Real Estate Finance Outline
Table of Contents
We’ll spend a fair amount of time in this class on cases involving residential real estate. We’ll do this not because it’s the main focus of this course: lawyers aren’t even involved in it much anymore. But we’ll emphasize it because the rules are about the same as commercial real estate. There are now some consumer protection rules in residential real estate. The rules don’t apply as harshly with commercial real estate. The law assumes in that case that the parties have roughly equal bargaining power and can take care of themselves. Residential real estate transactions are easy to understand, so it’s easier to teach and learn the rules in that context rather than deal with a commercial transaction where we have to spend a lot of time on the facts.
NPR said the other day that
it is expected that there will be one foreclosure for every 117 mortgages
The law of real property and
the law of real estate finance, which is a subset, used to be almost entirely local, meaning peculiar to the
state where the property is located and in many cases, peculiar to certain
parts of the state. There used to be
different practices in
Why was it the way it
was? Lawyers are typically licensed
locally. You’re admitted to practice in
The lawyer, especially in a residential transaction, has become less and less important, at least when it comes to the buyer and seller. The lender and title insurance company are represented by counsel, but not the buyer and seller. So the locality makes less of a difference. Also, banks now operate nationally. Depression-era bank restrictions and regulations have been relaxed, and you see more and more national lenders. National lenders want standardization. Every lender wants to standardize the process as much as possible to reduce transactions costs. When you don’t need separate processes and forms for different states, it doesn’t cost as much.
Another change is the rise of
title insurance. After World War II,
there was a big population increase and federal policies designed to encourage
people to buy single-family homes. There
was a lot of development, especially out West, that was not near established
financial institutions. The major
The Federal Housing
Authority, Fannie Mae, Farmer’s Home Loan Board and so on are
federally-chartered organizations. They
act as a private corporation but are infused with public interest and public
policy. Their debts are backed by the
federal government. The FHA wants to
help finance this real estate development that’s going on, particularly
residential real estate development after the war. They make a deal where they agree to buy
mortgages. If you borrow some money in
All of these forces are
working to make the law of real property, at least in the context in which
we’re studying it, more and more homogeneous throughout the country. Take for example the Restatement of
Mortgages. Now we can study cases from
all different jurisdictions to determine what the law is. We won’t just look at
Most of the lecture will be PowerPoint and the slides will be posted on TWEN. So good. E-mail him regular-like, not on TWEN. He’s Braunstein.1. In the subject line, no matter what you’re really asking, write “REF”. There will be a filter.
The exam will be similar to the one in Property. There will probably be a regular essay section, a short answer section and a multiple choice section. This exam will be open book.
Outline of the typical transaction
The typical transaction involves a contract. Even simple real estate transactions are more complex generally than transactions involving personal property. This is partly the result of tradition and partly the nature of the transaction itself that makes it more difficult. The typical deal starts, from the buyer’s perspective, with finding a property, with or without the aid of a real estate agent or broker. In the overwhelming majority of cases, the seller has already contracted with a real estate broker. The seller will have entered into a listing agreement that authorizes the broker to put up signs, etc. and hopefully bring buyers forward.
An aside: A real estate agent is a lesser qualification than a real estate broker. An agent takes an exam and is licensed by the state to engage in that practice. You don’t need any experience. But you have to do business with a real estate broker, who needs to have been practicing for a certain amount of time and have passed a certain more difficult exam. So a real estate agent cannot practice on his or her own. In terms of what we’re studying, there is no difference between the agent and the broker and so we’ll use the terms synonymously for the most part. Note how this is different than the meaning of broker that you’ll find in BA.
Next, the parties come together and decide that they’ve agreed on the property and terms, and thus a contract must be prepared. In residential transactions, the contract is almost always printed on a standard form that is published jointly by the Bar Association and the Board of Realtors. Braunstein says it’s not a bad contract. The idea is that there’s not enough money involved in residential transactions to draw up a contract from scratch every time. It doesn’t justify having a lawyer involved because the transactions are pretty routine. The parties can usually customize just a few clauses themselves. In commercial transactions, however, form contracts are rarely used, even for relatively simple transactions. Big transactions begin to justify the attorneys’ fees involved and negotiations that bring the two sides together in their understanding of their agreement.
Why do you need a contract of sale? There are two things going on. Banks don’t want to get involved in a transaction until they know what the transaction is. They don’t want to process a loan until the property and terms are already determined (though this has changed in the last 10 years with prequalification). Also, the buyer won’t want to commit to purchase until financing is secured. The buyer doesn’t want to unconditionally promise hundreds of thousands of dollars that the buyer doesn’t have. The seller has an incentive to have a contract as well, even if it’s somewhat contingent. The seller is going to essentially take the property off the market, and they want to make sure that the buyer is obligated to secure financing and do their best to close the transaction.
The other thing that distinguishes the transaction in the purchase of real as opposed to personal property is the question of title. We separate ownership from possession in the law of real property. Someone who is in possession of land may not own it or may not own the whole “bundle of sticks”. You must investigate title, which takes time and costs money. Buyers don’t want to take the time to investigate title and then find that the property is off the market. Title insurance works by telling the title insurer what property you want. They do a title search and then issue a title commitment, saying that if you buy the property they will insure title on the property.
Finally, we come to closing. Closing describes two different things: it describes, at least in some cases, a kind of conference that takes place with the buyer, real estate agent and title company and frequently a bank representative. You meet for the purpose of fully executing the transaction. When we say a transaction is to close on a certain date, we mean that all of the obligations of the contract are to be performed on that date. The obligations of the contract boil down to the buyer paying the money and the seller delivering the deed. At that point the contract becomes executed and is no longer executory. The deed is then transferred. Then documents have to be recorded, particularly the deed and the mortgage. Lawyers may handle this, but more frequently the title company takes care of it. Closing memoranda and “bibles” are prepared. And that’s it…unless there’s litigation.
Role of the lawyer
Lawyers don’t play much of a role in residential real estate transactions anymore because they’ve been driven out by title insurance. The most complex thing that the lawyer did was give an opinion of title. Now that’s done by title insurance companies. The reason for this is that has the real estate market has become more national, the demand for uniformity in documentation has become more important. Title insurance is on a standard form published by one or two different land title organizations. Because they are regulated insurance companies, title insurance companies must have a certain amount of assets to back their liabilities.
It is sometimes asserted that
title insurance is cheaper than a lawyer’s title opinion, but Braunstein thinks
that’s not necessarily clear. Title
insurance starts at $5 per $1,000 of value.
As the purchase price goes up, the insurance premium goes down somewhat. In
Residential real estate transactions
almost always go off without a hitch. A
lawyer might say that someone is taking a risk in buying or selling without
legal advice, but the transactions very seldom result in litigation. In
Who does the real estate broker represent? The broker typically represents the seller. The broker isn’t in a situation to advise the buyer, for example, “you shouldn’t buy this property because there’s a potential title defect!” It’s hard for the broker to give independent advice to the buyer. The broker represents the seller and it would be violating a duty to the seller to advise the buyer. Also, the buyer’s livelihood is contingent on closing the sale. So this is an unlikely source of independent advice for the buyer.
Buyers frequently say that they don’t need advice because the “real money” is coming not from the buyer but a lender who is putting up as much as 100% of the purchase price. So if the title and appraisal are good enough for the lender, why aren’t they good enough for the buyer? The bank looks at the collateral, but they also look at the borrower. Banks look at the transaction differently from borrowers. They know that a certain percentage of their loans will default and they’ll lose that money. But this is built into the interest rate. The bank can spread the risk over a whole bunch of people and a whole bunch of loans. The individual buying the house is not able to do that so easily.
There are some things that the bank might not care about that might be important to you, such as aspects that don’t affect the value of the real estate. Maybe you’d like to build a swimming pool but there is a restrictive covenant against building a pool. That wouldn’t affect the value of the property to the bank, but it would affect its value to you. The bank has no economic stake in whether you can use the property in the way you planned. In most transactions, the bank has a “cushion”. The buyer makes a down payment in most transactions. Even if there is a defect, the bank only cares whether the value of the collateral will be affected. If the value is cut by 5% but the bank has, for example, a 20% cushion from the down payment, then they won’t care. The risk of a bad title or undisclosed defect with respect to title turns out to be quite small, even though titles can be very complex.
There are four types of listing agreements, at least as courts see it:
What type of listing appears in the book on page three? It’s an “exclusive sale and listing agreement”! Says so right in the title. But they also refer to the exclusive right to submit offers. They have the exclusive right to “receipt for deposit”. What does that mean? If someone gives the agent a check along with an offer, they’ll give a receipt for it and they can deposit the check in their checking account, earning interest. So we have an exclusive listing. The agent gets a commission if it’s sold to anybody. What are the duties of the agent? They have to make efforts to sell the property and list it with the Multiple Listing Service. What does that mean? It’s very vague. Do they have to make their best effort? Reasonable efforts? Do they have to try more than once? If you were going to negotiate this contract, you might negotiate what efforts will be necessary. This is pretty much the only duty the agent has! The fact is that most agents will do what they told you they would do, but it’s good to have it in writing.
What about the owner? What are the owner’s duties? The owner must cooperate. What is the biggest pitfall? What happens if the owner doesn’t provide good title? The owner still owes a commission! That’s a dangerous situation to be in, because most people don’t understand what their title is! In addition, most people don’t have the cash to pay the commission unless a sale goes through.
When is the commission earned?
There are lots of ways under the listing agreement in the book. The agent gets a conclusive presumption that he or she caused the sale! Does there have to be a sale in order to have a selling price? How could there be a selling price if the seller removes the property from the market? But there is a selling price listed on the contract. How do we feel about the rules for when the agent earns the commission? If you’re representing the seller, you’ll want to change the paragraph about the commission in a number of ways. If you wanted to make it clear that the agent only received the commission in the event that the sale closed, what would you say? What about the doctrine of preventing performance? If the agent brings in a good offer but you screw it up in some way, they’ve probably earned their commission. Is it enough to say that the commission is due “at the closing” or “when the sale closes”? What if the buyer defaults? Do we protect ourselves by saying that the commission is payable when the sale closes? Wouldn’t the court just imply a reasonable time? If the condition that was agreed upon never occurs, then the court will say that the commission is at a reasonable time. Thus, you’ve only really agreed on when the commission gets paid, not if it gets paid.
There are other elements you might want to change. The agent want to be protected from being cut out of the deal by the buyer and seller waiting until the listing expires. So they put language in saying that if you sell the property to anybody who they introduced you to, even after the six months is up, they still get the commission. You would want to make the agent notify the seller in writing of everyone that they think they had introduced you to. Also, it can be negotiated so that it only applies if there isn’t another agent involved. The rationale is that you shouldn’t have to pay twice.
Drake v. Hosley – There are more than two people who want to buy
property in North Pole,
The simplest way to buy
property is to pay cash out-of-pocket.
One alternative is to borrow the money from the bank in exchange for the
mortgage. To the seller, it’s all the
same because they get cash. But it might
be hard to find a bank in North Pole,
Hosley sues for his commission. Does he get it? Yes!
What’s the rule of the case? The
commission is earned when the seller accepts the buyer: the seller is then estopped from saying that the buyer isn’t suitable. At that point, the seller becomes obligated to
pay the commission. What’s wrong with
that rule? What is the Dobbs rule? The Dobbs
rule requires performance,
that is, closing the sale in order for the commission to be earned. What’s the public policy here? The court says that people commonly
understand that you don’t pay unless the sale closes. So they make a new rule there for
What if you want to do business differently? What if the broker wants the commission as soon as a buyer is found and accepted by the seller? That seems to be the problem with the rule. Some say that we want people to be able to contract any way they want. But that’s not the sentiment of the consumer protection movement. Should we have freedom of contract, or should consumers be protected from themselves? Other courts who have adopted the Dobbs rule have said that you can waive it, but it’s kind of like a UCC requirement: you have to give lots of notice to the seller to assure that they know what they’re getting themselves into.
What happens here? Does it matter what rule the
What was the deal about who Hosley represents? Why did the court care? The court says that Drake’s attorney and Hosley can’t agree to anything because they both represent Drake. Whatever Hosley said, it doesn’t make a difference because the agreement wasn’t between the buyer and the seller. This is how the court upholds summary judgment. Does this make sense? Maybe Hosley talked to the sellers. You can at least imagine that he did. We don’t get a trial to find out. Maybe Hosley mediated an agreement. But as a matter of law, the court finds that Hosley is not an agent of the purchasers and can’t bind them.
But the court could have dealt with this differently. The contract doesn’t say that time is of the essence. They could have said that closing on the 12th or the 13th is okay. They could have said Drake is a creep who shouldn’t be able to weasel his way out of paying the commission. But they say that Drake’s attorney, Wickwire, and Hosley both owe their allegiance to Drake. Even if the court adopts Dobbs, Hosley still gets his commission. Most states use the old rule. A minority have adopted Dobbs. But Dobbs is the recent trend. (CRASH!)
A problem on liability for commission
“Pursuant to a non-exclusive listing agreement, O places his property in the hands of B1, B2 and B3 for sale at $10,000. B1 produces a buyer willing to buy the property for $10,000. Before the contract is signed, B2 produces a buyer for $11,000. So, O refuses to sign with B1’s customer and signs with B2’s instead. Thereafter, B2’s customer suffers financial reverses and refuses to go through with the deal. Thereupon B3 produces a buyer at $9,500. O, disgusted with the whole thing sells to B3. To whom does O owe a commission?”
Under the traditional rule and under Dobbs, O will owe a commission to B1. Under the traditional rule, he owes the commission to B2, but not under Dobbs. He owes a commission under either rule to B3 since the sale actually went through. Does it make a difference that it’s for less money than he originally wanted to sell it for? He could have held out for his $10,000 and not owed a commission to B3.
What about involuntary sales? What if the property is taken by eminent domain or foreclosed upon and sold at an auction? Do you have to pay a commission? Say the agent has an exclusive listing. Is there anything in the contract that says the sale must be voluntary? Nope. We don’t intuitively like the idea of the seller having to pay a commission when there is an involuntary sale, but that’s what the contract provides for. Many cases have held that in the case of involuntary sales the seller owes the commission. That could be one thing you would want to change if you were an attorney representing the seller.
Who does the broker represent?
Typically, the broker
represents the seller. But the law and
reality are totally out of whack.
Generally, you call a real estate agent and ask to buy a house. You want them to drive you around and show
you places. You
typically think of that person as being your
agent. You’ll ask if there’s anything
wrong with the house. If the agent were
really the agent of the seller, then the agent would say: “I can’t discuss that
with you.” But that’s not the way that
the market works! The agent, as a
factual matter, represents both parties.
But as a legal matter, the agent owes a fiduciary duty to the
seller. In litigation, sellers may claim
that agents violated an exclusive loyalty due to the seller. Many states, including
There is a duty to disclose
the agency relationship. There is a duty
to disclose material defects. In many
Statute of frauds
There are two different kinds of real estate contracts. There’s the marketing contract (or purchase and sale agreement) and the contract for deed/installment contract. The latter is not a purchase and sale agreement at all: it’s essentially a mortgage or a security device like a mortgages. We’ll put it off until after we’ve already covered mortgages. With the marketing contract, the parties contemplate that they’ll sign the agreement, which is highly conditional (like the one in the text), and then as soon as the contingencies are satisfied, there will be a closing, consideration will be paid in full, and the deed will be transferred. So the contract won’t have a long life before being fully executed. The contract for deed essentially says that the contract will remain in effect for a certain period of years, which may be a long time. The legal title to the property will be in the vendor until the vendee pays the consideration in full. The vendee will pay a certain amount of money per month. If all payments are made, then the vendee keeps the property. If the payments aren’t made, the vendee gets tossed out and the vendor keeps the property. Mostly, we’ll be talking about the marketing contract.
The most frequently used
marketing contract in
There’s an integration clause at the end of the contract. Are such clauses effective for real estate contracts? Is it legally enforceable to say that they can’t amend their agreement? What about oral modifications? You can orally rescind, but you can’t orally modify. The agreement that’s you’re making doesn’t have to do with the enforceability of the contract. Braunstein thinks this is kind of dumb. Modifications seem frequently more trivial than rescission. Modifications are like a new contract: that’s why they have to be in writing. But there’s an exception! There’s always the possibility of equitable estoppel.
