred the matter to EPA.

In the meantime, the trustee for the bankrupt debtor filed a motion under section 506(c) of the bankruptcy code seeking to subordinate the bank's lien. EPA, DEC and the town also filed administrative claims seeking reimbursement of their response costs. In the fall of 2006, HSBC arranged for the sale of the property for $3 million. Approximately $2.3 million of the sales price was used to reimburse some of the costs incurred by the regulatory agencies.

In its lawsuit against HSBC, the New York Attorney General asserted that HSBC was not entitled to the secured creditor exemption because it had become involved in the management of the facility when it seized the operating funds, refused to allow money to be used to properly dispose of the hazardous materials or otherwise enable the borrower to comply with its closure obligations, and failed to properly winterize the facility when it had assumed control of the building and constructive possession of the hazardous materials.

The attorney general also charged that the bank had an obligation to notify the NYSDEC of the conditions at the facility.

As part of the settlement,  HSBC must implement a training program that will educate its employees on the environmental compliance obligations of companies facing financial difficulty and a lender's obligations in such circumstances. In particular, the training program must address the extent to which facilities shut down without an opportunity to perform appropriate wind-down and environmental compliance measures can present significant hazards. In addition, the training program must also review the applicability of state and federal laws disclosure obligations for persons having knowledge of the release or threat of release of hazardous substances.

Reporter’s Comment: Perhaps the most interesting aspect of the HSBC case is the state's view that the bank had an obligation to notify the state about the presence of the drums and containers in the borrower's facility.

Lenders encounter their greatest risk of liability during post-foreclosure activities, and the HSBC case highlights the importance of a lender exercising extreme caution when winding down operations at a borrower's manufacturing facilities.

Many banks have become somewhat cavalier about environmental liability and have been accepting substandard Phase I ESA reports and otherwise diluting their environmental due diligence standards as part of a general decline in lending standards.  The mistakenly believe that federal law has been amended to relieve them of most potential liability.  Under the 1996 Asset Conservation, Lender Liability Deposit Insurance Act, also known as the Lender Liability Amendments, a lender may maintain business operations, wind down operations, take measures to preserve, protect and prepare the vessel or facility for sale or disposition, and even undertake response actions under section 107(d)(l) of CERCLA so long as the lender seeks to sell or re-lease (in the case of a sale/leaseback transaction) and complies with certain foreclosure requirements.  But this doesn’t absolve lenders from disclosure of environmental issues when disposing of the property or otherwise acting as a “good steward” when they control it, either through ownership or in post default activities.

Perhaps because of these developments, banks continue to find themselves subject to environmental issues because of the actions they took during workouts or following foreclosures. Many of these enforcement actions involve administrative orders or lawsuits that are quietly settled by governmental agencies. These situations have typically taken place when a borrower has gone out of business and the bank takes control of the facility in order to sell off the inventory, fixtures, machinery and equipment of the borrower subject to the bank's lien. The bank typically does not take title to the property because of fear that it will lose its exemption, but instead hires an auction house to conduct the sale of the property. Usually, there are barrels or drums of hazardous waste strewn about the facility and the equipment that is being auctioned off may even contain hazardous wastes. To avoid any suggestion that the bank or the auction had any control over hazardous wastes, the auction will often rope off the area where the drums or barrels are found. After the auction is conducted, the drums and barrels are then left in the abandoned facility. At some point, government authorities discover that there are abandoned drums at the facility and order the lender to pay for the removal of the materials.

Lenders should be aware that the definition of "release" under CERCLA includes abandonment of drums. Thus, a lender who has taken control of a facility to conduct an auction and leaves behind drums or equipment containing hazardous wastes could be deemed to have caused a threatened release of hazardous substances. EPA has consistently taken the position that such action constitutes abandonment of hazardous wastes (when the borrower is insolvent) and creates generator liability for the lender. As a result, financial institutions should consult with environmental counsel prior to taking possession of a former borrower's facility or conducting any auction at a manufacturing facility. It would also be advisable for lenders to retain an environmental consultant or environmental attorney to inspect the facility prior to taking control in order to evaluate the possible environmental liabilities that might be associated with the auction. The financial institution could have its environmental consultant or attorney perform a regulatory review of the facility to minimize the possibility that the lender could incur liability for releases of hazardous substances at that treatment or disposal facility.

The Reporter for this item was Larry Schnapf of the New Jersey bar, writing in his excellent periodical: “Environmental Journal.”

11.   When the bankruptcy estate has sufficient cash to pay claims of all creditors, a lender may collect a prepayment premium without regard to whether such premium is “reasonable” within the meaning of Bankruptcy Code Section 506(b).  The only relevant question is whether the fee is valid under state law, the test for creditor’s claims under Bankruptcy Code Section 502.

