Outline: Modern Land Transactions Avoid litigation through structuring: if opponent wants to say this was an equity deal not a loan; how to prevent this? Before signing the docs, send a letter outlining two choices of interpretation then state why one is chosen over the other. -Real Estate types 1. Industrial use: a. Players: owners, and its experts- the whole design team- then contractorsthen for small businesses- there are lenders- ; for someone like a GM building a plant- it is the end user; lawyers 2. Custom Home: developers (most developers do not behave like Toll Bros) 3. Using only Raw land: buy only land- no bldgs but just clear all the reg approvals for subdivision and other types of use then resell it: Land Development: regzoning approvals- then bring in infrastructure- electricity and roads4. Critical to securing a loan- Market Survey for the development proposed a. find land- make proposal- secure loan- make development (hire design and building team and manage)- sell or rentb. time-share ownership/clubs/ for resorts c. urban center: retail bottom/ mixed use of office and condo-or hotel d. trailer parks Chapter 1. Mortgage/ Interest Rate/Loan 1. Basics of the Mortgage Loan a. Banks will lend only 80% of the purchase price of a home w/out requiring the new owner to acquire private mortgage insurance (PMI) which is an extra monthly cost. b. This means that buyer has to have 20% of cash available for down payment c. Ex: $10K in savings, means borrowing power of $40K, or $50K house total 2. Mortgage Loan Risk – Rule: Total amount needed monthly to pay the mortgage installment, taxes, and insurance may not exceed 33% of the borrower’s gross income a. Ex: monthly payment on a 6.5%, 30 year $120K = $758.50 or $9102 per year. Plus $2500 per year and homeowner’s insurance of $500 for total = $12,102. If you make $30K gross per year t/f $12,102 of $30K = 40.3% of gross income. i. T/f it is a risky loan don’t want (mortgage + taxes + insurance) to be more than 33% b. How much, do you have to earn to pay $12,102 in taxes per year? .33X = $12,102. Meaning you have to earn $37,054. c. Borrowing to the full 33% ratio will leave homeowner w/ very little free income though. 3. If interest rate is lower, the monthly payment is lower 4. 5. 6. 7. 8. 9. a. Ex: If you obtain a 6% loan instead of a 6.5% loan, you need less income to qualify for the loan. The higher the rate, the higher the monthly payment Amortization a. Shorter the term of the loan (15 yr v. 30 yr.), faster the principal must be repaid. b. The shorter the loan, the faster you’ll pay it off. The longer the loan, the slower you’ll pay off the principal. c. Longer loans equal more interest, lower monthly payments Adjustable Rate Mortgage a. The interest rate changes at regular intervals to match current interest rates Deductibility of Interest a. IRC § 163 authorizes deduction for interest paid by a taxpayer on a residential mortgage. b. The higher your tax rate, the more the gov’t subsidizes your home ownership. c. Ex: See p. 7-8 of handout d. Converting Interest Rate to Actual Interest Rate 1. Find marginal tax rate. 2. Subtract from 100%. 3. Multiply that by the mortgage interest rate. APR and Points: a. Fees: Application, Document Preparation, and Appraisal Fees – you must add these to the finance charge which will result in an increase in APR b. Point = 1% of the loan. They are prepaid interest. c. You need to pay attention to how the point differential will effect the APR. See pg. 10 of handout i. APR = actuarial method of calculating interest rate Constant Payment Self-Amortizing a. Balloon: The borrower pays back nothing on the loan until some time in the future when the whole loan is due b. Installments: Involves a payment obligation that result in their being a zero balance after the last payment is made. It is known as constant payment selfamortizing loan. i. Constant Payment – refers to the fact that the monthly payment is computed so that the same payment is made each month throughout the term of the loan. ii. Self-Amortizing – refers to the fact that each month some principal is paid so that at the end of the term of the loan the entire principal the entire principal is paid. iii. Fixed Sum – Requires the borrower to pay a fixed sum toward principal every month, quarter, or other period. c. See tables p. 12 of handout for examples of typical constant payment selfamortizing loan Arithmetic of Interest Rates 3 methods of Calculating Interest a. Actuarial – Interest is calculated on the reduced balance of the loan after each monthly payment. See page 13. This is known as the APR rate. It is used by Truth in Lending Act. b. Add on – You add the interest payment at the beginning of the loan then divide by the term of the loan. Ex: 6% interest per year on $1000 = $60. So $1060 divided by 12 = 88.34 per month. i. You can convert the add-on rate using tables. c. Discount – You subtract the interest from the loan amount. But as a loan, you only get that discounted amount. Ex: $1000 loan at 6% interest. Subtract $60, t/f you receive only $940 and you pay it back over 12 months. T/f a payment of $83.30 per month. 10. Theory of Interest a. Interest: the compensation to the lender for the lender’s giving up the present availability of money. b. Thus in a loan transaction, a benefit is conferred upon the borrower (the value of the present availability of money) and imposes a cost upon the lender (the loss of the present availability of the money). c. In order for the lender to make a profit, the interest charge must be in excess of costs. T/f interest rates are made of 4 components: i. X% to cover the intrinsic cost to the lender making the loan ii. Y% to produce profit iii. A percentage charge to reflect inflation iv. The risk that the loan will not be repaid d. Present Value: present value of future money payments is determined by 2 factors: i. The length of time before the money is repaid ii. The cost of making the loan measured by alternative investment opportunities. 11. How Much to Borrow a. Loan to Value Ratio: Typical lender will require 20% of purchase price to be paid by borrower. i. If lender puts up 80% - this is a loan to value ration of 80%. ii. If you borrow more than 80%, you may have to pay a higher interest rate AND must obtain mortgage insurance on a portion of the loan b. Ex: Suppose you have cash to pay 50% of the purchase price, do you do it? i. Compare the after tax cost of borrowing w/ after tax earnings. ii. If you can get 6% on a tax free bond, which you lose if you put it in a house. And the after tax interest charge is 8%, it is more costly to borrow. c. In commercial real estate transactions generally people want to borrow as much as they can b/c the income from the property is higher than the cost of borrowing. i. A leveraged transaction is one in which a substantial portion of the investor’s funds is borrowed ii. See Example pg. 20 of second handout iii. You earn the money in this example b/c of the large difference b/w the all purchase yield of 14% and the 8% cost of borrowing money. iv. Leveraged Principle does not work when the annual debt service (principal and interest payments) as a percentage of the amount borrowed, exceeds the forecasted rate of return from the property on a cash purchase basis. v. i.e when debt service = a higher percentage of the loan d. When your cost of borrowing is less than what you’re getting off of interest rate (yield), then you invest. 12. Tax Benefits: a. You can deduct your home interest i. i.e. if you borrow $1M at 6%, that means you are paying $60K in interest the first year. That $60K is deductible using your marginal tax rate. ii. T/f the higher your tax rate, the more you can deduct. In other words, the richer you are, the more you will be subsidized by the gov’t. iii. The amount you can deduct is capped at $1M though b. There is also capital gains rate on home sales of 15% that goes into your pocket c. Stepped Up Basis: If your heirs get your home, they get as their basis the basis of the home as it is worth now, not what you bought it for. They get the stepped up basis. d. Exempt Gain: each person gets $250K in real estate gain untaxed. $500K if filing jointly. i. Ex: You have a $200K mortgage paid down to $150K. Refinance for $300K. Only the $150K is deductible. ii. When you refinance, you can only deduct the remaining amount on the original mortgage e. Everyone gets to deduct an extra $100K as home equity deduction. 13. Working w/ the Mortgage Terms a. From borrower’s perspective – the cheapest loan is the loan of the smallest amount at the lowest interest rate for the shortest period. i. See amortization tables in handout p. 22 b. The longer the term, the higher the total amount paid as interest i. The extension of the term reduces monthly payment, but the trade off for this lower payment is a higher interest cost ii. See interest tables p. 30 c. Very few home mortgages are paid to term – most are paid in 12-13 years b/c home is sold i. The balance of the loan is still due at the end of the 12 years ii. Obviously, the shorter the loan, the less balance left to pay if you stop short d. Which term should you go w/? i. If you interest rates are at 3% and your mortgage is 6.5%, you probably want the shorter term b/c your money isn’t worth as much investing ii. Conversely, if your interest rates are 10%, then the longer term mortgage where more money if freed up (b/c each monthly payment is smaller) is more advantageous b/c your money earns more than the 6.5% mortgage. e. Prepayment i. If person elects a longer term 30 year mortgage, they are not bound forever to paying interest for full 30 years. Standard mortgage documents permits prepayment at any time ii. Ex: If family has extra funds after 5 years, they can apply that extra to the mortgage each month f. Underwriting Criteria i. Mortgage Debt Test: Basic Home Expense (total of monthly mortgage, 1/12 of real estate taxes, insurance cost) may not exceed the following percentage of the borrower’s gross monthly income. i.e. .28(gross monthly income) = must be less than the basic home expenses added together 1. 26% if 5% down 2. 28% if 10% down 3. 33% if 20% down ii. Aggregate Debt Payment: Total of basic housing expense, monthly payment in education, car, personal loans, 5% of credit card balances may not exceed the following percentage of borrower’s gross income: i.e. .28(gross monthly income) = less than debt combined 1. 33% if 5% down 2. 36% if 10% down 3. 38% if 20% down iii. Now – post 1996 – more variables are used and weigh them based on actual experience iv. See Table p. 36 for the amount of principal and interest the bank will let you pay g. The cost of taxes and insurance directly relates to the amount that may be borrowed as does the interest rate. i. If interest rates go up, person w/ same income is not able to borrow as much ii. If taxes and insurance go up, borrowing power goes down as well 14. Refinancing a. Decision-making in refinancing i. W/out points: To refinance or get a new mortgage, you have to pay upfront costs. Title insurance, application and appraisal fees which can be up to $3K a year. If the interest rate difference is enough (i.e. 9% to 6%) you could probably recoup this expense quickly making it ideal to refinance if you’re going to stay awhile. ii. W/ points: Points can increase costs over and above fees. Thus it takes longer to recoup costs. If it takes too long, you have to factor in present value of money which reduces value of refinancing. It may not be worth it if interest rate difference is not large enough. b. Keys to Refinancing: i. (1) The rate spread; (2) total cost to refinance; (3) length of time the homeowner expects to remain in home. 15. Adjustable Rate Mortgages and Other Variations a. ARMs – mortgage instrument that links mortgagor’s interest rate to some index of interest rates. These are more popular when interest rates are high i. Lender’s ―cap‖ the maximum interest rate adjustment for each adjustment period. Typcially 2% per adjustment and 6% lifetime. 