real estate finance 4 by xuyuzhu


									   Construction Lender vs. Permanent Lender
                        (Text p. 728)
• Construction lender— “usually a commercial bank
  primarily interested in making short term, floating rate
• Permanent lender– “usually an insurance company
  primarily interested in a long term loan, possibly with
  an equity participation feature.”
• “Although two separate sets of instruments . . . may
  be used, the terms of the permanent loan are often
  embodied in the construction note and mortgage so
  that, when construction is completed, the original
  note will pass from construction lender to permanent
  lender with no need for execution of a new note by a
  possibly recalcitrant borrower.”

                                1                       Donald J. Weidner
   Construction Lender vs. Permanent
             Lender (cont’d)
• “Construction lending is labor-intensive and
  construction loan departments are usually
  well-staffed with loan administrators,
  architects, engineers and inspectors to
  monitor loan disbursements at every stage of
  a construction project.”

                        2                    Donald J. Weidner
                       Some Lender Liability Issues
Construction Lender as the disburser of funds is expected to assure the project
  is being constructed as planned and that those contributing services and
                     materials are being paid as agreed.
         Permanent Lender –
         classically, drafts itself as a
         notepurchaser who takes                                     Borrower
         free of most defenses

   Landseller                                                                   Fixture
                                           Its Draw Inspector                   financers

         Mechanics Lien                                         Members of public

                                                        3                              Donald J. Weidner
                            Rice v. First Federal S & L
                                                 (Text p. 238)
Borrowers are appealing from a judgment of foreclosure
  on a mortgage they gave on a building.
                     Note for $12,000
  B   M on bldg. to be constructed partly with loan

 B    CL charges B a fee for “inspection and
                [1% of loan proceeds]
  Building begins to crumble (shortly after completion)
 B               Defaulted on note
 B                 Sued to foreclose
          Counterclaimed for damages for
          negligent inspection
 B [the building began to crumble because of
   construction defects]
                                                          4      Donald J. Weidner
            Rice v. First Federal (cont’d)
• Court: a construction lender “has an interest in the
progress and quality of the construction of its security
proportional to the amount of the money invested and would
reasonably be expected to inspect the construction and be
entitled to additional compensation for its additional costs in
making such inspection.”
• Does this cut for or against imposing a duty on the
lender in favor of the borrower?
   – Court’s apparent rationale: it is not necessary to
       impose liability to induce the lender to prevent losses
       because the lender is already under an economic
       incentive to engage in loss-avoiding behavior.
   – Here, the Lender’s agent did inspect the project.

                                 5                         Donald J. Weidner
          Rice v. First Federal (cont’d)

• Did Lender, “by undertaking the inspection of
the construction site and requiring [borrowers]
to pay a fee therefor, impliedly [contract] with
[borrowers] to make such inspection for their
• If a Lender has a duty to its own shareholders
to behave a certain way, should that duty
extend to others who may suffer from its
   – Such as Borrowers
• If you expand the beneficiaries of the duty,
the shareholders lose, at least in the short run.
                          6                     Donald J. Weidner
• Court assumed that the Lender was not
  acting as an agent of the Borrower.
  – Rest. Agency (3d)(2005) suggests the court was
 “Agency is the fiduciary relationship that
 arises [a] when one person (a “principal”)
 manifests assent to another person (an
 “agent”) [b] that the agent shall act on the
 principal’s behalf and [c] subject to the
 principal’s control, and [d] the agent
 manifests assent or otherwise consents so to
                           7                         Donald J. Weidner
       Fiduciary vs. Contractual Duties
• The overarching mandatory obligation in contract
  is to act in “good faith.”
   – Stated somewhat differently, contractual
     provisions must be carried out “in good faith”
   – In general, the UCC defines good faith as
     “honesty in fact”
   – In the case of a merchant , however, the UCC
     states that good faith requires both:
       • “[a] honesty in fact and
       • [b] the observance of reasonable
         commercial standards of fair dealing in the
                           8                     Donald J. Weidner
 Fiduciary vs. Contractual Duties (cont’d)
• The primary fiduciary duties are (a) care and
  (b) loyalty, with loyalty being very powerful.
• It is often easier to establish a breach of a
  fiduciary duty than of a contractual duty
  – Burdens are often shifted against those who are
    classified as fiduciaries
• There may be greater remedies for breach of
  a fiduciary duty than of a contractual duty
  – Tort remedies, and not merely contract remedies,
    are often available for breach of fiduciary duties
     • Including punitive damages.

                            9                         Donald J. Weidner
  Good Faith as Gap-Filler Only
1. In Kham & Nates Shoes (Text p. 236) , Judge
   Easterbrook stated:
   “Firms that have negotiated contracts are
      entitled to enforce them to the letter, even to
      the great discomfort of their trading partners,
      without being mulcted for lack of ‘good faith.’
      Although courts often refer to the obligation
      of good faith that exists in every contract . . .
      this is not an invitation to the court to decide
      whether one party ought to have exercised
      privileges expressly reserved in the
      document. (emphasis added)

                            10                      Donald J. Weidner
       Kham & Nates Shoes (cont’d)
• Kham & Nates Shoes (continuing the
  Easterbrook quote):
   – ‘Good faith’ is a compact reference to an implied
     undertaking not to take opportunistic advantage
     in a way that could not have been
     contemplated at the time of drafting, and which
     therefore was not resolved explicitly by the
     parties. When the contract is silent, principles of
     good faith…fill the gap. They do not block use
     of terms that actually appear in the contract.”
     (emphasis added)
2. See also Penthouse (Text p. 744).

                             11                       Donald J. Weidner
      Jeminson v. Montgomery Real Estate
                     (Text p. 239)

• Lender (“mortgage corporation”) in 1970
  “loaned” a member of the “urban poor” the
  $11,800 purchase price for a home.
• She gave her note and mortgage, which the
  Federal Housing Administration insured.
• Shortly after she moved in, she realized that the
  seller had fraudulently represented the condition
  and value of the property.
• She abandoned the house as uninhabitable,
  whereupon the mortgage was foreclosed.

                             12                Donald J. Weidner
   Jeminson v. Montgomery Real Estate (cont’d)
• She then sued Lender, arguing she was
  unemployed and uneducated, and that Lender
  “knew or should have known” of the seller’s
  notorious and unscrupulous business practices.
• She argued:
   1. The precedent of the Connor case; and
   2. The cases that denied holder in due course
     status to parties who accepted notes either in
     bad faith or when a legal defect appeared on
     the face of the instrument
      • Some of these are known as the “close
        connectedness” cases.

                           13                    Donald J. Weidner
         Connor v. Great Western S & L
                (Discussed in Jemison at p. 241)

   Homebuyers from a Developer sued the S & L that
  provided the construction financing for defects in
  construction of new homes that started to crumble,
  alleging, inter alia, negligent supervision of
  construction (the building design was inadequate
  for the soil conditions).
• S & L was not the seller but was the land financer,
  construction lender and the permanent home
• Developer had no large-scale tract experience.
• S & L inspected the construction site at least once
  a week
                                 14                Donald J. Weidner
    Connor v. Great Western S & L (cont’d)
• S & L had many sources of return from financing this
  new development:
   – Sale/buyback of property to and from the S & L gave it
     a return on the site acquisition financing
   – S & L received a financing charge on the site
     acquisition loan and interest on the site acquisition
   – S & L received a financing charge on the construction
     loan and interest on construction loan.
   – S & L received origination fees and interest on the
     permanent financing (the mortgages taken out by the
     home buyers)
   – S & L received penalties if permanent financing went

                              15                       Donald J. Weidner
   Connor v. Great Western S & L (cont’d)

• Court concluded that the Lender had a duty to
  the homeowners to properly supervise the
  construction (unlike Rice).
• Which the Lender breached.
• Jemison said that the Connor court “was careful
  to observe that such liability arose because
  lender voluntarily assumed the duty to inspect,
  and had become involved in the overall
  transaction to a far greater extent than the
  usual lender of money . . . .”

                         16                  Donald J. Weidner
     Back to Jeminson (Court of Appeals)
• The foreclosed homeowner asserted many
  allegations that the Lender “knew or should have
  known”, including
   – Seller had a notorious reputation for
     unscrupulous practices; and
   – Seller charged more than twice what Seller
     had recently paid for the property.
• In holding for the Lender, the Court of Appeals
  stated: “[T]he transaction in this matter was not
  unitary, but binary”: there was a sale followed by
  a mortgage.
   – Recall Professor Barnett’s “Bifurcated
     Transaction” analysis of Tufts
                           17                    Donald J. Weidner
        Jeminson (Court of Appeals)
• Given that the sale and the mortgage are
  separate, any fraud or unconscionability
  attributable to the purchase agreement cannot
  be ascribed to the subsequent mortgage
• The mortgage “itself is neither fraudulent nor
  unconscionable; for good and valuable
  consideration, defendant mortgage
  corporation took a mortgage equal in value to
  the money advanced to the plaintiff.”