This description would be inadequate for a deed because it doesn’t describe one and only one parcel of land. When we’re putting something into public records, we need a greater degree of certainty than when we have an agreement between two people. Some courts, however, would say that the requirement is the same. But this court doesn’t adopt that standard. This court takes a looser standard and says that the property only need be identified with reasonable certainty. There must also be an indication of how much money was to be paid. It’s not hard to determine the price. So it’s not specified precisely, but it’s easy enough to compute. There must be a promise, subject matter, consideration, and price. What’s the difference between the consideration, price, and promise? What else is left for consideration once price and promise are taken into account? Braunstein thinks you need the price, and the essential promise which is to turn over the deed when the full payment has been made.
Was there really a contract for the sale of land here? Why wasn’t it a lease? Well, it has this percentage rate. It seems clear that there is a contract here and we know with some certainty what the terms of the agreement are. There doesn’t seem to be much reason not to enforce it. What’s the internal coherence requirement? How many documents are relied on here to prove the contract? The vendor kept copies of all the checks and a sort of “matrix” of records of payments. The court puts all the writings together and say that all of them taken together constitute the note or memorandum required by the statute of frauds. The court doesn’t tell us much about internal coherence. Normally, it’s required that there is some reference in the writings that they deal with the same subject matter. That’s clear here in that many of the documents are copies of each other.
The executor claims that the price is inadequate. Is that a statute of frauds claim? Keep in mind that when you win on the statute of frauds, all you’ve done is establish that there was an oral agreement that the court can legally enforce. You haven’t proved your case, because this is a suit for specific performance. You must prove all the elements that are required for enforcement of the contract. So the defendant tries to claim that the contract is inequitable. But the court says: this is an affirmative defense, and the defendant didn’t introduce any evidence about it. Inadequacy will be a successful affirmative defense if the price is shockingly inadequate. But there was no evidence that would either shock or not shock the court. If the price isn’t inadequate, you must show some other way that the contract was inequitable.
What about the contract on
page 31, the “
What if there was an exchange of e-mails? What if this same note had been e-mailed to Diane and Jim and they had responded with “OK”? Would that be enough to have a writing that satisfies the statute of frauds? Can you electronically sign over the telephone? Under the Electronic Records Act, the mark is defined in that it can be an electronic signal instead of a pencil or pen mark. But there also still needs to be intent: was this mark intended to be a signature?
Does the statute of frauds require a contract to be in writing? No! Just a note or memorandum of the writing, and maybe not even that in the case of part performance. Does the statute of frauds require the seller to sign the writing? Not in most states. Only the “party to be charged” needs to sign. You don’t know who has to sign the memorandum until you know who’s enforcing it. If one party can enforce the contract, the other one can’t necessarily enforce it too. It’s perfectly conceivable that only one person will have signed the agreement, or note or memorandum of the agreement. That’s a very exceptional circumstance in the law. Usually, if one person can enforce against the other, then there is mutuality of remedy and the other person can enforce too. But only one side in this case can prove the contract exists!
Must the writing be introduced into evidence in any action to enforce the contract? Not necessarily. The memorandum might have been destroyed. You could just introduce evidence that there once existed such a note or memorandum. You’d need a pretty darn good explanation, but just because you don’t still have the writing doesn’t mean you have a legal difficulty with the statute of frauds; you just have an evidentiary difficulty.
Note that the statute of frauds is an affirmative defense. The statute of frauds doesn’t require a single writing. What about a judicial agreement? If the purpose of the statute of frauds is evidentiary, then if you admit there was a contract there’s probably sufficient evidence that the contract existed. That ought to be enough. But what’s wrong with that? It encourages perjury! Instead of saying that we had an agreement but it’s not in writing, you simply lie! The states split on this. There are at least some states where a judicial admission would not be enough and could not be used to satisfy the statute of frauds for that reason.
If the statute of frauds is not satisfied, it doesn’t necessarily mean that there is no contract. The purchaser can still get rescission and restitution. You could argue, however, that this is based on an idea of unjust enrichment. But then there is also the part performance doctrine. Even if you have the statute of frauds, there are lots of exceptions, such as easements by implication or necessity that don’t have to be in writing but are enforceable.
There are three acts of part performance, and you need two of them: (1) partial payment of the price, (2) taking possession, and (3) making substantial improvements on the land. Which of these are actually performance? Is partial payment of the purchase price performance of the contract? It depends on when the payment is due under the contract. It sounds like, usually, that would be performance of the contract. But not taking possession: you can own land and never even see it. And not making improvements, for the same reason. Why should the vendor care if you make improvements to a house that they’re selling to you? So the last two aren’t typically performance of the agreement. So it might be a good doctrine, but the name is confusing.
Roundy v. Waner – The mother and daughter get into a fight! The court finds that there was part performance. What was the part performance? The daughter paid part of the purchase price, made some repairs, and took possession. There are lots of things that would establish the part performance doctrine. We have all three of the things we just mentioned! The court will enforce the agreement and the parents lose their house! The theory for the part performance exception is to protect reliance and prevent unjust enrichment. Does this make much sense? In practice, we’ve gone much further than protecting the reliance interest. But here, they invested $2400 and got the whole house, which gives them a lot more than their reliance interest. Why don’t we just give them $2400 instead of the whole benefit of the bargain? The second rationale the court uses is that people don’t do these acts unless they believe that the house is going to be theirs forever. If you use the evidentiary requirement, it’s a higher burden of proof because the acts can’t be ambiguous. Anytime you have these acts, there will be a question as to whether there is a temporary right of possession as opposed to a sale.
We left off talking about part performance. We mentioned the three traditional elements listed as part performance. But only the first one is really performance. The part performance in Roundy v. Waner was that the Waners had made improvements to the property, made some payments, and perhaps taken possession. Did the Roundys ever really intend to sell the property? Why do we give specific performance? That’s kind of an anomaly, at least if the intent is to prevent unjust enrichment. Also, did Mr. Roundy agree to any of this stuff? It seems like only Mrs. Roundy was in on it. How does the husband lose his interest in the house, unless Mrs. Roundy is his agent?
Braunstein has two problems with this case: (1) where you have a family or neighbor relationship, it may seem inappropriate to demand a writing in the way you would in a commercial transaction. That may justify some exceptions to the statute of frauds in those kinds of transactions, although that’s not what the court talks about. (2) The judges seem confident that there was a contract made, but was there one really? Did the parties contemplate the consequences of a contract? Wherever you have an exception to the statute of frauds based on acts, you must remember that acts are inherently ambiguous. You never really know exactly why people do what they do.
Can a vendor use the part performance doctrine to enforce an oral contract against a purchaser? The Waners paid some money and made some improvements. Is that enough to set up an estoppel against them? If they’re willing to walk away from the deal, is there any sense in which they’ve been unjustly enriched? Not really. There’s no basis for equitably estopping the Waners from denying the contract. If they want to deny it, you can argue that they should be able to. Could you prove acts of reliance on behalf of the vendor? In this particular case, it looks like it only goes one way. What if you use the evidentiary theory of part performance? Wouldn’t you have to say yes? Aren’t the Waners’ acts pretty good evidence that there was a contract? Isn’t it evidence that’s as good as a writing? So it depends on which theory you hang your hat on. We ask: “Do we have evidence that’s as good as a writing?” If the answer is yes, we enforce the contract.
There are also other acts
that could potentially constitute part performance, but they’re just not
mentioned as often. Lots of acts could
satisfy either the evidentiary or unjust enrichment rationale that would lead
you to conclude that there’s a contract.
Braunstein is persuaded by these three acts because in
In the end, Braunstein thinks we should get rid of the statute of frauds. When we enforce it, we’re frustrating the intention of the parties. We if say there was a contract but it’s not enforceable because it doesn’t meet the formal requirement of a writing, then we frustrate the parties’ intentions because we think it’s very important for the parties to put their agreement in writing. Braunstein thinks that there are enough reasons to put agreements in writing such that we won’t cause any contracts that were previously written to be oral. It’s debatable whether the statute of frauds adds anything; but we know it subtracts. If you’re going to have the statute of frauds, why have the part performance exception at all, then? If you’re going to have it, why not just say “we have the statute of frauds and will enforce it”? The law is of two minds on the statute of frauds.
Buyer’s remedies and seller’s remedies are basically mirror images of each other. That seems logical: in the event of a breach they should have essentially the same remedies. The buyer’s first remedy is specific performance, which means requiring the parties to do whatever they agreed to do. The essential requirement for specific performance is that the buyer cannot be in breach of the contract. As long as the buyer has performed all the buyer’s obligations under the contract and as long as the seller is capable of conveying the property under the contract, specific performance will be awarded. But what if the seller has sold to someone else who is a good faith purchaser for value without notice? At that point, the seller no longer owns the property and can’t convey it. The person who owes the seller isn’t obligated to convey it. If the seller says: “I promise to sell you my 100-acre farm”, and it turns out that the farm is only 47 acres, then there’s no specific performance (except specific performance with abatement, about which more later) because they can’t legally convey what they promised to.
The next remedy is damages: the benefit of the bargain. That means, for the buyer, the market price (on the date the closing should have occurred) minus the contract price. That usually won’t yield much money because fair market value is just what a willing buyer and seller will agree to when reasonably well informed and not under compulsion. Compensatory damages are unlikely to lead to a large recovery except in exception circumstances. When we’re talking about marketing contracts, it’s unlikely that there will be a big fluctuation in the value of the property during the short life of the contract. These damages are also difficult to ascertain. The market price and date of breach will require expert testimony because you must bring in an appraiser to say that the buyer had a really good deal. Opinion testimony is less reliable than evidence from an actual market transaction.
Next up, we have unilateral rescission with restitution. This isn’t mutual rescission. Instead, the breach gives the buyer the choice to declare the contract at an end. The buyer would be entitled to recover whatever earnest money deposit had been made, with interest, and out-of-pocket costs specifically related to the transaction. But the damages are always limited by Hadley v. Baxendale. But costs reasonably within the contemplation of the parties and that are site-specific should be recoverable as a result of rescission.
The hardest and least important remedy is foreclosure of the vendee’s lien. This exists only in some states. The vendee has parted with money. In the meantime, the vendor not only breaches, but goes bankrupt. How does the vendee get the money back from the vendor? The vendee’s lien is a way to get the deposit back by having the property sold. The only time this has any relevance is when you have bankruptcy or insolvency. Otherwise, you just get a judgment against the vendor and go through the usual process to have the judgment enforced.
Sellers are traditionally also entitled to specific performance under certain circumstances. For the buyer, money damages are exactly the opposite. We assume a rising market and subtract the contract price minus the market price. The seller can also unilaterally rescind and retain the deposit. When we talk about these remedies as being comparable, is it really true that this is similar to the rescission right that the buyer has? Who ends up better off as a result of rescission? What does the buyer get? They only get back their own earnest money. But if the seller rescinds, the seller gets the buyer’s earnest money! The seller’s right of rescission is actually much better than the buyer’s right.
What if the deposit is greater than actual damages or there are no damages? What if the value of the property has increased, but for some reason the buyer has decided not to go through with the deal anyway? Does the seller still get to keep the deposit? It wouldn’t seem fair for them to, but they get to keep the deposit anyway. This does strike Braunstein as unfair. He would try to write the contract to change the remedies if possible to put the buyer and seller on an equal footing. He also thinks that the seller shouldn’t get to keep the buyer’s deposit if the seller wasn’t injured. The only potential benefit is that you don’t have to go through a whole trial if the seller just wants to keep the deposit. That doesn’t necessarily mean that if you’re a buyer with a small deposit that you can walk away from the deal for cheap: you must check your contract.
The seller also has a vendor lien. This may have no practical importance, though it has some theoretical importance, especially when it comes to equitable conversion. When you enter a deal, the seller has legal and equitable title. But once you enter into a contract, the buyer has equitable title and the seller has only “bare” legal title. When the buyer breaches, you have a situation where the equitable title is still in the buyer and there needs to be some way to reclaim it and get it back to the seller. The foreclosure of the vendor’s lien is the way that it’s done. Braunstein doesn’t know of any circumstance where this would actually come up.
Donovan v. Bachstadt – What is the measure of damages when the vendor is unable to convey because his title is not marketable? Was this an intentional or unintentional breach of contract? Braunstein says that it’s irrelevant. The English rule, followed by about half of American jurisdictions, is that even though you’re entitled to benefit of the bargain damages generally, you’re not entitled to such damages in this one area. How come? How do we justify this? You might have a bad title for reasons you don’t appreciate. Maybe you gave someone an easement, servitude, or real covenant that rendered your title unmarketable, but you didn’t really understand that this was happening. The idea is that if people don’t get it, you shouldn’t punish them for it.
But in the
The court points out that this is a default rule only, meaning that the parties can contract around it. There’s no public policy here; it’s just a matter of how the court will interpret the agreement if the parties don’t specific otherwise. Who has the burden of brining up the issue in negotiations? The court says that the seller has this burden if the seller wants to be protected in the event that he doesn’t have marketable title. Since the seller knows best about his own title, you can make a strong argument that this is where the burden ought to be.
What about compensatory damages for the vendee? It’s usually the difference between the market price and contract price on the date of breach. With respect to the buyer, that rule makes sense. But when it comes to the seller, the rule about the date on which you fix damages is more problematic. The court says that it may not always be measured that way. When you have a buyer who has turned around and resold the property, the damages may be measured by actual lost profits. The damages may also include lost opportunities, particularly improvements made by the vendee while in possession. That’s a pretty open-ended contingent liability for the vendor as well. What does the court do with the interest rate here? Rates were high and rising rapidly when this case was decided. It was 1982. It was expensive to borrow because lenders pay out uninflated dollars and get inflated dollars back.
The last paragraph of this case says that what you have to do is not look at just the value of the house, but also the value of the house with the added benefit of a low-interest mortgage attached to it. Then you subtract from that the purchase price specified in the contract.
This is a great, powerful
remedy! It allows you to hold someone’s
feet to the fire. If the vendor sues for
specific performance, it means that the vendee has to keep prepared to purchase
the property while the suit is pending.
They must keep their financing in line.
They probably can’t purchase another home during the suit, since most
people can’t afford to have two of them.
In terms of negotiating, the ability to get specific performance is very
powerful for the vendor, just as it is for the vendee. The vendee can essentially force the vendor not
to sell to anyone else. Anyone who buys
would buy subject to the pending suit.
If the vendee gets specific performance, the person who purchases while
the suit is on will lose it. Thus, it’s
hard to sell the property when a suit is going on and specific performance is
being sought. An aside: “lis pendens” means pending
litigation. Once a lawsuit is filed and
you take advantage of this doctrine, then the judgment relates back to the date
the lawsuit was filed. Sometimes you have
to give notice to trigger the doctrine, but in
Centex Homes v. Boag – There’s this huge condo complex. What’s a condo? You own “from the paint inward” in fee simple. From the paint outward, that’s all common areas and owned by someone else. So you have some of the advantages of ownership combined with some of the advantages of renting. The Boags take a pretty strong approach when Mr. Boag gets transferred. Why didn’t they try to negotiate something? What does Centex want? They want specific performance, or, in the alternative, they want to keep the earnest money as liquidated damages.
Why might the vendee be granted specific performance in a case like this? All property is considered unique in the eyes of the law. But are these units unique? Is that self-evident? Some land may be suited to only one purpose or has attributes that make it different from all or most other land. But this rationale is not really factually supported, in Braunstein’s opinion. It’s much easier for the vendee to get specific performance than it is for the vendor. So what if Centex had told the Boags that they’re out of luck, and so the Boags sue for specific performance? Would the result have been different?
At the end of the day, if you order specific performance, what does the vendor get? They get money anyway! It’s just that they get a different (presumably higher) amount of money than they would get with their remedy at law. So from the vendee’s perspective, land and money aren’t fungible. But the vendor gets money either way. So the uniqueness of land argument doesn’t seem to make much sense in this case, and it doesn’t seem to make much sense in the general case. Why should the vendor get specific performance? How about the idea that it’s only fair that each side should have the same remedies? If one person can get it, it seems like the other person ought to be able to get it. This argument has some force and appeal, but Braunstein doesn’t think it’s a strong argument. The court in this case says that it’s enough to have mutuality of obligation. They say that as long as the contract is not illusory, that is, both parties have obligations, then that’s enough in terms of treating the parties fairly. But the method by which we enforce those obligations doesn’t necessarily have to be the same.
The damage remedy may not fully compensate the vendor because there are things that are not included, or else it is hard to compute what the damages were. It may also be the case that it’s hard to determine the market price of the property. The property may be illiquid: maybe no one will want to buy it. We might say that when the vendor decides to sell, all of the vendor’s risks are bargained away to the vendee. When you force the vendor to seek damages, you place those risks back on them.