1. Ex: If borrower has 4% rate w/ cap of 2% yearly and next term the new rate was 6.25%, the adjustment would be capped at 6%. If the new rate was 6% or less, the cap doesn’t come into play, and the borrowers rate is just adjusted accordingly. If the rates adjust downward, borrower’s rate is adjusted downward ii. The lender will use the first year ARM rate to qualify the amount the lender can borrow, t/f as rates go up, the borrower may be house rich (b/c he could borrow more than he would under a fixed rate) and cash poor by year 2. iii. Index (CMT – constant maturity treasuries) + Margin = adjusted 1. Then you see if this number is higher/lower than your capped number and adjust accordingly. iv. 1 Year ARM fixed rate for one year, then you adjust the rate to the 1 year CMT every year. v. 3Year ARM fixed rate for 3 years, then you adjust the rate to the 3 year and adjust every 3 years b. Deferred ARM – fixed interest rate for 3, 5, or 7 years and then the mortgage converts to a 1 year ARM for the balance. They have a higher 1 year ARM rate average and lower than the fixed rate on a 15 or 30 year loan. c. Short Term Fixed Rates/Balloon – Your payment is based on a 30 year payment schedule. But mortgage starts w/ an interest rate below the 30 year fixed rate, but the rate is only in effect for 5, 7, or 10 years. At the end of 5, 7, or 10 years, the borrower either obtains a new loan or converts to a new current market rate for the balance of the loan d. Interest Only – You set up the loan to pay interest only for 15 years. In year 16, you reset the monthly payment to amortize the full original debt. You won’t pay off principal until year 16. e. Buy Down Rates – If borrower agrees to pay $X in interest in advance and then b/c of this they get a lower interest rate for life of the loan. The prepaid interest is a ―buy down‖ of the rate. This may be used by a consumer w/ limited income streams but available assets. f. Reverse Mortgages – g. Graduated Payment Mortgage – You calculate the monthly payment for a loan. Then in the early years of the loan, you only pay a percentage of that monthly payment. BUT later on, you pay over the monthly payment to make up for the lesser payments earlier. In essence, you back load the payments. h. Option Mortgage – Borrower has option to choose how much they pay, if their payment does not cover the interest, then their principal increases. Chapter 2 A. An overview of Contracts for sale and the conveying process The Players 1. Real Estate Brokers – participate in most real estate transactions in a variety of ways 2. Title Insurance Companies – also involved in most transactions. If the buyer needs to borrow money for purchase, lender will require title insurance. 3. Attorneys – involved in commercial transactions. Residential sale depends on local custom. a. In PA – lawyers send more work to brokers than in other states, thus taking lawyers out of the equation. Title Issues 4. Quality of Title – Implied covenant of marketable title or a more comprehensive K term. (see p. 78 of Supp ¶19) 5. Investigate Title – title search and evaluation 6. Closing and Merger – accept deed and pay balance due on K; marketable title covenant merges into deed – the covenant is extinguished. 7. Deed Warranties – deed will either be general, special, or quit claim 8. Title Insurance – to assure there is a solvent entity around to pay the losses suffered if a deed is deficient, most buyers acquire title insurance. B. The Contract controls 1. CL – equitable conversion rule that the risk of loss is on the buyer from the time of execution of the purchase contract. (see PAR ¶21 in Supplement) a. Residential and Commercial transactions have are frequently subject to different statutory provisions b. But you can change this b/c of the power of K C. Real Estate Brokers 1. Who Brokers Work For: Duty of Loyalty Real Estate brokers serve as agents for sellers and owe fiduciary duties of care and loyalty to their seller clients a. Can’t disclose info to others that will prejudice the client b. Obligated to disclose all material info to the seller c. No Self Dealing 2. When do Brokers Earn their Commission: CL When the broker produces a ready, willing, and able customer on the terms given to him by his principal. Risk allocation is on seller. a. There also must be execution of the document. The K must be signed b. If seller insists on something that is not customary and it causes the buyer not to sign the K, this does NOT mean the broker hasn’t produced a ready, willing, and able buyer. c. Ready, willing, and able is under customary terms. d. It is atypical for seller to insist on a title insurance company e. Seller can not change terms of CL, unless you negotiate other terms. f. T/f, If buyer gets wet feet and defaults after signing K, broker still gets commission even if broker’s K provides a fee is only earned after closing takes place. (this term changes the CL and can only work when it is negotiated for). g. Seller can not take advantage of a situation he created. Seller’s Act can’t make closing impossible. T/f if buyer backs out of K b/c title is unmarketable due to seller’s act, broker still gets fee. h. If K language b/w seller and broker is explicit, then must follow the language i. Ex: K says ―no commission until I get cash in hand.‖ Broker won’t get commission until this is satisfied b/c he knows explicitly what he is getting into. i. Ellsworth Dobbs Rule: Requires that for broker to earn commission, title must actually close, unless failure to close is attributable to the principal. j. Risk Allocation: i. It is standard in real estate transaction to have a deposit (usually 10% purchase price of house) ii. This deposit is used to protect seller in case buyer back out. 10% is liquidated damages iii. Supp. p. 65 ¶7(e) – usually filled w/ 50% - meaning in case of buyer default, broker will get 50% of deposit and seller will get other 50%. 3. Types of seller broker arrangements a. CL Rule: There is no limit to how long after the agreement expires, as long as jury is convinced that the listing was sold due to work of the broker during the time of the listing agreement, even if the property is sold after the agreement expires, the broker is still owed fee. b. ¶7(D)(1) of Supp – solves this CL problem. The language is helpful b/c it puts to an end any possible confusion by setting up time limits. c. Open Listing: If Seller accepts a K from broker, a commission is due; must have terms of date; price to be sold; commission fee; the property to be sold i. Owner has right to sell ii. B must be procuring cause to get commission d. Exclusive agency: Where principal is not foreclosed from competing w/ the broker. i. Owner right to sell ii. Other brokers barred iii. B must be procuring cause, B only doesn’t get fee if owner is seller. B will still get fee if another broker sells. e. Exclusive right to sell: Broker is sole person w/ right to sell i. Owner may not sell ii. No matter who causes sale, B gets paid as long as it is w/in the time period f. Net listing: Broker gets a %age or all the purchase price in excess of the Seller’s minimum acceptable price. g. Barred in states: conflict of interest potential PAR has pro seller or pro buyer options: option 1 and 2 4. Post termination transaction under PAR listing a. Quality of Broker’s service b. Crutchley Non-Recourse Clause was at issue c. Non Recourse Clause: you have no recourse against the buyer if they default d. In this case, buyers signed note promising to pay full amount of 25 years plus put $300K down and $37K of interest paid. Then defaulted. On resale, seller recouped $576K, but were still out $536K. B/c of non-recourse, there was no obligation on part of buyers to pay the rest. e. The broker should have advised to the sellers to have a lawyer look at the agreement. Sellers said no one advised them. D. Brokers and their clients 1. Arrangements b/w Brokers and the Traditional CL a. Seller = Principal b. Broker = Agent c. Multiple Listing Service – Brokers band together and create a MLS. Each broker puts his listing into the MLS. Any other broker may show the house, and if that broker’s client (a buyer) buys the house, the two brokers split the commission. d. The cooperating broker (the one w/ a buyer) is technically a sub agent w/ a duty of loyalty to the seller. e. This creates potential conflict of interest b/c the seller is the one who pays fees and is principal to subagent. But the subagent is working w/ the buyers to find a property, technically, the subagent has not duty of loyalty to you 2. Buyer’s Broker (p. 63 of Supp – Buyer Agency) a. If you have a choice, you want a buyer’s broker, instead of the subagent arrangement in a MLS. They represent interests of buyer. b. If you (buyer) sees a house with a broker accompanying you, but buy on your own- you still owe fee to the broker c. Drawback: This is an exclusive buyer agency K, the broker wants it to be them and only them. T/f you won’t have the wide ranging pull that a MLS will have. Plus how much time can the broker devote to you? They also take same fee that subagent would. 3. Broker Duties: a. Seller’s Agency: Duties that broker owes to seller. Broker is agent of seller b. Buyer’s Agency: Same as above but for buyer c. Exclusive: Broker owes duties to buyer – but may also owe duties to seller d. Obligated to work for buyer e. Non-Exclusive: Broker and buyer are not obligated to work for each other f. Dual Agency: Broker is agent for both buyer and seller. Must not act to detriment of either. g. Designated Agency: Broker can designate another broker to represent the principal. h. Transactional Licensee: Limited confidentiality, not an agent. Performs limited duties which require a broker or sales person w/out being full agent. 4. Listing Contracts E. Contracts for the sale of real estate: Lawyer’s role 1. Residential Agreements – on standard forms prepared by realtors, joint groups of realtors and lawyers, or a third party organization. 2. Commercial Agreement – agreements of sale are not based on a standard form, but the commercial real estate K’s produced are similar to one another 3. General Provisions in a K: a. Deal Terms – which are stated as facts completely separated from the risk allocations considerations of the K. Ex: ¶3 of Standard Agreement for the Sale of Real Estate b. Conditions – generic conditions of the K. c. Who are the parties – i.e. if there is joint ownership status and you need to know who all parties are d. Risk of Loss – who bears the risk in the event of a default i. It can be customary which means boilerplate and common to all RE K’s, pro buyer/seller, or neutral. 