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Commercial Real Estate Financing 2003
Roger Bernhardt, Patrick A. Randolph & Dale A. Whitman
Program Title: Commercial Real Estate Financing 2003
A note on authorship
Some of this material was originally prepared by Professor Patrick Randolph, and was published on DIRT, an internet listserve edited by him. (See .) Those items sometimes refer to Professor Randolph as “the editor.” Some of the material was originally prepared by Professor Roger Bernhardt, and was published in the California Real Property Law Reporter, of which he is editor. Some of it was originally written by other authors, who contributed their comments to DIRT. All of it was given a final edit by Professor Dale Whitman. By now, we can’t remember who wrote which parts. In some cases a particular author is credited with a particular commentary. The authors express their appreciation to all who played a role in formulating the material and apologize to any who should have been given specific credit but were not.
Biographical Sketches of Speakers
Roger Bernhardt is Professor of Law at Golden Gate University in San Francisco. He is the author of two California Continuing Education of the Bar books: California Mortgage and Deed of Trust Practice, and Bernhardt’s California Real Estate Cases. He is also the Editor (and commentator) of CEB’s California Real Property Law Reporter. His other publications for attorneys include Bernhardt’s California Real Estate Codes and Deskbook of Federal Real Estate Laws. In addition to these books for attorneys, Professor Bernhardt has also written for law students: Casebook on Real Property, Real Property in a Nutshell, The Black Letter Law of Real Property, all for West, and also a Casebook on California Real Estate Finance.
Bernhardt is admitted to practice in the states of California and New York, and is also licensed as a real estate broker in California. He is Advisor to the Executive Committee of the Real Property Section of the California State Bar, Chair of the Legal Education Committee of the Real Property Probate and Trust Section of the American Bar Association, and a member of the American College of Real Estate Lawyers, the American College of Mortgage Attorneys, and the American Law Institute.
Patrick A. Randolph, Jr.
Patrick A. Randolph, Jr., a graduate of Yale University and the Boalt Hall Law School at the University of California, Berkeley, is currently the Elmer E. Pierson Professor of Law at the University of Missouri, Kansas City. He has taught at UMKC since 1980. He is of counsel to the law firm of Blackwell Sanders Peper Martin, Kansas City, Missouri. He has published seven books and scores of articles on real estate topics, and regularly appears as a speaker on real estate issues around the country.
Professor Randolph is particularly well known as the Editor and founder of DIRT, the internet discussion group for real estate legal professionals. The DIRT website is http:/www.umkc.edu/dirt/.
Realtor magazine recently named Professor Randolph as one of the 25 Most Influential People in American Real Estate. Professor Randolph is currently at work on revising the Friedman on Leasing treatise. He recently completed Chinese Real Estate Law (with Professor Lou Jianbo) (Kluwer 2001).
Dale A. Whitman
Dale A. Whitman is the James Campbell Professor of Law at the University of Missouri in Columbia MO. He received his B.E.S. degree in Electrical Engineering from Brigham Young in 1963 and his law degree from Duke University in 1966. After practicing for a short period with the firm of O’Melveny and Myers in Los Angeles, Whitman began his academic career at the University of North Carolina in 1967. He has since been a faculty member at Brigham Young University, the University of Washington (where he served as associate dean) and the University of Missouri-Columbia (where he served as dean from 1982 to 1988).
Whitman’s principal fields of interest are property and real estate finance. He is a co-author of five books and numerous articles in these areas. He was co-reporter, with Professor Grant Nelson of UCLA, of the American Law Institute’s Restatement (Third) of Property (Mortgages), published in 1997. He is President of the Association of American Law Schools for the year 2002. He is a member of the Joint Editorial Board for Uniform Real Property Acts, and is the reporter for the Uniform Power of Sale Foreclosure Act, approved by NCCUSL in August 2002. He is a member of the Order of the Coif, the American Law Institute and the American College of Real Estate Lawyers, and is a Fellow of the American Bar Foundation.
Table of Contents
1. Reference to the obligation in the mortgage.
Kalange v. Rencher
2. Future advances made after bankruptcy do not violate the automatic stay.
In re Stanton
Comment on In re Stanton by Roger Bernhardt
3. Construction lending; determination that default exists.
Storeck & Storeck v. Citicorp Real Estate, Inc.
Comment on Storek by Roger Bernhardt
4. Nonrecourse carveouts.
Heller Financial, Inc. v. Lee
5. Lender liability for release of appraisal.
In re Sallee
6. Payment of assigned mortgage loans.
Summit Financial Holdings, Ltd. v. Continental Lawyers Title Co.
7. Deed in lieu of foreclosure; application of merger doctrine.
United States Leather, Inc. v. Mitchell Mfg. Group
8. Master lessor’s right to rents paid by subtenants.
Hawaii National Bank vs. Cook
9. Mortgage loan participations may be recharacterized as loans to the lead lender.
Came Realty LLC v. DeMaio
1. Reference to the obligation in the mortgage.
Kalange v. Rencher
136 Idaho 192, 30 P.3d 970 (2001)
A mortgage does not secure obligations that are not specifically mentioned in the mortgage.
The Farnsworths were the owners of all the stock in the Twin Falls Athletic Club (“the Club”). In 1991 they executed a note to Kalange with a balance of $138,000, secured by their stock and some personal property (but not by real estate).
In 1994 the Farnsworths borrowed an additional $65,000 from Kalange, and this loan was secured by a deed of trust on the Club’s real estate. The deed of trust was recorded. The real estate was listed for sale, and the parties also entered into a “loan agreement,” which provided that Kalange was entitled to an additional “alternative performance payment” of $50,000 if the Club real estate was not sold by December 1996. The “loan agreement” apparently also provided that the deed of trust would secure the 1991 indebtedness. The “loan agreement” was not recorded, and was not referred to in the recorded deed of trust.
Finally, the Farnsworths borrowed money from Rencher, giving him two junior deeds of trust, one of which was a wraparound. These documents were recorded in 1995 and 1996.
When the Farnsworths defaulted in payment to Kalange, he filed a suit to foreclose his deed of trust and sought a determination that the entire balance owing to him, including the balance on the 1991 loan and the $50,000 “alternative performance payment” under the 1994 “loan agreement,” had priority over Rencher’s two deeds of trust.
The Idaho Supreme Court held that Kalange had priority only with respect to the $65,000 face amount of his recorded deed of trust. The side agreement making the that deed of trust secure the previous loan and the “alternative performance payment” was not recorded, and hence Rencher had no constructive notice of its contents. The court quoted its own prior decision to the effect that “where a mortgage is given to secure a specific debt named, the recorded, stated sum of the mortgage is sufficient notice of that indebtedness and will not be extended beyond the amount on the face of the mortgage.”
The court stated that “nothing on the face of the 1994 deed ... suggests that a more complete description of the security may be found in documents outside of the record so as to secure priority of a lien for Kalange's unrecorded 1991 security interest and the $50,000 alternative performance payment vis a' vis Rencher's all‑ inclusive deed of trust.” This statement is not quite to the point, of course, for what is in issue is not a “more complete description of the security” but a more complete description of the obligation.
The case raises a fundamental question: to give priority for the full obligation, must that obligation be stated in the recorded mortgage? The court answers affirmatively, although it is doubtful that its conclusion makes much sense. The reason is that no one can safely buy property subject to a mortgage, or make a junior loan on property already mortgaged, without first obtaining a payoff statement from the existing mortgagee. This is true even if the existing mortgage secures only a single promissory note with an initial balance that is recited in the recorded mortgage. The reason, of course, is that the current balance may be much greater than the original balance. Why? Because of such factors as:
· Accrued interest resulting from months or years of default in payment
· More accrued interest because a default interest clause has kicked in
· A demand for reimbursement to the lender for property taxes, insurance premiums, or other protective payments made by the lender
· Additional advances authorized under an innocuous “boiler-place” future advances clause in the mortgage
· Advances on other loans that are secured by a “boiler-plate” “dragnet” clause in the mortgage
In the aggregate, these factors may add up to many thousands of dollars, even there is only a very general reference to them in the recorded mortgage. As a result, the formal statement of the original loan balance in the mortgage is nearly useless information. To say, as the Idaho court did, that “indebtedness * * * will not be extended beyond the amount on the face of the mortgage” is egregiously wrong!
The court’s decision flatly disagrees with the Restatement (Third) of Property (Mortgages) § 1.5, which provides:
(a) A mortgage need not describe the obligation whose performance it secures, provided the parties have otherwise reached agreement identifying that obligation. * * *
(c) A mortgage need not recite the monetary value of the obligation whose performance it secures. * * *
Despite the fact that the case is difficult to justify, it represents a point of view that must be respected by drafters. There are two morals to the story, from a mortgagee’s viewpoint:
First, always identify in the mortgage all of the other specific loan documents that impose obligations on the borrower, reciting that the mortgage secures their performance; and
Second, include in the mortgage a generic list of obligations that are secured by the mortgage. Below is a sample of such a list. It’s not certain that it would have satisfied the Idaho court, but it’s certainly worth a try.
THIS MORTGAGE IS GIVEN FOR THE PURPOSE OF SECURING:
(1) The debt evidenced by and interest and all other sums owed pursuant to that certain Promissory Note (such Promissory Note, together with any and all renewals, modifications, amendments, restatements, consolidations, substitutions, replacements and extensions thereof, is hereinafier referred to as the "Note") of even date with this Mortgage and having a maturity date of _________, made by Mortgagor and payable to the order of Mortgagee in the original principal amount of ________________;
(2) The full and prompt payment and performance of all of the provisions, agreements, covenants and obligations herein contained and contained in any other agreements, documents or instruments now or hereafter evidencing, securing or otherwise relating to the indebtedness evidenced by the Note (the Note, this Mortgage, the Assignment (as hereinafter defined) and such other agreements, documents and instruments, together with any and all renewals, modifications, amendments, restatements, consolidations, substitutions, replacements, and extensions and modifications thereof, are hereinafter collectively referred to as the "Loan Documents") and the payment of all other sums therein covenanted to be paid, including, without limitation, any applicable yield maintenance premiums or prepayment fees;
(3) Any and all future or additional advances (whether or not obligatory) made by Mortgagee to protect or preserve the Property or the lien or security interest created hereby on the Property, or for taxes, assessments or insurance premiums as hereinafter provided or for performance of any of Mortgagor's obligations hereunder or under the other Loan Documents or for any other purpose provided herein or in the other Loan Documents (whether or not the original Mortgagor remains the owner of the Property at the time of such advances) together with interest thereon at the Default Interest Rate (as defined in the Note); and
(4) Any and all other indebtedness now owing or which may hereafter be owing by Mortgagor to Mortgagee when evidenced by a promissory note or notes reciting that they are secured by this Mortgage, however and whenever incurred or evidenced, whether express or implied, direct or indirect, absolute or contingent, or due or to become due, and all renewals, modifications, amendments, restatements, consolidations, substitutions, replacements and extensions thereof, it being contemplated by Mortgagor and Mortgagee that Mortgagor may hereafter become so indebted to Mortgagee.