Mahoney v. Tingley – Cheap property here! The buyer breaches the contract and the seller wants damages. What does the buyer say? The seller gets to keep the $200 deposit. What’s the seller’s argument? He argues that the damages provided for in the agreement aren’t his exclusive remedy. He says that if you construe the clause the way the court did, it’s a penalty and thus against public policy. That means he gets to sue for his actual damages, not liquidated damages as set forth in the contract. The court says the liquidated damages clause wasn’t a penalty at all. It will be tough to get a liquidated damages clause thrown out for being too low! You’re trying to say that it’s a penalty because it’s too low.
But what if it’s too high? Then it’s probably out. But when is it too high? When it’s way out of line with actual damages and you could have figured out actual damages ahead of time. You calculate as of the time the parties enter into the contract. The thing that actually seems to drive the courts is whether you did a reasonable pre-estimate of what the damages would be if there were a breach. So what’s called a penalty seems to depend to a large extent on the custom in the community. If a 10% deposit is customary, then a clause that requires forfeiture of that deposit will be upheld, but forfeiture of a 20% deposit will be held to be against public policy.
Does the court screw this case up? Does the court interpret the agreement properly? The court interprets this agreement as an election between liquidated damages and specific performance. The property had already been sold, so the vendor no longer owned the property. Specific performance is no longer possible. Then the court says that the only remedy available is liquidated damages. But is that what the contract really says? Arguably not. You can enforce an agreement by seeking damages, right? It seems to Braunstein that the court kind of went off on a tangent. When you bring a suit for damages, you’re brining a suit to enforce the contract. That’s every bit as much an enforcement action, according to Braunstein, as is a suit for specific performance. Can’t we interpret the contract to mean that the seller gets liquidated damages or else can sue for more if the liquidated damages aren’t enough?
We’re skipping time of performance and time to be conveyed. The former, he figures we’ve already covered; the latter, we’ll get to later.
In every contract involving the sale of real estate, there is an implied covenant that the vendor will deliver marketable title. Marketable title means good title, one that a majority of lawyers in a particular jurisdiction would advise a purchaser to accept without discounting the price due to some defect in the title. You don’t need perfect title, just a good one.
This is a very odd doctrine, and it’s the kind of thing that creates traps if you’re not aware of the doctrine. Most people think that the risk of loss is on the seller until you complete the purchase: as long as you’re in the contract stage, if something happens to the property you get out of the contract. But the doctrine of equitable conversion is to the contrary. It’s an old, stupid law. There are lots of proposals to change it. We have the idea that as soon as the contract is signed, equitable title is in the purchaser. The purchaser is considered to be the owner. The vendor still has legal title to the property, but not equitable title. If the property is damaged, for example, then the purchaser (as the owner of the property) suffers the loss, just as all owners do. But most people don’t think that way, so the doctrine has the potential for causing problems. Around the time of hurricanes, you get lots of cases along these lines. What’s we’re doing is recharacterizing real and personal property: that’s the “conversion”. The vendor starts with real property, and the vendee starts with personal property (money). When the contract is signed, the vendor is said to have only personal property (the proceeds of the sale) and the vendee is said to have real property (in equity): the title to the real estate.
If there’s no clause in the contract allocating casualty loss, then who has it? The vendee does, because we consider the vendee the owner of the property. This doesn’t seem consistent with regular people’s expectations. Pretty much every real estate contract written by a lawyer shifts the risk of laws and eliminates the conversion rule. If people do this without an attorney, they probably won’t even think of discussing this. This isn’t consistent with the way people generally insure real property! The vendor is the one who is likely to have the insurance, and the vendee won’t get the insurance until the contract closes. The vendee might fail to take the usual precautions that an ordinary vendee would.
Note that this doctrine doesn’t apply when the vendor causes the damage. You can’t burn your own house down and then ask for the full purchase price. It also doesn’t apply when equitable title has not yet passed to the purchaser, for example, if the title is not marketable or a condition specified in the contract has not been fulfilled. If the vendor is entitled to specific performance, the law treats it like it has already occurred. But if the vendor is not entitled to specific performance, then the effects don’t kick in.
When we say the purchaser has the risk, we mean that the purchaser has no right to rescind and is obligated to complete the purchase at the agreed price. In the contract on p. 21, we see that the risk of loss is on the seller until closing. That’s more in line with ordinary people’s expectations, at least with a marketing contract as opposed to an installment sale contract. Then the contract tries to make a distinction between major and minor damage, using the figure of 10% of the purchase price as a cutoff. If the damage is greater than 10%, the buyer can choose to proceed if the seller agrees to repair or to back out of the transaction. If the damage is less than 10%, the buyer must proceed unless the seller doesn’t promise to fix the damage in writing.
If the vendor has the risk of loss, the purchaser can rescind. We’ll talk about this doctrine more when we get into title, but the other possibility is that the purchaser has the right to specific performance, but doesn’t want to have to pay full price. The purchaser may want specific performance with abatement. They may want the transaction to go through, but they don’t want to pay full price. If the damage or defect is not substantial, the buyer has the right to specific performance with abatement. This usually comes up when the vendor agrees to sell 1,000 acres of land when it turns out he only has 998 acres. It’s the buyer’s choice of remedy to sue for specific performance in the first place, and equally so to sue for specific performance with abatement.
Uniform Vendor and Purchaser Risk Act
This Act provides that when
neither legal title nor possession has been transferred, and all or a material
part is destroyed or taken in eminent domain, then the vendor can’t enforce the
contract and the purchaser is entitled to recover her earnest money or any
price paid. So if neither possession nor
title has passed, the risk of loss is still on the vendor. But what is a “material part”? It means different things in different
circumstances. There is a case where the
building was destroyed and the buyer wanted to proceed with the contract
anyway. It came up under
What happens if the damage is not material? The risk stays on the buyer because there is no provision in the Uniform Act that would change it. What’s material to a very wealthy person or not material to a very wealthy person may be very material to someone who has less money. So for non-material damage, the equitable conversion doctrine continues to apply. Can the purchaser get abatement under the Uniform Act if damage is not material? The common law applies. If the purchaser would be entitled to specific performance with abatement under the common law, then the purchaser is entitled to it here. Can the purchaser recover other expenses and costs? Is the specific performance remedy exclusive? We’re talking about material damage. There’s nothing here that precludes the vendee from other remedies. But it would be unlikely that the vendee would be entitled to damages as well, because we’re assuming that the difficulty was not caused by the vendor. The doctrine of mutuality of obligation says that if the vendor doesn’t have the right to seek other damages, then the vendee shouldn’t be able to either.
How is the
situation described different from
Do the two rules seem consistent? If the statute says that a judgment attaches to any interest in real property, then that’s easy. If the statute says that the judgment attaches to any real property of the debtor, then it might be trickier. But Braunstein says that this is the former case, and the court made it more complicated than necessary. The two results seem consistent: (1) the vendee, not the vendor, is considered the owner when the lien is based on a judgment against the vendor and (2) we do consider the vendee to be the owner when the lien is against the vendee. The doctrine of equitable conversion leads to the same result.
Insurance and equitable conversion
The courts try to find a way around the insurance issue. The difficulty is that insurance is a personal contract. It’s a contract between the insurer and the insured. It doesn’t benefit anyone else. The insurance company doesn’t want to pay off to the vendee, even if the vendee has the risk of loss. That’s pretty uniform, good law. Some courts will say: that’s fine, but once the insured gets the money, the vendor holds the money in trust for the vendee. This is a way of ameliorating the harsh effect of equitable conversion. At least to the extent that there was insurance, the vendee will be protected to that extent. It might not be the full amount of the loss, but at least it helps to some degree.
Who has suffered a loss? What if the insurance company says that the vendor is the only person there’s a contract with, and they say that the vendor hasn’t suffered a loss because under the doctrine of equitable conversion the loss falls to the vendee? These issues are discussed in the notes. How does insurance come into play in these situations? You can get around this by simply contracting around it. You agree to keep the risk of loss with the vendor until closing, the transfer of possession, or whatever.
One more characterization issue: what if the vendor dies, leaving all of his real property to the son and all his personal property to the daughter? Who gets what? What does the son get? He gets legal title, subject to the purchaser’s claim based on the contract. The son must deed the land. The daughter gets the purchase price. That doesn’t seem fair! Wouldn’t this have surprised the vendor before his death and frustrate his intent after his death? It’s a bad result! What happens if it’s the other way around, and the purchaser dies, having left all his real property to his son and all his personal property to his daughter? The daughter has to pay the purchase price, and the son gets the land! Again, that frustrates the testator’s intention. But that’s the way the doctrine would work. If the purchaser agreed to pay cash, then it doesn’t matter whether the purchaser dies during the executory period of the contract or after it’s executed. But it the purchaser finances the transaction, the result is different!
We have two parties: a mortgagor and a mortgagee. There is a promissory note between them that is the principal obligation: namely, the obligation to pay back the money. It’s pretty much that simple. You give me $100,000, and I promise to pay it back. But you may not want to rely just on my word. So in addition to the promissory note, you have a mortgage. The mortgage is a lien for the repayment of the loan. If you don’t pay on the promissory note, the mortgaged capital serves as collateral. The note is the “dog” and the mortgage is its “tail”. When the dog “dies”, so does the “tail”. When the note is satisfied, the mortgage goes away.
If there is a default, then the lender has an option. The lender can either (1) sue on the promissory note, saying: just pay me my money, or (2) foreclose on the mortgage, have the property sold, and get the proceeds of the sale to satisfy the note. If that’s not enough, the mortgagee can sue on the note. Or the lender can do both at the same time. Up until recently, these were all options of the mortgagee. As we proceed, a lot of the notions of consumer protection from torts and contracts have been incorporated into the law of real estate finance. When we get to foreclosure, we will find that there are some limitations designed to protect borrowers. But for now, it works well to look at these as options the mortgagee has. There are two sets of obligations: the promissory note and the mortgage. The purpose of the mortgage is to aid in collection, and the way that happens is by foreclosure. But there is another set of obligations if you don’t want to use the mortgage in aid of collection.
There are many different ways to pay off a loan. What does the promissory note say? It tells you that you must repay, and it says how you must do so. You can enter into a loan for 90 days, at which point all interest accrued and the principal is paid all at once. That’s very unusual for a long-term mortgage, though. It doesn’t make sense! You could also have level payments with interest only: pay the interest each year, and then pay the principal back at the end of the loan. This type of loan is used frequently for a commercial loan where the loan won’t be in place for a very long time. But these aren’t used very often in residential real estate transactions. These were used before the Great Depression, when the idea of interest-only was more popular. Mortgages were much shorter in length. But interest-only led to a lot of defaults, and a kind of cascading effect. You could have a level payment that is some arbitrary amount. You could pay interest plus a certain amount of principal each month, followed by a payment of the remainder of the principal at the end of the loan. This is used with income-producing property. You pay the interest plus a given amount of the principal. You negotiate based on what the income of the building is.
The last and most common way to pay off the loan is the fully amortized mortgage, meaning that once you establish a term and an interest rate, you do a calculation. If you make a payment of a certain amount, then at the end of the term, the mortgage will be paid in full: principal and interest. It’s a constant payment of the same amount every month, and by the time you make the last payment, the loan is fully repaid. The last payment will be the same amount that the first one was. This is the most common mortgage, especially for residential transactions.
We went over the kinds of payment arrangements you can have with a mortgage. There’s one more: you don’t have to amortize the mortgage over the term of the mortgage. You can do smaller payments but then pay off the rest of the total as a lump sum at the end of the term: a “balloon” or “bullet”. This is primarily done when you have seller financing due to the fact that interest rates are high or the buyer doesn’t have enough money for the down payment. The seller will finance the purchase price, but will only agree to finance for five years or so.
When you start out paying a mortgage, you’re paying mostly interest and little principal, but then it gradually shifts over the term of the mortgage. Each month, the interest is getting smaller because it’s calculated on the outstanding principal. The interest is calculated each month based on what you owe at the time. As you pay less interest, you take the difference and put it into playing for principal. This makes up the amortization curve. The slope of the curve is relatively flat at the top: you pay a lot of interest in the first few years and not so much principal. But near the end, you’re paying primarily principal rather than interest. You don’t have a month where you pay more principal than interest until you get a good ways towards the end of the term. What does this say about refinancing? People do it all the time. When interest rates go down, people refinance. But when you refinance, you move back to the beginning of the curve! Remember that the interest is tax-deductible, while the principal is not. If you refinance and don’t take cash out and you keep your payment the same, then you’ll end up better off: you’ll pay off the loan faster. If you take money out, you’re even worse off: it’s like you go further back than where you started!
There is a very strong policy
(that Braunstein doesn’t understand) in favor of encouraging people to buy
houses. The idea is that it’s good for
people to own houses. It may be good for
people to own something, but why
houses in particular? Historically, it
may make sense with World War II veterans needing a place to live. We wanted to enhance their ability to buy
houses. You can argue that we overconsume housing: when you compare savings rates in the
You can reduce your payments by reducing the amount of principal you borrow. You could also try to get a lower interest rate. There are many programs designed to reduce interest rates. For example, the state borrows a bunch of money at 3-4% and then reloans it to home buyers for 4-5%. The state makes a little money and the homebuyer gets an interest rate lower than what they would be able to get on their own.
Another way to make the interest rate lower is to have the Fed fiddle with the interest rate. The interest rate equals the true cost of money (an absolutely safe investment, with no inflation, about 2-3%) plus the inflation risk plus the cost of credit risk. The federal government may intervene to reduce the risk of certain loans by insuring them, shifting the credit risk from the mortgage lender to the federal government. Note that there have been mortgage devices created to reduce inflation risk, like ARMs. If you can adjust the rate of the mortgage every year based on an index, then you take less of a risk with respect to inflation. Also, it doesn’t seem to make sense to pay extra for a 30 year mortgage when you’re only going to live there for seven years.
Also, the longer you have to repay the loan, the less you’ll pay every month. However, the total cost of the mortgage will also be greater over the life of the loan. You could also change the amortization rate so that your monthly payment is lower, but then you have the balloon/bullet coming at you at the end.
What options do the parties have in terms of the particular transaction, say a house for $125,000? First, you can have a cash sale. Buyer gives the money, the seller gives the deed, the buyer records the deed, and that’s it. Second, you could have a cash sale while paying off an existing mortgage. The seller delivers the deed, the buyer pays the money. Then the seller goes and uses the cash to pay off the mortgage. The buyer could get a new loan and use it to pay cash. The buyer secures the loan with the deed. The buyer could also take over the seller’s old loan instead of having it paid off. If the old loan was a good deal, the buyer may want to keep it alive.
You could also have seller financing, in whole or in part. The buyer could pay a cash down payment plus a promissory note and mortgage for the balance in exchange with the deed to the property (encumbered by the outstanding mortgage). In that situation, the seller wears two hats. The seller basically is the same person as the lender to the buyer. You could combine seller financing and taking over an existing mortgage. If the buyer doesn’t have enough money for the down payment, the buyer might take over the existing mortgage and then have the seller finance the down payment. The buyer could give the seller an additional note and a second mortgage. “Second mortgage” refers to the priority with which the mortgagees get paid off. These priorities are based on time.
Finally, we have wrapping around an existing mortgage loan. The terminology isn’t really helpful. This is really a combination of seller financing and keeping the existing mortgage in effect. The difference is that the new mortgage is for the total amount that’s being lent. The new, second mortgage will represent the total purchase price minus whatever cash is paid. The second mortgage is for the full purchase price less the down payment instead of the difference between the existing mortgage and the new mortgage. The seller has the advantage of being in control, because the buyer makes a payment that is sufficient to pay the old mortgage and the new one. Then the seller pays the old lender. The seller knows if payments aren’t being made and if a loan is about to go into default. When the buyer does it, the seller may not find out about a default until it’s too late to do anything about it. For a wraparound to be beneficial, you must be able to keep the old loan in effect, and that loan must have a lower interest rate than current market rates. Both of those are highly problematic in the current environment: wraparounds aren’t important right now.
How does the seller make money on a wraparound? The seller is really loaning $110,000 and really getting paid $885 a month. What the seller is doing is not loaning his own money: he’s reloaning the money from the old lender at a higher interest rate. He’s borrowing money from the old lender at a lower interest rate and then reloaning it at a higher rate. If the old loan was at 7% and reloan it at 9%, then you’re making a lot of interest on the “new money”. The return to the lender is quite high! At the same time, the interest rate paid by the borrower is below market rate. The borrower and seller do well, but the original lender suffers. Lenders will object to this! They’ll object to any situation where the buyer takes the property encumbered by an existing loan when rates have gone up. These were very popular when it was harder for lenders to enforce “due-on-sale” clauses. Now, this kind of financing has become less popular and valuable.