4. Common Problems Parties to the K should address: a. Who is the Buyer b. Who is the Seller: want to have the title holder to be the seller c. Title: want to know the covenants, conditions, and restrictions. Buyer should demand to know what he is expected to take. Obligate the buyer to take subject to restrictions not violated by present improvements and uses of the property or by purchaser’s intended use of property. d. Description: Description of property e. Damages (Title defects): forms do not adequately protect seller if title is not marketable. Seller could be sued for specific performance when an unexpected title defect occurs f. Damages (Seller’s Default): Agreements sometimes provide that the buyer’s only recourse, if seller gets cold feet and refuses to comply, is to get the deposit back. A more typical situation is to protect the seller to some extent if the title is unmarketable but leave to the CL a buyer’s remedies if the seller refuses to close g. Damages (Broker’s Commission): Under CL, a broker earns the commission when the seller accepts the offer and thereby also accepts the buyer as ready, willing, and able. If buyer breaches the agreement and does not close, broker is owned 6% commission. i. It is customary to have the buyer put down a deposit, if the buyer defaults, the seller keeps the deposit as liquidated damages. h. Damages (Buyer’s Default): PAR ¶29 in Supplement i. Closing Date: Must have closing date. Could also provide a clause in the K that provides for changing the date of closing. Seller may be willing to take less money in return for an earlier closing date. j. Financing Contingency: Almost all buyers finance their purchases. Buyer might not get loan for 3 reasons: i. Pre-qualified buyers might have gaps in their mortgage application that cause a rejection or reduction in the loan amount. ii. Rates might jump up and buyer can’t get loan amount needed iii. Lender does not accept the sale price as the ―value‖ of the house. There must be an appraisal, and if the appraised value is lower than sale price, buyer is in trouble for loan b/c lender will only loan money for the appraisal value, not the sale value. k. Mortgage Contingency: You ask for the terms of the buyer’s financing b/c the terms of the financing will determine whether the seller is more or less likely to sell to you as a buyer. This allows for broker and seller to check on the riskiness of the buyer. (seller and broker are aligned) i. Insurance for Buyer – if the buyer doesn’t meet these terms, the buyer has right to walk away w/out losing their 10% ii. Dates – broker wants date to be sooner so he can lock in buyer. Buyer wants date later so that he has more time to get out. Seller wants early date b/c wants to know if buyer qualifies as soon as possible iii. Seller has option to boot out the buyer if buyer has not met terms by closing date. Buyer just has to honestly process a mortgage application. iv. Is there dishonesty in mortgage application? 1. Yes, possibly buyer puts something on application to ensure they don’t get the loan and won’t lose their 10% b/c they don’t want the house 2. But provision says that dishonestly done applications will lose the 10% deposit l. Approval Contingency: Individuals and commercial developers often want to make their obligation to purchase contingent upon getting regulatory approvals needed to use the land the way they want too. To ensure that buyer/developer does not back out by failing to prosecute the necessary applications, seller may want to put in a ―good faith effort‖ clause requiring buyer to work to obtain all necessary permits and get documentation of those efforts. m. Inspections: Inspection contingencies. i. There are 3 inspections: 1. Home, a. PAR ¶10 – 2 options i. (1) is not a litigable standard. If buyer backs out, and uses this inspection contingency option, the seller can’t litigate against them ii. (2) core idea is that you’re obligated to buy the house unless the estimated repairs exceed a certain amount. Then, if the buyer is not satisfied w/ the info, they may get a corrective proposal, which can include the name of the contractor 1. And you give the seller the opportunity to fix b. Seller prefers option 2 b/c under option 1 the buyer can walk away if they don’t like the house. c. There is time limit on the contingency period in each option i. Option 1 – Buyer wants low #, seller high ii. Option 2 – Buyer wants high, seller low d. PAR ¶28(c) – all repairs done in workman like fashion 2. Property, a. PAR ¶11 – 2 options 3. And Environmental n. Wood Infestation o. Radon Contingency p. Risk of Loss – CL Risk of loss is on the buyer under equitable conversion doctrine. q. Default r. Assignment – CL of assignment – you can assign your K rights. The original purchaser remains liable to perform the deal though. i. Real Estate Assignments are very common ii. However, every standard instrument in the real estate world will disallow assignment unless there is consent. iii. Seller doesn’t want buyer to be able to assign b/c of the trouble of finding a buyer they like and they don’t want it just assigned away. s. Merger: CL doctrine of merger works automatically. Once you accept the deed, the marketable title obligation ends. In commercial Ks, the agreement regularly contains seller’s representations and some of these may specifically survive the closing as warranties. t. Options: Rather than having an agreement of sale w/ a host of conditions, a buyer may elect to pay for an option to purchase. Seller will take a deposit and agree to sell for $X on terms set forth in the attached agreement of sale if the buyer tenders an executed copy of the agreement and the required down payment w/in X days. In that time period, the buyer does whatever investigation he deems appropriate. The agreement normally doesn’t have any conditions. u. ¶27-28 of PAR – broad based release – the scope of the release doesn’t cover some things that were covered up by fraud though. 5. Baldasarre v. Butler a. NJ In real estate transactions there are too many opportunities for problems to arise from dual representation. T/f in commercial real estate transactions, lawyers can’t represent both sides in a single transaction b. Other States you can represent both sides as long as the conflict doesn’t get too bad and you have a signed conflict letter so that both sides are fully aware of your dual representation. c. All brokers must be licensed – you might be able to recover under a broker’s licensing agreement i. You can also file a complaint w/ state licensing board if you feel wronged by a broker F. Marketable title 1. K implies marketable title a. Marketable Title: If I go through the record books, it looks like I own it, and if I go to sell it, someone will have no trouble buying it b. Most Real Estate has encumbrances today: i.e. mortgage, easements, etc. i. Most of the time the lien is paid in discharge. The money to pay off mortgage comes from the purchase price of the property ii. No one will take subject to a lien, unless it will be paid off in the purchase price. iii. People used to be able to assume mortgages (it was a way of assuming a better rate) – but no longer can people assume the old mortgage 2. Title Recording System: 2 components a. Deed Books – easements, covenants, leases are all contained here b. Mortgage Books – liens are contained here 3. Title Search a. Title companies go back maybe 45 years (adverse possession is an issue in this context) b. When buyer gets title insurance – title insurance company just searches for whatever they find to be satisfactory c. To perfect title: i. Death Certificate of previous owner ii. Make sure that the prior people in the deed line have died. 4. Van Vliet & Place, Inc. v. Gaines (NY) a. Deed 50 years back in the chain of title contained a reverter to the seller if the property was used for manufacturing or other specified uses. T/f was the title marketable if most of the prohibited activities are now prohibited by the zoning ordinance or would be a CL nuisance? b. This court considered the reverter to make title unmarketable. But this is a conservative approach i. Normally, only the owner who made the conveyance w/ the reverter could enforce it, but he made the conveyance 94 years prior. ii. The court said that the risk that the buyer might lose everything meant that the buyer shouldn’t have to take under any circumstances. c. Normally if court won’t enforce the reverter portion of the deed it is b/c: i. The covenant is so old, or doesn’t make sense anymore, the community has allowed the covenant to become unenforceable in equity, the covenant activities simply won’t fit in the space, etc. 5. Drafting Approaches – 4 approaches: a. Put Nothing in the Agreement b. Attach List of All Known Encumbrances: buyer agrees to encumbrances disclosed by seller as part of the sale negotiations. If there are other defects that were not disclosed, then those defects must be evaluated under the CL marketability concept to determine if buyer can rescind. c. Attach a List of All Known Encumbrances (Insurable Title Only): Attach a list of all known encumbrances w/ buyer obligated to accept title as long as the title company insures against any other defects. i. This approach uses the title company as an ―ADR‖ facilitator. If the policy is issued, the title company presumably believes there is no reasonable basis to be concerned about the defect causing loss to the buyer. d. Subject to Recorded Encumbrances: seller asks the buyer to take ―as is.‖ The title company will insure and say that it is fee of all liens, encumbrances, and easements except: i. Existing restrictions, historic preservation restrictions, building restrictions, ordinances, easements of the road, visible easements, privileges and rights of public service companies ii. See PAR ¶19 In commercial transaction this form would never be used 6. Remedies a. If the defect originated before the buyer, so the seller caused it, CL says that the buyer will accept property w/out any adjustments or terminate the agreement. (¶19D of PAR) b. You would be reimbursed for costs, get nothing for hassle and bargain, and some for expenses. i. You can K out of CL – this probably happens in big real estate transactions. ii. Forms are not protective of seller if title is nor marketable. Seller could be sued if unexpected title default occurs. iii. CL benefits the buyer c. If the breach is against the seller for anything other than inability to convey good title, what are damages? i. There is nothing against the seller except for ¶19(D) ii. T/f you have CL remedies or specific performance d. If buyer defaults – you look to ¶29 of PAR i. B and C. C limits seller to liquidated damages. B gives seller options. So you must decide what is worst case scenario for your client. 7. Only Title Needs to be Marketable (Environmental Risks): Buyers address the quality of improvements by obtaining the right to inspect and/or having the seller warrant the condition of the improvements. a. Environmental risks should be managed by providing for inspections and sometimes warranties. If buyer forgets to take care of environmental issues in the agreement, the only possible way to recover from the seller if the property is contaminated is to fashion together the best possible argument that the environmental risks should be treated as making the title ―unmarketable‖ i. Most states have rejected arguments to expand marketable title doctrine to cover risks other than quality of title ii. Some courts have imposed a duty to disclose known environmental problems G. Deeds and Covenants of title 1. Recording Act a. Conveyancing Documents: all property has to be in writing from grantor, then it is put into a filing system. b. There are errors in the recording system – t/f there is Title Insurance 2. Agreement of Sale: the agreement of sale will specify what form of deed the seller must deliver a. General Warranty: Affords maximum protection to the GE b/c it contains all the standard covenants for title: covenant of seisin & covenant of right to convey (these 2 are identical), covenant against encumbrances, covenant of quiet enjoyment & covenant of warranty (these 2 are identical), and covenant for further assurances. You can look back in chain of title as far as possible. b. Special Warranty: GR merely warrants that it has done or suffered nothing to encumber the property and does not warrant against acts of the GR’s predecessors. c. Quitclaim: GR makes no covenants at all and simply promises to convey to the GE whatever interest the GR might have in the property. d. Fiduciary’s Deed: An executor or executrix of a decedent’s estate conveys the decedent’s property to those who are to receive it under the will or to a 3rd party buyer. A fiduciary’s deed is ordinarily w/out warranties. 