                        18                    Donald J. Weidner
         Jeminson (Court of Appeals)

• The Court of Appeals distinguished Connor as
   – Because Lender had become an active
     participant AND either knew or should have
     known certain facts, Lender came under a
     duty “to the individual purchasers to exercise
     reasonable care to prevent them from
     damages caused by major structural
• Connor sought “imposition of a duty at the
  point of effective financial control.”
                           19                    Donald J. Weidner
       Jemison (Court of Appeals Cont’d)

• Connor imposed liability “because the lender
  voluntarily assumed the duty to inspect, and had
  been involved in the overall transaction to a far
  greater extent than the usual money lender in
  such transactions.”
• Connor, in effect, held the Lender liable as a
• Interestingly, Connor rejected the idea that the
  Lender was a partner (or “joint venturer”) with the
   – There was no division of profits.

                            20                    Donald J. Weidner
       Jeminson (Court of Appeals Cont’d)
• There are no facts in Jeminson that suggest that the Lender
  took an extraordinarily active part.
• Indeed, the Jeminson Lender never inspected. Lender had
  no incentive to inspect:
   – “[The mortgagee had no real interest in the actual sales
     transaction. The mortgagee was merely a source of
     funds, and in the usual course of prudent business
     practice took a mortgage for the sole purpose of
     securing its monetary advance to the [borrower]. Given
     the existence of an FHA insurance policy, the value of
     the collateral was inconsequential.”
   – The lender did not “retain any risk”—it had no “skin in the
• Should the court impose tort liability to give Lenders an
  incentive to inform themselves?
                                 21                        Donald J. Weidner
Jeminson Court of Appeals: Right Result?

• If the court should not impose tort liability on
  lenders to give them incentives to monitor,
  should regulators provide the incentive to
  Lenders by requiring them to have some
  “skin in the game?”
  – Recall the “misaligned incentives” that
      gave rise to the mortgage crisis
  – “Risk retention” may be part of the FNMA,
      GNMA reform package (if there ever is

                         22                     Donald J. Weidner
Jeminson Court of Appeals: Right Result?
• Court of Appeals said:
1. In recent cases “in which new liabilities have
   been recognized, or old ones extended, the
   courts have consistently grounded their
   decisions on the theory that the person upon
   whom liability is sought to be imposed is in
   the best position to spread its losses to those
   who are benefited by the adverse
   consequences of their activities.”

                          23                     Donald J. Weidner
  Jeminson Court of Appeals: Right Result?

2. The “mortgagee is in no position to spread
   any losses due to fraudulent land sales
   transactions, nor is the mortgagee in a
   particularly good position to prevent such
   losses. Those parties most intimately
   involved in the sales transaction, the vendor
   and the vendee, respectively, are best able
   to diminish the number and size of losses
   due to fraudulent sales.”

                         24                    Donald J. Weidner
Jeminson Ct. App. Right Result? (cont’d)

3. “The mortgagee is not a beneficiary of
   the fraud, if any, which was allegedly
   perpetrated by the [seller]; all its
   profits came from the interest it
   charged on its loan. Any profits
   realized by the mortgagee because of
   the underlying fraud are too remote to
   form a basis for its liability.”
  • Stated differently, it was only profiting as a
    normal lender of money (unlike the
    situation in Connor).

                          25                    Donald J. Weidner
       Legislative Response to Connor
• See the California legislature’s response to
  Connor (Text p. 245).
  – “A lender who makes a loan . . . to finance the
    . . . improvement of . . . property for sale or
    lease to others, shall not be held liable to third
    persons for any loss or damage occasioned by
    any defect in the . . . property . . . unless such
    loss or damage is a result of an act of the
    lender outside the scope of the activities of a
    lender of money or unless the lender has been
    a party to misrepresentations with respect to
    such . . . property.”
                           26                     Donald J. Weidner
Jeminson Ct. App. Rejects Close-Connectedness
• Recall that a Holder in Due Course is a holder
  who takes an instrument:
  – “(i) for value, and
  – (ii) in good faith,
        *       *       * and
  – (vi) without notice that any party has a
   defense or claim in recoupment.”
     • UCC 3-302(a)(2) (Supplement p. 40)
• Arguably, knowledge of shoddy business
  practices of the seller means that you either
  – fail to take “in good faith” or
  – you take with “notice that [a] party has a defense.”

                             27                        Donald J. Weidner
 Jeminson Ct. App. Rejects Close-Connectedness
• It is possible to argue that a “holder” who takes
  an instrument is so closely connected with the
  payee that the holder either does not take “in
  good faith” or takes with “notice” of a defense.
• Jeminson cited authority that, to prevail against
  the holder under the “close connectedness
  doctrine,” two things are necessary:
   – (1) an extraordinary discount; and
   – (2) knowledge by the holder
      • such as through an infirmity on the face of the
                               28                         Donald J. Weidner
Jeminson Ct. App. Rejects Close Connectedness
• Jeminson said that there was no allegation
   that the lender was “intimately affiliated with
   the real estate company to that the real estate
   company’s “fraud could be chargeable
   against” the lender.
• There was “no allegation” that the Lender
   1. Acted as a subsidiary of the [seller], or
   2. Was the Mortgagee of all property sold by the
      [seller], or
   3. Was otherwise somehow viewable as the alter
      ego of the [seller].

                            29                    Donald J. Weidner
Jeminson Ct. App. Rejects Close Connectedness

• Finally: “It might be argued that, if the
  [Lender] did not extend a loan to the plaintiff
  because she was an uneducated black
  person, buying a house in an allegedly
  deteriorating neighborhood, it might incur
  some legal liability under the Federal Housing
  Administration Act.”
• Recall the Associates case. Is this “predatory
  lending”—a loan that is not suitable for the
  borrower because there is little chance the
  borrower will be able to repay?
                         30                    Donald J. Weidner
   The Dissent in Jeminson and On Appeal
The Dissent made two Major Points:
1. There were allegations that Lender knew,
  as a result of repeated dealings, that the real
  estate company seller had a reputation for
  unscrupulous practices
   – suggesting a duty to warn or at least to
     refrain from taking action that would
     increase the plaintiff’s peril

                          31                 Donald J. Weidner
The Dissent in Jeminson and On Appeal
2. Because there was a subject to
  financing clause, it was impossible
  to conclude that the transaction was
  binary, not unitary.

• Citing the reasons in the dissent, the
  Supreme Court of Michigan reversed the
  award of summary judgment for defendant
  and remanded.

                       32                   Donald J. Weidner
                Jeminson on Remand
• From FSU Law Student Mike Fidrych, 2/12/09:
I spoke with the attorney who argued the case for the lender
   (Albert Holtz) earlier today. He explained that the
   Michigan Supreme Court remanded for fact finding,
   basically to see "if plaintiffs unsupported allegations were
   true" and capable of establishing a "close
   connectedness" style relationship between the lender
   and the seller of the property. On remand the judge ruled
   that plaintiff did not establish facts to support the alleged
   relationship between the lender and seller, and
   subsequently dismissed the case. Mr. Holtz said "the only
   evidence the plaintiff had to offer were a few loans made
   by the lender to the seller over a period of several
   months." That was the end of the line for Jeminson v.
   Montgomery Real Estate and Co.

                                 33                        Donald J. Weidner
       Liability for Construction Defects
•   Connor and the Supreme Court remand in Jeminson are
    exceptional cases.
• In general, the Lender is liable for defects in the
  premises only in limited circumstances (see Text p.
  1. If Lender and Developer are joint venturers
  2. If a construction lender continues to disburse
     funds after receiving complaints about defects
  3. If Lender takes over construction upon a
     default and completes the project
• The lender will not become liable for defects in
  construction simply by taking a deed in lieu of
  foreclosure and then selling the property.
                            34                    Donald J. Weidner
Buy-Sell Agreements between Construction
  Lender and Permanent Lender (Text p. 743)
  Buy-sell agreements usually provide:
• Construction lender agrees to sell to the permanent
lender, and permanent lender agrees to purchase from
the construction lender, a Note and a Mortgage.
• Permanent Lender consents to the assignment by
the borrower to the Construction Lender of the proceeds
to be forthcoming under the permanent loan
• Construction Lender agrees to sell the Note and
Mortgage to no one except to the Permanent Lender and
to refuse to accept prepayment;
• Permanent Lender agrees to buy the Note and
Mortgage at par, subject to compliance with the
                            35                      Donald J. Weidner
Buy-Sell Agreements Usually Provide (Cont’d)

• The remedies in the event the borrower
  defaults under the construction loan
  agreement or under the permanent loan
  commitment; and
• Borrower agrees to comply with the
  permanent loan commitment and to amend
  the Mortgage documents if the Permanent
  Lender requests it,
  – and the Construction Lender agrees to obtain
    such amendments from the borrower.