(All of the sums referred to in Subsections (1) through (4) above are herein sometimes referred to as the "secured indebtedness" or the "indebtedness secured hereby").
2. Future advances made after bankruptcy do not violate the automatic stay.
In re Stanton
2002 WL 31041342 (9th Cir. 2002)
A future advance mortgage is a single lien, dating from the delivery of the original mortgage, and additional advances made after the mortgagor’s bankruptcy to a borrower who is not bankrupt, but which enlarge the balance owing on the mortgage, do not violate the automatic stay.
International made a loan to Fleet, a Washington state manufacturing company that was wholly owned by the Stantons. The loan was essentially a line of credit and allowed future advances. International took a security interest in Fleet’s property, and also obtained a guarantee of the loan from the Stantons. Later, International took a second mortgage on the Stantons’ house to further secure the line of credit.
Two months thereafter, the Stantons filed bankruptcy (although their corporation, Fleet, did not). Despite the bankruptcy, International continued to advance funds to Fleet. The trustee in bankruptcy sold the house, and International claimed the right to the proceeds of the sale (after payment of the first mortgage), based on International’s second mortgage. The trustee in bankruptcy resisted giving International any of the proceeds. The trustee’s sought to avoid International’s lien on the ground that it was based on advances made after bankruptcy was filed, and thus violated the automatic stay.
The Ninth Circuit held that the trustee was wrong. It held that the lien on the house originated when the second mortgage was placed, which was before bankruptcy was filed. “The subsequent advances merely affected how much money the lien secured.” Those additional advances after bankruptcy were made to Fleet, the corporation, not to the Stantons, the bankrupt shareholders. Hence there was no violation of the automatic stay at any time.
A key factor in the holding is the notion that, in a future advance loan, each advance does not give rise to a separate new lien. Rather, there is a single lien, established at a single point in time, that secures a fluctuating or rising amount. The court quoted the Washington Court of Appeals in John M. Keltch, Inc. v. Don Hoyt, Inc., 4 Wash.App. 580, 483 P.2d 135 (1971): "A mortgage for future advances becomes an effective lien as to subsequent encumbrances from the time of its recordation, rather than from the time when each advance is made."
The court correctly noted that, even though there was no violation of the automatic stay, that did not necessarily mean that International won “all the marbles.” That depends on the priority that Washington law gives to future advances. In the original version of its opinion, the Ninth Circuit simply cited Nat’l Bank of Washington v. Equity Investors, Inc., 81 Wash.2d 886, 506 P.2d 20 (1973), which stands for the proposition that future advances lose priority if they are “optional” and the future advance lender has knowledge of the existence of an intervening lien. Under this rule, International would have lost priority for the (admittedly “optional”) advances after bankruptcy to the trustee, acting in his “perfected lien creditor” capacity under 11 U.S.C. §544(a)(1).
Later, the Ninth Circuit revised its opinion to acknowledge that, by statute, Washington subsequently changed the rule of Equity Investors. See Wash. Rev. Code § 60.04.226, which on its face provides that all future advances take the priority of the original mortgage. Oddly, neither of the parties seems to have been aware of this statute when the case was originally argued.
In sum, the Ninth Circuit majority held that International’s lien on the Stantons’ house was valid (and probably had priority) for the full amount of the advances.
The dissent by Judge Gould argued that the Stantons violated the automatic stay by “continuing to use their house as collateral for Fleet's debts on post‑petition advances.” To buttress this view, Judge Gould cited Equity Investors for the proposition that “under Washington law, liens based on optional advances take effect at the time of each advance.” Once again, this ignores the 1973 statute, which states the contrary.
But if one disregards the 1973 statute (which most states do not have), the question becomes a much closer one. If optional future advances lose priority to intervening liens, don’t they in effect give rise to a different lien than the lien created by the original mortgage? Is it one lien or two? And if it’s two, doesn’t the second one, if recognized as valid, violate the automatic stay?
Restatement (Third) of Property (Mortgages) § 2.3(a) (1997) gives future advance lenders some comfort; it provides (like the Washington statute) that “if a mortgage secures repayment of future advances, all advances have the priority of the original mortgage.” Under the Restatement, the distinction between optional and obligatory advances is obliterated. However, it is unclear at this point how many state courts will be willing to follow the Restatement if there is no statute to back it up.
Comment by Roger Bernhardt. Although this decision came out of Washington State, California has the same rule: Optional advances keep the priority status of the original loan unless they are made with actual notice of an intervening lien. Had Fleet, the borrower, itself filed bankruptcy, the trustee’s status as a judicial lien creditor would have therefore defeated the lender’s further advances, under both state law and bankruptcy law (violating the automatic stay). This decision holds that the bankruptcy of the guarantor, however, does not trigger the automatic stay against advances to the borrower. But the opinion notes that, as a matter of Washington law, advances made to the borrower with knowledge of intervening liens on the guarantor’s security would lose priority to those liens. (Experts on Washington law tell me that the opinion is incorrect on the law of that jurisdiction, but I suspect that that is the result which California courts would reach.)
The federal court declared that this meant that the guarantor’s bankruptcy trustee’s claim therefore had priority over the advances made after the guarantor filed bankruptcy. Since I don’t know exactly what it means for a creditor to be junior to a bankruptcy trustee, I do hope it isn’t any worse than being relegated to unsecured status on those claims. Although that leaves the creditor secured with good priority on the earlier advances and unsecured on the later ones insofar as the guarantor’s security is concerned, the creditor does remain secured with good priority on all the advances insofar as the debtor’s security is concerned, so not much has been lost.
3. Construction lending; determination that default exists.
Storeck & Storeck v. Citicorp Real Estate, Inc.
122 Cal. Rptr. 2d 267 (Cal. App. 2002)
Where mortgagee reserves discretion to make determinations relating to whether borrower has met specific standards for further construction advances, mortgagee has implied duty to be reasonable in making such determination, but otherwise does not have a duty of good faith and fair dealing in invoking the standards.
Mortgagee and borrower, already in an unhappy relationship concerning a troubled $200 million dollar loan for renovation of some downtown buildings for offices, entered into a new loan agreement through which lender would provide a final $9 million to complete work, including tenant improvements relating to leases on the properties. There were many aspects to the agreement, but the one element in greatest dispute concerned the requirement that borrower's construction schedule be "in balance" as a precondition to any further advances.
After the loan moved down the road a bit more, and a number of advances were made, lender determined that the loan was "out of balance" in that the estimated balance of committed loan funds was not sufficient along with funds already made available by borrower, to meet the estimated cost of completion of the construction. Lender notified borrower that the loan was out of balance and that it did not regard itself as obligated to continue to make advances. Nevertheless, lender did advance monies for a while longer to pay certain expenses, including interest on existing monies owed to lender and certain tenant improvements to preserve existing leases. Only about $900,000 of the total $9 million committed remained undisbursed. Nevertheless, lender refused to make advances to pay the leasing staff, and consequently that staff resigned. The project did not rent up as mortgagor hoped, and mortgagee foreclosed and acquired the property by bidding in the debt.
Thereafter, mortgagor sued mortgagee for damages for breach of the implied duty of good faith and fair dealing. Apparently, in this case, there was no dispute that this fact was objectively true. The borrower, however, argued that the lender had violated its duty of good faith and fair dealing in refusing to make further advances unless borrower "topped off" the funds it contributed to bring the schedule back into "balance." The mortgagor alleged several particulars:
1. Mortgagee deliberately set the standards for the loan being "in balance" so low that it could make an out of balance determination at any time.
2. (As a more particular detail of the allegation set forth in 1:) At the time the negotiations were completed for the $9 million advance, a number of tenant improvements already in place were "out of balance" and contributed to the ultimate situation. In short, all through the time that the mortgagee made additional advances, it knew that the loan was "out of balance, yet continued to make advances."
3. After the mortgagee declared the loan out of balance, it "continued to fund items that would benefit its own interests (i.e., "hard" costs for physical improvements plus interest payments to mortgagee on [prior loans] while cutting of "soft" costs (such as salaries for the leasing staff) that were needed to keep the project operational."
At a jury trial, the jury determined that there had been a breach of the implied duty of good faith and fair dealing, and awarded damages in the amount of $900,000 (the amount of undisbursed loan proceeds) for breach of the implied covenant and $41 million for fraud. On appeal, the Court of Appeals reversed the entire judgment, but published only its opinion on the good faith and fair dealing issue.
On this issue the court held first that there was no duty of good faith and fair dealing in California with respect to issues as to which the parties had specifically delegated contractual rights under the agreement. Consequently, the mortgagee did not need to show a good motive or lack of malicious or self serving intent to support its invocation of its right to withhold further advances, so long as the contract conferred that right.
Further, the court noted that the lender disbursements for particular purposes following its declaration that the loan was out of balance, while withholding other advances, also was in accordance with the express rights the parties had conferred upon it in the contract.
The fact that the certain expenses relevant to the "balance" computation already had been made prior to the execution of the agreement did not mean that these expenses could not be taken into account in reaching the determination, so long as this was part of the formula the contract provided (it was).
On the other hand, the court noted that in making the determination as to whether the stated facts existed (i.e. whether the loan was in fact out of balance), California law indicated that with respect to determinations other than those based upon taste or artistic sense – such as financial determinations like these – the party making the determination had a duty to be objectively "reasonable" – more than just "sincere and in good faith." This requirement existed where some standard is required in order to make the contract more than an "illusory contract." Where the parties have specifically bargained for a "standardless determination" such as in an option contract, there is no such requirement. The instant case was one in which it was necessary for the court to impose a standard of determination, since without it the borrower would have transferred consideration to the lender (in the form of settlement of earlier disputes and, presumably, a loan fee) while the lender, not bound by any duty to lend, would be providing no promissory consideration in return.
To make sense of the case, it is important to differentiate this "implied duty to be reasonable" from the implied duty of good faith and fair dealing. The duty to be reasonable requires only that there be reasonable objective support for the determination by the party vested with the right to decide the issue that certain facts are true. The party making the determination may be a complete skunk and invoking the determination in order to do callous and "unfair" advantage of a situation, but if the other side has already conferred upon that party by contract the right to do this, there is no breach of the implied duty of good faith and fair dealing.
Note that the borrower (so far as we know from what's printed) entered into this agreement with its eyes open, and knew or should have known the degree of discretion it was conferring upon the lender. The editor agrees that when parties in the commercial marketplace enter into such arrangements, they should live with the consequences. Any other approach would lead to expensive, contentious, and wasteful battles as to motive and "marketplace fairness," issues that are almost impossible to resolve easily, consistently, or completely. Why should the courts, funded by the taxpayers, bail commercial parties out of bad deals that they knowingly entered? No good reason in the editor's mind. There's always bankruptcy (whoops ‑
the mortgagors tried that here, but relief was granted to the mortgagee to proceed to foreclose.)