3. Custom: In PA – special warranty deeds 4. Covenants: a. Seisin and Right to Convey: GR owns fee simple subject to any encumbrances stated in the agreement of sale. It is a present covenant (to be breached, it must be breached when made) only to the GE (it does not run w/ the land, i.e remote GE’s can’t avail themselves of it). Actual eviction by a competitor triggers the SOL. Action for money damages whenever the defect is discovered is remedy. The max damages are considerations paid to GR. b. Against Encumbrances: GR owns said premises free from encumbrances. It is a present covenant only to GE. Actual eviction by competitor triggers SOL. Measure of damages is actual loss suffered by GE. If the deed is a special warranty, then the GR is merely covenanting that HE has not done anything to encumber the land, it says nothing about predecessors. c. Warranty & Quiet Enjoyment: GR will forever warrant the title to said premises, quiet enjoyment of possession. This is a future covenant and is not broken until there has been a disturbance in the future and runs in favor of remote GE’s. Damages are actual loss, but not in excess of the purchase price plus interest. 5. See Problem p. 22 in Study Guide and answers in notes on 9/29/06 H. Remedies on Default 1. Compensatory Damages: The remedy at law for a breach by either the buyer or seller was compensatory damages 2. Specific Performance: Land is considered unique and, t/f, equity courts awarded specific performance to buyers. In most states, courts rely on mutuality of remedy concept to award specific performance to sellers 3. Buyer Forfeits Deposit: Deposits or down payments are standard in real estate sales b/c there is always 30-120 days or more b/w execution of K and closing. Putting up the deposit proves to the seller that the buyer is really interested and the deposit also secures the buyer’s performance. A deposit is almost universal b/c if buyer gets cold feet and defaults, the buyer might sue to recover the deposit if the seller resold the property quickly and did not have material damages. a. The defense to a forfeiture of a deposit is to assert that the forfeiture is a penalty. b. Court will decide if the amount forfeited is reasonable given time, place, and circumstances at the time the K was executed. c. Courts will also use independent criteria of whether damages flowing from a breach are readily provable or ascertainable. Most cases hold that damages that follow from a breach of a real estate purchase K are not readily ascertainable b/c of the unique nature of each parcel. T/f the parties bargained for liquidated damages amount and it will be enforced if the amount is reasonable. d. Sellers are not limited to liquidated damages, UNLESS the K language is specific. I. Title Protection 1. O to A 1995; O to B 2000 a. Inquiry Notice: Even under recording statutes, most of the time A is protected if A fails to record b/c A takes possession of the real property and B is deemed to have notice of whatever information B would obtain if B asked A why A was in possession. b. Land Scams: In the example if O is a thief. O sold property twice. Thus whoever wins b/w A and B, O has a second fraudulently obtained payment. O ordinarily has great difficulty perpetrating the fraud. Professionals always make sure the buyer’s deed is recorded and most of the time the buyer take possession. c. Mult Liens: The recording act establishes priority among multiple mortgages. Most people have multiple liens on their property d. Deed: deed gives you title, but it is not title. i. If you don’t record your deed, you get penalized. So if A didn’t record, B would get. 2. Who is Protected under the RA? a. BFP’s – bona fide purchasers for value w/out notice 3. Record Notice a. Acknowledgment: An acknowledgement is a notarized document i. A technically deficient document is excluded from constructive notice, ex: if the document lacks an acknowledgment. ii. If there is a technically deficient document that is recorded, then there is no notice, even if you find it in the search. You may have actual notice, but you don’t have constructive notice. 4. Off-Record Notice: Anytime anyone fails to record, there is a likelihood that the possession is going to be taken away. a. Inquiry Notice: Possession gives notice that creates a duty to inquire b. Impact of Quit Claim Deeds: i. Extreme: No BFP if thee is a quit claim deed in chain of title ii. Less, but still extreme: A GE under a QC deed is not a BFP iii. Notice: Duty to inquire about 5. Notice Types: a. Race: whoever records first wins b. Race/Notice: if you are a BFP and record first, then you win c. Notice: Doesn’t matter who records first, it just matters who has notice (actual or constructive) 6. Applying the Recording Act: a. First Tier Transactions – involves claimants who dealt directly w/ a common GR. [ ] means recorded i. O to [A] 1998, O to B 2000 1. B is out of luck b/c A in all 3 scenarios ii. O to A 1998; O to [B] 2000 1. B wins in all three. A never recorded his interest. iii. O to A 1998, O to [B] 2005 knows A’s interest 1. Race: B 2. Notice: A 3. R/N: A iv. O to A 1998; O to B 1999; 2000 [A]; 2004 [B] 1. Race: A, b/c A recorded first 2. Notice: B, B took w/out notice and A did not record until after B already took. Doesn’t matter that A subsequently recorded. B took in good faith and for value. 3. R/N: A, b/c B did not record. So when A recorded, A had no notice of B. b. Second Tier Transactions: When claimant doesn’t claim under O, the common grantor, but claims under A or B i. Derivative Title: If the A/B contest is won by B and B conveys to C, then C owns the property free and clear of A’s claim. C does not need to be a BFP, C could be a donee. ii. First Tier: O to A 1998; O to B 1999; 2000[A]. Second Tier: A to C 2005 [BFP] 1. Race: A beats B and A conveys free and clear to C. 2. Notice: B beats A, but B doesn’t record and creates a risk. That risk matures when A conveys to C and C has no notice. T/f C as a BFP w/out notice wins in notice jurisdiction. 3. R/N: A beats B and conveys free and clear to C. iii. First Tier: O to A 1998; O to [B] 1999 knows of A. Second Tier B to C 2000 [BFP] 1. Race: B beats A and B conveys free and clear to C 2. Notice: A beats B b/c B had notice of A. But A creates risk by not recording a. That risk matures when B conveyed to C. C was BFP and did title search. T/f C takes. 3. R/N: Same as notice. c. Wild Deed: These cases arise when a tier one GE fails to record, but a tier two GE under the tier one GE does record. i. Ex: O to A 1998 (no record); A to BFP #1 (1999) records; O to BFP #2 (2000) records 1. If BFP #2 looks for title chain, he won’t see BFP #1 2. BFP #1 should have made O to A record, but didn’t 3. So BFP #2 is in good shape and gets protection of RA d. Scope of Search: You begin the search from the date of the deed the person received it and search down in GR index until the date of a recorded deed out. (this is b/c normally people don’t make a second conveyance) i. Ex: O to A in 1998; O to [B] 1999 knows of A’s interest; [A] 2002; A to [BFP] 2005. 1. If BFP searches back, he’ll see that B recorded first. But in a notice or R/N jurisdiction A wins and B has no claim. 2. The title insurance company probably won’t search all the way back. They’ll assume the risk that it is unlikely someone would convey 2 times. ii. Common Grantor: Multiple Parcels 1. O owns Parcels 1 and 2. O to A parcel 1, 1990 w/ restriction of residential only. Parcel 2 is residential only as well. 2. O to B 2000. During search B won’t find the restriction on parcel 1. Does B have to read the deed to avoid risk of imputed notice of the terms of the deed? 3. If you represent A, you want to have the restriction that was recorded to also be filed so that it can be seen in the chain. 4. This could be done w/ a declaration of covenants, restrictions, and easements. 5. So when O says the entire thing is going to be residential, he files this declaration and subjects the entire parcel to it and it will be known. e. Judgment Liens i. States vary on whether a judgment lien is protected by the RA J. Title Insurance 1. Title insurance is a preventative practice. The policy will cover a handful of risks that require a search. 2. The industry is opening up and taking higher risks, but charging higher premiums 3. The insurance rate setting mechanism is part of the state regulatory insurance scheme a. It is exempt from federal anti-trust regulation 4. Insurers must keep certain reserves, but these reserves are always small compared to risks 5. The more insurance you buy, the less the rates are a. Ex: $500K-$1M = $3.75 per 1000; $1M-$2M = $2.75 per 1000. 6. You can usually buy title insurance in the amount of the value of your house K. PA Real Estate Disclosure Act/ALTA Form 1. ALTA Form a. It gives you areas and enumerates what is covered. It also gives exclusions: i. i.e. We won’t cover you if you commit fraud b. Schedule A: This gives you basic information c. Schedule B: This is most important. This gives exceptions of what the policy will not insure against loss or damage i. Generally they won’t insure you against any 1. Easements 2. Anything they find in the title records 3. Anything they need receipts for (receipts are needed for real estate taxes) ii. Since this is a national form, local practice will put in standard exclusions. There is a sample of regional exclusions at the bottom of p. 145 of the Supplement. 2. See Questions p. 137 of Supplement and note from 10/3/06 Chapter 3. Mortgage Law A. Mortgage Law in a Nutshell 1. At CL conveyance that creates a mortgage is a deed passed from MR to ME, in which the MR is allowed to remain in possession of the real estate during the duration of the mortgage. If the MR paid amount plus interest back in a timely manner, he go the property, if not the ME got it (condition subsequent fee simple if the loan isn’t paid) 2. Equity Response: MR could redeem or buy back property from ME w/ showing of fraud, accident, or some other equitable ground Equitable Right of Redemption (power to redeem) S a. But this left lender in limbo, how was he to know when he owned land 3. Lender’s Relief: Strict foreclosure. ME would ask the same chancellor to cut off/foreclose the borrower’s equity relief 4. Theories: a. Title Theory: ME obtains both legal title and right to possession of mortgaged premises (title transferred in the mortgage process b. Lien Theory: ME obtains a lien on the real estate i. Fee simple determinable ii. Condition subsequent 5. ME’s Remedies Now: a. CL Strict Foreclosure: Lender keeps the mortgaged property upon cutting off borrower’s right to equity of redemption b. Judicial Foreclosure: Property is sold pursuant to a court order c. Power of Sale: Foreclosure is authorized w/out a judicial proceeding under a power of sale contained in the mortgage deed or deed of trust instrument d. Deed of Trust: The property is conveyed to a trustee. In the event the borrower doesn’t pay, the trustee sells the property. 