                           36                      Donald J. Weidner
   Penthouse Int’l, Ltd. v. Dominion Federal S & L (Text p. 744)
Suit is primarily by the Developer, Penthouse, against a
  participating lender, Dominion, and the Law Firm that
  represented Dominion.
Dominion refused to fund a loan and Penthouse sued to enforce
  the loan commitment.
• 6/01/83—Penthouse had invested at least $65 million of its own
  money in a hotel and casino project that was at least 40%
• 6/20/83—Queen City S&L agreed to loan Penthouse $97million
  for construction and permanent loans, for a ten year term,
  provided it could get other lenders to participate to the tune of
  $90 million.
    – Commitment Expiration Date and Latest Closing Date: in
      120 days
• 10/20/83—Queen City’s Commitment Expiration Date and
  Latest Closing Date passed—yet no closing.
• 11/21/83—Dominion S & L decided to participate to extent of
  $35M.                             37                      Donald J. Weidner
                  Penthouse Overview (cont’d)
• November 21, 1983—Penthouse and Queen City agree to
  extend the Commitment Expiration Date to 12/1/83 [for only 10
  days?], stating also that the loan Closing Date shall be no later
  than March/01/84 (in a little more than three months)
   – The court was required to interpret the meaning of a Closing Date that
     was later than the Commitment Expiration date.
• February 9, 1984—Preclosing Meeting: The Melrod Law Firm,
  acting through its partner, Gorelick, represented participating
  lender Dominion S & L in a gratuitously caustic way.
• March 1, 1984—The Extended Final Closing Date agreed to by
  Penthouse and Queen City the previous November passed
  without a closing
• Nevertheless, the parties kept trying to work things out.
Court Below held: Dominion’s conduct after the February 9. 1984
  Preclosing Meeting and before the March 1, 1984 Final Closing
  Date constituted an anticipatory breach of the loan
                                        38                           Donald J. Weidner
              Penthouse –The Project
Penthouse assembled 5 contiguous parcels:

  (a) a fee in each of 3 parcels (subject to a declaration of
  encumbrances that needed to be modified or removed);

   (b) a leasehold in each of 2 parcels.
       1. The first leased parcel had a Holiday Inn on it.
  It was obtained from a Harry Helmsley Corporation (“the
  Helmsley lease”).
       2. The second leased parcel had a Four Seasons
  Hotel on it. It was obtained from the Rothenburgs (“the
  Rothenburg lease”).

Penthouse was going to use the Holiday Inn structure, rebuild
  the Four Seasons structure, and construct a 7-story building
  between these two towers.
                                39                         Donald J. Weidner
     Initial Commitment Expiration and Closing
• Initially, the Commitment Expiration Date was in 120
days, Oct./20/83, unless mutually extended in writing. The
Closing was to have been held on or before the Commitment
Expiration Date.
• If no Closing by the commitment expiration date,
“Lender shall have no further obligation to Borrower.”
• Para. 17 said “Lender’s obligation to close the loan [is]
contingent upon the satisfaction” of 20 Preclosing
• Para. 19 of the Preclosing Conditions said: “Lender’s
obligation to [close] is also contingent upon execution of
a participation agreement between Lender and other
lenders pursuant to which said other lenders will participate
in making the loan . . . at least to the extent of $90 million
on terms . . . satisfactory to the Lender.”
• Borrower was responsible for obtaining participating
lenders satisfactory to Lender.
                               40                       Donald J. Weidner
       Loan Participation Agreement
• Lenders who wished to participate in the
  syndicate (”participants”) would enter into a
  “Loan Participation Sale and Trust
  Agreement” under which the participants
  would purchase from Queen City (the “Lead
  Lender”) “undivided participating ownership”
  interests in the mortgage loan.
• Lead Lender was to act, not as an agent, but
  as an “independent contractor” for the
  participants and would serve “as a trustee
  with fiduciary duties” in connection with
  protecting the rights of the participating

                         41                   Donald J. Weidner
            Dominion’s Participation
• November 21, 1983, Dominion decided to
participate in the $97million loan syndicate of 12
financial institutions to the extent of $35million.
• “Dominion ‘accepted’ all of the terms and
conditions of both the Loan Commitment and the
Participation Agreement except that the Participation
Agreement was amended to include Dominion as ‘co-
lead seller’ for the syndicate.”
• Although Dominion never directly entered into a
written agreement with Penthouse, Penthouse paid
Dominion an up-front fee of $175,000 for Dominion’s
agreement to participate “as a Co-Seller.”

                           42                   Donald J. Weidner
 Confusing Extension of “Commitment Expiration”
               and “Closing” Date[s]
• On Nov. 21st, “Penthouse and Queen City
mutually agreed to extend the Commitment
Expiration Date to Dec. 1, 1983. * * * In addition,
[Penthouse and Queen City] agreed that ‘we shall
close the loan no * * * later than March 1, 1984.’”
  – How could the opportunity to close the loan continue
    after the commitment expired?
• 2d Circuit concluded “that not only was March
1st the closing date, but also that the commitment
was extended to and expired on that date,”
  – It expired even though “the parties’ conduct in
    continuing to negotiate after March 1st may be
    consistent with an implied extension of the expiration
                              43                        Donald J. Weidner
        Unsatisfied Preclosing Conditions
• Once the syndicate was complete, Penthouse tried to
avoid some of the preclosing conditions.
• Nevertheless, Lead Lender Queen City’s attorney thought
that the loan could close.
• Lead Lender Queen City did not ask Dominion or other
participating Lenders to waive compliance with the preclosing
• Instead, Lead Lender Queen City sent the participating
lenders a letter declaring substantial progress toward meeting
the preclosing conditions and scheduled a preclosing meeting
for Feb. 9.
• Meanwhile, Dominion was having trouble selling sub-
participation interests in its $35million share.
    – It could not legally lend a single borrower more than
• And, prior to the preclosing meeting, the title insurer raised
                                   Helmsley lease.
several objections to title on the 44                     Donald J. Weidner
                   To Secure the Loan
• Court said that Penthouse was required to deliver to Queen
City “a mortgage on the hotel and casino and the underlying
   – How could Penthouse give a mortgage on the two “underlying
     properties” it did not own?
   – Or, is a leasehold an “underlying property?”
• “Penthouse was required to deliver a note secured by a
‘valid first mortgage lien on all real estate owned by
[b]orrower covering the project site’ and all improvements
thereon and was required to provide a ‘valid first leasehold
interest’ in the Rothenburg and Helmsley leases and ‘a first
mortgage covering the improvements thereon.’
Penthouse also was required to provide assignments of its
interest in the leasehold estates to be effective in the event of
Penthouse’s default.”
• “Para. 6 required Penthouse to certify at closing that there
were ‘no violations’ of the Helmsley or Rothenburg leases.”
                                   45                             Donald J. Weidner
                The Helmsley Lease
1. The Helmsley lease parcel, with a Holiday Inn on it, was
    subject to two mortgages, the McShane mortgage and
    the Chase mortgage, “which needed to be discharged or
    subordinated before Penthouse could furnish the
    required security.”
• FO       1M          McShane
• FO              2M             Chase
• FO                    Lease          Penthouse, who
                                       promised lenders a
                                       1st M
Court: “Unless the McShane and Chase mortgages were
    discharged or subordinated, if foreclosed upon, they
    potentially could wipe out the Helmsley lease and any
    security interest in that lease.”