In essence, the mortgagor was arguing that the mortgagee was engaged in bad faith during the original negotiations, when it formulated its "scheme" to strip the borrower of its project by setting standards that the borrower couldn't meet. Of course, the immediate response would be, “If you couldn't meet the requirements, why did you sign the contract?” The borrower's response probably lies in those fraud allegations that we're not allowed to see. Without that, however, the borrower has few legitimate answers to this question.
The editor has been provided with an excellent and insightful analysis of the case in terms of California precedent prepared by DIRTer Stevens Carey of Pircher, Nichols and Meeks. The editor believes that Steve agrees with the above synopsis of where the court came out, but takes issue both with how the court expresses its views and supports them.
He notes particularly that prior courts, and even this court, are not so clear about the line of demarcation as to whether a duty of reasonableness is part of or separate from the implied duty of good faith and fair dealing. Further, there is not much clarity on the edges as to when a "reasonableness" standard applies to a given determination and when a "good faith" standard applies, or whether in some cases both apply.
As the editor, a former appeals court clerk, and an educator of many more, knows only too well, judicial clerks often are responsible for providing this support, and frequently are not up to the task. Judges who are less than cautious often find unintended consequences of such sloppy opinions ring down through history as precedent.
What the editor likes particularly about this opinion is that the court eschews the invitation to extend the duty of good faith and fair dealing to the negotiation stage. Whatever the alleged motives of the mortgagee during negotiations, it had every right to present certain contractual language to the borrower (absent fraud) and it was up to the borrower to figure out the degree of risk and decide whether that risk was worth taking.
Comment on Storek by Roger Bernhardt:
Predatory Lending Redux
It happens all the time: A line‑of‑credit lender cuts off its customer's credit just when she needs it the most, or‑as in Storek & Storek, Inc. v Citicorp Real Estate, Inc. (2002) 100 CA4th 44, 122 CR2d 267– a construction lender stops making the scheduled advances precisely when the project is almost ready to fly. Borrowers in such cases have long argued for liability on the ground that their lenders were their fiduciaries, but that claim has never gotten very far. In this decision, the borrowers made an even more serious accusation‑that the lender had never really intended to fully fund the project, but merely kept it afloat long enough to enable its own affiliate to foreclose on a related loan and thereby pick up the property on the cheap. According to the borrowers, the loan contract hedged in the construction draws so tightly that default was inevitable, and, indeed, intended.
The jury in Storek agreed with the borrower's version of the facts. Sometimes predatory lenders do make loans, not to earn interest, but rather to acquire the debtor's collateral for the price of the loan; foreclosure and forfeiture of the security being more profitable to them than even usurious interest. But here the dirty tricks arose, according to the borrowers, not when the loan was first made, but when it was later worked out. Is that predatory lending, too?
Once a loan gets into trouble, the lender's attitude often changes; but even when a deal is heading south, a lender may agree to pump more rather than less money into the project. The loan officer may describe this benevolence to the borrower as altruism and confidence, but the underlying fact is that the loan committee has decided that it is in the lender's best interest: A completed project will more likely be able to pay itself off, or–if it is still underwater after completion–the pickings may be more attractive at that later stage than they are when the project is still only a hole in the ground. And that last consideration can be true even when the lender has already written off the project as an ultimate loser: It still may be more advantageous to advance enough additional funds to enable the borrower to finish the project first before taking it over and pushing him out. After all, if the borrower still sees a mirage of hope (for example, that the market will completely turn around tomorrow), why not indulge him for now, especially if it makes the bank better off later?
Predatory Lending: Good Faith or Reasonableness Standard? Is it a predatory practice for a lender to keep a troubled loan alive in order to make the ultimate foreclosure easier or more profitable–i.e., does such conduct violate the implied covenant of good faith and fair dealing, which the courts are so often prone to find in such situations? Not necessarily, according to the Storek decision, because sometimes a duty of good faith is simply not involved. Citicorp (the lender) may have been as bad as Storek (the borrowers) alleged, but everything it did was authorized by the terms of its loan contract. Only if there was a duty of good faith over and above the duty to comply with the terms of the loan contract would Citicorp's dirty intentions (keeping alive a loan it didn't believe in) be actionable. Storek might have had to prove that Citicorp acted in bad faith, but, more importantly, it had to prove that Citicorp had a duty to act in good faith. Surprisingly, it could not do so.
The duty to act in good faith does not require a party to do anything that the contract expressly says she doesn't have to do, nor does it require her to do something that the contract expressly says she may decline to do. This loan agreement said that Citicorp could elect to stop advancing funds when the budget was out of balance. Although a duty of good faith is sometimes imposed even in the face of contradictory language in the contract, that happens only when necessary in order to keep the contract binding, by making a promise real rather than illusory. This loan agreement had sufficient other consideration to make it enforceable without adding in such a duty. A duty of good faith is also sometimes imposed in order to prevent abuse of a "satisfaction" clause, but that occurs only when aesthetic or personal taste is involved; when the issue is one of commercial value (as here), an objective standard of reasonableness is employed instead of the subjective standard of good faith. Thus, Citicorp's obligation to continue funding was subject to a reasonableness standard, but not also to a good faith standard.
Sensible or Honorable? At first blush, reasonableness might sound like a more demanding standard than good faith because it appears to permit the arbiter to second guess the original decision maker. In common interest developments, it is usually the critics of excessive control by homeowner association boards who want judicial review to be objective rather than subjective. In loan law, however, a requirement of good faith is considerably more terrifying than reasonableness. Here, for instance, the project budget was out of balance, and the loan contract said it shouldn't be if advances were to continue; that makes it almost impossible to call the decision to halt funding unreasonable. But when good faith is the standard, even a reasonable decision can be tainted with mala fides.
For example, suppose one of the loan review committee members argued to his skeptical colleagues that, even if they believed the project would probably fail, giving the borrowers extra time or extra funds would not hurt, because it would increase the value of the project and would give the borrowers more time to hang themselves, making it easier for the bank to ultimately get rid of them. Does that statement now make the committee's decision to continue funding, or to increase draws, a bad faith action by the bank? Even if the speaker denies having said it, does it matter? A good‑hearted banker is an oxymoron to many jurors; and, even for bankers, good faith is not regarded as the best way to get your money back. Thus, the court's rejection of the good faith standard entirely is most significant, like keeping a negligence claim against a rich landlord from getting to the jury.
But is the victory complete? The bank's behavior in taking advantage of favorable provisions in the loan contract may have been reasonable–and may be insulated from review for good faith–but what about the inclusion of those provisions in the contract in the first place? That was where the bad faith arose according to Storek: entering into the loan agreement with no real intention of fully financing the project. But that seems to me to be an even less plausible place to impose good faith on parties.
In the initial negotiation of a contract, the negotiators may be subject to principles of truth and honesty, but I do not think they are also subject to the duty of good faith. A is not prohibited from demanding things of B on the ground that they would hurt B. Some of my friends set ridiculously high prices on houses they want to sell, while others make only sportingly low offers for ones they are interested in buying. Because the other side can always say no, good faith applies more to ongoing performance of a completed contract than to formation of the contract itself. (Or am I confusing unreasonable offers with bad faith offers?)
But the kicker here was that this was not really a new loan between complete strangers. The peculiar structure of the transaction may have made it look that way, but in substance it was more like the workout of a troubled existing loan (a line of credit from Citicorp's parent corporation, Citibank, to the City of Oakland, that was secured by deeds of trust on Storek's property if it ever was drawn down). A differently minded court might have found a way to impose a good faith standard on new demands made during a workout without imposing that standard on demands made in the original loan contract.
Storek asks only whether Citicorp's decision to stop funding was subject to a good faith standard; it does not ask whether a similar standard applied to the lender's demand for the provision in the loan agreement that allowed it to stop funding. Perhaps the court was just fooled by the overly complex structure of the transaction, or perhaps it intentionally didn't want to add yet another variable into the mix. Either way, lenders are probably better off than they were before. They can probably get away with demanding favorable provisions in the original loan documents, and can thereafter invoke those provisions without fear of being accused of bad faith during later workout sessions; only when the workout leads to another, new set of different loan provisions is there any uncertainty about how those will be judged.
Afterthought on Fraud. One inevitably wonders about fraud in a case like this. The jury awarded the plaintiffs $40.92 million for fraud, in addition to $900,001 for breach of the covenant of good faith, but the appellate court threw out the fraud verdict in an unpublished part of the decision. Although the original trial court decision in this case was not certified for publication (and was vacated by the appellate decision), it can be found on Westlaw. See Storek & Storek, Inc. v Citicorp Real Estate, Inc. (Alameda County Super Ct, Feb. 14, 2002, No. 7320277) 2002 WL 222574. That opinion indicates that the plaintiffs' theory was promissory fraud: a false implied promise by Citicorp to perform in accordance with the implied covenant of good faith. In trying to decide whether an action for promissory fraud lies in this case, the court wondered about what to do "when the promise itself is implied such that the misrepresentation is doubly implied–once from the implied promise and again from the implied intention to perform that promise." (Opinion, p 9.) I think we should all be grateful that this part of the opinion went unpublished, so that we don't have to figure that one out.
4. Nonrecourse carveouts.
Heller Financial, Inc. v. Lee
2002 WL 1888591, 2002 U.S. Dist. LEXIS15183 (N.D. Ill. 2002)
Carveout provision imposing general deficiency liability when specific, quantifiable injuries to security occur is enforceable, and should not be evaluated as a liquidated damages clause.*
Lee and VanWhy, along with others, formed a Florida limited partnership, Royal Plaza, Ltd., to purchase a Hotel. Madlee, Inc. ("Madlee"), a Florida corporation, served as the general partner of Royal Plaza. Royal Plaza and Maddlee obtained two loans to purchase the Hotel, one for approximately $34 million from Bankers Trust Company, and the other (the subject of the litigation in this case) from Heller Financial, Inc. ("Heller") for approximately $10 million ("Loan"). Lee, VanWhy, and Royal Plaza, Ltd. executed an Equity Loan Agreement ("Loan Agreement") and a Promissory Note ("Note") in connection with Loan.
The Note contained a nonrecourse provision, which provided that no maker would be personally liable to pay the Loan or to perform any obligation under the Loan documents, and that the holder of the Note would look solely to "the Assignments and any other collateral heretofore, now, or hereafter pledged by any party to secure the Loan." The Note further provided, however, that notwithstanding the nonrecourse nature of the Note, each maker (except for one individual maker, Robert Ahnert) would be personally liable, jointly and severally, for repayment of the Loan "and all other obligations of Maker under the Loan Documents" in the event of any breach of certain covenants in the Loan Agreement "pertaining to transfers, assignments and pledges of interests and additional encumbrances in the Property, the Partnership or the Corporation."
One of the specific covenants in the Note triggering carveout liability stated that each of the makers would not, without the prior consent of the lender, "grant or permit the filing of any lien or encumbrance on the Project, the Collateral or the general partnership interest of the Corporation in the Partnership," other than those created by the senior loan documents and certain personal property leases; provided that Royal Plaza could contest the validity or amount of any asserted lien if (1) it gave prior written notice to Heller, (2) such contest stayed the enforcement of the contested lien, and (3) the contested lien was bonded or insured over by the title insurance company or Royal Plaza posted security in a manner acceptable to Heller.