6. MR’s Remedy: a. Statutory Redemption: MR has right to buy back the property after foreclosure by paying the foreclosure sale price to the purchaser at the sale. b. Pa Act number 6, §404; FNMA Mortgage ¶¶19&25: Borrower can pay any accrued arrearage up to the date of the foreclosure. Borrower only has to pay the gap in what has not been paid. There is no requirement to pay the entire accelerated balance. Chapter 13 also says the same thing. i. Note: PA Act 6 says you don’t have this option if the mortgage is under $50K c. Lenders allow this in home mortgage setting b/c it is not good for public image to foreclose, and it is also expensive. d. Mortgages with a payment plan: when a default isn’t cured, the mortgage loans are accelerated (paragraph 19 of the Fannie Mae mortgage form) B. Nature of Mortgage Law 1. Mortgage as Security for MR’s Performance a. A mortgage almost always secures the amount that the borrower borrowed from the lender to finance the purchase of the property. b. Jeffrey Towers i. Unliquidated debts. Can an unliquidated obligation ever serve as the basis for a mortgage? An obligation that is enforceable in common law courtd YES ii. Almost everyone has assets hot in their personal portfolio in order to back up loans made by their corporation. (Personal guaranty) iii. Rule: A mortgage can be used to secure anything as long as it is reduceable to monetary damages. But if the damages are speculative, you can’t get damages. 1. Mtg can secure unliquidated debt (promise to secure zoning) if the debt is determinable amount at the time of enforcement. Some breaches can’t get compensatory damages such as speculative damages like future profits. iv. Ex: Stop Smoking provision: This has no monetary value that is translatable. v. Ex: Uncle to cancel $5000 if Martin stops smoking: This has monetary value that is ascertainable. c. Restatement §1.4 – a mortgage is enforceable only if the obligation whose performance it secures is measurable in terms of money or is readily reducible to a monetary value at the time of the enforcement of the mortgage d. Hypo: Contractor secures its obligation to build an apt by giving the owner a mortgage on the contractor’s property. Contractor defaults. Is there valid debt? i. Yes, b/c the value of the contractor’s property is translatable into $ at the time of the debt e. Note: Debt is thought of as a fixed amount, but debt can be increased w/ interest, fees, chargeable expenses, or w/ more loans. But your loan is recorded not recorded after these possible increases. This could be a problem b/c the loan amount could be larger than what is recorded. 2. Note as obligation a. Intro: i. A mortgage secures a debt or other obligation that is reducible to money 1. The mortgage itself is technically a conveyance of property for which consideration need not be given. 2. But the correct characterization is the obligation secured by the mortgage must be supported by consideration 3. Charitable promises to give donations are not enforceable ii. FNMA Mortgage: 1. It is a traditional mortgage b/c a. It secures a note in a fixed amount that reduces over time b. The mortgage discloses the amount of debt 2. It is not a future advance or dragnet mortgage b/c only a single debt or borrowing is secured by the mortgage. b. Additional Borrowing from the Original MR i. Future advances or Open End Mortgage: The mortgage will state a line of credit, but the actual debt owed fluctuates. 1. Rst: A mortgage is a future advance if it secures performance of an obligation that comes into existence or is enlarged after the mortgage becomes effective 2. i.e. construction loan: loan in installments per phase- so that corresponding collateral of construction can be secured…File on a fixed amount, loan a fixed amount, but you haven’t advanced any money initially. When the architect certifies things have been completed, money it disbursed. Banks finance only when it’s finished. 3. If there are no future advances in the document then you can’t pick them up c. d. e. f. ii. Hypo p. 41: If construction lender had discretion to make an advance, then any subsequent advances would not take priority over an intervening lender. 1. But this law changes from jurisdiction to jurisdiction iii. Open End Mortgages 2 categories 1. Home Equity Loan: A transaction that contemplates multiple borrowings, but for a fixed amount. It is basically a line of credit 2. Construction Loan: An agreement to advance money as the building goes up. Emporia State Bank: The Mounkes financed the family’s purchase of its home w/ a home mortgage. 8 years later they obtained an unsecured loan from the home mortgage lender. The lender contended that the second loan was automatically secured by the home mortgage: i. Dragnet Clause: consumer protection issue: home equity loan: this has no cap like construction loan ii. Court in Emporia: dragnet clause unenforceable because the second loan has no relationship to first one and no specific mention thus they together suggest no intention to be bind first Mortg. No bargaining about line of credit. iii. Restatement §2.4: dragnet enforceable only when: (1) the parties agree that such advances will be secured; (2) the transaction must be of similar character or related to the same transaction or series of transactions as the principal obligation (Specific and limited); (3) the document evidencing the subsequent advance refers to the mortgage as providing security therefore iv. Typically, Dragnet clauses are not going to be enforced in residential clauses You only see future advances w/ (1) Construction Loans and (2) Home Equity Loans. i. These are safe b/c of the capped amount. Priority theories i. Best - All construction loans taken together, then 2nd mortgage 1. Must provide notice st ii. 1 construction loan, 2nd mortgage, then advances form construction loan After acquired property: disfavored – not really used i. Maj: After acquired property will be considered a promise by the MR to subject the after acquired property to the lien of the mortgage. ii. Minority: Only when the subsequently acquired property bears a functional relationship to the property originally mortgaged iii. Reasons Not Used: 1. No reason for MR to agree to such a provision and subject land they acquire later to this danger 2. RA problem. If you own property in PA and subject it to after acquired clause, then buy property in NY, the clause is not filed in NY leaving any subsequent lender in NY unprotected. iv. Exception 1. Building the railroads…The railroads were financed by mortgage bonds secured by the real estate that the road bed was on. The railroads didn’t own the road beds all along, purchased the beds on the way through. The collateral was the operating railroad. g. Non Recourse Financing i. Payee of note agrees to waive a deficiency judgment against maker ii. Typically the improvement is substantially rented insuring high value iii. Debt is large compared to the resources of the maker or guarantor iv. Maker develop has strong track record and repeat business is important v. Where borrowing entity is a limited partnership or LLC achieving favorable tax treatment may be dependant on obtaining non recourse financing vi. Allows a more efficient use of the depreciation deduction by the members of the LLC h. Mortgage Law Issue i. Purpose of the mortgage if there is no personal liability is to create a mortgage lien of specific collateral to satisfy a specific debt 3. Personal Liability of Mortgagor a. Bedian: Non Recourse Provisions i. Non- Recourse Loan: The ME releases the MR from paying the deficiency of the debt in the event that the collateral (property) is not enough. It is the ME’s prerogative to enter into this type of agreement 1. In Limited Partnerships, the limited partners are like stockholders with no personal liability in the firm, but the general partner is the only person who has personal liability on the note. Where collateral has a high value…Taxation benefit ii. In case of default, L only has payment received and equity of down payment and not to a deficiency through personal asset of B. b. Note triggers personal liability but ME waives that right to personal liability c. Common to commercial lending: why? Bs usually don’t have a lot of money and is usually protected through limited liabilities entities. L is usually interested in income producing capacity of bldg- the rental income- this is the real collateral d. ―Carve Outs‖: measure of recovery: i.e. if project is abandoned- we will go after you personally. ―We wont’ go after you, unless x,y,z happens‖ i. Payee lender may only be willing to given on recourse loan if one or more conditions are satisfied or if certain bad things don’t happen, ie. 1. Building finished and opened by a specific date 2. Plus gross rental income from approved leases is at least 1.5 million 3. No material errors or misrepresentations in the loan agreement e. Tax reasons for limited liability: If recourse is used instead of non-recourse, the partners may not be able to deduct their distributive share of tax losses in excess of their equity investments. 4. Equitable mortgages : when there is no document a. Generally, mortgage must be in writing per statute of frauds- involves transfer of interest in land b. Oral Transactions: parties did not execute a writing that created a mortgage, but the court finds intent to create a mortgage and imposes an equitable mortgage on the land i. Statement of the parties ii. The presence of a substantive disparity between the value received by the grantor and the fair market value of the real estate at the time of convenience iii. The fact that the grantor retained possession of the real estate iv. The fact that grantor continued to pay real estate taxes v. Who paid the post-convenience and improvements c. Technically Defective: Equity will enforce writings that are deficient in some way to create a legal mortgage d. Equitable Lien as a Remedy: A defrauds X and uses the gains to build a new home. If the facts are proven, an equitable lien may be imposed upon the new home. e. Absolute Deed Disguised as a Mortgage: A goes to his brother and says if you loan me $X, I will deed you my house and brother orally commits to deed it back when A pays him back. Then brother refuses to deed the house back and he now has fee simple conveyed in a deed. i. A’s Burden of Proof: He must prove the intent of the parties by clear and convincing standard w/ evidence that the conveyance was merely intended as a security device ii. Factors that A can use to show this: 1. Statements of the parties 2. Presence of disparity b/w value received by the GR and FMV at time of conveyance (important one!) 3. Did GR retain possession of real estate? 4. Did GR pay real estate taxes? 5. Did GR make post conveyance improvements? 