Wraparound mortgages were very popular back in the day! The seller got a great return on their investment, and the buyer got a good deal too. Only the bank got screwed. Amfac didn’t like the deal! If they could get the money back, they could relend it at current rates. They could lend it to the Schraders or someone else entirely. They would like to get rid of old, low interest rate loans. They exercise their “due on sale” clause, which is included in virtually every mortgage contract prepared by a commercial lender. These clauses may not be present in mortgages made by individuals, or you may be able to bargain around them. The “due on sale” clause is required to make a loan saleable to FHA, Freddie Mac and Fannie Mae.
The court said that the buyers could either pay all cash or could assume the existing loan on terms acceptable to Amfac and then pay the sellers the $12,700. This is all the same to the lenders. The court says that the buyers could assume the mortgage, pay $7,000 cash, and give the seller a second mortgage for $5,700 due in two years. The court of appeals doesn’t like this! They say that the trial court abused their discretion in offering this option to the Schraders. The problem here was that the parties bargained without considering the “due on sale” clause. The only way to negotiate an arrangement like this is to bring the lender in to the negotiations.
With a wraparound mortgage, the buyer gives the seller a note and mortgage for the entire amount of the indebtedness. The buyer makes payments on that loan at whatever rate they agreed upon. The seller would take a portion of those payments and pay them to the original lender. The seller is in a position to assure that the payments are made on time. But if you do a second mortgage and the buyer doesn’t pay, the seller has no way of knowing until he gets a notice that the mortgage is in default.
The original mortgage started as a fee simple subject to a condition subsequent. The mortgagor has a right of entry and the mortgagee has a fee simple that can be defeated by the mortgagor paying off on time. That means that if the mortgagor is late, at all, and time is of the essence, then the condition can never occur. The mortgagee becomes the owner of a fee simple absolute and the mortgagor has nothing. There is a great potential for an inequitable result here! If the mortgage is small with respect to the value of the real estate, the mortgagee gets a windfall. If the debt has been paid down, the mortgagee also gets a windfall. The mortgagor gets screwed!
The courts of equity come in
and develop the concept of the equity of
redemption (more specifically, the equity of tardy redemption). The
mortgagor can come in late and pay the mortgage, even though the law courts
wouldn’t have allowed it. The courts of
equity say: “You’re late, but so what?”
You originally had to provide a good reason, but later you didn’t really
need to. But that creates another set of
problems. The mortgagees say that if
you’re late but have the right to pay off the mortgage, how late can you
be? How do you terminate the
equity? The doctrine that the courts
come up with is a process for foreclosing the equity of redemption. Everybody talks about foreclosing the
mortgage, but it’s not really the
mortgage that’s being foreclosed.
What’s being foreclosed is the further exercise of the equity of
redemption, that is, your right to
pay off the mortgage. The result is that
the court sets an “outside date”, which is essentially the date of sale. The court orders that the sheriff seize and
sell the property at public auction.
That is the date beyond which the mortgagor cannot exercise the equity
of redemption. The courts in
When we looked at the mortgage as a fee simple subject to a condition subsequent, it was very much like strict foreclosure, meaning that the mortgagee is not required to sell the property. The mortgagee, upon declaring a default and foreclosing the equity of redemption, simply becomes the owner of the property. But the problem with that is that the mortgagee may get a windfall because whatever equity the mortgagor has in the property is lost and held in its entirety by the mortgagee.
Almost every state in the
There is a so-called rule against “clogging”. Mortgagees would sometimes demand that mortgagors waive the equity of redemption. This was found to be against public policy and would not be upheld. The assumption is that the mortgagor and mortgagee have unequal bargaining power and that the law will be entirely circumvented if we allow these waivers to take place. The circumstances under which the courts find an attempted waiver can be surprising. Courts look very closely at mortgage deals to look for anything that looks like a waiver of the equity of redemption.
Before default and
acceleration, you have the legal right of redemption: you may have the right to
pre-pay, you may have to wait until a specified date, but the law lets you
eventually take the property free of the encumbrance and hold it in fee simple
absolute. After default but before
foreclosure, there is the equitable right of redemption, which is what we’ve
just been talking about. After
foreclosure, you have a statutory
right of redemption in some states (mainly Midwestern farm states not including
Any time you create a right in the mortgagor, you create a risk in the mortgagee. The mortgagee will try to protect itself from that risk by raising interest rates or changing some other term of the mortgage. There’s no free lunch here! The person who buys the property at the foreclosure sale in a state with statutory redemption will probably get it at a discount because they’re taking subject to statutory restrictions. That increases the personal liability for the person who suffers the foreclosure. The farm lobby is powerful! The farm states all get two senators.
An acceleration clause says that in the event of a default, the whole amount of indebtedness becomes due. You must have an acceleration clause in the note for this to be allowed. It would be very risky to foreclosure prior to acceleration: you would only get the payments in default, not the entire balance.
A mortgage is a right to get paid out of the proceeds of that sale in preference and priority over everybody with a subordinate right. That means that if you have a mortgage on certain real property, you get paid before the unsecured creditors of the mortgagor. You get paid before the other people that may own an interest in the property that is junior in time to yours. The property gets sold at foreclosure. What is the state of title of the purchaser? The purchaser at foreclosure gets the title as it existed immediately before the original mortgage was entered into. That’s important! This is part of the definition of a mortgage. In the overwhelming majority of cases, the original mortgage ceases to exist; the purchaser at foreclosure takes free of the first mortgage. When we get to the problem of omitted junior lien holders, we’ll find that the mortgage will be considered to still be in existence for certain purposes. What if a second mortgagee forecloses? Who owns what? The purchaser at foreclosure gets the title as it was just before the mortgage was entered into, namely, they take the property encumbered by the first mortgage. [See hypo in slides]
Junior mortgages are more risky because you get paid second. What’s a less obvious reason? The second mortgagee can’t control the timing of the foreclosure, and that may be important. If you’re in a situation where your judgment as the lender is that if you wait you can sell the property for more money later than now, and if you’re in control of the foreclosure process, then you can decide to wait. But if you’re the second mortgagee, you can’t control the timing. The first mortgagee is in control. If you have a sale by the first mortgagee, the purchaser will pay no more than fair market value. But if you have a sale by the second mortgagee, you buy for fair market value minus the value of the first mortgage. When the second mortgage forecloses, the first mortgagee receives none of the proceeds of the sale, but the mortgage is still in effect. The first mortgagee can foreclose later.
Deeds of trust
This is a not a mortgage substitute. There are some states where these are common,
These are designed to avoid the equity of redemption. One is the covenant not to coney or encumber the property. The bank asks the mortgagor to promise not to convey the property to anyone else or use it for collateral in any other transaction. It’s not a very powerful device, but it at least keeps some property there that will be available to satisfy the bank’s personal judgment. The second thing you can do is just lie. Instead of a mortgage, the borrower conveys the property to the lender without reference to a loan, but with a secret agreement that it is a mortgage. This doesn’t work either, but the idea is that in the event of a default, you don’t have to go through foreclosure or sale or anything else. These kinds of deeds are actually quite easy to set aside if you can prove this arrangement. Finally, you have the installment or land sale contract. This looks like a purchase agreement, but in substance it’s a mortgage. Law treats the last two as mortgages. The first one is not treated by a mortgage. You have a cause of action for breach of contract, but you don’t have the priority that a mortgage would have given.
The three types of deeds
The warranty deed – this contains the five or six warranties that we’ll be talking about. This one contains the most promises. You warrant, for example, against all encumbrances. If there is an encumbrance, the warranty is breached.
The limited warranty deed – this doesn’t warrant that a predecessor in interest didn’t mess up the title.
The quitclaim deed – this says, in essence, I’m conveying to you whatever I own. If I own nothing, you get nothing. If I own an unencumbered fee simple, then you get that.
All three of these deeds are, in essence, contracts.
Warranties of title
Warranties of title are just
contracts. They’re only as good as the
solvency of the person who makes the warranty.
It can be a long time before any defect is discovered! It could be hard to collect at the time you
find out the title is bad. Also, you
don’t really know what the state of the title is. You’re just being promised that the other
person has good title. You don’t get any
evidence of the truth of the promise.
The other systems for title assurance give you at least some evidence
that the person who is saying the title is good has
actually checked to some degree if that’s the true state of affairs. So warranty titles are a little “flaky”: it’s
a “band-aid”. In most states, including
It is warranted that the property is “free and clear from all encumbrances”. What are encumbrances? They’re bad things like mortgages, easements, leases: anything that takes away one of the sticks out of the bundle of sticks that constitutes a fee simple absolute. The only thing that isn’t considered an encumbrance is if you own less than you purport to convey in the deed. The most important encumbrance would be a monetary encumbrance such as a mortgage or judgment lien. It is warranted that “he has good right to sell and convey the same”. This comes up in situations involving corporations. Maybe only the president has the power to transfer real estate, but the deed is signed by the vice-president or secretary.
The grantor also “warrants” the title: this means that it is promised that no one with a paramount title to the grantor will evict the grantee. The grantor also promises to “defend” the grantee and his heirs and successors. That’s kind of tricky: if you sue someone to defend your title, you can sue the grantor for attorney’s fees. But if you lose, you have to pay your own attorney’s fees.
General warranty deed
You don’t have to use the
form in R.C. 5302.05, but if the legislature gives you a form that will work, why reinvent the wheel? It’s very short, too. You put in the person’s name, and then their
marital status. Why does the marital
status matter? You want to know who has
to execute the deed. In
Brown v. Lober – What are they claiming as the breach of the covenant here? They thought they had all the coal rights, but the grantor reserved two-thirds of the rights. They claim that the covenant of warranty has been breached. The court holds that there was no constructive eviction. The coal company searched the title and found there was a reservation of two thirds of the interest in the coal. The plaintiffs claim that this constitutes an eviction because the grantor didn’t tell them about this reservation. But the court holds that this isn’t an eviction because the plaintiffs weren’t denied possession of the subsurface. One thing that doesn’t constitute eviction is the fact that you turned out not to have good title: you must have more than just that. Was there a breach of the covenant of seisin? Absolutely. They didn’t own it, because the grantor had reserved two-thirds of the coal. They lose because the statute of limitations for bringing an action for breach of the present covenant had started to run on the date of the delivery of the deed, which was over ten years ago. This seems like an odd position for the plaintiffs to be in. They say it’s too late to bring the action for breach of covenant of seisin, but it’s too early for them to bring an action for quiet enjoyment.
This is an example of a case where it was not prudent to rely on the lender. The surface was enough collateral to rely on for the loan, and so they didn’t care about the subsurface rights. But once we get past the statute of limitations on the covenant of seisin, the likelihood of an actual eviction based on this title defect gets increasingly less probable. If they haven’t shown up in ten years, they probably won’t show up at all. To award damages in a case like this creates a substantial risk of miscalculation: you might be awarding damages for a bad thing that’s never going to occur. Why not just live with the uncertainty? In that way, what the court does here makes sense. Say the coal company starts mining the coal, and then the person owning the outstanding two-thirds interest shows up and complains. What result then? Would we advise the coal company to start mining the coal? If the seller has the means to pay the previous grantor, then they reimburse the person who really owns the two-thirds. Doesn’t that require that the person who owns the two-thirds to come forward and claim it? The other reason to start mining the coal is because the only way that they’re ever going to clear up their title is to acquire the coal by adverse possession. But in order to possess the coal, you must use it in some way.
What damages would they be entitled to when the true owner comes forward? Can they get the value of the coal? They basically get rescission. In whole or in part, what the grantee will get as a remedy for the breach of covenants of title is the consideration that the grantee paid. Basically you just unwind the transaction. If I bought the land for $10,000 and it turns out that the grantor didn’t own any of it, I get the $10,000. If I happened to build a factory on that land or the value of the land went way up, it’s just too bad. You don’t get expectation damages, you just get back what you paid. In this case, however, at worst, only a portion of the land will be lost. The only defect we know of has to do with the subsurface rights.
Let’s say the purchase price is $50,000 and the value of two-thirds of the coal is $75,000. How much does the grantee recover from the grantor? You won’t get more than rescission, and in fact you’ll get less. You haven’t lost everything; you’ve only lost a portion. Your loss is greater than the consideration you’ve paid. You would think that in the case of this partial loss you would get the $50,000 back. What you’re entitled to is some ratio of the value of the coal relative to the value of the entire property that you purchased. Let’s say the true value of the property is $150,000, so you’ve lost 50% of the value of the property. That’s your recovery: you get 50% of the consideration paid. That’s not a great remedy for several reasons. You’re not getting back your entire damages. You’re getting nothing for improvements made to the land or future appreciation. These breaches of covenant can be outstanding for a long time. It doesn’t seem fair to make people bear a contingent liability for a long time for a large and hard-to-determine amount. So we limit liability to return of the consideration.
What the court does makes sense, but it creates a problem in terms of mining this coal. They take a risk if they mine it in that the people who truly own the coal could show up, claim conversion, and attempt to get punitive damages.
The Recording Acts
These are remedial
legislation that create an exception to the common law.
But they don’t replace the
common law. The common law says “first
in time, first in right”. If I sell to A on day 1 and B on day 2, A wins at common law because A
bought first. This wasn’t a problem in
The purpose of the Recording Acts is to protect people who acted in good faith and property in commerce. The person must say that they took without notice and for value. The property wasn’t just given to the transferee. Finally, the property right at issue must be one capable of being recorded. This is the interplay between the statute of frauds and the Recording Acts. The statute of frauds says that if you will transfer an interest in real property, it must be in writing. The Recording Acts say that you better record the writing or else it won’t count. But there are exceptions to the statute of frauds. In any case where your interest is based on an exception to the statute of frauds, that is, an interest that can be created without a writing, it’s also an exception to the Recording Acts, and you revert to common law.
“First in time, first in right” is the rule unless you can take advantage of the Recording Acts. You can do so if the interest was created by an instrument. If you have an instrument, it’s capable of being recorded. But if there’s no instrument, there’s nothing to record, and thus an exception to the Acts. Take some hypotheticals: O conveys the property to A on the first day. On the second day, O conveys the property to B. Who’s the owner of the property? First in time, first in right under the common law, so A owns the property. You can’t sell what you don’t own! O doesn’t have the right to convey the property to B because he’s already sold it to A. He’s committed a tort! He doesn’t have the right to do what he’s done, but he does have that power, to convey a good title to B even though he didn’t own the property at the time. The source of that power is the Recording Acts: the whole panoply of acts that make up the Recording Acts. These statutes, taken together, are designed to create a public record of land ownership. We want the public to be able to rely on these records with some degree of confidence. That’s why we must give O the power to convey a title that he doesn’t own.
Three types of recording statutes
Notice statute – this requires that B, the subsequent purchaser, pay value and take without notice. It doesn’t say anything about B recording; it’s not necessary for B to record. Take the example of O grants to A, then to B, and B is without notice and pays value. It turns out, under a notice statute, B is the owner of the property! Does that mean B doesn’t have to record? No. If O tries to transfer to C without notice then C is the subsequent purchaser and will prevail over B. The Recording Acts don’t create a criminal penalty for not reporting, but they create a very strong incentive to record. Until you record, your title is at risk from subsequent good-faith purchasers. But the Recording Acts create no incentive to “unrecord” or “erase”. There is no provision to erase. The public record gets longer and longer. There is no editing process that’s even permitted. There are certain procedures that are followed, but that’s all. The best way to give notice is to record: everyone who deals with the property has constructive notice of what’s recorded about that property as long as it’s recorded properly. So once you record, no one else can take without notice.
– this is the simplest. This creates a
race to the courthouse. Whoever gets
there first, wins! These statutes are
only used in
Notice-race statute – this one is the most popular, and it’s a combination of the two above. In states with this statute, the subsequent person who wants to be protected must give value, take without notice, and record first. There are variations on these, but they’re not particularly important. Sometimes there are grace statutes: as long as you record within 30 days, it will be retroactive to the date of the deed. These were designed for the times when it took a long time to get to the courthouse. Many closings actually take place at the courthouse.
So the incentive is to record as soon as you buy. How do you do that? You use a title insurance company and do escrow. The seller says: don’t deliver the deed until you have the cash. The buyer says: don’t deliver the cash until you have recorded the deed and checked and made sure that no one got in line ahead of them. The third party makes sure that both buyer and seller were honest.
“All unrecorded conveyances are void as against a subsequent good faith purchaser for value.” What kind of statute is this? It’s a notice statute. It doesn’t talk about having to record anything. Is an unrecorded conveyance void as against anybody? What about as to O? What if you add: “…who records first”? Then it’s a notice-race statute. If you don’t meet all the requirements, you’re back to the common law and whoever was first in time will prevail. What if you get rid of the “good faith” part? What kind of statute is it then? It’s pretty much a race statute. But make sure to read the cases on this statute. There’s a lot of judicial interpretation involved. Courts generally don’t like pure race statutes. In some states, there may be statutes that appear to be just race, but courts will find notice implied.