After the purchase of the Hotel by Royal Plaza, six liens (in the form of tax liens and mechanic's liens) were placed against the Hotel, none of which was consented to by Heller or of which Heller was notified, and none of which was bonded over or insured by the title insurance company. As a result of these liens, Heller declared a default under the Loan and informed Lee, VanWhy, Royal Plaza, and Madlee that the entire outstanding Note balance was due and payable and that a public sale of the equity interests in Royal Plaza and Maddlee (which had been pledged to Heller as security for the Loan) would occur. The Hotel and part of the equity interests of Royal Plaza subsequently were sold and the proceeds paid to Heller. Heller then filed the instant action for the deficiency remaining, claiming that Lee and VanWhy were personally responsible for the deficiency.
Lee and VanWhy argued that they were not responsible for, and had no knowledge of, the liens placed against the Hotel because it had been managed "with the knowledge and agreement of Heller" by a separate management company unrelated to Royal Plaza. The court rejected this argument, stating that "Lee and VanWhy contracted with Heller for the loan and not [the manager]. Further, Lee and VanWhy cannot claim ignorance of the liens when they were a matter of public record."
The court stated that under Illinois law (which all the parties agreed governed the loan transaction), a loan would be deemed to be nonrecourse where the borrower "is not personally liable for the debt upon default, but rather, the creditor's recourse is solely to repossess the property granted as security for the loan" (citations omitted). Under this definition, the court ruled that the loan from Heller was a nonrecourse loan. The court noted, however, that lenders commonly create certain carveouts to nonrecourse provisions in loans to "provide the protection that lenders require, personal liability, to insure the incentive to repay the loan and maintain the viability of the loan."
The court concluded that the carveout language was unambiguous and clearly provided for personal liability on the whole loan upon the occurrence of any of the enumerated exceptions to nonrecourse, including the placing of liens against the Hotel. The court noted that the carveouts had been negotiated and agreed to by all parties, as evidenced by the fact that one of the makers of the Note, Ahnert, had been exempted from any personal liability for violation of the carveouts. As the court succinctly summarized, "[i]t is painfully clear that the nonrecourse loan from Heller to Royal Plaza and Madlee included carve‑outs. Further, these carve‑outs caused Lee and VanWhy to be personally liable. Lee and VanWhy acknowledged and agreed to this."
The court noted that because the Loan was secured by the equity interests of the entities that purchased the Hotel and not the Hotel itself, Heller was especially concerned about the operation of the Hotel due to the direct impact on the value of the collateral securing the Loan.
Lee and VanWhy argued that the carveouts were actually liquidated damages provisions and were unenforceable as penalties. They pointed out that the "trigger" for the invocation of the carveout was the imposition of liens in unspecified amount against the hotel, while the consequence was exposure to a significant liability in connection with a $10 million loan. The court rejected this argument, finding that the section of the Note dealing with the nonrecourse carveouts was not a liquidated damages provision because it provided for only the recovery of actual damages incurred by Heller, i.e., the amount of the unpaid Loan indebtedness at the time of the default. Therefore, according to the court, "[t]his amount is the actual damages to Heller based on Lee and VanWhy's breach. Since [the carveout section of the Note] involves actual damages it cannot be a liquidated damages provision."
Comment by Jack Murray: With respect to the argument that carveouts from nonrecourse provisions are unenforceable liquidated damages provisions, the court stated that, at least in Illinois, "courts lean toward a construction that excludes the idea of liquidated damages and permits the parties to recover only damages actually sustained (citations omitted). " However, the carveout provision in Heller v. Lee provided that the makers of the Note (with the exception of Ahnert) would become personally liable, jointly and severally, for the entire outstanding balance of the loan "and all other obligations of Maker under the Loan Documents" if any of the enumerated exceptions (including liens created against the Hotel) occurred.
The six liens placed on the Hotel property were for an aggregate amount of approximately $820,000, and occurred over a five‑month period of operation of the Hotel. Although the amount of the unpaid balance due on the Loan at the time of default is not stated in the court's opinion, the court noted that as a result of the violation of the covenant not to place liens against the property, there had been a public sale of both the Hotel and "the equity interest in Royal Plaza and Maddlee, which had been pledged to Heller as security for the Heller loan," Even though Heller received proceeds from the sale covering a portion of the debt, it is conceivable that the "actual damages" of approximately $820,000 (which clearly were quantifiable) were in fact less than the outstanding balance due on the Loan after application of the sale proceeds.
Comment by Pat Randolph: In response to Jack Murray's comment above, it was also possible that, due to the circumstances of the foreclosure sale, the liability of the borrowers would have been considerably greater than the $820,000. It is not clear that payment of the $820,000 would have been an acceptable "cure" of the default once acceleration had occurred and foreclosure was proceeding. Consequently, the borrowers did have a point that they could be viewed as being penalized.
But the court answers this with the response that the bank's collateral was only in the equity interest in the hotel, so that the liens against the hotel itself were not truly "junior" to the bank's lien, and could in fact have devalued it. This justifies the bank's special concern here supporting acceleration.
Note that the consequence of the language stating that the borrowers would be liable if they "permitted" the filing of certain liens against the property was that they assumed to obligation to monitor and prevent those liens from being filed. Of course, the fact that the liens were of public record did not mean that the borrowers would be notified of them. But, in the view of the court, it was up to the borrowers to devise a scheme under which they would be notified or otherwise become aware of and prevent such liens from arising.
It certainly is hard to argue with the court's decision in Heller based on the facts of the case. However, the precedential value of this decision may be somewhat limited, at least with respect to the validity and enforceablity of carveouts to nonrecourse provisions in mortgage loan documents. As the court stated, "the loan was secured by the equity interests of the entities that purchased the Hotel, and not by the Hotel property itself. This means Heller is concerned with the successful operation of the Hotel since it affects the value of the collateral that secured the loan. Any lien on the property compromises the equity interests of Royal Plaza and Madlee. Thus, the carve‑out under [the nonrecourse section of the Note] is of the utmost importance in acquiring the loan and is known and agreed to by all the parties." But the same rationale underlies the insertion of carveouts in nonrecourse mortgages: the prevention of deliberate "bad acts" by the borrower or the occurrence of acts or events that diminish the value of the property or divert or misapply the cash flow derived therefrom.
5. Lender liability for release of appraisal.
In re Sallee
286 F.3d 878 (6th Cir. 2002)
Where lender releases to borrower information concerning appraisal of property for which lender is financing borrower's purchase, lender has the duty either to disclose other information in lender's possession placing value of appraisal in doubt or to otherwise limit inference that the information is accurate and complete to otherwise limit inference that the information is accurate and complete.
This case is a colorfully written account of "when bad lenders get worse." The court excoriates both the Bank and the borrowers for incompetence and naivete, and ultimately concludes that the borrowers were just a little less dumb than the lenders, and affirms an verdict upon fraud and punitive damages, although modifying the damages and remanding for recalculation.
The story begins when a small bank, with traditional activity as a consumer lender, decided in the early 80's to devote 40% of its portfolio to commercial loans. (Sound familiar so far?) Bank loaned quite a lot of money to a consortium of interests controlled by a local family. Almost all the loans were sloppily documented and poorly analyzed, and many were supported by appraisals from the same appraiser, which the court characterized collectively as the worst it had ever seen in ten years on the bench.
The borrower family, the Brambletts, predictably got into deep trouble on its loans and the bank officers, not ready to admit its own failures, repeatedly refinanced the borrowers by funding new and higher loans, justifying the increases based upon the questionable appraisals, and using the loan proceeds to pay off defaulted amounts.
In the court's words: "Into this sorry mix stepped Worth and Sandra Sallee." The Sallees moved to the area when Worth was appointed manager of a large chain store for which he had worked for some time. They elected to remain rather than to accept a transfer to another store, and looked for local businesses in which to invest. The Brambletts had plenty of businesses to sell.
The Sallees first acquired a convenience store and car wash business from a Bramblett, with financing provided by Bank. Soon thereafter, the Sallees discovered they could get better terms from another bank, and refinanced the Bank loan on the convenience store, giving a mortgage on the store and a second mortgage on their home. In both of these loans, there was some discussion of a pledge of Worth Sallee's accumulated assets in a pension account with his old employer. Worth agreed to make the pledge to the second lender, but it does not appear that a formal pledge was ever entered into because Worth never delivered the stock certificates that were part of the account.
Within a year, Sallees were in serious trouble on the store, and their alternate lender had determined to no longer finance their operation with new loans. During basically the same period when the above events were occurring, the Brambletts were dealing with financial problems on a laundromat the owned located adjacent to the convenience store. Two Brambletts financed an acquisition of the store from their son, to resolve his problems with Bank, and Bank loaned the entire purchase price, based on an appraisal of the laundromat at $469,000. A year later, after operating unsuccessfully and falling deeper into debt, the owner Brambletts came back to Bank and borrowed more money to deal with their deficits. This time the appraised value was raised to $647,000, even though no improvements had been made and the laundromat had run at losses all year.
In order to bail out, the laundromat owner Brambletts then commenced negotiations to sell the property to Sallees, who had been so accommodating when there was a need to dump the store and car wash. Five months after the refinancing described above at an appraisal of $647,000, and with losses continuing, Bank loaned the entire purchase price of $575,000 to the Sallees, and obtained an appraisal (again from the "can do" appraiser it had used throughout,) showing a value of $726,000.
In the course of negotiations, Sallees had extensive conversations with Bank loan officers, who assured them that they would have comfortable banking relations in the future if things got bad and that they were getting a "good deal" on the laundromat. Specifically (and fatally), a bank lending officer told Worth Sallee that the property had been appraised at $750,000. This revelation was not only a mild exaggeration, but more importantly did not disclose that the property had been regularly reappraised higher and higher by the same appraiser over the preceding 18 months, during which the laundromat had sunk deeper and deeper into red ink. (As they say in business school ‑ you can't make it up on the volume.) This time Sallee did in fact assign his stock certificates in his ESOP retirement plan to Bank.
A few months later, Sallees were back, still losing money. The bank agreed to some kind of 48 day extension of their laundromat loan (which then was only five months old). This 48 days later was extended for additional periods. In connection with each extension, Bank required Sallee to sign a general waiver of "any and all rights, claims, or causes of action with respect to the Loan Documents and Collateral." At this time, Bank discussed that there later would be a "package" loan by which it would resolve Sallee's problems going forward, covering all Sallee's loans with Bank.
The owner of Bank had finally caught wind of what was going on there, and at the time of the extension deal with Sallee, Bank was undergoing an investigation from its owner following a highly critical audit, which investigation resulted in a suspension of commercial lending authority a few months later. This made it highly unlikely that Bank would be able to do the promised "package" loan.