6. What was the nature of the relationship b/w the parties before and after the conveyance? iii. Caveat: If Brother recorded the deed, then he can convey to a BFP or borrow from a ME. If the BFP or ME fulfilled the requirements of a Notice or R/N jurisdiction, he would cut off A’s equity of redemption iv. If there is a big disparity, you are subject to equitable doctrine…maybe recommend that they make it a mortgage instead of not. v. Don’t want to ever create an absolute deed with a family member because you may have problems with them and they won’t give you the mortgage back. vi. COULD structure this as a sale with an option f. Negative Pledge: It is a loan that is unsecured that provides that the borrower will not encumber its real or personal property w/ a mortgage or a security interest. i. Present Rule: In the absence of other evidence of intent to create a mortgage, a promise by a creditor not to encumber or transfer an interest in real estate, does not create a mortgage, equitable lien, or other security interest. g. Vendor and Vendee Liens: i. Vendee Lien: This is the buyer’s lien. If there is money that the buyer put into deposit, and the seller won’t give it back, then the buyer can put an equitable lien on their property. Equitable remedy for that particular real estate transaction, if there was a state insolvency proceeding, remedy of the uninformed who turned money over as a down-payment of a seller. ii. Vendor Lien: If the vendor conveys the property and does not receive full price they are given a similar lien on the property for the balance for the purchase price. There could be situations where you pay 85% and you pay the balance in a year. C. Deed of Trust as Mortgage substitute 1. Trustee owns the legal title- trustee will foreclose property upon default a. Pros Sidesteps court supervision; avoids time and money cost; possible that trustee sales tend to get better prices b. Cons the title that lender gets may not be as secure- there may be defects, and there may not be default. But this risk is manageable because of the title insurance (Police the files) 2. Consumer Protection quirk: It is good for lender, some lender will pay extra to use this in lieu of mortgage: Ex: In CA the lender will waive the right to a deficiency. Becomes non recourse mortgages. Can foreclose deed of trust in 20% of the time the judicial foreclosure takes. 3. If trustee rigs the bidding (clog the sale), or trustee is an employee or principal of lender, then sale can be set aside (or right to stop the sale by injunction) if it can be proven. a. A lot of cases trying to void sales citing non-independence of trustee- should select someone independent unless it is completely clear that it is ok. b. Some states have protected or allow certain conflicts. Resolution: Institutions serve as trustees (Trust companies) 4. In Re Bisbee: not naming trustee is not significant. The equitable ownership is in the beneficiary. 5. Some concern that statutes provide inadequate protection to junior lenders…protection mimics judicial foreclosure more, except there is notice of trustee sale rather than judicial captions. 6. Independence of Trustee: a. CL: there cannot be any association between trustee and lender b. UCC: lender’s agent OK so long as the sale was commercially reasonable c. Statutory: lender’s agent OK, is excluded from the bidding strategy D. Seller Financing: Installment Land K Installment Land Contract: Seller Financing= Absolute Deed with condition subsequent. These are attractive for people who can’t get mortgages. (Trade: Deed for mortgage) 1. The idea is that the buyer will pay over X number of years. But there is a condition in the K that he seller promises to deed the property to you if you make a certain number of consecutive payments of X dollars. 2. Risk: Title may not be marketable at the end of the term; Seller refinanced a. If you miss one or two payments, you lose everything: payments, appreciated value of property, and property itself b. Also, in the classic installment land contract, when you default, you lose the right to buy the property. You lose not only the money you spent in installments, but the interest on the property value since you started making payments. 3. Response to Buyer’s Plight a. Penalty Analysis: Courts police the forfeiture provisions by examining in each case whether the buyer’s loss would constitute a penalty. i.e. if tenant has paid up to X dollars, we won’t enforce. b. Rst: Treat the installment land K as a mortgage 4. Issues arising in Installment Land Contracts: a. When is title due? Full or partial price? Usually buyer must make certain number of payments b. Can you prepay? c. Who has possession? Purchaser takes possession upon execution of K, while seller retains legal title. d. Who pays RE taxes? Buyer??? e. When does seller have to have marketable title? By the time the purchaser completes the sales K…No buyer guarantee that seller has to prove he has marketable title to a potential purchaser. PA statute protects. f. What are buyer’s remedies for breach? Refund isn’t adequate b/c buyer’s total loss includes time and value of appreciation of the land. If the property goes up big and quick you breach to get your installments back g. When seller sells, he could have an existing mortgage, meaning you are acquiring an encumbered property 5. Drafting: a. Want to create opportunities for buyer to avoid consequences of default b. Want to have buyer have a way to share in value of foreclosure c. Want buyer to be able to record K of Sale so that the buyer ―owns‖ it and no subsequent BFP can cut him off. But you need to make the K of Sale a recordable instrument. 6. Remedies a. Restatement: Ignore the form of the transaction and make it a mortgage b. UCC – if you set up a transaction as a conditional sale, it isn’t a conditional sale…title passes, and you retain a property interest c. Prevention of unjust enrichment of lender. Check to see if the total payment was a fair value of rental for the property. If you paid more than fair value of rental you get that back. However, you won’t get back the interest on the land d. Equity may not enforce contractual remedies that enforce penalties (to attack an installment land contract as unenforceable when you have a large paydown of principal) 7. EXAMPLE a. Paid down 100 million to 44.5m = 55.5m b. Sell for 130m yielding total of 185.5m to lender c. Seller’s bonus over debt is 85.5m d. Buyer’s loss of equity of 55.5 reduce principal and 30m price increase for 85.5 loss compared to mortgage foreclosure e. Demonstrating classic common law installment land contract…equity is lost f. Veteran’s Administration Sales use this method of financing E. Mortgagee’s Lien v. Other Interests in Real Estate 1. Priority Status: a. Basic Rule: The ME is secured by MR’s title as of the date the mortgage is executed. Any subsequent conveyances by the MR do not in any way change the MR’s security. This assumes the ME recorded the mortgage, if he did not another ME may be able to trump b. A mortgage takes subject to the easement and lease. Recording act sets higher relationships to the interest. c. When a ME forecloses, they can’t impact pre-existing liens, or easements. Can’t force a senior lien off d. Titles after Foreclosure (PMM forecloses) (fee subject to mortgage). PMM is able to offer at foreclosure title subject to easements and restrictions. i. Doesn’t effect easements and subdivisions ii. Clears off Lease iii. Clears off 2nd mortgage e. If 2nd Mortgage forecloses: (Collateral – reversionary interest in the estate. Subject to 1st mortgage and easements and restrictions) i. Easements and subdivision? NO ii. PMM? NO iii. Lease? NO f. ME’s Foreclosure: will extinguish any and all interests created by the owner after the mortgage as long as they are joined in the action, but any interest existing prior to the mortgage are not affected g. Exceptions to the RA rule of first to record: i. Unpaid Real Estate Taxes: RE tax lien has priority over all other ME’s and other lienors ii. Mechanic’s Lien: ML’s are not dated as of the filing date, but relate back to the date on which construction job started iii. PMM (purchase money mortgage): PMM’s often have a 20-30 day grace period to record and have a relation back to the date of execution 2. Subordination and Non-Disturbance a. Priority of Liens: parties are free to contractually re-arrange their priorities b. Priority Among ME and Lessee: i. Subordination: ME may subordinate the mortgage to the lease in order to protect a strong tenant w/ a long lease. Or, it the value of the land is less valuable than the debt, then their collateral improves. (The revenue source minimizes a default) 1. Conversely, a tenant w/ priority status may subordinate to a new loan/refinancing in order to benefit from the improvements. ii. Non-Disturbance: A powerful tenant will subordinate itself to the mortgage w/ the agreement that upon foreclosure the lease won’t be terminated. iii. Attornment: Tenant accepts and acknowledges that the purchaser at a foreclosure sale is the new landlord for the balance of the term. This helps to avoid issues of quiet enjoyment b/c QE is implied breached by foreclosure 3. Chart p. 133 Direct v. Indirect Encumbrances a. See Answers to Questions in Notes 10/17/06 4. Direct or indirect encumbrance? Fee people, lease people, ten the sublease people. If sublease people affected, lease and fee people aren’t affected. Chapter 4. A. Prefinancing Considerations: How Do you Figure Out How Much a Building is Worth? 1. Two Kinds of Loans: construction and post construction a. Construction: Short term; collateral is land and dirt initially, then the building as it goes up piece by piece; more risk involved so they get 5-6 points over prime; generally recourse b. Post Construction: Long term loan; generally non-recourse c. Note: Generally you can’t get a construction loan w/out a post-const L in place. Some well established builders may be able to though. 2. Selecting the Real Estate: a. Buying real estate and rental income b. Basic Formulas i. Rental Income – Expenses = cash flow ii. Taxable Income (x) Rate = (tax) iii. Cash Flow – Tax = Available Cash iv. % Yield for the Year = Available Cash / Investment c. In conservative market, lease commitments are needed with tenants list; if no leases are required- then it is a speculative bldg. d. Rental income is the actual collateral for post con loan; the reason as to why non recourse loans are made (D is usually a corporate entity that has no asset anyway) e. The most pertinent info to making a loan to build a building is demographic info: What companies want is growth potential, indication that it can be rented f. Existing Building: i. Gross income and expenses for future years are based on historical performance and scheduled rental increases g. New Building: i. No record. T/f obtaining solid tenants is the highest priority. h. Expenses: Include debt service and interest paid on mortgage 3. Permanent Financing: a. Commercial Lending Cycle: (1) Post Const L commitment; (2) Obtain Const L commitment and Buy Sell Agreement; (3) Buy/Sell Agreement b/w developer/post const L/const L; (4) Const L closes and disbursements authorized; (5) Construction is funded by disbursements pursuant to const L; (6) Post Const L closed when commitment conditions are met. i. There are times when the construction loan is done before a permanent loan. (Mostly done in speculative markets where people want to get in) ii. Buy/Sell: Agreement among the construction lender, post-construction lender, and Borrower under which the constL agree to sell and the PCL agrees to buy the construction loan. T/f the constL and borrower can gang up on PCL if he tries to get out. b. Sources of Permanent Loans: Life Insurance Companies, Savings Banks, and Commercial Banks these entities vary on what they like to engage in. i.e. Life Insurance doesn’t really like long term loans. i. Additional Sources: 1. Pension Funds (TIAA CREF) 2. GE Capital (GE Credit) 3. Wall Street – best place to get cheap money. Able to get money b/c of securitization. People are buying non-recourse paper in chunks with a minimum of $1 million. Other institutions who don’t want to invest in one building are investing in several buildings B. Negotiating the Mortgage Commitment Commitment: Addresses in summary form both the deal terms and the details of the loan agreement, mortgage, and note. Commitment is long and involved because it addresses in summary form both the deal terms and the details of the loan agreement, mortgage, and note. These issues must be resolved between developer and lender. 