                              46                       Donald J. Weidner
         The Helmsley Lease (cont’d)
2. Further, unless the Helmsley lease was
   modified, the closing of the loan would itself
   violate the lease terms (ex., if there was a
   clause prohibiting further encumbrances).
   •   But the closing commitment required Penthouse
       to certify to “no violations of the lease.”
3. In short, there would have to be negotiations
   1. the 1st Mee,
   2. the 2nd Mee and
   3. the Fee Owner as Lessor
   (or the closing conditions would have to be
                             47                    Donald J. Weidner
  Other Title Problems/Lack of Progress
• There were other title problems with respect
to the Rothenburg lease (the Four Seasons
Hotel parcel) and with respect to the parcels
that were owned in fee (a declaration of
• Penthouse’s outside counsel knew that
there would need to be negotiations on the title
problems, but no negotiations had begun prior
to the February 9th pre-closing meeting.
• The day before the pre-closing meeting, the
Melrod firm, through Gorelick, was contacted to
represent Dominion (the participating lender
with a $35 million share).
                         48                   Donald J. Weidner
   Feb. 9th Preclosing Meeting and Beyond
• Lipari, representing Lead Lender Queen City, circulated
a “Blumberg” form for a “plain language” mortgage.
• The draft mortgage included a rider requiring Penthouse
to satisfy each of the preclosing conditions.
• Gorelick, representing Participating Lender Dominion,
called the documents “idiotic” and said the transaction was
not in a position to close.
   – To satisfy Gorelick’s concerns, Queen City and Penthouse
     agreed to allow Gorelick and his firm to prepare documents and
     to review condition compliance
   – they also agreed to pay his firm’s fees.
• Gorelick started requesting documents and information.
• March 1 (the commitment expiration and closing date)
passed, but the parties kept trying to work things out.
   – Did this result in an implied extension of the loan
                                    49                           Donald J. Weidner
The Final Unraveling and the Lower Court
• Participating Lender Dominion’s Chairman of
  the Board said Lead Lender Queen City was
  in over its head.
• Other loan participants started to say their
  commitments had expired.
• Court below: Dominion’s conduct during
  February and March was an anticipatory
  breach of the loan commitment.
• Court below: the lease and title problems
  were “minor” and could have been worked
  out, in part through a waiver of conditions.
   – It found a waiver of some key conditions.
                            50                   Donald J. Weidner
         The Lower Court/Second Circuit
• Court below awarded $128,000,000 to Penthouse
  against Dominion and Gorelick’s law firm, who were held
  jointly and severally liable!
   – The judgment included 10 years of lost profits on the
      hotel and casino project!
• In addition, $7,000,000 was awarded to Queen City.
• On appeal, the Second Circuit reversed, taking a
  philosophically different approach than the lower court:
   – In the guise of construing the terms of an agreement,
      “court[s] will not make a different or better contract
      than the parties themselves have seen fit to enter
• March 1 was the final closing date and was the date on
  which the commitment expired.
   – even though “the parties’ conduct in continuing to
      negotiate after March 1st may be consistent with an
      implied extension of the expiration date.”
                                51                       Donald J. Weidner
           The 2d Circuit’s Reversal

1. “The parties bargained for a loan commitment
   that remained open only for a stated duration
   and we are not at liberty to construe that
   agreement in a manner inconsistent with its clear
     1. Recall Kham & Nates Shoes (Easterbrook)
        (Slides 10-11, this set).
     2. It does not matter “that the parties’ conduct
        in continuing to negotiate after March 1st
        may be consistent with an implied extension
        of the expiration date.”

                           52                    Donald J. Weidner
      The 2d Circuit’s Reversal (cont’d)
2. To determine whether there was an
anticipatory breach, only conduct prior to March 1
is relevant.
  •   On March 1, the commitment expired and there was
      no further commitment to breach.
3. The only example of a change requested prior
to March 1, which was not required by the
commitment, was Gorelick’s demand concerning
amendments to the Helmsley lease.
  – It was proper for Dominion (through Gorelick) to
    insist on eliminating the title and lease problems.

                            53                       Donald J. Weidner
      The 2d Circuit’s Reversal (cont’d)
4. It is arguable that Gorelick’s demands at the
   February 9th preclosing meeting “were
   sufficiently clear and unequivocal to give rise to
   an anticipatory breach if his refusal to proceed
   was unjustified.”
Although closing was scheduled in just a few
   weeks, there were no active negotiations to
   resolve the title and other problems with the
   Helmsley lease.
Milbank Tweed’s Nelson testified there was no
   way the loan could have closed by March 1.

                           54                     Donald J. Weidner
     The 2d Circuit’s Reversal (cont’d)
“Gorelick’s insistence on marketable title in the
  face of the objections reported by the title
  company by itself would justify his position
  that the deal was in no position to close and
  thus, cannot, as a matter of law, constitute an
  anticipatory breach. Grouping the title and
  lease problems with Penthouse’s failure to
  establish that it was in a position to fully
  satisfy all of the preclosing conditions, we
  conclude that Gorelick properly refused to
  proceed unless his concerns were

                          55                    Donald J. Weidner
            The 2d Circuit (cont’d)
5. Even if Dominion had refused to perform on
   time, Penthouse can not recover because
   Penthouse was unable to perform on time.
   1. Penthouse could not perform on time unless the
      pre-closing conditions were waived, and
   2. Queen City did not have the authority to bind
      Dominion to a waiver of the conditions.
6. Note the FHLBB urged as amicus that a
   Lead Lender should not have the authority
   to “waive or modify significant conditions of
   a loan to the detriment of participants.”

                           56                      Donald J. Weidner
     Lead Lender Authority to Waive Conditions?
• Does the Lead Lender have the authority to waive
  conditions in a way that binds participating lenders?
   – Court says must look both to the A. loan commitment
     and to the B. participation agreement.
• A. The Loan Commitment. Court said: under the loan
  commitment, Lead Lender Queen City “was not empowered
  to waive Penthouse’s compliance with the pre-closing
• B. The Participation Agreement provided: Lead Lender
  was to act, not as an agent, but as an “independent
  contractor” for the participants and would serve “as a
  trustee with fiduciary duties” in connection with protecting
  the rights of the participating lenders.

                               57                       Donald J. Weidner
          The Participation Agreement
• The Second Circuit said that Queen City was an
  “independent contractor,” not an agent. As to its
   – Queen City was given discretion “as to the means
      and manner of contractual performance,” but was
      not empowered to make material changes that
      rendered the participants less secure.
• Even if Queen City were authorized to act as an agent
  for the other participants, the waiver would have been
  outside the scope of its authority: it would not have
  been authorized “to waive or alter material terms ‘or
  otherwise to diminish or discharge the obligation of the
  third person.’”

                              58                       Donald J. Weidner
   The Participation Agreement (cont’d)
• And even if Queen City had been an agent
  who had been delegated that authority, the
  authority was revoked and the revocation was
  communicated to Penthouse.
   – As a result of the communication, there could
     be no implied waiver.
• Note, even the FHLBB admitted that its policy
  consideration (“loan participants must satisfy
  themselves that the participation is a loan that
  the participating association would make
  itself”) is not binding if the parties agree
                          59                     Donald J. Weidner
   Lead Lender’s Authority in a Nutshell

• Lead Lender was not an agent of the
  participating lenders
• Even if Lead Lender was an agent, it did not
  have this authority.
• Even if Lead Lender was an agent and had
  been given this authority as an initial matter,
  that authority had been effectively revoked.

                          60                        Donald J. Weidner
                                                 (Text p. 775)

                          “Permanent loan commitment” in base amount of $1,200,000
                                                                                                PL
3/11/74      
                          which provided that it would “automatically expire” unless the
                          loan was closed by January 1, 1975. Proceeds of the loan would
                          be disbursed only upon “final inspection.”

Nov. ‘74                 Proposed closing with a “holdback” of $20,000, an amount the
                                                                                                PL
                          court said is the “approximate dollar amount of all the unfinished
                          work.” “This type of closing is not uncommon in mortgage
                          loan transactions where new construction is involved.”

                                    Took the matter under consideration.
                                                                                               PL

                             Christmas eve notice that all must be completed and closed by
12/24/74                                                                                       PL
                             January 1, 1975 (per the “Permanent loan commitment”).
1/1/75                Time for automatic expiration passes. Carpeting, tiling was not done,    PL
                       primarily in non-rented apartments. Heat was not yet on in those, and
                       developer did not want to put the heat on (which was, as a practical
                       matter, needed to complete the unfinished work) until the units were
                       rented.                              61                                 Donald J. Weidner
       Specific Performance for Borrower?
•   The casebook cites Selective Builders for this
    proposition: “Courts have specifically enforced
    mortgage loan commitments against hesitant lenders on
    the theory that money damages are inadequate [as a
    remedy for the developer] because of the unavailability
    of other funding or the time required to obtain a
    substitute loan.”
•   However, a leading text states:
    1. “Manifold authorities hold that [specific performance]
       is unavailable [to the borrower] for breach of a loan
       commitment, the remedy at law being fully adequate
       . . . .”
    2. Selective Builders is “apparently the only American
       case granting specific performance when no
       mortgage had been executed to the lender.”