When the other lender discovered that Worth had transferred his stock to Bank, when he had originally agreed to pledge it for the convenience store loan, it reacted with threats. Bank then agreed to refinance the convenience store loan, and entered into the third extension of the other loans. At this time, a bank officer again assured Sallee that everything would shortly be wrapped up together in a comprehensive package loan going forward. It also sold some of Sallee's stock and applied it to reduce his debts. Bank apparently told Sallee that this was a "mere technicality," and that it would sell some of the stock but later replace it when it refinanced all of Sallee's lines in the comprehensive new business loan.
Unfortunately, at the same time that the loan officer was saying these things to Sallee, the fact was that the Bank's owner had cut off Bank's commercial lending authority. The loan officer believed that he might be able to get all this resolved, but at the time in fact knew he had no further authority to negotiate new loans with Sallee in the future.
Note that the court is somewhat mushy in its discussion of the time relationship between the execution of the various waivers and the fact of the Bank's ability to deliver on the promised "package" loan. It appears to assume that all of the waivers were obtained by fraudulent representations of some kind, even though the first two times a waiver was signed Bank had not yet lost it's ability to make commercial loans. Perhaps there was a looming threat of loss of lending rights that ought to have been disclosed, but the court does not tell us.
There is a lot in this opinion to discuss, but for purposes of this report, we'll take up only the court's conclusion that the failure to disclose fully all of the information concerning the accuracy of the appraisals amount to fraud, thereby rendering Bank liable for the difference between the actual value of the laundromat and the appraised value report to Sallee.
Punitive damages were tacked on to that. As indicated, the court found the waivers bootless because also induced by fraud. Lower courts had found them too broad to be effective, but the court here didn't choose to based its decision on that ground. The court found that the duty to disclose existed even though there was no fiduciary relationship between Sallee and Bank. The duty arose from Bank's affirmative disclosure of some information, leading to a duty to provide complete information.
The court commented that when asked for information in a commercial context, a party to a commercial transaction has three choices: (1) refuse to answer; (2) answer, but indicate that the information is given without any responsibility for accuracy or reliability; (3) answer fully without qualification, in which event the party must also disclose any significant other information that might impact on the accuracy of the answer. "Where one party to a contract knows that the other relies on him to disclose all material facts, the duty rests on him not to conceal anything material to the bargain or assume responsibility for damage caused by the concealment."
The court also upheld the punitive damages award, even though the Bank had been sold to others. The purchase was made under indemnity by the Seller concerning damages, so the Seller had been paid to assume the risk. Further, the court commented, that even the entry of punitive damages, although indemnifiable, is likely to provide a deterrent to wrongful conduct for the current owner of the Bank.
As to this part of the case the editor must agree, although the editor understands that there is a significant liability trap here for the accommodating lender. The case can be distinguished from the more innocent cases because of all the other data indicating that the Bank was disclosing the appraisal information for the purpose of influencing the borrower's conduct. Where the release of the information is not made in that context, there is certainly a good argument that the recipient of the appraisal information had no reason to believe that the lender was disclosing all it knew about the deal. Still, lenders should crank up the training programs again. Officers should not release appraisals. Period.
Here's a puzzler: What if the bank has one appraisal, and releases it. But the bank has other information that affects whether the house is a good deal at all, or a good deal for the borrower. Still, the bank thinks the security is adequate and is willing to make the loan. No funny business (unlike here). Is it liable for not spilling its guts? This case could be construed to say yes.
6. Payment of assigned mortgage loans.
Summit Financial Holdings, Ltd.,
Continental Lawyers Title Company
27 Cal.4th 705, 41 P.3d 548, 117 Cal.Rptr.2d 541 (2002)
If a mortgage loan has been assigned, an escrow company paying off that loan has no liability to the assignee (who is not a party to the escrow) if the payment is made to the assignor instead of the assignee who is entitled to it.
In 1994 Furnish borrowed $425,000 from Talbert, giving Talbert a note and deed of trust on Furnish’s real estate. Talbert immediately assigned the note and deed of trust to Summit. The assignment was recorded, but Talbert didn’t inform Furnish of the assignment. The note called for monthly payments, which Furnish presumably paid to Talbert despite the assignment (since Furnish didn’t know about it). It would have been extremely wise of Summit to send Furnish a notice, informing Furnish that Summit had bought the note and deed of trust; but Summit didn’t do that.
In 1995 Furnish decided to refinance the loan with a different lender, and instructed Beverly Hills Escrow (BHE) and CLTC to handle the payoff. CLTC issued a title report showing the assignment, and BHE received a copy of it. BHE nevertheless asked Talbert for a payoff statement and instructed CLTC to pay off Talbert. At closing, that’s just what CLTC did. Talbert never sent the payoff amount to Summit, and seems to have disappeared with it.
Furnish, now in bankruptcy, found himself with a claim by Summit for its money. The bankruptcy court denied the claim on the ground that the mortgage assignment was a “transfer of servicing” as the term is used in Civil Code §2935, and that Summit had never given notice of the transfer to Furnish as that section requires. Hence the assignment was not binding on Furnish, and Furnish’s payment to Talbert fully satisfied the debt. Summit then brought this proceeding in state court against CLTC for the money, arguing that CLTC had breached a duty to Summit by sending the payoff to Talbert.
The California Supreme Court declined to decide whether the assignment of the note and deed of trust was a “transfer of servicing” (which it pretty obviously was not). It noted that Summit had already given up on trying to hold Furnish liable for another payoff to Summit, and that Summit was only going after the escrow company. It held that an escrow company generally has no duties to third parties – persons who are not parties to the escrow. Absent clear evidence of fraud, an escrow holder's obligations are limited to compliance with the parties' instructions. Although CLTC had knowledge of the assignment, the court saw no evidence that it was aware of any fraud. Since CLTC followed the instructions of the parties, it had no liability to Summit. Interestingly, the Nevada Supreme Court had reached the same result on very similar facts more than 30 years earlier; see Giorgi v. Pioneer Title Ins. Co., 454 P.2d 104 (Nev. 1969).
The court is doubtless correct, but it is hard to understand the escrow agent's behavior. On what basis did it honor Talbert's (the creditor/assignor) payoff demand? In principle, it should not have sent Talbert the money without requiring that it be given the note (to mark "paid") and a reconveyance from the trustee under the deed of trust (which in California arises when the beneficiary – now Summit – makes a “request for reconveyance.” It is quite possible that the escrow agent did receive these documents from Talbert, which means that Talbert retained the note and requested the reconveyance from the trustee despite the assignment to Summit. If so, then Summit brought the loss on itself; failing to get delivery of the note would have been a horrendous case of bad judgment or ignorance on Summit’s part.
On the other hand the title company may have sent the payoff check to Talbert without requiring that the note be produced first. Escrow companies and other closers very often do so, since it is often inconvenient for them to verify who has the note. If Talbert did indeed retain the note, and if the note was negotiable, under Article 3 the right to payment was not legally and effectively transferred to Summit, and the title company did nothing that could be remotely construed as wrong. However, if Talbert had delivered the note to Summit, and the title company simply didn’t bother to verify who had it, then the title company was indeed negligent (although with no resulting liability). In this case, the title company had already issued a preliminary title report showing the assignment of the mortgage. In all probability a copy of that title report was actually in the hands of the escrow officer. Under these circumstances, the escrow officer would have had actual knowledge that he was sending the check to the wrong party. Even so, the court’s reasoning would be that the escrowee has no liability to the right party, because it (here, Summit) was not a party to the escrow.
As a question of pure escrow practice and liability, this decision is unremarkable, and was probably worth the Supreme Court’s time only to get rid of an older, inconsistent Court of Appeal decision ( Kirby v. Palos Verdes Escrow Company, Inc. 183 Cal.App.3d 57, 227 Cal.Rptr. 785 (1986)). If A and B instruct their escrow agent to pay money to C and she (the escrow agent) does exactly that, then the fact that C had previously transferred his right to those funds to D without telling anybody means that D has no basis for recovery against the escrow agent because C got the money instead of him. As a matter of general tort law, there is no reason to impose a duty of escrow agents to discover and pay nonparties, and – since D was not a party to the escrow – there was no fiduciary reason to do so either. So, as far as escrow law is concerned, escrow agents aren’t liable to outsiders for following the instructions given to them by insiders.
But that ruling doesn’t make the harm to D disappear, and nothing in the court’s ruling does very much about that problem. A mortgage, i.e., a secured right to funds, had been properly created and later properly assigned to D, but D never received payment. Either D should still have his security or else his payment. But fairness to D may come at the expense of B, whose debt was originally owed to C. If B has already paid C, then it seems equally unfair to B for D to demand payment a second time or to foreclose the mortgage if the second payment isn’t made. What’s obviously needed here are some rules governing assignments of payment rights that treat both B and D fairly. While California has several statutes dealing with this, none of them really solve the problem.
The logic of the law of promissory notes states that only a person who holds a note (literally and physically) can enforce it. UCC §3-602 formalizes that concept with regard to negotiable notes by requiring that payment be made to the person entitled to enforce the note and defining that person generally (in §3-301) as the one in possession of it. Mortgage notes are not always negotiable, but there’s a good deal of common law case authority applying the same rule to nonnegotiable notes.
Today, with global and electronic banking, this “payment” rule is sadly out of date. The old branch bank that originally made the loan has sent all of its loan documents down to central filing, where they were probably packaged into a large pool and shipped off to Fannie Mae to be sold into the secondary market as collateralized mortgage-backed securities, and the mortgagors were given a package of envelopes and payment book to use each month to mail their checks to a remote servicing agent (or else arranged to have the payments made automatically and electronically out of their bank account). See Whitman, Reforming the Law: The Payment Rule as a Paradigm, 1998 B.Y.U. L. Rev. 1169 (1998). If lenders really had to produce their notes for exhibit in order to get paid every time, the crash would exceed anything terrorists could ever hope to accomplish.
A system that borrowers do not understand and that creditors can not honor is not one that seems worthy of preservation. In 1988 the California legislature (like a number of others) enacted Civil Code §2937, providing that borrowers are not bound by transfers of servicing until they get written notice of them. Unfortunately, the drafters did not take into consideration the fact that two different types of transactions (transfers of servicing and outright assignments of secured notes) raise exactly the same problem – that the borrower is legally supposed to begin paying someone else now, but has no way of knowing it. The language of Civil Code §2937 on its face simply doesn’t cover assignments of mortgages themselves, although the policy reasons stated in the preamble fit both situations equally well.
Life would be easier for everybody if the California legislature would consider applying the same principle to all kinds of transfers (both of servicing and of mortgages themselves), all kinds of notes (both negotiable and nonnegotiable), and all kinds of payments (both regular installments and complete payoffs). A few legislatures have already done so. This long overdue revision should be made before anyone gets really hurt. A revision of UCC Article I, now in the drafting process, is expected to make the needed change with respect to negotiable notes, and Restatement (Third) of Property (Mortgages) §5.5 (1997) purports to do so with respect to nonnegotiable notes (although the court in this case seems to have been blissfully unaware of it).
7. Deed in lieu of foreclosure; application of merger doctrine.
United States Leather, Inc. v. Mitchell Mfg. Group, Inc.