2 Kinds of Commitment: Unilateral: Residential, Fannie Mae (FNMA). A goes to bank and applies for loan. If bank makes A the loan, they offer a rate for $X w/ terms. If A doesn’t sign, A has just paid for application fees, etc. There is not much recourse for lender if A doesn’t take it. Bi-Lateral: Commercial. B/c the amount of money is so high, there is generally recourse if A doesn’t take the loan. You can’t just leave it and shop for a lower rate if lender goes through trouble to figure out financing for you. K Analysis: Loan application is borrower’s offer to borrow a certain amount of $, and the commitment letter is the lender’s acceptance of the offer. By executing a commitment letter, both obligate themselves Core terms for post construction loan commitment: (Economic package) Amount of loan - How Much (most important) How Long Amortization Schedule Guaranteed Maturity dae Pre-Payment (i.e. you can’t prepay for X years) Interest Rate Description of Land Generic Terms: In addition to the above, the commitment should also contain the following customary conditions and requirements Documents: everything that evidences or secures the loan Title Insurance: must be insisted upon - Required Survey: Required w/in reasonable time prior to date of closing of mortgage Hazard Insurance: In amount and form satisfactory to both sides Construction loans: Lenders must approve Fees and Expenses: Lender imposes upon the Borrower fees for the above plus attorney’s fees. Lender’s Possible Conditions (Can’t breach a condition) (In contemporary drafting, shall is the trigger word for a promise, and “must by a certain date” is a trigger for condition) Rent Achievement: Borrower shall deliver to the lender a rent roll certified to be correct, indicating the apt of which said rooms comprise the total rooms relied upon to satisfy the condition Sometimes this will include requiring a ―lead tenant‖ New Construction: Construction loan generally requires a permanent loan to be in place and that two lenders and the developer execute a buy/sell agreement. The const and post-const loan commitment will address important aspects: Start and completion date for construction: Need firm dates. If you don’t start the project by X, what happens? Approval of plans and specs: before you get the $, we need to approve in advance. Completion as planned: construction loan-maker wants to be sure that it is getting as security what it bargained for. Compliance with applicable law: zoning- environment- construction Infrastructure: Must be ready when you start…Cases when commercial building is finished but the road isn’t there. public facilities, street access, etc. Fees: Cost to Borrower: Application Fee: The cost to get you in the door w/ the bank. It is a fractional percentage of the loan paid simultaneously w/ the submission of the application. Lender must appraise property, evaluate borrower, and determine economic feasibility. Commitment Fee: Security deposit to protect the lender against uncertainties of the money market, since the borrower may go elsewhere. Standby Commitment: Unilateral commitment. All residential commitments are unilateral. Borrower will ask for this. It states that lender is obligated to make, but the borrower is not obligated to take, the loan. This is a last resort to the borrower in hopes that he can find more favorable financing. Lender will charge fees while the commitment is still outstanding/pending. Generally used as hedges. (How much will you charge me to guarantee that you will be able lend me this amount of money at this interest rate during these periods). 8. When you buy a building, you buy the land, the building, and the rental value of the property a. If the interest rate is too high, a rent structure may not sustain a profit TIAA v. Butler: Prepayment Penalties TIAA provided the final note and mortgage which included a ―default prepayment fee‖ which provided that in the event of default on the loan or if payment necessary for entire indebtedness is tendered, it is considered an evasion of the prepay fee and will require payment of a prepay fee. If it happens before the 17th year is up, then the fee is tripled. When they accelerated the fee, you just pay it off Borrower shopped around after they got their interest rate. Rates drop, then rental rates drop because cost of renting space go down. Building and Defendant in CA, TIAA deal located in NY: NY law governed because lawyers in their documents put in a choice of law provision describes where they practice. Commitment: $20 million / Int. Rate: 14.25% / Kicker: Present / Prepay lock-in: 17 years (Cannot prepay for 17 years – no refinancing) / Default Prepay Fee: 18% Note on Policy: A lender makes loans as a business and relies upon those deals to earn money. If a borrower repays quickly against deal terms, then lender’s calculations re: the loan are down the tubes and it loses money. Moreover, the borrower can now just re-borrow at a better rate. However, you can’t have a bar on prepayment b/c it will be considered a penalty. Lock-in: Not able to prepay for X years. Borrower wants short lock-in period, lender wants long Kicker: If market it tight, lender will put a kicker in. Kicker says when we have success, you pay me additional interest. Good Faith Argument (TIAA-CREF): Borrower didn’t act in good faith in this instance. Went out and shopped for a better deal. Had documents in possession for 9 months. Didn’t object to prepay language until 4 days before closing. Didn’t make a counter-offer, simply refused to negotiate and asked for total deletion. Industry Practice: Prepayment fees are OK. Fee must be w/in bounds of industry practice. The finding that prepayment was customary was very important to TIAA-CREF’s success. Big Picture: Boiler Plate v. Deal Specific: Expected Boilerplate: Typical terms that shouldn’t surprise either party. Repairs, insurance, maintaining the property, not degrading the property (Protecting security interest of lender) Deal Specific Terms: These should be negotiated up-front in conformity w/ the document. Problem 4.1 - 25 million dollar loan, 3% in fees that are deposited. A change in the rate of 3%/year ($750,000). In big transactions. Not an impediment because you are saving 3% every year. How do you structure these fees, and what are the options. C. Remedies for breach of mortgage loan commitments 1. Concerns: If interest rates go down, borrower wants to walk and find better financing. If interest rates go up, lender wants to breach and re-lend money out. How do we prevent this result? 2. Breach of Commitment by Borrower: Lender’s remedies a. Three Types of Commitments: i. Unilateral: Residential. Binding on the lender alone. It is an option K in essence. Lender will lend, but borrower doesn’t agree to borrow, just has option to borrow paid for by application fees. In this instance, there isn’t anything to worry about for breach by borrower b/c it isn’t an issue un a unilateral K. Only issue arises in breach by lender. Then borrower seeks borrower’s remedies ii. Bi-Lateral: Binding on both parties. Lender can recover if borrower refuses to close the loan and if lender can prove it has suffered damages as a result of borrower’s default. iii. Standby: It is a form of a unilateral K. It is non-refundable compensation paid to a lender for an option to borrow if borrower can’t get less onerous loan from someone else. b. Liquidated Damages: A refundable commitment fee enforced if (1) damages are not ascertainable w/ reasonable certainty; (2) the predetermined amount is not excessive. i. Issue: Determine LD at time of breach of K or at time K was entered into 1. These are measured at the time the K was entered into in LD ii. Difference b/w liquidated damages and security deposit: 1. Liquidated Damages: Lender keeps money in the event of a default. It is a percentage of the loan. No actual damages are calculated 2. Security Deposit: It is a deposit against which a lender can seek actual damages in the event of default. Lender will keep the deposit as partial payment of the actual damages. a. Actual Damages: The difference in the interest rates c. Specific Performance: Ordinarily SP is unnecessary b/c damages are ascertainable and they are adequate. SP is only warranted when damages are (1) unascertainable and (2) damages are not adequate at law. i. BUT If lender defaults borrower can’t obtain any other financing (typically during construction phase), then SP may be granted anyway. This is b/c at this point the borrower’s remedy at law isn’t adequate. He can’t go out and obtain new financing b/c (1) there is a lien already from the first mortgage and another lender will be secondary to that; (2) borrower is precluded from refinancing w/ PCL b/c the project is incomplete. ii. Note: Lenders do not get SP against borrowers d. Solutions: i. Lender should have an allowable rate run-up in the commitment to prevent breach. Tie the rate to an index. ii. Lender should ask for option of liquidated AND actual damages. Want option of going to either depending on circumstances. 1. This will depend entirely upon the market and interest rates. If interest rates are large, then borrower will want LD. If they are small, then borrower may want actual damages. Vice a versa for Lender. e. Drafting Issues: Woodbridge Place Apts. p. 139 i. Issue: Lender didn’t fund the loan b/c the borrower didn’t meet a provision requiring a certain amount of rental fill up. Plus lender kept deposit. Minimum occupancy condition. Distinction between condition and promise. ii. Problem was that the K didn’t say whether the provision was a liquidated damage or security deposit. It is blank on what the 3% is for. 1. It is one thing to say I won’t fund the loan b/c rental achievement wasn’t met. It is another to say I won’t fund the loan AND I’m keeping the deposit. iii. 2% Refundable stand-by, deposit, and inspection fee iv. The K needs to be specific in what the 3% is for and in what event it will be triggered. v. The lender gets none of the 2% even though the condition wasn’t satisfied vi. The 2% for failure to close is not thought of as inappropriate in any respect 3. Breach By Lender: Borrower’s damages in event of default by lender a. Extra Expenses: Costs of applying for and obtaining a new loan are recoverable (residential context) b. Basic Measure: Difference b/w interest rate of what the loan you would have gotten (commitment) compared to what you got when the lender defaulted. Discount back to PV. c. Lenders have institutional pressure to not default. But they will look to vague K language in order to get out if they can. D. Pre Closing Conditions and Covenants 1. Appraising Value of Income Producing Property a. Federal Regulations require loan amts based on loan to value ratio 65% raw land; 80% construction; 85% take out. Private Sector utilizes similar numbers b. Appraising Income Properties: i. Value = net income / cap rate (yield or discount rate) 1. Also Net Income (x) Cap Multiple = Value ii. Net Income = cash flow – expenses iii. Cap Multiple = 1 / cap rate c. Cap Rate Components: Since buyers incur debt and also must raise equity to purchase real estate, the cap rate must a combo of the investment yield a lender would require and the (higher) investment yield an equity investor would require i. loan to value ratio to know the debt and equity proportion ii. interest rate attractive enough for a lender iii. term of loan- debt iv. income projection- collateral for debt v. equity yield vi. adjust for future market value d. Proposition: An increase in interest rates will decrease the value of fixed cash flows. This is called capitalization see p. 136 in Supplement and handout from 10/25/06 email i. Example: If investor: 1. Required Int Rate = 15%. Net income = $100. Value = net income / cap rate Value = 100/.15 = $666.67. 