Real Estate Finance Outline
Table of Contents
Contracts for the sale of land
Historical development of the mortgage
Contracts
for the sale of land
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
outstanding in
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
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
states, including
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.
Schrader v.
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.
Historical
development of the mortgage
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.
Mortgage foreclosures
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,
such as
Mortgage substitutes
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.
Title assurance
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
In
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
feudal
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.
Race statute
– 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.
Recording defects
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.
Notice
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
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
insurance? In
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
states, including
Intermediate states
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.
Hypotheticals
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
like
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.
A problem
“Illustration: 14.
Mortgagee-1 makes a loan of $80,000 to Mortgagor, who executes a promissory note
to Mortgagee-1 secured by a mortgage on Blackacre,
which has a value of $100,000. Mortgagee-2 then makes a loan of $10,000 to
Mortgagor, secured by a second mortgage on Blackacre.
During the ensuing five years, Mortgagor makes all scheduled amortization
payments on both loans, reducing the first loan balance to $70,000 and the
second loan balance to $5,000. Blackacre's value
remains at $100,000. Mortgagor then commits waste, reducing Blackacre's
value by $20,000 to $80,000. Since the scheduled loan-to-value ratio on the
first loan at the time of the waste was $70,000 divided by $100,000, or 70
percent, Mortgagee-1 is entitled to a restoration of that loan-to-value ratio.
The value of Blackacre now being reduced to $80,000,
Mortgagee-1's damages recovery should reduce the debt balance to 70 percent of
$80,000, or $56,000. Mortgagee-1 may recover (and upon recovery must credit
against the debt balance) damages of $70,000 minus $56,000, or $14,000.
“The real estate value
available to Mortgagee-2 at the time of the waste was scheduled to be $100,000
minus $70,000, or $30,000, giving Mortgagee-2 a scheduled loan-to-value ratio
of $5,000 divided by $30,000, or 16.67 percent. As a result of the waste, the
value available to Mortgagee-2 has been reduced to $80,000 minus the balance
owing on the first mortgage loan. If Mortgagee-1 does not in fact recover for
waste before Mortgagee-2's action for waste must be decided, the balance owing
on the first mortgage loan will still be $70,000, leaving only $10,000 in value
available for Mortgagee-2. Hence, Mortgagee-2 can recover damages in an amount
necessary to restore Mortgagee-2's loan-to-value ratio to 16.67 percent of
$10,000, or $1,667. Mortgagee-2 may recover (and upon recovery must credit
against the debt balance) damages of $5,000 minus $1,667, or $3,333.
“However, if Mortgagee-1
actually recovers $14,000 from Mortgagor in a waste action before Mortgagee-2's
action for waste must be decided, Mortgagee-1's recovery will, as noted above,
reduce the balance owing on the first mortgage to $56,000. In this situation
the value available to Mortgagee-2 will have been reduced to $80,000 minus
$56,000, or $24,000. Mortgagee-2 can recover damages in an amount necessary to
restore Mortgagee-2's loan-to-value ratio to 16.67 percent of $24,000, or
$4,000. Mortgagee-2 may recover (and upon recovery must credit against the debt
balance) damages of $5,000 minus $4,000, or $1,000.” REST 3d PROP-MORT § 4.6
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.
Hypotheticals
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.
Prepayment
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?
Merger
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.
Foreclosure
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.
In
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?
Judicial foreclosure
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?
Antideficiency legislation
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.