                                62                       Donald J. Weidner
    Specific Performance for Borrower? (cont’d)
• If you assume that a lender must act “in good faith,” does
  that mean that, in order to insist on the borrower meeting
  the deadline, the lender must have a reasonable belief
  that the lender’s security might be impaired?
• What would Judge Easterbrook say?
• Recall the Penthouse language: “The parties bargained
  for a loan commitment that remained open only for a
  stated duration and we are not at liberty to construe that
  agreement in a manner inconsistent with its clear
   – Any distinction here?

                               63                       Donald J. Weidner
       No Specific Performance for Lender
• Both the casebook and the leading text agree
  that specific performance has generally been
  denied to the lender on the ground that the
  lender’s damages can be ascertained with
  reasonable precision based on the difference
  between the commitment’s interest rate and the
  current interest rate.
  – Even though one could argue that the lender had
    bargained for an interest in real property, a mortgage.
     • Real estate historically is presumed unique.
     • However, the lender’s interest in property is only as security
• What of a lender who was promised an equity
                                   64                             Donald J. Weidner
             Subordination Agreements
A. In one category of cases, a seller has signed signing a
    contract to sell in which the seller has agreed to take back
    a purchase money mortgage for some or all of the
    purchase price. The contract also contains the seller’s
    promise to subordinate the purchase money mortgage to
    the mortgage of the buyer’s construction and/or
    permanent lender. The seller subsequently decides to
    refuse to close.
In this class of cases, the question is whether the buyer may
    obtain a court order specifically enforcing the seller’s
    promise to sell.
Consider the language of subordination used in 4 litigated
    cases in this first category:

                                 65                        Donald J. Weidner
              Subordination Cases
1. Buyers agreed in writing to purchase from seller-
    defendants a parcel of unimproved property for
    subdivision purposes. The Seller agreed “to
    subordinate the Deed of Trust which will
    become a second deed of trust to a first trust
    deed to be filed concurrently . . . and said first
    trust deed not to exceed in the amount equal to
    $6.50 per square foot exclusive of garages,
    stairways and porches.”
May the Buyer force the seller to close?
In this case, what further language might have been
    added to the Subordination Agreement to further
    protect the seller?
                           66                    Donald J. Weidner
          More Subordination Cases
   There are two alternative rationales for letting
sellers off the hook on account of the
subordination agreement: uncertainty and
2. Seller agreed to the following subordination
clause: “In the event the [buyer] should erect a
building on subject property at a total building
cost of not less than $75,000.00 or more than
$300,000, then Beneficiary [seller] agrees to
subordinate said Trust Deed to the lien of a first
trust deed not to exceed 60% of the true building
cost. In the event of such subordination then the
payments on said Second Trust Deed loan to be
$400.00 or more per month, including 5%
                           67                    Donald J. Weidner
           More Subordination Cases
3. Seller agreed to subordinate “to a mortgage
    from A S & L Association” with specified debt
    service variables. Buyer got a mortgage from B
    S & L.
   • Recall Kovarik v. Vesely (Text p. 99), involving a
       buyer under a contract that provided that his
       financing was to be through a “$7,000
      purchase-money mortgage from the Fort
      Atkinson S & L.”
      • When Fort Atkinson denied the loan, the
        question was whether the buyer could be
        forced to “close” the acquisition by accepting
        financing from the seller.

                            68                     Donald J. Weidner
         More Subordination Cases
4. Seller agreed to subordinate “to a Savings
   and Loan construction loan mortgage in an
   amount not greater than $500,000 at a rate
   of interest not to exceed 10%.”
B. In a second category of cases, after the
   construction loan is closed, something goes
   wrong (usually, a portion of the construction
   loan proceeds is diverted away from the
   project) and the landseller who subordinated
   wants its junior purchase money mortgage
   declared to be a first mortgage.
  •   Middlebrook-Anderson is one of the best-known
      cases in this area

                           69                     Donald J. Weidner
      Middlebrook-Anderson v. Southwest S&L (Text p. 777)

                   Contract to sell land on

  Landseller/       Agrees to pay over time:
                    gives Note and Mortgage      Developer

                   Agrees not to record
                   mortgage until after
                   construction loan mortgage
                   is recorded (subordination
                   agreement?)                                   Construction Loan Agreement “for the benefit
                                                 Developer       of construction lender and developer only”      CL

                                                                             Note and Mortgage

                                                             Records Construction Loan Mortgage

  ?Subordinator?       Records Purchase Money Mortgage

Developer defaults; project is thrown                                   Disburses $1,500,000
                                                Developer                                                        CL
into foreclosure; foreclosure sale
                                                                        [$300,000 is used for something
proceeds will not be sufficient to
                                                                        other than construction]
satisfy both the CL and the landseller.
To what extent does CL have first
mortgage priority?
                                                            70                                                  Donald J. Weidner
         Middlebrook-Anderson (cont’d)
• Construction Lender disbursed $1,465,000 into a
  construction loan account and $300,000 of this
  amount disappeared.
• Landseller, who recorded his purchase money
  mortgage after the construction loan mortgage was
  recorded, nevertheless sued to obtain mortgage
  priority over the construction lender’s prior
  recorded mortgage.
• Landseller’s claim was based “on the failure of the
  [construction] lender to limit the use of the loan
  funds for construction purposes.”

                           71                    Donald J. Weidner
       Middlebrook-Anderson (cont’d)
• Buyers represented to the Seller that the funds
  received from the construction loan would be
  used exclusively to construct improvements on
  the property.
• Did the Buyer’s representation to the Seller
  become a condition precedent to the Lender’s
  first lien priority?
   – If Buyer is not an agent of Lender, how is
      Lender bound by Buyer’s promise?

                          72                   Donald J. Weidner
     Middlebrook-Anderson (cont’d)

• What were the arguments that the law
  of subordination agreements should not
  – There was no document called a
    “Subordination Agreement” and
  – The Landseller never had a senior lien to

                        73                      Donald J. Weidner
     I. Is there a “Subordination Agreement”?
• Court applied the law of subordination: “Subordination is,
  strictly speaking, a status, not a form of litigation. It refers to
  the establishment of priority between different encumbrances
  on the same parcel of property, by some means other than
  the basic priority involved in the concept of ‘first in time, first
  in priority,’ or the automatic priority accorded purchase
  money liens.”
• “By statute, a purchase money deed of trust is prior to other
  liens on real property.”
• Landseller recording second reflects a “typical automatic
  subordination arrangement,” which Lenders prefer to written
  agreements “because of the reluctance of courts to enforce
  written agreements that are deemed to be unfair to the

                                    74                         Donald J. Weidner
II. Assuming the Law of Subordination Agreements
   applies, what Duty, if any, Does a Construction
           Lender Owe to a Subordinator?
   A. One Possibility: A duty imposed as a
      matter of Tort law. As in Connor, a lender
      who actively participates in a project has a
      duty imposed by tort law, in this case a duty
      to the seller-subordinator.
    A. Because the construction lender is the best
       person to avoid the loss (even if there is no
       active involvement beyond the Lender’s usual
    B. Does the construction lender already have an
       incentive to avoid loss?
       •   Which way does that cut?
    C. What would the tort duty be—reasonable care?
                             75                        Donald J. Weidner
  Duty of Construction Lender to Subordinator
B. Another Possibility: Contract Theory.
1st Argument: Seller-Subordinator is a third-party
    beneficiary of the Construction Loan Agreement
    between developer and construction lender.
   --However, the Middlebrook Construction Loan
    Agreement stated that it was for the benefit of
    borrower and lender only. What did court say?
2nd Argument: Construction lender is a third-party
    beneficiary of the Subordination Agreement
    between seller and Developer and must perform
    its part of the agreement before it can enforce it.
   --However, there was no document called a
    subordination agreement. What did the
    Middlebrook court say in response to the absence?