Let’s say A buys on day 1, B buys on day 2, then A records on day 3 and B records on day 4. B is a BFP (bone fide purchaser). If B didn’t have notice on day 2, it doesn’t matter what happens after that in a notice jurisdiction. Once B records, nobody else can be a BFP. With a race statute, A wins. In a notice state, B wins because he was a BFP at the time B obtained the deed. In a “notice-race” state, A wins because he got to the courthouse first.
Interests outside the Recording Acts
We have mentioned some of them: short-term leases are not usually recorded. The law says that we protect the tenant because they’re going to be gone soon anyway. Adverse possession has no document; it happens by operation of law. There’s no penalty for non-recording and no requirement for recording. It’s the same thing with prescriptive and implied easements, dower, and curtesy.
When you have unfiled mechanics’ liens, you have an owner and a contractor who is going to build something. The contractor enters into contracts with subcontractors, laborers and material suppliers. The problem is that the contractor doesn’t get paid, or gets paid but doesn’t pay the other folks. If you just go by the law of contracts, the other folks have no claim. They’re in privity of contract with the contractor. They can sue the contractor if they want, but they have no claim against the owner because there’s no contract between the owner and any of those people. Unjust enrichment may or may not help. Therefore, the law creates a lien in favor of the subcontractors and others.
If you do work on a property and don’t get paid, you have a lien (like a mortgage) for whatever amount is owed to you. You have a certain number of days (usually 60 or 75) in which to file that lien and record it. Here’s the killer: if you record within that certain number of days since you last did work, it relates back in time to the date you first worked. Therefore, your priority is from the date the work first commenced. This means that you can buy property and find out that there are mechanics’ liens that were filed after you bought the property but the priority relates back to before when you bought it, and thus your property is subject to the lien.
If you search the public records diligently and don’t find anything, you may still take subject to this unrecorded stuff! How do you protect yourself from interests outside the Recording Acts? Dower is tough, because all you can do is look at the deed. But unfiled mechanics’ liens, especially if they’re significant, you can actually come out and look and see if work has been done in the last 75 days.
You also can’t rely 100% on things being present in the public record to say you have good title. Forged and undelivered deeds are void, though many states have statutes saying that if a deed is recorded, that is conclusive evidence as to subsequent purchasers that the deed was delivered. If the deed was not acknowledged or acknowledged ineffectively (like if it was notarized wrong), then it wasn’t capable of being recorded.
If you search the public records and find out that John Doe has a power of attorney for Jane Smith and then you see that John Doe has executed a deed within the powers granted by the power of attorney, then everything’s okay. But if Jane Smith died or became incompetent between the issuance of power of attorney and the time of the deed, then the deed is no good. Even though you see the deed and even though there is no way you can tell that any recording defects exist, the deed is void and transfers nothing to the grantee. These are “off-record” risks. The only way to protect yourself is with some kind of insurance whether that be a guarantee from an attorney, title insurance, or otherwise. But the Recording Acts can’t protect you from this stuff.
To be a bona fide purchaser
for value, you must (1) pay value. This
is not designed to protect donees (people who take by
gift or inheritance). It’s designed to
allow property to be used freely in commerce.
The only exception is in
Is a mortgage a purchase? Will banks and commercial lenders tolerate a situation where they’re not protected by the Recording Acts? No way! The legislature will protect them! What if O grants to A by an unrecorded deed, then B lends money to O, and then gets a mortgage from O for no consideration? Is B a purchaser for value? The mortgage wasn’t given in consideration of any value. It doesn’t have to be much to support the mortgage. He could give a little bit of consideration, and that would be enough to make B a purchaser. The consideration doesn’t have to be fair or anything, it just has to be valuable. What if it’s the same situation except O gives B a deed to satisfy the debt? Is B a purchaser for value? Then there’s plenty of consideration. B had a right to money and gave it up, and O had a right to property and gave it up. We’ll look at this again when we study deeds in lieu of foreclosure.
What does it mean to be a bona fine purchaser such that you’re a subsequent purchaser for the purpose of the Recording Acts? A purchaser buys something. But mortgagees can also be purchasers. We also want to know whether you parted with consideration or whether the consideration was preexisting.
How can B get notice of A’s rights? There are four ways: (1) actual knowledge, (2) recorded documents, (3) persons in possession, or (4) the duty to inquire from any of the above. The principal basis for the Recording Acts is constructive or actual notice from recorded documents. If you look in the record, you’ll see things and have notice that way. But even if you don’t look in the record, you’re still deemed to know what you would have known if you had looked. In order to get notice from the person in possession, it must be somebody other than you’d expect. So what’s really the difference between a race jurisdiction versus a race-notice or notice jurisdiction? If you’re in a race state, you only have to look at the public record. If an earlier deed is not of record, you know that you’ll win. In a race-notice jurisdiction, you must look not just at the public record, but also the property itself. If notice is required, then if there is someone in possession inconsistent with the record title, you’ll be deemed to know that for the purposes of determining whether you’re a bona fine purchaser.
You may not know everything, but you may know something. There may be a recorded document that you actually see, but it’s defective. Or you might see someone on the property who isn’t the person selling it to you. A defectively recorded document still gives you notice of something: someone is claiming an interest in the property. Once you see that, you’re required to make a reasonable investigation, and you’re charged with notice of anything that a such an investigation would reveal. Thus, you might not have complete notice, but you may have enough notice to require you to dig deeper. Only certain documents can be recorded, as specified by the statutes, but the recorder will accept virtually anything. Frequently, when there is a dispute concerning title, an affidavit will be recorded saying a certain person claims interest in the property. That doesn’t charge you with notice because it’s outside the statute, but it creates the duty to investigate the claim in the affidavit to see if they’re valid or not.
Let’s say a neighbor informs a potential buyer about an unrecorded deed. Then you have actual notice. Let’s say O gives A an unrecorded easement, then O takes out a mortgage with X, and the mortgage mentions the easement. The mortgage is recorded. The easement itself isn’t recorded, but a purchaser, if they search the record, will be charged with at least inquiry notice of the easement. Of course, what constitutes a reasonable inquiry is a question of fact. But if you don’t see the mortgage, then you’re not charged with inquiry notice and you’ll take free of the easement.
One of the most common forms of notice is when you have someone in possession whose possession is inconsistent with the record ownership. For example, there’s a transfer from O to A that’s unrecorded. O goes to sell the house to B, but A is in possession. B is charged with notice that something is wrong in a race-notice or notice jurisdiction. This happens all the time. What happens if it turns out that A is really O’s son? Is that possession inconsistent with the public record? Maybe A has a short term lease. You’re on notice that there is a lease if you say that there is a tenant, and you are also on notice of anything that a reasonable inquiry would reveal about the lease. That means you probably have to talk to all the tenants or look at all their leases. When people buy commercial buildings that are rented, they must get information on all the tenants and what’s called an “estoppel letter” from each tenant saying that they are only a tenant.
How the Recording Acts work
Lawyers don’t do a lot of the
title search, but they do a lot of litigation with title insurance
companies. Title insurance companies
typically do the title search. Lawyers,
when litigating or negotiating must understand how the system works. The way we do it is probably the worst
possible way. The system is improving,
but it’s happening slowly. In
Nobody is going backwards and
trying to put all of the title
records on computer for two reasons: (1) It’s time consuming and difficult with
a tremendous potential for error. The possibility
for transposing numbers or misspelling somebody’s name is great. You might make things worse! (2) Gradually, as a result of the statute of
limitations and other curative legislation, old titles become irrelevant. Lawyers and title companies don’t search back
to the founding of the
The best way to do this sort
of a fully computerized system would have been to have a tract index. The tract index
is simple. Assuming you can identify the
tract, which is not hard in the western
The grantee-grantor index is difficult to use, but easy to maintain. You make a copy of the record that’s filed, and then fill the index. The clerk doesn’t need a lot of special training and shouldn’t have to exercise any discretion. In the index, you have the type of instrument, the grantee’s name, the grantor’s name, information on where you can find the document, and what tract of land the document relates to. The grantee index is same thing, except for how they’re alphabetized. The grantor’s index is alphabetized under the grantor’s name; the grantee’s index is alphabetized under the grantee’s name.
How to do a title search
The whole premise of the system is that you can’t own the property unless you were the government or unless you were previously a grantee. Somebody must have conveyed the land to you. Your goal is to establish a chain of title. You want to say, starting today in 2004, we have a method of search to determine everyone who has been an owner or owned an interest in a certain property from some date forward. You want to find that whoever you’re interested in now (for example, the buyer is interested in the seller) is the current owner. So you work backwards. You only know who the current owner is. When we looked at the general warranty deed, it included a blank for the book and page of the prior instrument. That can aid your title search.
So you start in the grantee index, starting today, and you look backwards in time. At some point, you should find that O, the person you’re getting ready to buy from, was a grantee. You get the deed itself and make sure it’s valid. Then you’re done with looking under O’s name in the grantee index. If it’s B that was O’s grantor (you find a transfer from B to O), then you must ask: how did B become the owner of the property? At some previous date, B must have been a grantee. So you look in the grantee index under B’s name. You keep looking and find that B was a grantee and A had previously conveyed the property to B. So you start looking under A’s name. You keep looking back until you find a patent (a deed from the government) or you just look back the customary time period in the jurisdiction where you’re working. You’ll find that the grantor was previously a grantee, and then whoever conveyed the property to that earlier grantor was herself a grantee, and so on.
So we’ve established a chain of title! But that doesn’t give you the whole picture! The next problem is that under the Recording Acts, O only has good title if O and everyone in the chain of title was a bona fine purchaser. So if we’re in a race-notice jurisdiction, we must look at B and make sure that B’s deed was recorded prior to any other deed from A. We must make sure that no one in this chain of title sold the property to someone outside of the chain of title prior to selling it to the next person in the chain of title. We have to make sure A didn’t sell to X before A sold it to B. So the next step is to start with A, look in the grantor’s index, and search until we find the recorded deed to B. If we find a deed to X before the deed to B, then we have big problems! That would mean that B, at least in a race-notice or race jurisdiction, is a “loser” and didn’t get good title! In a notice jurisdiction, it will be a little more complicated. But if we assume that the deed from A to X was recorded before the deed to A and B, then B loses everywhere.
Once you find the deed from A to B and you find nothing intervening (from the date A acquired the property until A transferred to B), you stop searching under A’s name and start searching under B’s name. You’re no longer concerned with any transfers from A because at this point we’ve discovered that B was first to record and thus has “won”. So you start searching under B’s name and search until you find a transfer from B to O. You shouldn’t find anything intervening. That would mean that O acquired good title. Then you search under O’s name from the time O acquired title until the present, which would mean that O is the owner of an unencumbered fee simple absolute. It’s not going to be this simple or clean in practice, though.
“Wild” deed problems
There are a lot of possibilities of transfers that you won’t find using the standard technique that we’ve just discussed. What if the deed isn’t indexed at all? What if you have a deed from O to A that is recorded, but not indexed, then you have a deed from O to B. B has two choices: B can look through every deed, or look at the index. There’s no way you would do it without the index. But in this situation, searching the index won’t help B because the recorder’s office made a mistake. Who wins? Some states would say that B loses, but Braunstein thinks that’s dumb. The mere recordation of the instrument doesn’t do you any good unless you have a way to find it. You can’t say B has notice of something that’s impossible to find! What do you do if you’re a careful attorney? A has a potential problem: there’s a transfer from O to A, A has recorded. So if you’re A you better check the records to make sure that the deed was both recorded and indexed. This is a cheap process that A should undertake. That’s why A should lose if he doesn’t do this. In some states, the index isn’t considered part of the public record at all, and B loses, and Braunstein thinks that’s dumb. That’s the wildest deed, because there’s no way to find it at all.
A transfer from A to B and then from B to Y who doesn’t record and then to Z who does record. Then B transfers to C, who doesn’t have any actual notice of the unrecorded deed from B to Y. The problem is that there is a deed in the record. There’s a recording of the transfer from Y to Z, but C has no reason to look in the index under “Y”. When C is getting ready to purchase from B, he looks in the grantee index and finds that B was a grantee from A. He also finds that A was a grantor to B. There was no transfer between when A acquired it and when it was sold to B. There’s no transfer from B on the books. Therefore, it appears that the title is clean. How do you decide that C ought to win over Z? You could argue that both of them are innocent parties. But it looks like Z didn’t do a proper title search. What should Z have done? Z should have had Y record the deed. Then Z would have good title and C would have notice in the record.
The statute says that the only people who can take advantage of the Recording Acts are people who took without notice and whose deed was the first recorded. But Z’s deed was the first recorded! C has no practical way to find out about the transfer from B to Y and then Y to Z. Z can find out there’s a problem and solve it rather cheaply. It would be very expensive for C to solve the problem. The policy is that we ought to put the loss on the least cost avoider, which is what will tend to make the Recording Acts effective. C can’t say that his deed was first recorded. But we deem Z’s deed as unrecorded. What we do is that we read into the statute (sometimes because it’s there and sometimes because courts imply it) that deeds must be “duly” or “properly” recorded. We say that Z knew that there was a break in the chain of title and that Z should have done something to fix it. Therefore, C, who took without notice and recorded before Z straightened the situation up, prevails. If we had a tract index, then C would have notice! C would see everything except the transfer from B to Y. This particular wild deed problem would be solved by the tract index.
Title insurance is an odd thing. It’s not insurance in the typical sense. Typically, if you buy, for example, life insurance, the insurance company knows that it will suffer a loss, but it just doesn’t know when. Title insurance doesn’t work that way. If everything works right, the title insurance company should never suffer a loss, that is, there should never be a valid claim against the insurance policy. But not everything always works the way it should. There can be off record risks such as fraud. There can also be violations of zoning laws, covenants and restrictions, and so on. All of these are detectable and should be detected if title insurance works the way it should.
Here’s how it works: with the typical policy, you fill out Schedule A with the elements of the fee simple absolute. The Schedule A in the book at p. 236 is a bit different in two respects: not all of the risks are for the full policy amount. But it does have a space to fill in your interest in the land, for example: “fee simple absolute”. Inflation protection is available for title insurance policies. The other thing that makes title insurance different than most policies is that it’s a single-premium policy. At the time you purchase the property, you pay a premium that is calculated as a percentage of the amount of insurance, and then that’s it. It’s a one-time payment for coverage basically forever. If there’s a mistake in the policy, that is, if there is some loss that is covered by the policy, then the policy doesn’t necessarily pay the full amount of the loss. You do the same calculation of damages that you do with warranties of title. Title insurance only insures legal matters. It doesn’t deal with acreage or quality of the land.
Who pays for title
In Schedule B, exceptions and exclusions are listed. “Schedule A giveth, and Schedule B taketh away.” If you look at Schedule B, you’ll see why there should never really be a claim under a title insurance policy. Exceptions should be everything that a diligent search of the public records would reveal: liens, leases, easements and so on. You’re not insured against losses resulting from any of those things. You have a vested fee simple absolute except for everything that’s in the public records and is a defect in the title. As a result, if the title insurance company is careful, then you won’t suffer any loss at all. If an encumbrance is not of record, you don’t take subject to it, and if it is of record, the title insurance policy doesn’t cover you. If you don’t read Schedule B, you don’t really know what insurance you have, if any.
In addition to the exceptions
that are specific to that property, there are also exclusions that are general
to all policies issued by the title insurance company. You can negotiate to have some of them
removed for a price. The most important
exclusion is the exclusion for things that are known by the buyer at the
closing date but not known by the company.
You can’t hide defects from the company, you
must disclose all defects to the company.
The Schedule B exceptions listed on p. 239 are more similar to the way
we would see them drawn up on a policy issued in
Is a title policy an opinion of title? Isn’t there an incentive on the part of the title insurance company not to search the title at all? It depends on how high the search costs are. You could do this on an actuarial basis. You could say: “We’ve been in this business a long time, and we know what the risk is.” You could charge a premium based on the historical risk rather than doing a search of the title. This may make more sense for the title insurance company than for the purchaser of the property, since title insurance won’t cover your full loss. If you sue, you might be disappointed that the title insurance companies aren’t trying to determine if the title is marketable. Is the title company obligated to be reasonable in conducting a search? What difference does it make? You might want to find a basis for tort liability if your policy doesn’t fully cover your loss.