276 F.3d 782 (6th Cir. 2002)
Debtor's grant of security interest in its personal property (including "instruments") to corporate parent did not result in "transfer" of mortgage, which thereafter was extinguished when mortgagor issued quitclaim deed in lieu of foreclosure, notwithstanding anti‑merger language in deed.*
Courts generally will not enforce a non‑merger provision in a deed in lieu of foreclosure where the rights of innocent third parties may be affected – or even lost – because of fraud or inequitable conduct by the parties to the deed. Here, the Sixth Circuit found to be unenforceable certain language in a quitclaim deed in lieu of foreclosure that no merger of the mortgage and fee would occur. The court ruled that to deny merger would inequitably permit the mortgagor to avoid its obligations to an intervening judgment creditor to the sole advantage of the mortgagor's corporate parent.
This decision involved a very complicated factual situation. The case arose out of the efforts of the plaintiff, United States Leather, Inc. ("USL"), to enforce a judgment of approximately $1.5 million against Mitchell Automotive, Inc. ("Mitchell Automotive"), which owned personal property and a manufacturing facility in Clare, Michigan. Mitchell Automotive was in the business of manufacturing and selling leather products for use in automobile interiors.
Over time, Mitchell Automotive built up a substantial debt to USL (as a supplier of finished leather), as well as to its parent corporation, Mitchell Corporation of Owosso ("Mitchell Corp."). Mitchell Automotive eventually succeeded in finding a buyer, Lamont Group, Inc., and Lamont Group Acquisition Corp. (collectively, "Lamont Group") to purchase Mitchell Automotive's real and personal property. Lamont Group paid $6.5 million in cash to Mitchell Automotive and gave two promissory notes for the balance of the purchase price of $27.5 million. To secure the indebtedness, Lamont Group granted Mitchell Automotive a security interest in the purchased assets and a mortgage on the real property. Shortly thereafter, Mitchell Automotive granted its parent, Mitchell Corp., a security interest in all its personal and intangible property (including all "instruments") to secure any and all existing and future indebtedness to Mitchell Corp. According to the court, "It is undisputed that Mitchell Corp. obtained a security interest in the Lamont Group's mortgage and promissory notes through their agreement."
The Lamont Group subsequently defaulted and agreed to surrender all the personal property collateral and to deliver a deed in lieu of foreclosure to the secured real property to Mitchell Automotive. The quitclaim deed to the real property contained language stating that it was the intention of the parties that the deed did not constitute "a merger with or extinguishment of the indebtedness secured thereby." (The deed also provided that the recourse obligation of Lamont under the Asset Purchase Agreement for the purchase of Mitchell Automotive's assets would be reduced by $6 million). As a result of the conveyance, Mitchell Automotive held title to both the mortgage and the fee interest in the real property.
Shortly thereafter, USL obtained a consent judgment against Mitchell Automotive and Lamont Group in the amount of approximately $1.5 million, and levied on the personal property of Mitchell Automotive at its offices in Owosso, Michigan. The levy officer did not take actual possession of the property, based on the agreement of Mitchell Automotive's attorney that the property would not be moved, sold, or disposed of and that Mitchell Automotive's remaining personal property was not sufficient to satisfy the judgment.
Mitchell Corp. then advised USL that it claimed priority against the assets of Mitchell Automotive by virtue of its prior security agreement and that it had "peaceably repossessed" the personal property of Mitchell Automotive in accordance with its rights under that agreement. USL responded to this development by filing a formal Notice of Levy against the manufacturing facility owned by Mitchell Automotive (which was the property previously conveyed by the deed‑in‑lieu from Lamont Group to Mitchell Automotive), and served a garnishment on the tenant of the property – eventually collecting $46,000 in lease payments before the lease was terminated.
USL then filed a "motion for determination of interests in the property of Mitchell Automotive," arguing that "Mitchell Corp.'s security interest was extinguished by merger, was not perfected, was fraudulent, and that the corporate form should be disregarded." Id. at 786. The district court adopted the findings of the magistrate judge, who held that the mortgage was extinguished by merger notwithstanding the non‑merger language contained in the deed in lieu of foreclosure. The district court further ruled that the question of whether Mitchell Corp. had to perfect its security interest until after USL's garnishment and levy of Mitchell Automotive's personal property was irrelevant.
In upholding the ruling of the district court, the Sixth Circuit first stated the general rule in Michigan regarding the merger doctrine
“The general rule in Michigan is that when a holder of a real estate mortgage becomes the owner of the fee, the mortgage and fee are merged and the mortgage is extinguished. . . This rule is, however, subject to the exception that when it is to the interest of the mortgagee and is his intention to keep the mortgage alive, there is no merger, unless the rights of the mortgagor or third persons are affected thereby.'” (citations omitted)
The Sixth Circuit rejected Mitchell Automotive' argument that there was no merger because it did not hold both the title to the real property and the mortgage. The court reasoned that although Mitchell Automotive had granted a security interest in the Lamont Group's mortgage and promissory notes to Mitchell Corp., it "did not assign, transfer, or convey Lamont's mortgage to anyone." Id. at 787.
The court then ruled that because of equitable considerations involving the conflicting rights of USL as an intervening third party, it would not enforce the express non‑merger intent of the parties as set forth in the deed in lieu of foreclosure from Lamont Group to Mitchell Automotive. According to the court:
“Allowing an exception to [the] merger rule in this instance would do grave injustice. Such a finding would permit Defendant [Mitchell Automotive] to avoid paying an uncontested $1.5 million debt to [USL] in favor of its parent corporation, Defendant [Mitchell Corp.]. The fact that these two corporations share the same office space, computers, employees, and are run by the same President who originally incurred the debt to [USL] only highlights the inequity of applying the exception."
The court found that this case was distinguishable from other Michigan cases where non‑merger language contained in a deed in lieu of foreclosure had been enforced, as this was not a situation where the mortgagee was trying to protect itself from the claims of junior lienholders of the mortgagor. As the court stated
“[Mitchell Automotive] is not in the position of a mortgagee trying to protect itself from junior lienholders of the Lamont Defendants; it is attempting to protect itself from having to pay a debt it acknowledges owing to Plaintiff. We agree that equitable considerations preclude Mitchell Automotive from avoiding merger when the effect is not to protect its own interests from the creditors of the Lamont Group (the mortgagor), but rather to prefer the debt of its parent corporation over the debt owed to USL as a third party.”
The Sixth Circuit further noted that unlike the Michigan cases cited by Mitchell Corp., USL did not expressly acknowledge the priority of Mitchell Corp.'s mortgage and its judgment was not expressly made subject to Mitchell Corp.'s mortgage. The court also rejected Mitchell Corp.'s argument that it was itself a third party whose rights were "most affected by merger or non‑merger." The court held that USL was equally affected by the merger issue. The court further denied Mitchell Corp.'s claim that it was unfair to "lump" Mitchell Corp. and Mitchell Automotive together without first determining whether the corporate veil could be pierced. The court was greatly influenced by its finding (as stated earlier) that both corporations shared the same office space, computers, employees, and officers.
The court reasoned that because USL had abandoned any claim against Mitchell Corp. for the indebtedness owed to it by Mitchell Automotive, it was not necessary to make a determination as to whether the facts of the case justified piercing the corporate veil. The court noted that the district court had instead been "called upon to weigh the equities between USL and Mitchell Corp. as secured creditors competing for the sole asset of the debtor," and in this regard "it was proper to consider the relationship between Mitchell Automotive and its respective creditors." Id. The court found that the equities of the case prevented Mitchell Automotive from relying on the exception to the merger rule "to favor the debt owed to the parent company over USL's judgment lien." Id. at 789.
The Sixth Circuit's ruling effectively employed the "balancing of the equities" doctrine to thwart what appeared to be an attempted preferential transfer or fraudulent conveyance of mortgaged property by a deed in lieu of foreclosure (although the court never decided this precise issue) to avoid an obligation to an innocent third‑party judgment creditor. This case has complicated and unusual facts, and the Sixth Circuit was careful in its opinion to limit its holding to the facts presented. The court expressly acknowledged and confirmed that the generally permitted exception to the merger rule – i.e., that the mortgage would not be extinguished if the parties expressed their intention in the deed not to terminate the mortgage– would be valid and enforceable in those situations where the mortgagee's reason for keeping the mortgage alive was for the purpose of preserving its rights (including foreclosure) against subordinate lienholders of the mortgagor.
As evidenced by other cases and applicable state statutes (see below), the unique facts of this case should not prevent the parties to a more conventional deed‑in‑lieu transaction from entering into a deed containing specific non‑merger language, or prevent the owner‑mortgagee from subsequently enforcing its rights under the preserved mortgage.
Many states rely (at least in part) on the intention of the parties, either express or implied, to determine whether a merger occurred as the result of a deed‑in‑lieu transaction. In Tidwell v. Dasher, 152 Mich. App. 379, 393 N.W.2d 644 (1986), the court dealt with the issue of whether a deed in lieu of foreclosure created a merger that would affect the priority of an intervening lien. The court stated that "[t]he question of intention of a mortgagee or vendor is a question of fact which must be developed from evidence produced to show what the intention was at the time the acts were done." Id., 152 Mich. App. at 385, 393 N.W.2d at 647. In Weitzki v.Weitzki, 437 N.W.2d 449 (Neb. 1989), the court noted that the intention of the mortgagee is controlling as to whether the mortgage is kept alive. The court held that when the mortgagee becomes the owner of the fee, and there is no expression of intention as to whether the mortgagee wished to keep the mortgage alive, it will be presumed that the mortgagee intended to do what would prove most advantageous to himself in the absence of circumstances indicating a contrary purpose. The court then found that in this case no merger of title and lien occurred in light of the mortgagee's intent to retain the priority of his lien against the subordinate lien. See also FDIC v. Lee, 988 F.2d 838, 843 (8th Cir. 1993) ("[t]he doctrine of merger is not favored and will not be applied in the absence of an intent on the part of the mortgagee, or unless the application of the doctrine is require by equities of a particular case" [quoting Construction Machinery v. Roberts, 307 Ark. 252, 819 S.W.2d 268, 270 (1991)] ); Sylvania Savings Bank v. Turner, 27 Mich. App. 640, 645, 183 N.W.2d 894, 896‑97 (1970) ("whether [merger] occurs depends fundamentally on the mortgagee's intention. If it is in his interest to preserve his lien separately from the fee, it will ordinarily be concluded that he did not intend to merge the lien into the fee"); Long Island Lighting Co. v. Commissioner of Taxation and Finance, 652 N.Y.S.2d 640, 641, 235 A.D.2d 637, 638 (N.Y.A.D., 3rd Dept. 1997), leave to appeal denied, 90 N.Y.2d 801, 660 N.Y.S.2d 554, 683 N.E.2d 19 (1997) (noting that "the doctrine of merger is disfavored," the court stated that "the determinative issue is whether the owner intended there be a merger, which must be discerned from all the circumstances"); Nancy J. Appleby, Negotiating and Structuring a Friendly Foreclosure or Deed in Lieu of ForeclosureA Lender's Perspective," Negotiating and Structuring a Friendly Foreclosure or Deed in Lieu of Foreclosure, American Bar Association Section of Real Property, Probate and Trust Law, New York, NY (August 10, 1993), Tab 8.
