Real Estate Finance Notes 9/29/04

Waste – Prudential Insurance Company of America v. Spencer’s Kenosha Bowl, Inc.

Here we have (presumably) a bowling alley in Kenosha. What happened? Delco was operating the bowling alley. They borrowed money from Prudential and then Spencer’s buys the property, but doesn’t assume the mortgage. What is an assuming versus a non-assuming grantee? Say you have a mortgagor and mortgagee, and the mortgagor is also a grantor, who transfers to a grantee. The grantee could assume the mortgage, which is similar to the idea that a tenant can assume a lease. Assumption is a third-party beneficiary contract: between the mortgagor and grantee for the benefit of the mortgagee. The grantee is then liable not just on the mortgage, but also on the promissory note. That means that if the mortgage goes into default, the grantee is liable. The assuming grantee is liable to lose the land, and to the extent that the grantee paid anything, will also lose her equity. The grantee will be liable for any deficiency created by the fair market value being less than the amount of the debt outstanding. That is, you must make up the different between the debt and the proceeds of the foreclosure sale.

There is another possibility: taking subject to as opposed to assuming. When you take subject to, the grantee is perhaps paying something for the land, perhaps just agreeing to take it, but there is no agreement on the part of the grantee to pay the mortgage. The land is still encumbered by the mortgage, meaning that the grantee is liable to lose the land and any equity that the grantee has in the land, but that’s the maximum liability the grantee will have on the note (zero). The grantee has no obligation to pay the promissory note because the grantee never agreed to do so. This is unfortunate terminology because people often say: “I’m buying land subject to a mortgage”, but what they really mean to say is that they’re buying land encumbered by a mortgage. They could be assuming or taking subject to.

In this case, Spencer was a non-assuming grantee. Prudential is seeking damages from Spencer. The outstanding debt was about $1 million, but the property sold for only two-thirds of that. Prudential wants to recover more than the $600,000. They claim that there is a deficiency here. Prudential could have recovered from Delco because they promised to pay the debt, and the fact that they transferred it to someone else doesn’t relieve them of their responsibility to pay. But Delco is out of the picture, possibly bankrupt, so Prudential chooses to go after Spencer instead.

Prudential claims that they’re not suing for a deficiency, knowing that they can’t get a deficiency against Spencer as a non-assuming grantee. Instead, they sue Spencer for waste. Here’s what’s odd about waste: when we studied waste in Property, we talked about it as a common pool problem between two or more people who owns interests in property in common. Future interests are the most basic example. The common law doctrine of waste is designed to counteract the incentive that common ownership creates to use the property up before you have to hand it over to the next guy. If the tenant causes damage to the property, they have to live with it for a while, but the real cost will be borne by the landlord when they take the property back. The law of waste is designed to give a remedy for this.

In the mortgage situation, it’s a little different. In a title theory state, we wouldn’t have any problem with waste: we have two people with an ownership interest in the same property at the same time. But in a lien theory state, the mortgagee has no ownership interest at all, just a security interest! The court decides that even in lien theory states, the law of waste protects mortgagees even though they don’t own the property.

Spencer claims that because they’re not an assuming grantee, they’re not liable for the deficiency, but rather their maximum liability is to lose the property (which they did). Prudential says they’re liable for waste even though there is no contract and no assumption. But waste is a tort. You can have a tort between parties who don’t have a contractual relationship! The court is enforcing an obligation created by law, not by contract. What’s the amount of Spencer’s liability? It’s the amount of the deficiency, not the amount of the waste. But why aren’t they liable for the whole amount of the tort damages? Because Prudential is only entitled to their actual damages (the debt) and they have already received part of the damages.

What happens to the other $144,000? The grantee has created a tort resulting in $444,000 in damages, but only has to pay $300,000. Does this give the grantee an incentive to commit waste? Not exactly. If there had been no waste, such that the property would have brought $144,000 more than the debt, the grantee would have gotten that money as equity. The grantee has the same incentive to preserve their equity as anyone else. If you damage your own property, you bear 100% of the loss.