What happens if you have something that is a matter of record but it’s not listed in Schedule B? Is the title insurance company liable? Sure they are! That’s exactly what they’re supposed to do. What if there is something that’s a matter of record, isn’t on Schedule B, but also comes within one of the exclusions? For example, “encroachments or questions of location, boundary and area, which an accurate survey may disclose”. You can’t rely on the policy to tell you that this condition doesn’t exist. Say there is an easement that a survey would reveal. Why would they be liable? The cases say there ought to be coverage: the exclusions can’t be relied on by the title company to eliminate Schedule B. Whether or not you have a duty to search, if you do the search and list something in Schedule B, then if you find it, you must include it there. The idea of title insurance is to provide protection from on-record risks. If you find an easement, for example, and then exclude it anyway, you’ve basically eviscerated the policy.
Most residential transactions are very low risk transactions, at least as far as things that lawyers could discover. There are lots of bad things that could potentially happen, but in practice, the system seems to work very well without lawyers. So Braunstein thinks it doesn’t make much sense to have lawyers involved in these highly routine, standardized residential transactions. If you read the title policy and saw something that you didn’t understand, you might want to get a lawyer involved. But generally, lawyers don’t need to be involved and lawyer don’t make much money being involved, partly because you don’t add much value.
Possession is the deal. We want to try to understand the mortgagee’s and mortgagor’s right to possess the mortgaged property. These theories of mortgages are sometimes difficult because it’s so ingrained in us that the mortgagor is the one who has the right to possession. Why would you buy a house if it meant that a bank employee would be living in it instead of you? But that’s not the way the mortgage developed. We have different theories that give different possessory rights to the mortgagee. We know that after foreclosure, the mortgage is wiped out. Why would the mortgagee want possession prior to foreclosure? There are a number of reasons: they may want to stop waste or make repairs, in other words, they want to protect the collateral. If the mortgagor is doing something that the mortgagee doesn’t like, they may want to intervene. Maybe the property is a rental property and it’s vacant. Similarly, if the mortgagor is taking the rents and using them for some purpose other than to pay the mortgage, the mortgagee might want to stop that as well (“intercept” the rents). The ability to collect the rents depends on the right to possession.
The title theory of mortgage
This is based on the
old-fashioned fee simple determinable.
There is possession by the mortgagee that defaults to the
mortgagor. This theory is most prevalent
in the states closest geographically to
The lien theory of mortgage
This is the theory in most
How does a mortgagee get possession? In a title theory state, possession can be gained on demand. In an intermediate state, possession can be gained on demand after default. In a lien theory state, you can only get possession by a voluntary act of the mortgagor, or when the mortgagor abandons the property, or when possession is authorized by the mortgage itself.
These theories of the mortgage don’t make much difference these days because we use the same sorts of instruments all throughout the country, and they have the same provisions. These theories may be important in other contexts, for example, in determining whether a mortgage severs a joint tenancy. But mostly, we’ll be thinking about what the mortgage instrument provides rather than what these theories would dictate.
Lower inflation risk leads to lower long-term interest rates. Even though the Federal Reserve raises short-term interest rates, more confidence is created that there won’t be inflation long-term.
The balance of bargaining power
The Restatement of Mortgages § 4.1(a) sides with the lien theory states. § 4.1(b) says that generally mortgages can’t grant an enforceable right to possession in the future to the mortgagee. Why do you need both? You can’t make an agreement at the time the mortgage is being entered into that will give the mortgagee the right to possession. But later events can allow that to happen. The balance of power changes between the borrower and lender once the borrower has the money. When the borrower needs the money, the law presumes that they may agree to just about anything in order to get their hands on the money. So the law tries to protect these people due to their perceived lack of borrowing power. Once the borrower has the money and the lender wants to get it back, the borrower has the upper hand. So you can’t make an agreement like this at the outset as part of the loan transaction, but if certain events come up later, agreements with respect to possession will be enforced. This is a concept we’ll come back to again and again: the premise is that borrowers lack bargaining power at the outset, but not once the transaction is completed.
The mortgagor gives a mortgage, and is supposed to pay it in 10 equal installments. After three payments, the mortgagee discovers that the mortgagor is in financial difficulty and the remaining payments are unlikely to be made. The mortgagee sues to obtain possession. What’s the result? It doesn’t matter if you discover you’ve made a bad loan. You have no right to possession until something happens. So in this case, the mortgagee will lose. The worry that you won’t get paid in the future is every mortgagee’s worry to some extent, but it doesn’t authorize possession.
Now let’s say that the mortgagor defaults on the fourth payment. The mortgagee forecloses and seeks an order placing the mortgagee in possession. What happens now? Can the mortgagee get possession now? Nope. You can only get the property sold and get the money. But keep in mind that the (former) mortgagee could show up at the foreclosure sale and buy the property. In that case, the mortgagee is not entering into possession as a mortgagee, but rather as a purchaser. In a lien theory state, the mortgagee as mortgagee almost never has a right to possession.
What if the mortgage contains a provision that says the mortgagee will get possession on demand after default, and the mortgagee makes a demand for possession? This is unenforceable under the Restatement.
But should the mortgagee take possession? Is it advisable? Even if you have a right to possession as a mortgagee, it’s probably not a very good idea. The mortgagee is delegated a very strict fiduciary duty of accounting. Any rents or income you collect that are above the amount owed must be credited to the amount owed. You must act like a prudent owner, which may well mean you have to dig into your own pocket to take care of the property and make it productive. You may also be liable to third parties in tort. So this is a risky proposition, and there is a cleaner, easier route to take: the receivership. Finally, the mortgagee in possession will work just like a foreclosure as far as leases are concerned. If you want to go into possession to intercept the rents, but going into possession terminates the leases, then it’s not such a great idea to take possession. Lenders prefer to have a receiver appointed by the court. But there are costs and risks in this case too. The receivership may be expensive, and you’re not guaranteed a receiver who is competent. But all in all, it’s a better alternative than taking possession.
The effect of mortgages on lease obligations
In commercial mortgages, the lease obligations of tenants may be more important than the value of the real estate. Take a shopping center, for example. Easton and Northland both have buildings and land and stuff, but Northland is not worth nearly as much as Easton because the landlord gets paid by having a loan on productive property, that is, by having enough rent coming in to pay the mortgage. The lender goes into the transaction hoping to get repaid with interest. If the lender takes possession, however, the leases get terminated.
What about when a mortgage is foreclosed? It depends on the relative priority of the mortgage and the lease. The purchaser at foreclosure gets the title as it existed immediately before the mortgage being foreclosed was granted. If the lease was entered into before a mortgage and that mortgage forecloses, then the tenant is still bound under the lease. But if the lease came after an earlier mortgage, then the foreclosure of the mortgage will terminate the lease. So if the lease has priority, the tenant has no right to terminate the lease, and neither does the purchaser at foreclosure. The tenant must attorn to the foreclosure purchaser, meaning that the tenant must treat the purchaser just the same as they treated the original landlord.
If the foreclosure is going to terminate the lease, why does the lender care about the continuation of the leases anyway? If we represent lenders, we can protect ourselves up to the moment of foreclosure by having a receiver appointed instead of going into possession. Why does the lender care what happens after foreclosure? The purchaser at foreclosure is going to pay more for a productive property with lots of leases, which makes it more likely the lender will get their debt paid back.
So if the lease has priority, we know the legal result. But what if the mortgage has priority? If the tenant is a party to the foreclosure, the tenant’s lease is terminated. That means that even if the foreclosure purchase wants to keep the tenant, the tenant can walk away. Also, the tenant can’t force the purchaser at foreclosure to accept the tenant since the lease is terminated. In some states, the mortgagee can intentionally omit the tenant and keep the lease in effect, or in other words, pick and choose. If you don’t join a party and they don’t have notice, their rights can’t be adversely affected. The lawsuit won’t have an effect as to them. So if the lender doesn’t join the tenants they want to keep, their leases will not be terminated. (Come back to this, I’m a little unclear on it.)
Dover Mobile Estates v. Fiber Form Products, Inc. – So
Then what happens?
The lease is above market
rate (unless there is some problem with Fiber Form). So
This deal was structured with “optional unsubordination”. It’s fine if it works right, but you could get a problem like we saw in this case. The Restatement says that you can’t have a subordination or unsubordination that “materially prejudices the person whose interest is advanced in priority without their consent”. Another way the deal could have been done is with an “attornment” clause in the lease, saying that the lessee agrees to attorn to the purchaser at foreclosure and their successors in interest. Finally, you could use a so-called “new lease” agreement. This is not automatic. But you could have a provision in the lease that in the event of a foreclosure or transfer, the tenant agrees to execute a new lease that is identical to the current lease with the subsequent purchaser. The problem is that it’s not self-executing, so the tenant might not make the new lease. Also, what if the tenant can’t execute the new lease. It might be difficult to get performance of this future act. From the mortgagee’s perspective, the attornment clause is the most desirable. The clause must be in the lease, or something else that the tenant has signed. It can’t be just in the mortgage.
Leases are pretty important
in the process. How does the mortgagee
preserve a favorable lease that’s junior?
We know how to get rid of it: join the tenant, and the foreclosure
terminates the lease. If you want to keep the lease in a “pick and choose”
state, you can omit the junior tenants from the judicial foreclosure. But in some states, there are
power of sale foreclosures. A
power of sale is a right the mortgagor (or the person in the position of the
mortgagor) gives to the trustee to sell the property and apply the proceeds to
satisfy the debt. In a judicial state
If you’re in a state that doesn’t allow you to pick and choose, the junior tenants can intervene even if you don’t join them in a judicial foreclosure state. And in a power of sale state, the tenant is bound anyway. Automatic termination may be better because it allows the parties after foreclosure to renegotiate the lease more or less on equal footing. The parties can contract around this if they want. This is an area where the lawyer plays a number of different roles. The lawyer is a planner, drawing up leases and mortgages. The lawyer may also be a litigator. The person drafting the instruments must think about what happens to them in the event of a dispute. The lawyer also plays the role of financial advisor. They advise borrowers as to what terms may and may not appear in the lease such that they’ll be able to get a mortgage later. Some lease terms may even render the property unmortgageable.
Lender’s evaluation of leases
When the lender looks at leases, the lenders wants to know what the rent is and what it will be in the future. The lender wants to know about the tenant’s financial condition. Are they creditworthy? The lender is especially interested in anything that will cost it money, so if the landlord has financial obligations to the tenant, the lender will want to know about it. If the landlord is obligated to rebuild in the event of a casualty loss, the lender will be concerned. If there is an exclusive clause in the lease, the lender will be concerned because the lender or purchaser at foreclosure may be in violation immediately upon completion of the sale or mortgage. These clauses say that only a certain number of similar businesses can be in the same shopping center, for example. The lender is also concerned with assignment and subletting. The lender wants to have the same control in the future as a potential landlord as does the current landlord. One of the most heavily negotiated clauses is the duty to operate, or operating covenant. Landlords want shopping centers to have tenants who are operating. It’s bad for the shopping center to have a lot of empty storefronts. It has a cascading effect on the other stores in the center. The landlord establishes that the tenant is creditworthy, but the landlord also wants a promise that the tenant will stay in business. The tenant will tend to resist this clause.
When the lender evaluates the collateral, the income the property is bringing in is the most important factor to be considered. The lender will impose on the developer some kind of debt service ratio. The net rents must equal some percentage greater than the debt service (your monthly payment, principal plus interest). 120% is not uncommon, and the riskier the project, the higher the ratio will be. If you have 120% as the ratio, the lender wants to see operating income that is at least 120% of the amount that must be paid on the debt. So the lender is looking at rents and operating expenses. The net operating income is the gross rent minus the expenses of operating the building. Then you subtract the debt service and you get your net cash flow. You calculate your debt service ratio by dividing your net rents before debt service by the debt service itself.
When lending on a building that’s already there and has existing tenants, the lender requires “estoppel statements” from the tenants. The “estoppel certificate” is designed to estop the tenant from denying the truth of certain facts, even if those facts aren’t actually true. The tenants must state that the lease is valid and binding. The lender wants to know that the lease that the landlord has looked at and approved is actually the lease in effect (no modifications have been made). The lender wants to know that the rent is whatever is stated in the lease. Also, landlords engage in lots of tricks to make their property look better to lenders. They know about the debt service coverage ratio. So if the tenant can’t pay enough, the landlord will sign a side agreement with the tenant saying that they get every twelfth month free. This is called a rent concession agreement. If the tenant denies that such an agreement exists, it could be fraud, but the tenant can play it both ways as long as the tenant isn’t deceptive. Prepaid rent is particularly dangerous: when the landlord is in financial trouble and asks for a year’s rent in advance in exchange for a 25% discount, then the rent may already be in the pocket of the landlord before it gets into the lender’s hands. The lender also wants to know how large the security deposits are, the term of the lease and renewal options. Finally, the lender wants to know that the tenant has no claims against the landlord for breach.
Subordination, nondisturbance and attornment
This is known as “SNA”. These are the three basic agreements that adjust the post-foreclosure/post-default relationship between the lender and the tenant. A nondisturbance agreement is an agreement by the lender that if the lender or a purchase at foreclosure comes into possession, that person will not disturb the tenant’s right to possession. The lender promises on behalf of itself and its heirs and assigns (namely, the purchaser at foreclosure). If the leases are in place when the loan is made, it may be necessary to have a three-way negotiation (mortgagor-mortgagee-tenant). If there are no leases yet, this is just a negotiation between the mortgagee and mortgagor.
What terms are favorable to the mortgagee? The mortgagee wants subordination, that is, that the lease is junior to the mortgage, and also wants attornment. The mortgagee can kick the tenant out, but the tenant can’t decide to terminate on her own. You can kick the tenant out because the lease is subordinate, but you can keep the tenant because the tenant has promised to attorn. Other clauses you can have are the “new lease” clause or optional “unsubordination”.
When you have a small tenant, the deal that the landlord offers them and the mortgagee will try to insist on is automatic subordination plus a promise to attorn. In the Fiber Form case, only the mortgagee could exercise the option. It is a stronger clause to have the tenant agree to attorn to any person acquiring the premises.
The tenant would like to only have a nondisturbance agreement: a promise from the mortgagee that the mortgagee and purchaser at foreclosure won’t kick the tenant out and terminate the lease even though the relative priorities of the parties would give them the right to do that. This is the “mirror image” of the attornment agreement.
In the real world, the parties will bargain, and depending on the bargaining power of each party, one side or the other will get their preferred clauses, or the parties are balanced, you get all three agreements: subordination, nondisturbance and attornment, which have some benefits to both sides. But why would the lender care about a subordination from the tenant if the lender is going to give the tenant a promise not to disturb the tenant? If the lender can’t throw the tenant out on foreclosure, why bother to get the tenant to subordinate? Many states require that certain kinds of lenders only have first liens. You’re required by law if you’re a certain kind of company to secure all or most of your loans with first liens (not second, third etc.). Also, the lease and mortgage may have some conflicting provisions.
Any subordination agreement should be recorded. Does the attornment agreement need to be recorded? Is there a possibility of a good faith purchaser for value without notice? Yes, for all three of these agreements. The rights of third parties could intervene and they won’t be bound if they don’t have notice. They don’t need to be recorded necessarily in that they are valid as to people with actual notice of them and they will probably be discovered without recording from the estoppel certificate, but they may not be. The best practice is to record.
There are some rights or obligations that the lender may be unwilling to assume that would be included in the nondisturbance agreement. But there are some exceptions. The lender or purchaser at foreclosure is willing to be bound by the lease, but not by things that happened before they became landlord. They want to have a clean slate when they take over. You can include, for example, that the lender isn’t bound by modifications to the lease that occur without the lender’s consent.
Assignment of rents
So far, we’ve been talking about the fact that the lender wants to ensure a stream of income (i.e. rents) available to repay the loan. How does the lender get possession of the rents? What priority does the lender have with respect to the rents? The purchaser at foreclosure gets the title as it was just before it was foreclosed. What about judgment creditors? They may come in first in time with respect to the rents (though not to the realty). The obligation to pay rent is treated as if it were part of the real estate. Courts get confused about this: they talk about both when assignment of rents becomes effective and when it becomes perfected (which is the language of the Uniform Commercial Code having to do with security interests in personal property rather than real property). The proper way to do it is to talk about rents as real property.
There are lots of reasons to want assignment of rents. You might want to get the rent during a foreclosure proceeding. The foreclosure period may be lengthy. If the mortgagor is getting rent but not paying the mortgage, it’s a problem that assignment of rents can solve. If waste is ongoing, an assignment of rents will allow the mortgagee to capture the rents and stop the waste. The mortgage on the rent must be drafted to trigger assignment of the rents upon particular events.