                            76                       Donald J. Weidner
       The “Agreement” in Middlebrooks-
•  Court implied an agreement of subordination (assigning a
   duty that the lender must satisfy before enforcing the
   seller’s promise to subordinate) “from the Lender’s actual
   knowledge of the . . . seller’s lien . . . and of the
   subordination . . . .” (factors always present?)
Court gave the following reasons for the implication:
1. Lender is in a better position than the Seller to
   control the use of the loan proceeds to prevent
   misappropriations by the Developer.
2. Lender can require documentary evidence that
   expenses have been incurred and can corroborate
   this by on-site inspection.
3. If Lender loses priority as a result of improper
   disbursements, it can redeem the Seller’s purchase
   money mortgage and thereby own the property for a
   price presumably less than fair market value.
                                  77                    Donald J. Weidner
  Reasons to Imply An Agreement Conditioning
 Subordination on Lender’s Performance (cont’d)
4. By contrast, if the Seller’s mortgage is junior
   to the construction loan mortgage, the Seller
   is not normally in a position to protect itself
   by redeeming the larger construction loan
5. A construction lender has the additional
   remedy of a deficiency judgment whereas a
   purchase money mortgagee does not (in
6. The Lender is in a better position to avoid
                          78                    Donald J. Weidner
     Reasons to Imply An Agreement Conditioning
    Subordination on Lender’s Performance (cont’d)
7. Allocation of loss to the lender gives the lender
     incentive to contract to cover the contingencies.
    –   Doesn’t the lender already have an incentive to exercise care
        (recall the Rice case)?
•    Does this sound like contract or tort?
    –   Court said it was deciding the case as a matter of contract law
•    If it is a matter of contract law:
    –   Presumably, no punitive damages are available for breach of
        the duty.
    –   If the contractual promise is a warranty, then the lender may not
        defend on the ground that it exercised reasonable care
•    If this is a contract rule, is it a default rule or a
     mandatory rule?
                                      79                            Donald J. Weidner
 Cambridge Acceptance Co. v. Hockstein
            246 A.2d 138 (N.J. Super. Ct. 1968)

I. Fee Owner, Hockstein, entered into a ground
    lease with Tenant, American, under which:
• Fee Owner leased vacant land to Tenant.
• Tenant agreed to construct a 52 unit motel.
• Fee Owner agreed to “subordinate” his
    interest to a “construction loan mortgage”
    and a take-out thereof
   – mortgage not to exceed 25 yrs. or $5,500
       per motel unit.
• Fee Owner was to receive the
    improvements at the end of the lease.

                               80                 Donald J. Weidner
Cambridge Acceptance Co. v. Hockstein
II. Fee Owner, Tenant and Construction Lender
    entered into an “Agreement”:
• Construction Lender agreed to advance
    “construction monies.”
• Tenant agreed “to deliver its mortgage on
    the land.”
• Fee Owner agreed “to subordinate his fee
    title” “to a construction loan mortgage and
    take-out loan.”

                        81                   Donald J. Weidner
             Cambridge (cont’d)

• The Construction Lender disbursed monies
  into the Developer’s “Master Account” and
  none of it was applied to construction.
• Does Lender still have 1st mortgage priority
  over subordinator?
• For some or all of the reasons articulated in
  Middlebrook-Anderson, a variety of doctrines
  have been used to dislodge Construction
  Lenders from their first lien positions.

                         82                   Donald J. Weidner
                 Cambridge (cont’d)
• Theory # 1: Middlebrook’s conditional
  subordination theory.
• In Middlebrook, $300,000 of the $1,400,000 in loan
  disbursements disappeared. The result of the application
  of the theory of conditional subordination was that lender
  had a first mortgage only to the extent the disbursements
  went into the improvement:
   1) Lender got a $1,200,000 first mortgage to the extent
  the money disbursed went into improving the property.
   2) Seller got a second mortgage for the amount of his
  purchase money.
   3) Lender got a $300,000 third mortgage for the
  amount of the loan proceeds that went somewhere other
  than into construction.

                               83                       Donald J. Weidner
                 Cambridge (cont’d)
• Theory #2: Landsupplier is a third-party
  beneficiary of the construction loan
• The courts have said different things.
• Middlebrooks suggests that, even if the construction
  loan agreement provides it is for the benefit of buyer
  and lender only, there may nevertheless be a cause
  of action on this theory
   – Middlebrooks said there is wide latitude to admit evidence to
     explain what the parties intended by this language.
• However, in Brooklyn Trust, the landsupplier-
  subordinator was not permitted to claim to be a third
  party beneficiary of the construction loan agreement.

                                  84                            Donald J. Weidner
                           Brooklyn Trust Co. v. Fairfield Gardens
                                                256 N.Y.S. 719 (N.Y.A.D. 1932).
             sued to “foreclose its mortgage”.

                                                                   Building Loan
                                                          Dev      Agreement                Lender

                                                                                      Prudence Company
                                                   Fairfield Gardens

                                                                                   All advances made hereunder to be secured by
7/13/28                              Title                                         “valid first lien.” Dev did not yet have title.
                                                                                   As of here, Dev must either pay off landseller or get
                                  $96,400 PMM
            RHB                                            Dev                     him to subordinate, OR, no construction loan.

Riverdale Home Builders

                        Additional M for
                        $47,500 for loan
                        and consolidated                    Dev
                        this with PMM

                                             Signs a “subordination agreement”                Lender               Cont’d…
                       After examining Building Loan Agreement that specified
                       apartments with garages.                          85                                              Donald J. Weidner
Con’t…                                Brooklyn Trust (cont’d)
                                                             Loan $
                                                       1st Mortgage that             Lender
                                            Dev        expressly incorporated
                                                       terms of the Building
                                                       Loan Agreement and
The building was constructed                           the Subordination
without the garages that were                          Agreement
specified in the Building Loan
Agreement                                                                                          Assigned Note
                                                                                      Lender                             
                                                                                                   and Mortgage


                                                                   Accelerated and sued to foreclose

                           ’s right to foreclose was clear. What was not clear: Does /Lender’s                          
  RHB                      Assignee or landseller/subordinator RHB have first Mortgage Priority
                           Because the Project was Changed (the garages were not built)?

                                                            86                                                 Donald J. Weidner
                 Brooklyn Trust (cont’d)
• After a loan is closed and a lender disburses money and
  receives its mortgage, it is more difficult to argue that the
  subordination agreement is unenforceable either
  because of a) vagueness or b) unfairness.
   – Because the lender has closed the loan in reliance on the
     subordination agreement.
• Did Subordinator in Brooklyn Trust lose because he did
  not rely on the terms of the building loan agreement?
   – No, some degree of reliance appears to be presumed
• Or, did Subordinator in Brooklyn Trust lose because,
  independent of his subjective intent, his subordination
  agreement failed to condition itself on the building loan
   – Yes

                                    87                           Donald J. Weidner
            Brooklyn Trust (cont’d)
• In Brooklyn Trust, the construction lender
  never told the subordinator that a decision
  had been made to continue the project
  without the garages.
   – Should that have mattered?
• Court said that construction lender has only a
  duty of “good faith.”
   – “The problem would be different if the lender
     cooperated with the borrower in diverting
     monies advanced from the purposes of erecting
     the building described in the building contract.”
• This is the third theory that could be used to
  provide a remedy in Cambridge.
                             88                          Donald J. Weidner
        More Possible Theories in Cambridge
• Theory #3: Construction lender owes the
  subordinator the duty to perform its obligations in
  good faith.
• What does the duty of good faith require the construction
  lender to do in this context?
• Brooklyn Trust suggests a minimalist test for good faith:
  The construction lender has a duty to refrain from
  cooperating in the diversion of construction loan monies.
   – Does this duty lie in contract or in tort?
• Recall the UCC definition of good faith in the case of a
   – “honesty in fact and the observance of reasonable
     commercial standards of fair dealing in the trade.”

                               89                       Donald J. Weidner
  More Possible Theories in Cambridge
• Theory #4: The promise to subordinate to a
  “construction loan” will be strictly construed,
  and will not be interpreted to include a
  promise to subordinate to a loan administered
  as if it were unsecured.
• Theory #5: The construction lender owes the
  subordinator the duty to refrain from gross
  – Compare Rice
• Theory #6: The construction lender owes the
  subordinator a duty to exercise reasonable
  care in disbursement.
  – Compare Rice
                         90                    Donald J. Weidner
          The Optional/Obligatory Distinction
                        (Text pp. 736-740)

  Theory #7: Lender is dislodged from first lien
  priority because and to the extent that, after it had
  notice of an intervening lienor, it made payments
  that were optional rather than obligatory.
• At bottom, a construction loan is secured by a mortgage
  that embraces future advances.
• The basic notion behind the optional/obligatory distinction:
  the construction lender will retain the priority established
  by the mortgage at the moment when it was first recorded,
  even as to money it doesn’t disburse until future points in
  the construction process, to the extent its future advances
  are obligatory rather than optional.