We wouldn’t have waste if we had an assuming grantee. So what is the relationship between the judgment for waste and the deficiency judgment? Why didn’t Spencer pay the property taxes? Maybe Spencer didn’t have the money to pay! Say there is no waste. What if we had vacant land? Let’s say property values in Kenosha fall. When the mortgage was entered into, the property was worth a lot more than it is now. Would the non-assuming grantee be liable for a general economic downturn? There’s no tort liability, and the grantee didn’t assume liability. With respect to the passive waste, isn’t it at least possible that that’s what happened here? Maybe the value of the property went down, and it was the decline in the market that led to the neglect of the property, not the neglect of the property that led to the decline in value.

If Spencer had paid the property taxes and then gone into default on the mortgage earlier, the deficiency would have been close to the same. Instead of paying the mortgage down during the period that the property taxes accrued, he chose to prevent foreclosure. So is this really waste, or just a decline in value, which is exactly what a non-assuming grantee should not be liable for? The deficiency judgment is very closely related to the concept of waste.

What are the remedies for waste? We know you can get damages after foreclosure. You could also get an injunction. You may be able to get a receiver appointed depending on whether the mortgagor was solvent. What can you do prior to foreclosure? Waste may be a default, and thus you may be able to foreclosure or activate an assignment of rents clause. You can try to get the debt reduced because the security has been impaired. The mortgagee might want to keep the mortgage in existence. If you have a solvent mortgagee, you might sue for damages but not foreclose.

A problem

“Illustration: 14. Mortgagee-1 makes a loan of $80,000 to Mortgagor, who executes a promissory note to Mortgagee-1 secured by a mortgage on Blackacre, which has a value of $100,000. Mortgagee-2 then makes a loan of $10,000 to Mortgagor, secured by a second mortgage on Blackacre. During the ensuing five years, Mortgagor makes all scheduled amortization payments on both loans, reducing the first loan balance to $70,000 and the second loan balance to $5,000. Blackacre's value remains at $100,000. Mortgagor then commits waste, reducing Blackacre's value by $20,000 to $80,000. Since the scheduled loan-to-value ratio on the first loan at the time of the waste was $70,000 divided by $100,000, or 70 percent, Mortgagee-1 is entitled to a restoration of that loan-to-value ratio. The value of Blackacre now being reduced to $80,000, Mortgagee-1's damages recovery should reduce the debt balance to 70 percent of $80,000, or $56,000. Mortgagee-1 may recover (and upon recovery must credit against the debt balance) damages of $70,000 minus $56,000, or $14,000.

“The real estate value available to Mortgagee-2 at the time of the waste was scheduled to be $100,000 minus $70,000, or $30,000, giving Mortgagee-2 a scheduled loan-to-value ratio of $5,000 divided by $30,000, or 16.67 percent. As a result of the waste, the value available to Mortgagee-2 has been reduced to $80,000 minus the balance owing on the first mortgage loan. If Mortgagee-1 does not in fact recover for waste before Mortgagee-2's action for waste must be decided, the balance owing on the first mortgage loan will still be $70,000, leaving only $10,000 in value available for Mortgagee-2. Hence, Mortgagee-2 can recover damages in an amount necessary to restore Mortgagee-2's loan-to-value ratio to 16.67 percent of $10,000, or $1,667. Mortgagee-2 may recover (and upon recovery must credit against the debt balance) damages of $5,000 minus $1,667, or $3,333.

“However, if Mortgagee-1 actually recovers $14,000 from Mortgagor in a waste action before Mortgagee-2's action for waste must be decided, Mortgagee-1's recovery will, as noted above, reduce the balance owing on the first mortgage to $56,000. In this situation the value available to Mortgagee-2 will have been reduced to $80,000 minus $56,000, or $24,000. Mortgagee-2 can recover damages in an amount necessary to restore Mortgagee-2's loan-to-value ratio to 16.67 percent of $24,000, or $4,000. Mortgagee-2 may recover (and upon recovery must credit against the debt balance) damages of $5,000 minus $4,000, or $1,000.” REST 3d PROP-MORT § 4.6

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