What does “rents” mean? The Restatement defines it pretty broadly: it’s not just payments by lessees, but also licensees and others. The common law would limit rents to payments made by lessees. A common question is whether something is rent or not. These are tough questions under common law, but not under the Restatement. If a payment is made in exchange for the right to use or possess the property, then it’s a rent. There are other things that could be financial obligations of the tenant that may not be included in the Restatement definition. A lease may commonly provide that the tenant is required to help maintain the common areas. You could argue that such payments are not made for the right to use or occupy the property. If the tenant is required to purchase insurance, and the landlord is authorized to purchase it on behalf of the tenant if the tenant doesn’t do it, is that a rent? There are a lot of questions remaining. But lenders will insist that in leases, all of these things are to be defined as rents.
We talked about what a rent is. It’s a matter of classification. But then things get more confusing. Focus on these three issues: (1) when does the assignment become effective between the mortgagor and mortgagee? (2) When does the assignment become effective (or perfected) as between the mortgagee and third parties? This is the priority issue. (3) What must be done to foreclose on the assignment of rents? In other words, when does the mortgagee get to actually start collecting the rents?
There are three types of assignments of rents: (1) The lender collects all rents from the beginning of the loan: this is called absolute assignment of rents. This is relatively rare. Many clauses that purport to create this provide that the mortgagor can maintain possession until something happens. The lender usually doesn’t care to get into the business of managing the property and collecting rents. You could have just a sale of the rents, or the right to collect the rents in a security transaction. (2) The assignment of rents becomes absolute after default. This occurs much more frequently. The language gets confusing: some documents say this is an absolute assignment of rents, except for the fact that the mortgagee appoints the mortgagor as an agent who is authorized to receive rents on the mortgagee’s behalf. The mortgagee actually gets the money, though, until default occurs. (3) The mortgagor gets to keep the rents and the mortgagee doesn’t get actual possession of them until something happens. This is usually a combination of default and some other action by the mortgagee.
The purchaser at foreclosure will get the rents because the purchaser becomes the owner of the property. The mortgage on the rents is gone, just as the mortgage on the property is gone. But who will get the rents in the interim between default and foreclosure? That’s the issue here.
The actions that can trigger an assignment include taking possession (but that often terminates the leases if the leases are junior to the mortgage), bringing an action at law to “impound” or “sequester” the rents, getting a receiver appointed, making a written demand on the tenants to give the mortgagee the right to possession of the rents, or making a written demand on the mortgagor. What if you make a demand on the mortgagor, but the tenants continue to pay the mortgagor? What is the liability of the tenants? We have a contract between landlord and tenant. The landlord is also the mortgagor. Then you have an assignment of that contract right to a third party, who is the mortgagee. The assignment becomes effective as against the obligor, the tenant, when the tenant receives actual notice of the assignment. Even though the assignment is effective just by giving notice to the mortgagor, you’ll still have to do something to actually get the rents. You must give the tenants actual notice; they are protected until that happens.
In the Matter of Millette
There are a whole gaggle of Millettes and a Fridge. They mortgage some property with assignment of rents to a lender called Eastover. Eastover assigns the mortgage to another company and appoint Security National to service the loan. What kind of assignment of rents clause was in the deed of trust? The court reads it as automatic on default. O’Neal Steel gets a judgment lien against the Millettes and brings an action to garnish rents. Security National claims that they have priority with respect to the rents. When are the rights to the rents effective? It doesn’t become operative until the mortgagee triggers it somehow. Whenever the rights become operative or effective as between the parties (when you could demand the rents), what acts are required to perfect it with respect to third parties (namely, O’Neal)? Security National is not entitled to possession of the property in a lien state. But during the pre-foreclosure period, they are entitled to possession of the rents.
The court adopts the Restatement rule, which provides that the mortgage on rents is effective against the mortgagor and third parties upon execution and delivery. What else is required to make it effective against third parties? It must be recorded. The Restatement also answers the second question: when does the mortgagee’s right to actually get the rents accrue? First, whatever conditions that are in the mortgagee must be satisfied: this mortgage says that the right accrues on default. In addition, notice must be given to the mortgagor and any subordinate mortgagees. What does that mean in this case? O’Neal already has some of the rents. Does Security National get them back? Security National wins this case. The court finds that they have a higher priority than O’Neal. But their right to possession to the rents isn’t going to arise until they get O’Neal notice that their mortgage is in default and that they are demanding the rents. It looks like O’Neal will win as to the rents it received from garnishment before it received notice. Notice that O’Neal is not a mortgagee, but will be treated as a mortgagee.
How is a mortgage on rents “perfected” as against third parties? Rents are real property, so you must record. But some courts and some parties think that rents are “just money”, meaning that you must file a Uniform Commercial Code Article 9 financing statement. This is something you file with the Secretary of State to give everyone else notice that you have a lien on someone else’s money. The best practice is to file both places—a “belt and suspenders” approach.
Receivership – Dart v. Western Savings & Loan Assocation
What’s the best way to “trigger” or “actuate” an assignment of rents? Possession is a sticky business. The best thing is receivership! Why? A receivership is easy to get. You don’t terminate junior leases. You don’t have to have a strict fiduciary accounting duty. You don’t have tort liability. You can make repairs, but don’t have to. Finally, you can evict delinquent tenants and fill vacancies.
In this case, there are two mortgages. Someone is embezzling Dart’s money! Western Savings and Inland Mortgage are both granted mortgages, and both mortgages provide that a receiver shall be appointed. Both mortgagees want a receiver appointed, but we’re not sure why. They don’t get receivers. Why not? They have security in the rents and there is no waste of the property. There was also a federal tax lien of almost $200,000. But the tax lien was junior of the other mortgages, so the purchaser at foreclosure will take free of the tax lien. So when the court evaluates the collateral as to the two mortgagees, they’re fine. It’s not the mortgagees’ problem whether Dart’s debts get paid off.
In order to get a receiver appointed in most jurisdictions, there must be inadequate security. Some courts say that the mortgagor must be insolvent. The idea is that it doesn’t matter if the property isn’t enough to secure the debt if the mortgagor has lots of other assets that could secure the debt. This makes some sense, but it arguably deprives the mortgagee of just what they bargained for: being able to rely on the property itself and not the solvency of the mortgagor. In addition, you usually must show that waste is threatened. You have to show that you’re being threatened and that you don’t have a remedy.
What is inadequate security? When is security inadequate? Why was it adequate here? What does the mortgagee bargain for? The mortgagee bargains for two different kinds of “cushions”. First, the mortgagee typically won’t loan 100% of the value of the property, but something less, like 80%, which leaves a 20% cushion. The mortgagee also bargains for the debt getting paid, meaning that the principal is reduced and the cushion gets bigger over time. So you could argue that if the value of the security is less than the lien, then security is adequate. The other way to argue it is to say that if the ratio of the amount of the outstanding lien to the value of the property is greater than originally expected, then the security is inadequate. The mortgagee typically expects that the principal will be paid down and the loan, in some sense, will become more secure as time goes on. The Restatement takes the view that you bargained for the cushion: not just the original 20%, but the rest of the cushion built into the amortization of the mortgage. If the mortgagee isn’t where they expected to be on the amortization curve, then we say that the security is inadequate.
To find out about waste, look at the Restatement § 4.6.
It is easier to get a special receiver appointed to get the rents than to have a general receiver take possession of the property. To get the rents, you must have a default, which would satisfy § 4.2(1), and a demand, as in § 4.2(2). In Dart, they’re not trying to get possession of the rents, but rather of the property itself. Not only do you have to show what you must show to get the rents, but you also have to show inadequate security, waste, and possibly the insolvency of the mortgagor. An “assignment of rents” or receivership clause in the mortgage is not binding on the court. Such a clause, however, is helpful in getting a receiver appointed.
The additional power is the right of the receiver to disaffirm leases. The problem is that a mortgagor who know that a default is threatened may do commercially unreasonable things, like rent the property out at a very low rate just to get some cash. Does the receiver have the right to disaffirm the leases? The Restatement says that the receiver has this power if three conditions are satisfied: the lease must have been made when the mortgagor was in default, it wasn’t commercially reasonable when made, and it was not consented to by the mortgagee.
Waste – Prudential Insurance Company of America v. Spencer’s Kenosha Bowl, Inc.
Here we have (presumably) a
bowling alley in
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
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.
“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
Environmental liability – CERCLA
The Comprehensive Environmental Response, Compensation and Liability Act imposes liability for the cost of cleanup, health assessment and health effect studies. Owners and operators can avoid liability for cleanup costs if they are innocent purchasers, but that doesn’t mean you get off scot-free: you bought a dirty site, and the next purchaser will have to clean it up. This will greatly reduce the value of the land. Liability is imposed on hazardous waste generators and transporters as well as the current owner and operator when any dumping of hazardous material occurred. This is strict liability, and it’s joint and several liability. This is a very harsh statute!
Super fund is different from super liens. There are certain states that have their own miniature versions of CERCLA. Cleanup costs are said to be not only a lien against the property, but also that there is a super lien. That is, the lien for cleaning up the environmental costs takes priority over all or some of the other liens on the property. In particular, they take priority over mortgages.
Why do we talk about this when a lender is not responsible for the physical condition of the real estate in which it has a security interest? “Owner and operator” is defined to exclude mortgagees. Normally, you would say that as a lender, you’re not an owner or operator and thus do not have CERCLA liability. But the lender loses the exemption if the lender participates in management. But just what does that mean? Fleet Factors defines it very broadly: participation in management is said to mean having the capacity to influence management. If the lender could affect hazardous waste disposal conditions, then the lender could be liable. This is very broad! Almost every mortgage requires the mortgagor to comply with all applicable laws, including CERCLA. That means you’re in default of the mortgage as soon as you violate CERCLA. The lender can threaten to make the borrower pay off the whole loan. Maryland Bank and Trust held that the security exemption existed only while the security interest existed.
In 1992, the EPA issued regulations designed to protect lenders. These regulations define participation in management as “actual participation” and limit post-foreclosure liability as long as the lender is not itself a polluter. The regulations set up a safe harbor: so long as within twelve months of becoming the purchaser the lender makes serious efforts to sell it, the lender will be able to take advantage of the general exemption that says lenders are not owners. However, the 1994 case of Kelley v. EPA invalidated the regulation, saying the EPA exceeded its authority in promulgating it. Then Congress passes a statute that basically codifies the 1992 regulation. But Congress goes further: the lender liability exemption continues to exist and goes on to define what participation in management is for purposes of CERCLA liability. Congress defines management in two stages: pre-foreclosure and post-foreclosure.
What if prior to making the loan, the lender requires an inspection of the premises? 42 U.S.C. § 9601(20)(F)(iii) says that any action or non-action before a security interest is created doesn’t count as management.
What if the lender requires the borrower to comply with all laws before making the loan? Same thing. But what about after? This is where we got into trouble with Fleet Factors. 42 U.S.C. § 9601(20)(F)(iv)(II) says that including conditions related to environmental compliance doesn’t constitute participation in management.
What if the lender finds something bad on the land and tells the borrower to clean it up? That’s not management under § 9601(20)(F)(iv)(V).
What if the lender reviews the borrowers financial statements after making the loan? That’s not participation in management.
What if the lender inspects the real estate? Nope. Inspections and monitoring of the facility won’t constitute participation in management. What if the lender exercises decision-making authority over environmental compliance? That seems like the case where the lender could be liable. § 9601(20)(F)(ii)(I) talks about exercising decision-making authority.
What if the lender takes over day to day management of the company? Then they’re participating in management according to § 9601(20)(F)(ii)(II)(aa), even if they’re not specifically in charge of environmental decisions.
After default, what if the lender renegotiates the loan? That won’t result in liability. If the lender provides advice, that won’t result in liability either.
What if the lender becomes the owner of the property through foreclosure or deed in lieu or foreclosure?
What if the lender becomes the owner and continues to operate the business?
What if the lender becomes the owner, continues to operate, and continues to pollute?
What if the lender becomes the owner but does not seek to resell until 18 months later? If you go over the 12 month period, you’re out of safe harbor, but you still could be safe if there’s a reason that you waited a year and a half before trying to market the property other than wanting to be the owner of the facility instead of just holding collateral.
When you take these together, so long as you act the way lenders usually act you’ll be exempt from CERCLA liability. Is that a windfall to lenders? Should they get that exemption, or should they be forced to pay and then collect from their borrower? What’s the lender going to sell the property for? If the lender is exempt, does it mean that the lender will sell the property for the same price that you would get if there was no CERCLA liability? No way! The lender is not an owner or operator, but whoever purchases from the lender will be an owner-operator. They won’t be able to take advantage of the innocent purchaser defense. The realization on the collateral will be reduced, and the lender suffers anyway. Braunstein thinks that you’re just allowing the loan to proceed and letting the lender escape cleanup liability, but the lender still has a strong incentive to protect the collateral. When the lender goes to sell the collateral, any purchaser is going to deduct the cleanup costs from what they paid.
Edwards v. First National Bank of North East – How should you advise lenders who fear liability to adjoining landowners or third parties? You decide how much liability you have. Then you have a receiver appointed. You escape tort liability when you don’t become a possessor of the property. Don’t forget that there are two options open to the lender: the lender can either foreclose on the mortgage or sue on the note. If you have a solvent borrower, you can forget the collateral and just sue on the note, forgetting about the mortgage.
Fire insurance and eminent domain awards – Starkman v. Sigmond
Who gets the fire insurance
proceeds if both the mortgage and insurance policy are silent? This case holds that the mortgagor gets the
proceeds, assuming that the collateral isn’t impaired at the time before the
proceeds are applied. Under the facts of
this case, the security wasn’t impaired, but the loan-to-value ratio was
affected. What if the mortgage says that
the mortgagee gets the proceeds? Is that
enforceable? There is a
What are the limits on the mortgagee’s recovery of insurance proceeds? The mortgagee never gets more than the amount of the debt. Does the mortgagee get the full proceeds, or just enough to put him in the same position he would have been in as far as loan-to-value ratio if the casualty loss hadn’t happened? I missed the answer.
In a standard mortgage policy, the insurance as to the mortgagee (not affecting the mortgagor) will not be invalidated by acts of the mortgagor which would otherwise invalidate the policy. Insurance will be paid to the parties as their interests appear. The mortgagor’s interest may be invalidated if they do something wrong, but the mortgagee is protected. What if the mortgagor burns down the property? The mortgagee wants the proceeds from the insurance. What if the insurer says that arson isn’t covered? What if you have the standard or union clause? The mortgagee still gets paid. What if the mortgagor commits fraud in the mortgage application? No, that won’t affect the mortgagee’s insurance. Same thing if the mortgagor manufactures paint thinner on the property. What if the mortgagor fails to pay the premium? Usually the policy provides for some period of notice before the policy is cancelled due to non-payment. It will invalidate the policy and thus the loss payable or standard loss clause along with it.
So in Starkman, the Sigmonds
buy a house in
Let’s say that the place burns down. The mortgagee makes a full credit bid at the foreclosure sale, not knowing that the place burned down! Well, the mortgagee bid for the property as it existed on the date of the sale. They may have made a mistake, but they bid the full amount of the mortgage, so there’s no mortgage anymore! There’s no basis for the mortgagee to collect anything!
For eminent domain awards, use the Fannie Mae form. In a partial taking, the mortgage is reduced by the proceeds times the ratio of the pre-taking debt to the pre-taking fair market value. The problem is when the condemnation award undervalues the property taken, which makes the mortgagee worse off. If the award overvalues the property, then the mortgagor will be worse off.
Today, we start asking the question: Where is the money going?
Who is obligated to pay the mortgage debt? There are two principal options: the grantee may assume the mortgage debt, in which case we refer to the grantee as an assuming grantee, or the grantee may take subject to the mortgage. The “subject to” language isn’t particularly accurate: you’re always taking the property “subject to” the mortgage in that it’s encumbered by the mortgage. But we mean something different with this “subject to” language: we mean that the grantee is a “non-assuming” grantee. The person becomes the owner of the land but has not assumed any personal obligations as to the repayment of the grantor’s debt.
Basically, the mortgagee has two remedies against the defaulting mortgagor: one is the right to sue on the contract (the promissory note). The other is that the mortgagee can sue to realize on the collateral (foreclosure). The mortgagee has the collateral sold and a fund created to pay off the debt.
Will the assumption/non-assumption decision affect who is expected to make the payments on the debt? Does it affect how much cash the grantee will pay for the real estate? The owner of the property will always pay the mortgage. Does it affect how hard the non-assuming grantee is going to try to make the mortgage payments? The assuming grantee will work harder to keep the mortgage out of default than the non-assuming grantee.