                                  91                      Donald J. Weidner
            Optional/Obligatory (cont’d)
• On the other hand, if the future advances are optional,
  they will enjoy priority as of the time the mortgage was
  first recorded only if the lender made the future
  advance with no notice of an intervening lienor.
• Classically, the reason for the rule was to protect the
  borrower by preserving the borrower’s ability to get
  junior financing from a new lender.
• Otherwise, a borrower could be “trapped” by a first
  lender who can expand its first mortgage security to
  include future advances it is not obligated to make.
   – Potential new lenders are less likely to become
      second mortgagees if the first mortgagee can
      choose to expand the amount of the debt covered by
      the first mortgage—in effect, making a limitless first
                                92                        Donald J. Weidner
        Optional/Obligatory (cont’d)
• Some courts also use the optional/obligatory
  distinction to protect other kinds of creditors,
  1) subordinators and
  2) mechanics lien claimants .
• That is, an additional reason for the rule is to
  protect junior lienors as well as to protect the

                          93                     Donald J. Weidner
           Optional/Obligatory (cont’d)
1. What kind of notice to a lender is necessary to
   prevent an optional future advance by the lender from
   taking priority as of the time the mortgage was first
    A. Majority rule: the majority rule subordinates the
   lien of the mortgagee’s subsequent optional
   advances only to the extent the mortgagee making
   the subsequent advance had actual notice of an
   intervening lien at the time of making the subsequent
   – This rule puts the burden on subsequent lienors to give a
     senior mortgagee actual notice that they have an intervening
     lien (they cannot simply record their junior lien).

                                  94                            Donald J. Weidner
             Optional/Obligatory (cont’d)
   B. Minority rule: Subordinates the mortgagee’s lien for the
   subsequent optional advance if the mortgagee making the
   subsequent advance had either actual or constructive
   notice of the intervening lien.
   – This rule puts the burden on the senior mortgagee to
      search the title before every optional disbursement.
   – The senior mortgagee also can be put on notice by
      facts other than those recorded with the land titles.
       • Ex., a lienholder has been held to have been put on
         notice of an inchoate mechanic’s lien when the lien
         holder's site inspector saw a subcontractor on the
2. When is an advance optional and when is it obligatory?

                                95                       Donald J. Weidner
           Optional/Obligatory (cont’d)

• Some courts and legislatures believe that lenders acting
  reasonably should not be punished by an application of
  the doctrine.
   – What if a lender makes a subsequent advance to
     pay unpaid property taxes (to protect the
      • Some statutes protect the lender in this
   – What if a lender makes a construction loan
     disbursement prior to the required time in order to
     keep the project moving forward (economic

                              96                       Donald J. Weidner
          Optional/Obligatory (cont’d)
• Some impose on construction lenders a duty of
  good faith and fair dealing in their disbursement
• Others say there is no implied duty to monitor
  disbursements for the benefit of borrower,
  subordinator or mechanics lien claimant.
• Some states have “cut-off” notice provisions that
  permit the mortgagor to issue a notice that
  freezes advances having priority under an
  open-end mortgage at their current amount.

                           97                    Donald J. Weidner
   Florida Statute on Mortgages for Future
              Advances (Supp. P. 85)
697.04 Future advances may be secured. --
• “(1)(a) Any mortgage or other instrument given for the
  purpose of creating a lien on real property, or on any
  interest in a leasehold upon real property, may, and
  when so expressed therein shall, secure not only
  existing indebtedness, but also such future advances,
  whether such advances are obligatory or to be made
  at the option of the lender, or otherwise, as are made
  within 20 years from the date thereof, to the same extent
  as if such future advances were made on the date of the
  execution of such mortgage or other instrument . . . .
  Such lien, as to third persons without actual notice
  thereof, shall be valid as to all such indebtedness and
  future advances from the time the mortgage or other
  instrument is filed for record as provided by law.”
                              98                       Donald J. Weidner
    Lender Liability: Originators of “Subprime”
• Recall Carrick Mollenkamp, James R. Hagerty, Randall
  Smith, “Banks Go On Subprime Offensive,” March 13,
  2007 Wall Street Journal, p. A3 (Supp. P. 7):
• “Although the specifics vary from deal to deal,
  repurchase agreements obligate the mortgage originator,
  under some circumstances, to buy back a troubled loan
  sold to a bank or investor. That obligation sometimes
  kicks in if the borrower fails to make payments on the
  loan within the first few months or if there was fraud
  involved in obtaining the original mortgage. The total
  volume of mortgages nationwide that might meet those
  criteria isn’t known, but such agreements cover billions
  of dollars in mortgages.”
• The materials we have just concluded suggest other
  theories that might be used to support a claim against
  the originator.

                              99                      Donald J. Weidner
              Leasehold Mortgages

• A Leasehold Mortgagee has a security interest in a
  defeasible estate
   – A term of years that can end on any number of
• The leasehold mortgagee must be in a position to
  control all the contingencies that would end the
  leasehold estate.
• Leasehold mortgagee needs
   – notice of all defaults and
   – an opportunity to cure those defaults.

                           100                  Donald J. Weidner
       Leasehold Mortgages (cont’d)
• The leasehold mortgagee seeks all the rights
  of the tenant.
• In some states, a leasehold mortgagee
  apparently is not bound, unless it consents, to
  a modification or cancellation of the original
  – In others, it is.
• Leasehold mortgagee requires warranties by
  the tenant.
• Leasehold mortgagee requires the landlord to
  give estoppel certificates stating that the
  lease is still in effect and not in default.

                         101                   Donald J. Weidner
          Leasehold Mortgages (cont’d)
•   State insurance or banking laws may require
    different levels of security for regulated lenders
    who accept leasehold mortgages as security.
    For example:
    – Mass. may require that the fee be
       unencumbered but
    – N.J. may require only that the lender have a
       first lien on the leasehold estate itself.

                             102                    Donald J. Weidner
       Leasehold Mortgages (cont’d)

• Even if there is no legal minimum on the
  length of the lease term, a leasehold
  mortgagee wants a lease term
  1. longer than the life of the loan
  2. with no right in the landlord to terminate the lease
     simply because the improvements are destroyed
• Recall that both these factors were present in
  Bolger, in which the rent obligation continued
  throughout the period of debt service, even if
  the building was destroyed.

                             103                        Donald J. Weidner
       Leasehold Mortgages (cont’d)
• If a senior fee mortgage is permitted, the
  tenant should insist on protective provisions
  in a nondisturbance agreement that the fee
  mortgagee should execute.
  – The agreement should reserve to the tenant the
    proceeds of condemnation or fire insurance on the
    tenant’s improvements so the tenant can replace
  – The rent should be sufficient to service the
    mortgage on the fee, and the tenant should have
    notice and opportunity to cure any default on the
    mortgage on the fee.
                          104                      Donald J. Weidner
        Leasehold Mortgages (cont’d)
• Bankruptcy law retains the basic idea that a
  trustee in bankruptcy can assume or reject an
  executory contract, including an unexpired
• An executory contract is one in which there are
  performance obligations on both sides.
   – The idea is that an executory contract is
      distinctive because it is both an asset and a
• If the trustee rejects the lease, the Bankrupt
  Estate will be liable for the breach.

                           105                   Donald J. Weidner
         Leasehold Mortgages (cont’d)
• The more common situation is the one in which the
  tenant goes bankrupt.
   – Prior to 1978, the landlord could provide that the
     lease terminates on the bankruptcy of a tenant.
• Under current law, a provision that the tenant’s
  rights under the lease terminate in the event of
  bankruptcy is not enforceable.
   – Therefore, the tenant’s Trustee in bankruptcy
     may assume or reject the lease.
   – If the Tenant’s Trustee rejects the lease, the
     landlord has a claim in the tenant’s bankruptcy
                            106                   Donald J. Weidner
                 Foreclosure of Leasehold Mortgage
                   Kirkeby Corp. v. Cross Bridge Towers
                             219 A.2d 343 (N.J.Super. 1966)
   Foreclosure action brought by a leasehold mortgagee. The defendants are
Cross Bridge, the net lessee of a high rise apartment building on the New
Jersey side of the George Washington Bridge, and the tenant-occupants.
            Ground lease    
 FO                                 Leases with          Sub-tenants
              Net rent     Cross    subordination/       (occupants)
                           Bridge   agreements
                                            $454,000 loan
                                                                               
                                         Leasehold mortgage with
                           Cross                                             Kirkeby:
                                    1)      promise by Cross Bridge to
                           Bridge           refrain from collecting rent     LENDER
May, 1963                                   from subtenants for more
                                            than one month in advance
                                    2)      rents assigned to , but 
                                            waived its right to collect
                                            rents prior to any default, so
                                            the leasehold mortgagor
                                            kept collecting.

                                          Records mortgage 6/7/63

                                                       107                              Donald J. Weidner
         Kirkeby Corp. v. Cross Bridge Towers (cont’d)
July, 1964                                                                  
                   Default       Cross              Default                Kirkeby
                   on            Bridge             on Note
                                              Institutes foreclosure and
                                              is appointed (on 8/21/64)
                                              the mortgagee in

                                                   Sub-tenants   Sues
                                                   (occupants)   for

                                                                           that many
                                                                           rents have
  When  Lender became the mortgagee in possession,                        been prepaid
  he discovered that many subtenant-occupants had
  prepaid rents; notwithstanding the assignment of rents to
   in the leasehold mortgage, and notwithstanding the
  subordination clause in the leases of all the subtenant-
  occupants. They entered into the 6 for 5 prepayment --
  some did so on the advice of counsel!