UPS Capital Business Credit v. Gencarelli (In re Gencarelli), 2007 W.L. 2446883 (!st Cir. 8/30/07)

Debtor, a donut maker,  filed a voluntary bankruptcy petition.  Apparently, at that time, there was intense competition regarding the donut business in debtor’s region, and when Debtor’s assets were sold at a bankruptcy auction, a bidding war ensued, they produced a three million dollar surplus after all creditor’s claims were paid (except those at issue here).

UPS claimed that it was entitled to a prepayment penalty as provided in the instruments.  The penalty was a sliding scale percentage of principal, declining after the first five years.  The trial court ruled that the prepayment fee claim was required to be a “reasonable fee or charge” within the meaning of 506(b), and conducted two hearings in an attempt to give UPS an opportunity to demonstrate the reasonableness of its fee.  (In re Bess Eaton Donut Flour Co., 2005 Westlaw 1367306 (1/19/05)).At least according to the trial court, UPS failed abysmally to do this:

“When asked as to how the questioned penalties were calculated or established, [UPS’s witness] stated, surprisingly, that he "had no knowledge," and instead concentrated on the process UPS follows in selling notes in the secondary market. [The witness’] testimony turned out to be completely irrelevant to the issue about which the matter was reopened.”

The trial court consequently denied the claim for the prepayment fee and the District Court upheld this ruling.

On appeal to the First Circuit Court of Appeals, held: Reversed.

The court ruled that the applicable statutory test for the collectability of a prepayment fee is Section 502, which requires merely that the creditor’s claim be valid under state law.  The “reasonableness” test of Section 506 (b) becomes relevant only when the question is whether the claim is secured - in other words whether it enjoys the priority of any security interest securing the note containing the fee language.

Here, of course, there was no question of priority.  Everyone else had been paid and there was still some pudding in the pot. [Donuts in the box??]

The court noted that this interpretation was a matter of first impression in the First Circuit, but that the question had already been resolved the same way in the Eleventh and Ninth Circuits, and, in dicta in the Second Circuit.

“It is apodictic that ‘unsecured creditors may recover their attorney’s fees, costs and expenses from the estate of a solvent debtor where they are permitted to do so by the terms of their contract and applicable non-bankruptcy law . . . Thus, under the statutory scheme envisioned by the debtor . . . unsecured creditors would be permitted to reap the full benefit of their contractual bargains through the medium of Section 502, while oversecured creditors would be uniquely singled out for unfavorable treatment by the operation of Section 506.  There is no conceivable explanation as to why Congress might have wanted oversecured creditors to be treated in so draconian a fashion. . . .

“Let us be perfectly clear.  This is a solvent debtor case and, as such, the equities strongly favor holding the debtor to his contractual obligations as long as those obligations are legally enforceable under applicable non-bankruptcy law.”

[The editor larded on this quote largely to write out the word “apodictic” even though he has no idea what it means.  Obviously the First Circuit panel did.]

Comment 1: So the lender collects the fee - right?  Not so fast, cowboy!!!  The court simply remands for a determination of whether state law would permit the fee.  An important question for state law is whether the fee ought to be construed as a possible penalty.  The answer to that question depends a great deal upon whether the prepayment fee was triggered by default and acceleration under the documents, and whether such default and acceleration actually occurred here.  It may be that the note never went into default and was prepaid merely to facilitate the bankruptcy sale.  Neither of the opinions the editor has read explains what happened on this score.

If, indeed, there was an acceleration and the fee is payable as a consequence of that, then the creditor in most jurisdictions would have to show that the fee met the test for liquidated damages.  As the fee provided for a sliding scale percentage of the loan amount, the lender will have to work relatively hard to demonstrate that the fee approximated any damages to the lender resulting from the prepayment. [Apparently the loan was intended to be sold and was sold on the secondary market, making the problem even murkier.]

If the prepayment could be characterized as “voluntary,” then the only question is whether the documents clearly provide for it.  Most jurisdictions view a voluntary prepayment as an option for which the parties are entitled to require the borrower to pay an additional fee.

Comment 2: Of course, this is a relatively unusual case because of the surplus resulting from the auction.  More typically, secured creditors will have to deal with Section 506(b).  On this score, the court holds clearly that 506(b) is an independent federal test.  The fact that state law might have authorized the fee, even as a ‘reasonable” liquidated damages provision, appears to be irrelevant to the First Circuit.

12. If a group of parties receive partial assignments or participation shares in a note and mortgage, and if they do not specifically agree among themselves as to their priority, the court is not bound to treat them as pro-rata participants, but instead can assign priority among them based on the equities of the case.

Carbon v. Spokane Closing & Escrow Co., 147 P.2d 605 (Wash. App.2006).

This case involves the creation of a set of partial assignments (participations) in a $2.5 million note and deed of trust. The facts are complex, and it isn’t clear that the court understood them perfectly, but here’s what seems to have happened.