It’s possible to have a situation where the grantee doesn’t undertake the obligation to repay the mortgage, but pays the grantor the full price. This makes sense if you’re selling a very small part of a large tract of land.
If the grantee assumes, is the mortgagor still personally liable on the debt? Yes, unless the mortgagee does something to consent to releasing the mortgagor or otherwise changing the mortgagor’s obligations. There is nothing that the grantee and mortgager can do between themselves that will adversely affect the mortgagee. The mortgagee has a contract and security for that contract and the other two parties can’t take it away without his consent.
Does the assumption have to be expressed, or can you have an implied assumption? It must be expressed with one or two exceptions (just a couple of states). That doesn’t mean that the assumption must be clear. How about a parol assumption? Is consideration required? The answer is almost always yes.
The mortgagee can sue the mortgagor on the debt, sue the grantee on the debt, foreclosure the mortgage and then sue the mortgagor for deficiency, or sue the grantee for any deficiency. If the grantee is a non-assuming grantee, his only liability is to lose his equity in the real estate.
Legal effect of assumption
An assumption creates an equitable suretyship. The mortgagor is secondarily liable. The assuming grantee is primarily liable. The land is subject to foreclosure. When we say that a party is secondarily liable, we mean that there is another party that owes the first party indemnification. If the assuming grantee gets sued, he can’t sue the mortgagor for indemnification. If the mortgagor and grantee rescind their assumption agreement, the mortgagee can only sue on it if he relied on it to his detriment.
Courts say that it would be unjust enrichment to the grantee to assert fraud because he assumed the liability on the mortgage debt in lieu of paying the full purchase price.
What happens where you have the transfer from mortgagor to grantee #1 that is non-assuming, but then a transfer from grantee #1 to grantee #2, and grantee #2 assumes? What is grantee #2 assuming?
Mortgagor’s recourse against grantee
The mortgagor can seek subrogation to the debt and the mortgage (stepping into the mortgagee’s shoes) if the mortgagor pays the debt in full. The mortgagor can seek reimbursement if the grantee is personally liable, even if the mortgagor made only a partial payment. This is just a personal claim and is unsecured.
What if you have a non-assuming grantee? Subrogation is available, but only as recourse against the land. The essence of reimbursement is that it is a personal liability. If the grantee was non-assuming (“subject-to”), then there is no reimbursement and no exoneration.
Given that subrogation is all-or-nothing, what if there is a partial default? Mortgages can secure any obligation, not just the obligation to pay money, as long as the value of the obligation can be converted into money.
And now for a complicated concept: equitable suretyship. It’s not a suretyship, but it’s sort of like one. You could also call it a “constructive suretyship”.
When the mortgagee and the grantee make any change, is the mortgagor bound by it in asserting recourse against the grantee? In general, yes. But why do we discharge the mortgagor in the event of certain types of modifications? What harm is there to the mortgagor? First of all, mortgagors will argue that the modification increases the risk of default.
There are many ways that the mortgagee may impair the security.
The secondary mortgage market
The secondary mortgage market started mostly after World War II. There was a big demand for residential mortgages. There was a big public policy in favor of ownership of single-family homes. Local banks loan money to individual mortgagees. But at some point, they run out of money: it’s all loaned out. The federal government created Freddie Mac and Fannie Mae, which are federally chartered corporations. These act as private companies, but they operate in the public interest. The FHA serves as a clearinghouse. When money goes to the borrower, you get a promissory note and mortgage from the borrower to the bank. Then the banks turn around and sell the promissory note and mortgage to the FHA, which pays them for it. Now, the bank has more money with which to make mortgage loans. The FHA turns around and sells the notes and mortgages to investors, which could be banks, insurance companies, or wealthy individuals. Mortgage notes are very safe investments. In the event of a foreclosure, the process sort of unravels.
This is a more important issue currently than transfers by the mortgagor because due on sale clauses are now enforceable. Will the transfer of the promissory note alone constitute a transfer of the mortgage? Yeah, that’s the only thing that makes sense. Will a transfer of the mortgage alone also transfer the note? No, even though it leads to the same absurd situation. But when the later happens, it was probably an accident. Notes and mortgages are transferred in different ways. With notes, it depends on what kind of note it is. If the note transfers the mortgage, why bother having a separate assignment of the mortgage? You do it just to have something that can be recorded. Recordation isn’t as important as you might think, but it is important. The assignee wants the protection of recordation, and in order to have that, there must be some written instrument to record.
Why would you want to transfer a note with the mortgage that secures it? One reason is that you might just want to sell it. You might rather have cash than the note. There are plenty of people out there who would rather have the promissory note as an investment than cash. So there’s a market there. Or maybe you want to use the promissory note and mortgage as security for some other debt. The promissory note is an asset you have, and you can use it as collateral just like any other asset.
Here are the two big issues: (1) Is the collateral assignment perfected under UCC Article 9? Article 9 has nothing to do with the mortgage itself, but it does apply to creating a security interest in the promissory note. (2) Is the assignee a holder in due course? That would mean that you’re exempt from certain defenses that the original obligor may have; it’s a fairly desirable status. We need to distinguish fraud, though. There is garden-variety fraud, where you basically intentionally lie to get the promissory note. That’s a personal defense. The real defense with respect to fraud is when you sign the promissory note thinking that it’s something else. That’s called “fraud in the execution”. The requirements for a holder in due course are that the instrument must be negotiable, you must be the holder of the instrument, you must possess the instrument, and you must exhibit certain behavior. UCC § 3-104(1) deals with negotiability. There is also other stuff.
This is the more important half of the equation: what happens when the mortgagee transfers its interest in the mortgage?
Negotiable instruments and holder in due course
Last time we talked about an alternative to holder in due course protection: get an estoppel certificate in favor of the assignee. This is the only alternative with a non-negotiable note. The holder in due course doctrine only protects against personal defenses and not real defenses. An estoppel statement is not effective if obtained by fraud, or against “latent” equities, that is, an equity in favor of someone other than the mortgagor. There are limits on the holder in due course doctrine.
There was the Peters case where there was a note and
mortgage granted by Peters to
The UCC Article 3 says that transfer of an instrument happens when it is delivered with intent (for a purpose). Transfer vests in the transferee the right to enforce the instrument. The “symbolic writing” doctrine won’t be a problem when the original mortgagee has a “servicing contract”, is otherwise an agent, or when the assignee is estopped to deny the payment. So there are some protections from this problem. The best protection is to make sure the payee is solvent.
Most courts that consider the issue say that prepayment penalties are part of the bargain. Since you can lock in the loan entirely with no prepayment at all, then the lesser measure of prepayment with a penalty is included. If a promissory note is silent on prepayment, do you have a right to prepay? There is a common law presumption that the lender doesn’t have to accept prepayment. This is the majority rule, but this is a default rule only.
Metropolitan Life Insurance Co. v. Promenade Towers
Mutual Housing Corp. – If the
promissory note says that you’re going to pay over a certain period of time,
that’s what you’re required to do, and you don’t
have the right to prepay. There are a
few states that by judicial or legislative action have reversed the common law
presumption, saying that if the promissory note is silent, you do have the right to prepay. This is only true in
Lenders have a number of reasons for prepayment fees and lock-ins. Lenders are concerned about changing interest rates. The lender wants to maximize the return on its investment. If interest rates are going down, it’s in the lender’s interest to keep the mortgage in existence. It also costs them money to reinvest or to cover loss from a delay in reinventing. The lender may also have costs of initially placing the loan that are amortized over the life of the loan. Usually, those costs are covered by “points”: the interest rate will be, for example 5%, but 1-2% will be charged up-front to cover these initial costs. If a loan is locked in or requires an extremely high prepayment fee, does that necessarily mean that the loan won’t be prepaid? Not necessarily. The parties can negotiate out of the original agreement if that’s mutually beneficial.
Let’s say that interest rates fall and the borrower has the desire to repay a high interest rate loan and get a lower interest rate loan. If the present value of the lender’s loss due to repayment is less than the present value of the borrower’s gain from refinancing, then both parties will benefit from prepayment at some fee. However, this situation doesn’t make sense: how can the borrower refinance for less than the lender is willing to reloan? If that’s the case, then there is no gain from exchange. So is the prepayment penalty an unreasonable restraint on alienation? The Restatement argues that it is not because there is the possibility of bargain. The prepayment penalty may be attacked as interest if there is a state usury law that controls. But in most states, such laws have been greatly watered down. If the fee is unconscionably high, the courts will reject it. Also, recall that improper liquidation of damages can be found to be a penalty. This is judged looking from the perspective of when the contract was formed and asking whether the parties reasonably estimated their damages. The Bankruptcy Code says that prepayment penalties will be allowed and will be secured by the mortgage if they are reasonable.
Should there be a prepayment penalty when the promissory note contains a due on sale clause? What if the promissory note is silent? Is this a question of interpretation? Is this a default rule that the parties can contract around, or is this a matter of law? The courts approach this as a matter of interpretation and divining the parties’ intent. The question is whether it is even a prepayment. What about cases of fire, casualty, or eminent domain? The insurance company pays. You can argue that in the event of a prepayment, you have to pay the prepayment fee no matter what. But it’s more controversial to have the lender say that the borrower can’t rebuild even if they want to.
Fleet Bank of
How do you discharge the mortgage obligation? Knowing what you have to do to get out of the obligation is crucial to being able to enforce it. There is only one mechanism that can be used to assist with paying off a promissory note. If the obligation is not reducible to dollars, then you can’t determine how to distribute the proceeds of the foreclosure sale. You can’t determine what the mortgagor should do in order to redeem the property from the mortgage. Therefore, the obligation must be measurable in money.
To pay $100,000 is a valid mortgage obligation. That’s an ordinary mortgage obligation. But a promissory note can secure a promise to construct a house. As long as you can tell with some amount of certainty what the house is worth and when it’s supposed to be built, it’s okay. Note that there is a different standard depending on who you are enforcing the mortgage against. If you are enforcing against a third party, there will be a greater degree of certainty as to what the obligation is than when you’re talking about the understanding between the original two parties. The mortgage obligation could be to obtain rezoning of land. What about the purported obligation to support the mortgagee for life?
The purpose of this doctrine is to simplify title. If someone has a life estate and a remainder, they basically have the whole bundle of sticks, and we just say that they have the fee simple. That’s what the law does. The merger doctrine does not work to modify any substantive rights, but sometimes courts use it this way. If the mortgagor and mortgagee become the same person, for example when the mortgagee buys the property at foreclosure, we might say that the mortgage is gone and the former mortgagee holds a fee simple. But keep in mind the purpose of the doctrine. Sometimes when we say the mortgage is extinguished, we modify the substantive rights of the parties.
There was a land price boom and land price crash at the same time as the big stock market crash 75 years ago today in 1929. There were a tremendous amount of foreclosures, which hurt both mortgagors and mortgagees. Farm real estate went down by an amount comparable to the fall of the stock market. People felt at the time that it was temporary, that is, that the pre-1929 levels of real estate prices represented their “real” market value, and that the stock market crash was just a temporary downturn from which there would be a quick recovery. A lot of the regulation that we study in this course is a result of the bank failures and decline of the real estate market in 1929. There was also a move towards title insurance, which was a precursor of the secondary mortgage market.
The Restatement of Mortgages says that the doctrine of merger doesn’t apply to mortgages. If the same lender has two mortgages, you have two choices. If you want to preserve your right to a deficiency judgment in the even that there is a deficiency, either (1) you foreclose on the first mortgage first, or (2) if the local rules of civil procedure allow it, you foreclose on both simultaneously. But what you don’t do is foreclose on the second mortgage first, because that would extinguish both the first mortgage and the first mortgage debt.
Deed in lieu of foreclosure
This is fast and cheap. If the mortgagor can’t go forward, the mortgagor might say: “Let’s get it over with. I’ll just give you the property back.” The lender might want to avoid the publicity of a foreclosure. Also, the lender might get a windfall. For the borrower, it doesn’t look as bad for your credit to have negotiated a settlement instead of being foreclosed upon. The lender will also usually waive any deficiency judgment. There are lots of problems with these, though.
Here we have the foreclosure
of the equity of redemption. There is a
period after default where there can be an acceleration (assume that there
is). So then you have the equity of
redemption. The mortgagor still has the
right to pay off the mortgage and then own the property unencumbered by
it. How long does that right exist? That equity of redemption exists until it is
foreclosed. Typically, the time at which
it is foreclosed is the foreclosure sale.
There is a bit of a delay between the foreclosure auction and the
foreclosure of the equity of redemption because the sale must be confirmed by
the court. This is pretty much
perfunctory, but it does take some time.
There are mainly three types: (1) judicial sale, (2) power of sale, and (3) strict foreclosure. In every state that has power of sale foreclosure, it is a mere alternative that exists along with judicial foreclosure. Both involve sales, but one involves a court proceeding at the courthouse (the judicial sale). The process begins with a lawsuit and proceeds the same way a regular lawsuit proceeds. Power of sale simply allows the trustee to advertise for some period of time, and then the property is sold. This typically takes place at the property. The third and least significant method of foreclosure is strict foreclosure. For our purposes, there are only one or two states that still allow this. The problem with strict foreclosure is that it denies the mortgagor the surplus of the equity that the mortgagor has in the property. Under strict foreclosure, you have no sale. Default occurs, a lawsuit is commenced, the order is not an order that the property be offered for sale, rather, it’s a decree that the mortgagee owns the property. Is the cost of a judicial foreclosure worth the effort?
What’s the purpose of a foreclosure? What are the necessary parties? You need to join all the parties needed to get rid of all the mortgages. But just who is that? It could be people other than just mortgagees. It could be easement holders. It could be people who own condominiums where the condos are located on the property being foreclosed. Basically, anyone who holds a lien against the property or claims to own an interest that would be lost as a result of the foreclosure is a necessary party. We’re looking to eliminate all these junior interests. There are also proper parties. The senior mortgagee is a proper but not necessary party. How should junior leases be treated if the lessee isn’t joined? What if you don’t join? Maybe the lease is at a below-market rate. What happens when the senior mortgagee forecloses but fails to join the junior mortgagee? Why would this happen on purpose? It’s hard to imagine. But it can happen by mistake.
The Omitted Junior Mortgagee
What are the remedies? What about the purchaser at foreclosure?
There are three kinds of redemption, based on the time when they occur: (1) legal, which is the redemption when you pay the mortgage on the date it is due, (2) equitable redemption: the right to reinstate or pay off the mortgage in full prior to the time that the right of equitable redemption is foreclosed (the date of sale), and (3) the statutory right of redemption.
Does judicial foreclosure give you any protection you couldn’t get from non-judicial or strict foreclosure?
What is the purpose of this? The mortgagee has two remedies that are alternatives. You can sue on the mortgage to foreclose on the mortgage and have the property sold, or you can sue on the promissory note that is the personal liability of the mortgagor, or you can do both. What does it mean to sue on the note? What is a deficiency? If you only sue on the note, you just get a personal judgment. You execute against all of the assets of the mortgagor including the mortgaged property. If the mortgagor is solvent, then suing on the note will get around the deficiency judgment legislation. The legislation is designed to make sure that the lender evaluates the property so that it’s sufficient collateral for the loan and you don’t need a deficiency. Also, foreclosures can have a “domino effect”. If you have an economic downturn where people are out of work and property values are tending lower, deficiency judgments just aggravate that problem.
There are several types of antideficiency legislation. Some are procedural. You may have to bring the deficiency judgment within a certain amount of time. You may need to give a certain kind of prescribed notice. There is also the “one action rule”, which is a statute that says that there is one and only one action to realize on an action to recover debt secured by a property. If you sue on the note, you waive the security and thus don’t have the option to proceed against the collateral. If you proceed against the collateral first, then, assuming there aren’t other statutes involved, you have the right after that to seek a deficiency judgment. But the basic idea is that we’re going to have just one lawsuit.
Then there are substantive rules. The main substantive rule is that in some states and under certain circumstances, you can’t get a deficiency judgment. There is also fair value legislation. The legislature decides that you’ll get the property appraised and determine the fair market value. The deficiency judgment will be the difference between the debt and fair market value. The property must sell for some fraction of the appraised value. “Low ball” bids are prevented.
This class is dealing with issues of priority. Mortgages may be “replaced”.
The rule is that you lose priority only to the extent of material prejudice. Extensions of time are generally not materially prejudicial. Increases in interest rate or principal can amount to material prejudice.
Subrogation is appropriate to prevent unjust enrichment if the person seeking subrogation performs the obligation in full upon request from the obligor and reasonably expected to receive a security interest in the real estate with the priority of the mortgage being discharged and if subrogation will not materially prejudice the holders of intervening interests in the real estate.