                                                         108                              Donald J. Weidner
                  Cross Bridge (cont’d)
• Tenant Cross Bridge defaulted on the ground lease and
  on its note to Kirkeby, its leasehold mortgagee.
• Kirkeby instituted foreclosure and was appointed
  Mortgagee in Possession.
• Mortgagee in Possession Kirkeby discovered that many
  subtenant-occupants had prepaid rents,
   – notwithstanding the assignment of rents to Kirkeby in the
     leasehold mortgage and
   – notwithstanding the following subordination clause in the leases
     of all the subtenant-occupants:
   “This lease and all rights of the Tenant hereunder are hereby
     made subject and subordinate to any and all mortgage or
     mortgages now of record or which may be hereafter placed
     against the premises and any and all clauses in said
     mortgage or mortgages contained.”
• Mortgagee in Possession sued the subtenant-occupants
  for rent.
                                    109                           Donald J. Weidner
               Final thought on Cross Bridge
    1. FO enters into a mortgage and records it.
    2. FO subsequently leases to tenants.
If the mortgagee wants to foreclose, it can add the tenants as
     additional defendants in its foreclosure action.
However, if the mortgagee wants to hold the tenants to their
     leases (as in Cross Bridge), some jurisdictions (perhaps a
     small minority) have denied recovery, saying either:
a. The leases subsequent to the mortgage can not affect the
     mortgagee adversely because the mortgagee is not bound
     to the tenants either by Privity of Estate nor by Privity of
     Contract. Therefore, the tenants are not automatically
     bound to the mortgagee who enters possession; or
     (perhaps another way of saying the same thing),
b. There is no mutuality of remedy: if the tenants can not bind
     the Mortgagee, the Mortgagee can not bind the tenants.
                                 110                       Donald J. Weidner
         Balch v. Leader Federal Bank for Savings
                               (Text p. 828)
• Fee Owner executed net ground lease of 4 lots to tenant developer.
   – Tenant intended to construct a hotel building on the 4 lots and to
     construct a hotel parking garage on 4 adjacent lots Tenant owned
     (similar to the site assembly in Penthouse).
• Para. 17 of the ground lease “is confusing,” said the court:
   – “MORTGAGE OF THE FEE.” is the title of Paragraph 17.
   – Then: The Lessor agrees that “this lease will be subject and
     subordinate to the lien of the first mortgage to be held by Liberty
     National Life [Tenant’s Lender # 1] . . . , the maximum term of said
     mortgage not to exceed 30 years.”
   – “This agreement on the part of the Lessor to mortgage the fee shall
     apply only to the [Tenant’s] original construction loan and
     permanent financing loan and any renewal, extension or
     refinancing thereof.”
   – “Provided, however, that this lease shall be subordinated only for
     the actual cost of the improvements placed upon the demised
     premises or the amount of the loan, whichever is less.”
                                      111                        Donald J. Weidner
5/13/70             Balch v. Leader Federal (cont’d)                                                   Intends to construct
           O             Net Ground Lease of 4 lots                       DEVELOPER                    a hotel building on
Fee                                                                                                    the leased parcels
                     “MORTGAGE OF THE FEE. The lessor agrees
                     that this lease will be subject and subordinate to     (Ground
                                                                                                       Owns 4 adjacent lots on
                     the lien of the first mortgage to be held by                                      which he intends to con-
                     Liberty National Life” (etc)                           Lessee)
                                                                                                       struct hotel parking
                     “[T]he maximum term of said mortgage not to                                       garage
                     exceed 30 years.”                                                           Loan
                     “This agreement on the part of the lessor to
                                                                                 Signs                         National
                     mortgage the fee…shall apply only to the
                     original CL and permanent financing loan and                Mortgage                      Life
                     any renewal, extension or refinancing thereof.”             (“M on the                    (Lender
                      “Provided, however, that this lease shall be               hotel lot that                #1)
                      subordinated only for the actual cost of the               was signed
                      improvements placed upon the demised                       by both the
                      premises or the amount of the loan, whichever              owner and
                      is less.”                                                  the lessee.”)
                    Signs Mortgage (“Mortgage on the hotel lot that was signed by both the
                    owner and the lessee.”)
                        Stipulated: the Mortgage to
                        Liberty Nat’l was effective to
                        encumber the fee in the hotel lots.

           O                                                               Developer

      Convey                                                    Assigned               Convey
      Fee                                                       lease                  adjacent lots
          Balches         Stipulated: the ground lease                     Crestwood
                          remained binding on Balch &
                          Crestwood                                       (New Ground
                                                                  112                                             Donald J. Weidner
1987                 Balch v. Leader Federal (cont’d)
       Balches                      Leader        Loan $          Crestwood   $ to pay      Liberty
                                    Federal                                    off Liberty    National
                                                              (New Ground
       (New Fee                   (Lender #2)   Note (signed Lessee—New        Nat’l loan     Life
        Owner)                                  by Crestwood)                  (in default)
                                                                Tenant)                       (Lender #1)

                                                M on adjacent                  Releases
                  “Estoppel and                 lots                           Mortgage
                  certificates”                 M on lots (only
                                                [the new
                                                Tenant] signed
                                                the Ms on the
                                                Balches [the
                                                NFO’s] lots.
                                                The Balches
                                                did not sign
                                                the M. “In fact,
                                                the mortgage
                                                recites that
                                                had only a
                                                interest in the
                                                hotel lots.”

                                                          113                                   Donald J. Weidner
       Balch v. Leader Federal (cont’d)

• Lender # 2 never asked the New Fee Owners to
  execute a mortgage in connection with the loan
  to the New Ground Lessee.
• Instead, the New Fee Owners executed
  “Estoppel and Subordination Certificates” to
  Lender #2.
• New Ground Lessee’s mortgage purported to be
  nothing more than a leasehold mortgage.
• When New Ground Lessee defaulted on its loan,
  Lender #2 attempted to foreclose on the New
  Fee Owners’ lots.

                         114                  Donald J. Weidner
      Balch v. Leader Federal (cont’d)

• Lender #2 argued: The “Estoppel &
  Subordination Certificate,” when considered
  with the lease, was tantamount to a lien on
  the lots of the New Fee Owners.
• New Fee Owners argued: they were never
  even asked to be a party to the mortgage and
  the Certificate only subordinated their interest
  in the ground lease, and did not mortgage
  their fee.

                         115                    Donald J. Weidner
        Balch v. Leader Federal (cont’d)
• Key language in the Estoppel and Subordination
• “Lessor [New Fee Owner] acknowledges and
  consents to the loan in the amount of
  approximately $1,924,000.00 by [Lender #2] to
  [New Ground Lessee] to be secured by a
  mortgage on the premises which is the subject of
  the Net Ground Rental Lease. Lessor
  recognizes that the proceeds of such loan are to
  repay the loan to [Lender #1] and therefore
  pursuant to Paragraph 17 of [the Lease], the Net
  Ground Rental Lease is subordinate to the loan
  and mortgage in favor of [Lender #2] . . . .”

                             116                   Donald J. Weidner
     Balch v. Leader Federal (cont’d)
• Court said the Certificate is ambiguous and
  must be interpreted against the drafter,
  Lender #2.
• If the Certificate does not mortgage the fee,
  what does it do?
   – “By signing the Certificate, the Balches
      effectively either (1) agreed that the
      amount of the [Lender #2] loan was equal
      to or less than the cost of the
      improvements placed upon the hotel lots or
      (2) waived the applicable provisions of the
      ground lease regarding that limitation.”
                         117                   Donald J. Weidner
       Balch v. Leader Federal (cont’d)

• According to the court, what should Lender #2
  have done?
   – Get New Fee Owner to mortgage the Fee, or
   – Get New Fee Owner to authorize the Tenant
     to mortgage the fee, or
   – Draft Estoppel Certificates that clearly
     mortgage the fee.

                         118                 Donald J. Weidner
     Balch v. Leader Federal (cont’d)
• The first Fee Owner mortgaged the fee, with
  the mortgage covering only the original
  construction loan and its takeout “and any
  renewal, extension or refinancing thereof.”
   – With the Lender # 2 loan proceeds,
     Crestwood paid off the original loan, and
     Lender #1 released its mortgage.
   – Is the Lender # 2 loan a “renewal,
     extension or refinancing” of the original

                        119                      Donald J. Weidner

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