The section of the Illinois mortgage foreclosure statute that deals specifically with deeds in lieu of foreclosure, 735 ILCS 5/15‑1401, states (with respect to the issue of merger) that "A deed in lieu of foreclosure, whether to the mortgagee or mortgagee's nominee, shall not effect a merger of the mortgagee's interest as mortgagee and the mortgagee's interest derived from the deed in lieu of foreclosure."
A deed in lieu of foreclosure does not "wipe out" any subordinate liens, and the grantee takes subject to all existing liens, whether known or unknown. To attempt to eliminate these liens, the lender still must foreclose the mortgage or otherwise deal with each of the existing encumbrances. (The lender actually may have an incentive to pay something on lien claims to avoid a contested foreclosure proceeding; after all, the primary purpose of a deed‑in‑lieu transaction usually is to avoid foreclosure).
Recent case law (Professor Randolph's protestations to the contrary) generally supports the ability of a mortgagee to foreclose its mortgage after acceptance of a deed in lieu of foreclosure. See, e.g., PNC Bank, Delaware v. Philben, Inc., 1997 Del. Super. LEXIS 467 (Del.Super.Ct. 1997) (not reported in A.2d) (holding that where the deed‑in‑lieu documents contained an anti‑merger provision, the owner‑mortgagee could subsequently commence foreclosure proceedings; the court noted that "where the mortgage includes an anti‑merger provision to protect an existing mortgage balance, the deed is merely additional security for the mortgage debt" and that "[the mortgagee] preserved its right to foreclose"); GBJ, Inc. v. FirstAvenue Investment Corp., 520 N.W.2d 508, 511 (Minn. App. 1994) (ruling that "[the mortgagee] did not forfeit its rights as mortgagee when it took the deed in lieu of foreclosure. To the contrary, the doctrine of merger presumes that the mortgagee retains all rights"; the court further stated that "[the mortgagee] therefore retained the right to foreclose"); Runge v. Runge, 1999 Minn. App. LEXIS 1187 (Ct. of Appeals of Minnesota) (unpublished)(stating that "[the mortgagee] did not forfeit his rights as mortgagee when he took the deed in lieu of foreclosure"; and noting that deed contained "an unambiguous anti‑merger clause evidencing [mortgagee's] intent not to merge his interests"); Olney Trust Bank v.Pitts, 200 Ill. App.3d 917, 926‑27, 558 N.E.2d 398, 403‑04 (5th Dist. 1990) (holding that "because there is no merger, the mortgage debt is not satisfied or extinguished"; the court permitted the lender, who had obtained a deed‑in‑lieu, to foreclose but prohibited it from pursuing an action for a deficiency judgment) In re Estate of Ozier, 225 Ill. App.3d 33, 36, 587 N.E.2d 77, 80 (4th Dist. 1992) ("In the absence of evidence to the contrary, the law presumes that a mortgagee intended to keep his mortgage alive, when such course was essential to his protection against an intervening title or for other purposes of security"); Zubrys v. Harbor Country Banking Co., Docket No. 192822 (unpublished opinion per curiam of the Michigan Court of Appeals, December 19, 1997) (holding that where the first mortgagee took a deed in lieu of foreclosure and subsequently foreclosed its mortgage after discovering the existence of a second mortgage, there was sufficient language in the deed‑in‑lieu documents to prevent a merger of the security interest and ownership interest; the court also held that the second mortgagee did not have standing to challenge the adequacy of the consideration given to the mortgagor for the deed in lieu); Union Bank & Trust Co. v. Farmwald Development Corp., 181 Mich. App. 538, 547, 450 N.W.2d 274, 278 (1989) (ruling that junior mortgagee's objection to entry of foreclosure of mortgages of first mortgagee was unfounded, because first mortgagee's interest was not extinguished and discharged by mortgagor's conveyance of the secured property to the first mortgagee); Clark v. Federal Land Bank, 167 Mich.App. 439, 444‑45, 423 N.W.2d 220, 222 (1988) (refusing to permit a subordinate judgment lienholder to have bank's foreclosure on property subject to lien declared invalid; and stating that "the quitclaim deed executed by the [mortgagors] to the bank manifested unequivocally an intention that the mortgage not merge with the fee. Additionally, plaintiff's rights were not affected by the intention to keep the mortgage alive, for she knew her judgment lien was subject to a first mortgage pursuant to the judgment of divorce"); 55 Am.Jur.2d Mortgages, § 1345, Intervening or Junior Claims or Liens.
Comment by Pat Randolph. Jack Murray indicates that he has a disagreement with me on this issue. Our disagreement is somewhat narrow. It relates to situations in which a mortgagee takes a deed in lieu of foreclosure with actual knowledge of the existence of other interests junior to the mortgage. These interests are not foreclosed away, of course, and are still binding on the property. Jack has argued that courts should preserve the mortgagee’s rights against these parties, notwithstanding the probable merger that results from the transfer of the fee to the mortgagee. I have argued that although this result may be appropriate where a mortgagee was unaware of the competing interest, even though it was recorded, it is not appropriate where a mortgagee deliberately seeks the advantage of a deed in lieu with actual knowledge of the existence of other interests.
I have not before seen Jack emphasize the argument that the result is affected by “anti-merger” language in the deed in lieu. I have understood him to argue that, even absent such language, the court should set aside the merger. I have acknowledged the authority supporting Jack’s result in the past. For instance, the DD of 8/11/00 reported the case of Miller v. Martineau, 983 P.2d 1107 (Utah App. 1999), where merger was not found when there was an intervening leasehold interest.
I don’t know how many of the cases that Jack cites indeed deal with the situation of the known intervening interest, nor how many also involve the feature of an express reservation denying merger. If they all directly support Jack’s position on the point, that indeed is persuasive.
My view in the past has been based upon the notion that parties ought to live with the consequences of their actions. They have the device of foreclosure to clear the title. If they choose not to use it, then they should abide by the consequences of that choice, which is that title is not cleared.
Jack’s position here has driven me to rethink the issue. What harm results by denying merger? The best scenario that I can think of that raises a question would be where the mortgagor believes that the mortgagee is taking title subject to the other interests, and thus does not appreciate that it has much of a bargaining position in the deed in lieu negotiations. Courts are careful in reviewing such deals, since they do involve a waiver of the equity of redemption. If the mortgagor believes that the mortgagee is taking title subject to other interests, and this is not the case, the mortgagor may be giving up more than it should. This is particularly true if the mortgagor thinks that the mortgagee would have no right of recourse if liens attached to the property foreclosed.
This problem is avoided to a certain extent if the parties stipulate in the deed in lieu that the mortgagee continues to assert its priority position as against the existing liens. Since that’s the only scenario I have been able to come up with so far, I will withdraw my general view in favor of merger where the parties have so stipulated. I’m not sure that general boiler plate “anti-merger” language is such a stipulation.
8. A lessor has an equitable claim to rents paid by subtenants.
Hawaii National Bank v. Brian R. Cook,
2002 WL 31297214 (Oct. 14, 2002)
Where leasehold mortgagee has assignment of rents of sublease rentals, and there is no economic advantage to mortgagor to pay rent on master lease to maintain value of mortgagor's interest in it, leasehold mortgagee (through foreclosure commissioner) may collect sublease rents and keep them with priority over master lessor until master lessor takes action to "activate" its implied priority claim over such rents, which claim is based upon mortgagor/sublessor's involvency.
This case arose in Hawaii, where there are a large number of ground-leased estates that form the foundation for the real estate market. Mortgagor held a tenant’s interest in a ground lease, and had placed several mortgages upon its leasehold interest. (There were actually two ground leases, running about parallel, But they are described here as one for convenience.) It had also subleased this property to apparently solvent tenants who were paying substantial rents. Further, it had mortgaged its sublease rights to Bank, which took an assignment of rents under the sublease as part of the mortgage. By time of this dispute, Bank had also obtained the rights of another lender that also had an assignment of rents and leases. The Master Lessor had consented to these security interests.
The assignments were phrased in typical broad language. The Bank's original assignment, contained in the mortgage, stated that upon default Bank had the "immediate right to receive and collect all rents . . .due or accrued or to become due, and said rents . . . are hereby assigned to the Mortgagee." The other lender's assignment stated that, upon default lender, "at its option" could sue for a receiver, take possession, or, without taking possession, "demand, sue for or otherwise collect and receive all rents . . . "
With only two years or so to go on the master (ground) lease, and with the Master Lessor apparently indicating that it was not planning to renew, the mortgagor became insolvent and stopped paying on both the mortgages and the master lease, although the sublessees apparently continued paying like clockwork. The Bank sued to foreclose, and an order of foreclosure issued from the court on Valentine's Day of 1997. The foreclosure action did not name the Master Lessor as a defendant. Under Hawaii procedure, a "commissioner" then commenced collecting the rents in the period prior to the scheduling of a foreclosure sale.
It appears that the primary purpose of the foreclosure action was to formalize the Bank's access to the rents, since the leases, now with only months to go, and subject to the Master Lessor's right to terminate for nonpayment of rent even earlier, had virtually no value at foreclosure auction.
In October of 1997, the Master Lessor brought an action to terminate the leases and in November it intervened in the foreclosure action, asking that a receiver be appointed to collect the rents and that these rents be allocated to it first, as it had an equitable priority in those rents pursuant to the rule that sublease rentals collected by an insolvent sublessor must first be paid to the master lessor. The Master Lessor's action to terminate the master lease succeeded in January of 1998, three or four months before it would have expired by its terms. The $363,000 in rents ultimately collected prior to the formal termination of the leases exceeded the amount of the master lease arrearages, although they fell far short of the Bank's million dollar claim. The rental figure mentioned above represented the net collection from July, 1997, until January, 1998. It is not clear why the court started counting as of July. The Commissioner had been on the land longer, and had already filed one request for an order of distribution prior to July 1997. The Master Lessor didn't intervene until November of 1997.
The trial court awarded Master Lessor the rents it needed to make up the arrearages out of the monies collected by the Commissioner. On appeal, the intermediate appeals court affirmed on the grounds that the Commissioner had an equitable obligation to preserve the estate of the Master Lease for the benefit of the mortgagors (who apparently were not taking a position in this fight – they owed everybody). A dissenter pointed out that there could be no need to preserve the leases, since they effectively had no value as they were about to expire. Neither the dissenter or the court points out that the substantial monies that were accruing might have continued to accrue for another three or four months – apparently generating a surplus – had the leases not been terminated for non payment of rent. Perhaps the sublease rent was cyclical and would not have been payable in the same amounts during the last few months that were lost.
On appeal to the Hawaii Supreme Court, held: Reversed in part and affirmed in part. The Master Lessor got the net sublease rents accruing from time of its intervention in November of 1997 until the termination of the lease.