Mr. & Mrs. Carbon sold a parcel of land to A&P Properties for $930,000. A&P gave them a note for $330,000, secured by a deed of trust on other property (which was never paid to them), and they also received $30,000 from one of the promoters of the deal. They were supposed to receive the remaining $566,000 by way of a 15-day note from A&P, but that note was never paid to them. Instead, A&P gave a note and deed of trust to Solid Rock for $2.5 million; this deed of trust was a lien on the land the Carbons had sold to A&P. (A&P never received anything of value for the $2.5 million note). Solid Rock then issued five partial assignments of the $2.5 million note to five individuals, one of which was a partial assignment to the Carbons in the amount of $566,000. The deed to A&P, the deed of trust from A&P to Solid Rock, and the partial assignments were all duly recorded.

Thus, the partial assignment received by the Carbons was evidently intended to represent payment of the remaining purchase price owed to them for their land, and they evidently accepted it in lieu of payment of the 15-day, $566,000 note. However, of the $566,000 they were to receive on the partial assignment, they were paid only $150,000; at that point, the $2.5 million note went into default and payments on it ceased.

This transaction was ill-thought-out, to say the least. Why would the Carbons have accepted a one-fifth share of a note for $2.5 million in partial payment for, and secured by, land that they had just sold for less than $1 million? Why did they not insist on receiving immediate payment of the $566,000 note, and sue on it when it was not paid? There are no clear answers to these questions. The trial court concluded that the escrow officer who prepared the document breached a fiduciary duty to the Carbons.

In effect, the Carbons were holders of about a 23% participation share of the $2.5 million note and deed of trust, although there was no participation agreement. When the note went into default, the Carbons brought a suit against all of the other parties, demanding among other remedies that they be given first priority in the payout of the foreclosure proceeds on the deed of trust.

Ordinarily, when there is no contrary agreement, the parties to a participation share pro-rata in the proceeds of a foreclosure if a shortfall occurs. But here, the court granted the Carbons the first priority as they had requested. In doing so, it applied equitable principles: The Carbons were entitled to first priority, in essence, because they had provided the real estate that made the whole deal possible. Their priority would extend, the court held, to let them recover up to the full purchase price they had originally agreed to accept.

The court found that the $2.5 million note and deed of trust were fraudulent conveyances, by which it presumably meant that they were executed without receipt of equivalent value, and that their issuance left A&P, which issued them, insolvent. Nonetheless, the court refused to set the note and deed of trust aside on the basis of the fraudulent conveyance statute, because the Carbons and each of the other holders of the partial interests had contributed value to the deal, and hence all were BFPs.

Not only did the Carbons receive first priority, but the court prioritized at least some of the other parties’ interests as well. One party who made a cash investment in the property received second priority, and another party, who did not provide any cash but who renegotiated “existing security interests in other properties,” was given third priority.

Reporter’s Comment 1: The fact that the Carbons were given first priority is not surprising when we remember the principle that a purchase-money mortgage to a vendor is presumed to have priority over other security interests that come into effect in connection with the purchase. While the Carbons’ interest was not, strictly speaking, a purchase-money mortgage, it was in effect granted to them in lieu of a purchase money mortgage. Hence, the priority they received makes sense.

Reporter’s Comment 2: The purchase-money mortgage doctrine, however,  doesn’t explain the allocation of priorities among the other partial assignees. That was done on the basis of pure equity. The lesson is clear: if the parties to a participation want a particular priority, they had better spell it out. They can’t assume that the court will treat the participants as all as pro-rata if their agreement is silent on the point.

Reporter’s Comment 3: There was no participation agreement or other contract regarding the priority of the partial assignments here. It’s interesting to think about what the court might have done if there had been. It is likely that the court would have enforced the agreement. After all, the purchase-money mortgage doctrine is only a presumption, and can be reverse by specific language of subordination. There is every reason to suppose the court here would enforced a specific priority agreement as well.

Reporter’s Comment 4: In one paragraph, near the end of the opinion, the court goes off on a tangent concerning UCC Article 9. It points out (correctly) that the perfection provisions of Article 9 apply to security interests in a note, even one secured by a mortgage. This is true but irrelevant, since the partial assignments in this case were (so far as one can tell from the opinion) outright assignments rather than security assignments. (Article 9 provides that outright assignments of “instruments” – such as promissory notes – are automatically perfected, without the necessity of either delivery of the instrument itself or of filing a UCC-1; see UCC 9-309(4). And perfection as to the note automatically perfects as the real estate security – the mortgage or deed of trust – as well; see UCC 9-308(g)). The court concludes by saying that since none of the partial assignees perfected, none of them had secured interests in the note. Again, true but completely irrelevant, since their interests were outright shares of fractional ownership, rather than security interests in the $2.5 note. The paragraph does no ultimate harm, but illustrates how confused judges and lawyers can become when faced with the interaction of Article 9 and real estate interests.