The court relied heavily on Friedman on Leases for an analysis of the rights of the Master Lessor to the sublease rents. It noted that Friedman cites extensive authority for the proposition that "if the prime tenant is insolvent the head landlord may resort to the subrents and has a preference therein ahead of other creditors of the prime tenant – to the extent necessary to satisfy the prime tenant's liability under the head lease." This seems to be something akin to the priority of the purchase money mortgagee.
The court went on to follow Friedman's analysis that the rights of the Master Lessor are not automatic, but must be "activated." Friedman basically analyzes this issue only in the context of a formal provision for a lien right on the sublease revenues created by the master tenant in favor of the master lessor. But the court applies the same analysis here, despite the fact that there was no such formal lien or assignment. It concludes that the issue should be treated analogously to the question of the validity of a claim of a rents assignee in a mortgage. Typically, even if the assignment of rents contains language providing for "automatic" attachment of the claim to the rents upon default, courts have held that the mortgagee/assignee must take some action to activate (the court uses the somewhat discredited term "perfect") the assigment before its priority claim actually takes effect.
The Hawaii court acknowledged that a few American courts have given effect to language in a rents assignment that purports to "automatically" vest the mortgagee with the accruing rents upon the execution of the mortgage, subject only to conditional collection by the mortgagor until default, but it indicated that Hawaii had never ruled on the question, and the lien theory of mortgages in Hawaii would appear to support in general the recognition of the rights of the mortgagor's interests in the rents for as long as possible. "Absolute assignments are generally disfavored in lien theory jurisdictions." (Quoting from Thompson on Real Property (Thomas Edition)).
The court concluded that "public policy weighs against construing assignment of rents clauses as absolute assignments absent a clear indication that the parties intended to create one." Consequently, where, as here, there was no language expressing the rights of the Master Lessor at all in the master lease, and the Master Lessor's rights were based purely on equity, the Master Lessor had to have taken some action to activate its interest. It did so, the court held, when it intervened in the foreclosure action in November of 1997, and therefore the pro rata share of the net rents that covered the period from November 1997 until January 1998 should be paid over to it.
The court apparently agreed with the dissenting judge below that the Master Lessor had no claim to rents based upon the argument that the Commissioner had a duty to preserve the master lease. The court acknowledged that this was an unusual case in this regard, since without a potential extension of the ground lease, it had no marketable value. (Again, the court does not mention rents that might have accrued from January to April, 1998 when the lease term would have expired.)
As a final argument, the court noted that the Master Lessor got the benefit of restoration of possession of the property through its action to terminate, and thus got "full benefit" of the lease rights when it also collected the rent. It stated that "this can hardly be called fair, just and equitable," where the Bank got only around $100,000 to be applied to its million dollar deficiency.
The court's closing comments are mysterious to those of us who aren't aware of the rents situation for the last three or four months of the lease. Perhaps the sublease revenues terminated on January, 1998, regardless of whether the master lease had continued. We just don't know.
In any event, surely this case cannot be about what is "fair just and equitable." These parties were all "players," and they were entitled to get exactly what their documents and their legal positions gave them, no more and no less.
The editor has weighed in quite a bit in past law review articles about the appropriate characterization of the mortgagee's interest in an assignment of rents. In virtually every case, the parties, in fact, intend an arrangement that is a collateral assignment, not a present absolute assignment. The Editor not only agrees with the Hawaii court's tipping in that direction here, but hopes that it will continue to "tip" when it gets the issue in a battle among rents assignees.
Because landlords under master leases are not in privity of estate with subtenants, in general they have no claim for the rents. But they do have the right to reach the rents, under established authority, when they have been collected for period in which the master tenant/sublandlord is not paying the rent on the master lease. It does seem equitable that if the possession conferred by the master lease is creating these revenues, that the master lessor (and its creditors) should not enjoy the benefit of these revenues without paying the cost. Of course, these rights can be disclaimed, and perhaps tough-minded mortgagees will see that they are so disclaimed in the future, but the result seems appropriate as a "default construction" of the parties' relationships.
9. Mortgage loan participations may be recharacterized as loans from the participants to the lead lender.
Came Realty LLC v. DeMaio
746 N.Y.S.2d 555 (Sup. 2002)
Specific factors in the manner of the fractional assignments of mortgage may indicate an intention to create a loan and not a participation plan, thus entitling the assignees to the proceeds from any foreclosure sale. The assignments merely gave the assignees an unperfected security interest in mortgagor's note.
DeMaio gave a note and mortgage and note to Churchill. Churchill went bankrupt and Plaintiff sought to foreclose the mortgage. Churchill, prior to bankruptcy, had assigned fractional mortgage notes of the DeMaio mortgage. The fractional mortgage notes had a one (1) year term and an 11% interest rate as opposed to the thirty (30) year term and 9% interest rate of the DeMaio note. The investors never took possession of the original DeMaio note and mortgage. Churchill guaranteed them their return. Churchill's principal was later found guilty of fraud in connection with the scheme to sell these interests.
The assignees of the fractional assignments of mortgage contended that they were entitled to a share of the foreclosure proceeds. The court described their argument as being that they had "a perfected security interest in the note." It does not say how their interest became perfected. Although the court doesn't say so, it appears that their argument was that they were perfected because Churchill held the note as their trustee.
The plaintiff, however, contended that the fractional assignments of mortgage represent loans made by the assignees with a guaranteed return on their investment and thus, did not entitle them to the proceeds from a foreclosure sale but, at best, give them an security interest in the DeMaio note, which security interest was unperfected.
Because of the difference in term and interest rate between the assignments and the original DeMaio note, the court agreed with the Plaintiff and held that the fractional assignees had no purchased participation shares in the original loan, but instead had made loans to Churchill, secured by (unperfected) security interests in the underlying mortgage and note.
The investors’ argument made no sense at all. They couldn't both be participants and have a "security interest in the note." Either their interests, as participants, were as owners of the note, or they were lenders. If they were lenders, under the old Article 9, they could be perfected only by having possession of the note. Under revised Article 9, it would have been possible for them to perfect by making a UCC filing. (That sort of filing would, it is hoped, satisfy the perfection requirements of bankruptcy, although the priority still would be "bumped" by a competing claimant holding possession of the note.)
These investors were victims, and likely nothing was going to help them. However, for planning purposes, the following precautions will assist the participants in avoiding the argument that the participations are loans rather than sales. While some participants have succeeded despite the absence of some of the factors listed below, following all of them presents the strongest possible case. See In re Autostyle Plastics, Inc., 1999 WL 1005647, 42 Collier Bankr.Cas.2d 1555 (W.D. Mich.1999).
1. Describe transaction as a sale. The participation agreement should clearly state that a sale of interests, and not a loan to the lead lender, is contemplated. This was critical to the court's decision to sustain the participant's rights when the lead bank was taken over by FDIC as receiver in Northern Bank v. FDIC, 242 Neb. 591, 496 N.W.2d 459 (1993) (lead bank held legal title, but as a constructive trustee for participant to the extent of participant's equitable interest). See also In re Okura & Co. (America), Inc., 249 B.R. 596 (Bankr.S.D.N.Y. 2000). Cf. In re Churchill Mortg. Inv. Corp., 233 B.R. 61 (Bankr.S.D.N.Y.1999), in which the failure to describe the transaction as a sale of interest in the underlying loan was fatal to the participants’ claims.
2. Avoid guarantees and buybacks. To provide maximum protection in case of the lead lender's bankruptcy, the lead lender should not guarantee payment of the underlying mortgage loan, and should not agree to repurchase the participants' interests in the event of default on the mortgage loan. In other words, the sale of the participation interests should be without recourse. See In re Coronet Capital Co., 142 B.R. 78 (Bankr. S.D.N.Y. 1992), holding that the "participation was in reality a disguised loan because the lead lender guaranteed the payments to the participant, and in fact paid them even when the underlying loan was in default; In re Woodson, 813 F.2d 266 (9th Cir. 1987); In re Lendvest Mortgage, Inc., 119 B.R. 199 (9th Cir. B.A.P. 1990); Rechnitzer v. Boyd, 40 B.R. 417 (Bankr. C.D.Cal. 1984). But see In re Golden Plan of California, Inc., 805 F.2d 1334 (9th Cir. 1986) (opinion withdrawn 812 F.2d 1088), upholding the transfers as sales despite the lead lender's guarantee of payment to the participants; In re Lemons & Assoc., 67 B.R. 198 (Bankr.D.Nev. 1986) (same); Savings Bank of Recleaned County v. FDIC, 668 F.Supp. 799 (S.D.N.Y. 1987), upholding the participation as a sale despite the lead bank's obligation to repurchase any defaulting loans.
3. Designate trustee. Language in the participation agreement should designate the lead lender as the agent or trustee of the participants for the purpose of holding the note and collecting and enforcing payments on the underlying mortgage loan, or should designate an independent trustee for those purposes. See In re Southern Indus. Banking Corp., 45 B.R. 97 (Bankr. E. D. Tenn. 1984); In re Columbia Pacific Mortg. Co., 20 B.R. 259 (Bankr. Wash. 1981). The lead lender's powers and duties in this capacity should be spelled out.
4. Indorse notes. The notes should be indorsed to the participants, to the lead lender in its capacity as trustee for the participants, or to an independent trustee. See In re Southern Indus. Banking Corp., 45 B.R. 97 (Bankr. E. D. Tenn. 1984).
- Segregate documents and funds. The lead lender should be required by the agreement to segregate the mortgage loan from its portfolio of loans held for its own account, and to refrain from interchanging loans from the two portfolios. Funds received on the loan should also be segregated and placed in a special account. See Women's Fed. Sav. & Loan Ass'n v. Nevada Nat'l Bank, 811 F.2d 1255 (9th Cir. 1987), in which the participant was allowed to rescind the participation transaction because the lead lender had failed to segregate the funds as the agreement required. But see Savings Bank of Recleaned County v. FDIC, 668 F.Supp. 799 (S.D.N.Y. 1987), upholding the participation despite a failure to segregate the funds.
6. Yield to participants. The interest yield to the participants should be computed as the equivalent or composite of the underlying mortgage loan or loans (less whatever fee the parties have agreed to allot to the lead lender). It should not be based on other factors, as doing so will make the transaction appear to be other than a mere sale of interests in the underlying loan. See In re Churchill Mortg. Inv. Corp., 233 B.R. 61 (Bankr. S.D.N.Y. 1999); In re Woodson, 813 F.2d 266 (9th Cir. 1987). But see Savings Bank of Rockland County v. FDIC, 668 F.Supp. 799 (S.D.N.Y. 1987), upholding the participation as a sale despite the fact that interest yields to the participants were not based on the underlying mortgage loan interest; In re Lemons & Assoc., 67 B.R. 198 (Bankr. D.Nev. 1986) (same).
7. Record the Participation Agreement (or a Memorandum of it). Doing so ensures that if the lead lender later transfers its interest (or the FDIC takes the lead lender's assets as receiver, and transfers them to another lender), any party acquiring the lead lender's interest will do so with notice of the contents of the participation agreement.
*Jack Murray of the Illinois bar participated in the preparation of this commentary.
*This commentary was prepared by Jack Murray of the Illinois Bar.