2. Conversely, Req Int Rat = 18%. Value = 100/.18 = $555.56 ii. Related Proposition: As cap rates rise, the cap multiple will go down, resulting in lower value 1. Ex: a. Cap Rate = 15%, Cap Mult = 1/.15 or 6.66. i. 6.66 (x) $100 = $666.67 b. Cap Rate = 5%, Cap Mult. = 1/.05 or 20 e. Issue: Treating Net Income as a constant number disregards the present value. You need to discount back. f. Real estate industry tries to pass along increased operating expenses to the tenant…pass-through of increased expenses and percentage rent on retail side. i. You see differences in bidding despite this straightforward equation because people think they are better businesspeople g. Ellwood Method: Assume mortgage yield is 11%, Equity is 22%. i. 80% of 11% = 8.8 ii. 20% of 22% = 4.4 iii. Blended = 13.2. Taking two different yield demands and take them proportionately iv. Dynamic capitalization – real rates of interest designed to take into account the time value of money. h. Other approaches to value i. Cost Approach – How much did it cost to build? ii. Market Approach – What did other buildings in the area sell per square foot, or whatever relevant dynamic. What will the market rent it for? INCOME VALUATION iii. Income Method – Cap rate is a composite of market rates and rate of return on equity investment that would attract a buyer. 2. The Gap Financing Issue: Where costs of the project exceed the amount of the committed loans. Need rental committments a. Gap: Const Lender may require that B has funds to cover gap in a different bank account chosen by lender b. Reasons: i. Building over budget: management- change orders; ii. costs overrun: upgrades to building during construction phase or rental achievement is not met iii. Construction is commenced prior to plans and specs being completed c. Gap Standby Commitment: covers the contingent part of commitment loan between the min rental requirement and max: i. Standby lenders do this for higher interest rate and high fee d. Gap also covered by: i. Letter of credit; from a bank to a construction lender: UCC governs unconditional promise of bank; only select few gets this ii. Personal guarantee (only if v. credit worthy) iii. Deposit securities or other collateral iv. Developer Cash e. Rental Achievement: Gap caused by failing to meet the ceiling rental requirement: full loan conditioned upon floor/ceiling rental requirement: big tenant may be required to have fully executed i. Ex: If floor amount is met, developer gets $22 out of $25M. If ceiling is achieved, then developer gets $25 out of $25. ii. Sometimes full loan amt conditioned on a named T who can bring prestige 1. Sometimes both are used. If floor is met, D gets $22. If ceiling is met, D gets $24. If ceiling is met w/ a big tenant, D gets all $25. iii. Encouragement to rent up the building in order to get the full amount on the construction loan iv. Construction lender will want a personal guarantee from developer 1. It gets people’ attention v. In order to fill the gap, you need a standby commitment. There are conditions in the permanent loan that will dictate how things must go in the short-term. 3. No Assignment of Commitment a. Lender will require an anti-assignment clause. This is b/c lenders commit their funds by relying heavily on reputation and expertise of borrower. They don’t want their funds going to anyone b. Obligations to loan money are unassignable. c. Unsatisfactory to construction lender because. ConstL will allow himself to be assigned though if the construction lender wants to reassign to new developer or in lieu of developer default. The construction lender may get a deed in lieu of foreclosure and developer may get guarantee lease. It may be beneficial for the construction lender to finish the project to get the full value of the building. d. Takeout commitment will have an absolute date certain...if it doesn’t close, then the loan can be gone. 4. Timely Completion: a. Necessary Elements in Commitment Letter: i. Start Date: Need to know timeline of the project ii. Approval of Plans: design needs to be done iii. Complete as per plans and specifications as determined by the lender’s architect iv. Fixed closing date w/ the completion date at lease 30-60 days earlier b. The Construction Documents need to match these terms in the commitment letter c. Substantial Completion: General Rule: even if the contractor has not completed the project 100%, the contractor is still entitled to payment if the project is substantially complete. i. This is the rule, unless 100% completion is expressly required by the commitment letter d. Whalen v. Ford Motor Company: i. Contractor has a completion date in this contract. Contractor has problem of an all-or-nothing job. If you don’t complete on time, you don’t get the money. Even though you’ve spent tons of money to build the project, you lose everything. ii. Quantum Meruit performance: You can’t own a construction company where you can afford to roll the dice. iii. Illustrative of: lender cannot walk away if everyone has relied on the lender and the building is substantially complete. Lender cannot walk away from the deal. You can write an objective standard of loan occupancy into the deal, and the bargain-for term will replace substantial performance. 5. Approved Documents: The lender will condition its obligation to fund the loan on approval by counsel of all security and collateral documents. 6. 7. 8. 9. a. i.e. the mortgage, the promissory note, assignment of leases. b. Collateral docs – hazard insurance policy, preliminary title report, and certificate of occupancy Buy Sell Agreement: Tri-party agreement b/w ConstL, PCL, and Borrower a. Contractor is not a party b. PCL wants opportunity to purchase the construction loan to ensure their investment doesn’t fail. c. Pre-Closed Buy/Sell This is designed to reduce the number of things that are going to be of concern when it comes time to close the loan. PCL will approve the form of the construction loan and mortgage before the construction loan is closed. d. Buy/Sell precludes borrower from shopping the permanent loan b/c the constL can enforce the PCL. And the construction lender is only obligated to sell to the named PCL. T/f if borrower shops around the lender, then there is no longer the necessity of the PCL lender being obligated. e. It also ensures liens priority of construction loan Pre-Closed tri-party agreement is an ideal world a. Everyone has an agreement, they approve and sign and documents, and push the approval process in advance so you don’t have to fight over the documents later. No Material Adverse Change: must be quantifiable/ formula a. B should get a chance to cure a failure b. Bankruptcy is adverse change; if B files bankrupt, cannot force L to continue funding the loan Opinion Letters a. These are rendered w/ the expectation that a third party is going to rely upon them. b. Can get sued on your opinions…need two lawyers to sign an opinion c. Fundamental Purpose of OL: To facilitate counsel’s due diligence in ensuring the lender’s basic expectations from the loan transaction. Borrower’s counsel gives an opinion letter to lender, which will give lender’s counsel assurance that there will be no extraneous litigation. i. When counsel for borrower opines about the loan documents, this does not estop the borrower from challenging the provisions though. However, it is a nice piece of evidence for the lender to have. d. Opinion Letters and Modern Practice i. Legal Opinion Accords: Tried to standardize the various opinions. Failed b/c there were too many variations ii. ABA Inclusive Real Estate Opinion: Instead of being formulaic, it says what sorts of things should be incorporated XXXXX May want Judy’s help here Chapter 5 A. Post Closing Terms: 1. Financial Leverage and Economic Rewards a. Leverage: You’re playing with someone else’s money i. Hedge funds are borrowing money at 9-10% hoping to yield 14%. In order to earn the difference, they put in a tiny bit of money, so when you compared the tiny amount you put in with the 4% yield on the entire investment, their yield looks very large ii. The ratio of money received to money expended increased from a 10% yield to an 18% yield. iii. Borrow at a lower rate than what you earn at iv. Real estate is always leveraged b. Negative leverage i. When the yield drops after the agreement. The yield expressed as a percentage of the cost drops and you are losing money because of the leverage. 2. Debt/Equity Spectrum a. Pure debt financing Participating mortgages Potential Equity Pure equity financing b. Fixed rate mortgage contingent interest convertible mortgages joint venture c. Variable rate mortgage Shared Appreciation Mortgage 3. Interest Rates: a. Options for mortgage loans: i. Debt: fixed, variable, contingent interest ii. Quasi Equity: Participating % (kicker) from net; Shared appreciation% of gross; (shares income only and not tax benefits and management control) iii. Equity option: Convertible to Equity iv. Equity: Joint venture w/ part ownership (shares ownership, tax benefits, management control) v. Kicker: term used to describe a lender’s extra yield over fixed interest. It is either a contingent interest (i.e. a %age of cash flow) or a contingent share of appreciation (% of sale proceeds in excess of costs) b. Participating Mortgage/Quasi Equity: For a lower rate and/or a higher loan/value ratio the lender gets a percentage of ownership and priority of payment i. Trigger for Additional Payments: Because borrower’s income producing capacity is how lender gets compensated for taking additional risk, the additional payment is triggered when the capacity is affected: Monthly Cash Flow; Upon Repayment of Loan; Refinancing w/ new subordinate loan; Sale of property; Receipt of condemnation awards or casualty insurance proceeds; Maturity of loan ii. Danger of Scarce Money: High rate and fear of inflation could cause negative leverage (debt service is more than cash flow). iii. Lender Pays for This Econ Benefit: By giving the borrower a lower interest rate, i.e. in a high interest rate environment, or a lower interest rate that will allow the project to have a 1:1 debt coverage ratio (meaning the project’s net operating expenses = current debt service) 1. Potentially in trouble - If projections show $3 million in cash flow and $3.2 million debt service iv. Lender’s Alternative: Riskier ―all equity position‖ as a limited partner or LLC member c. Borrower: i. Borrowers want percentage of profits over cash flow because revenue may go up but profits may not go up ii. Increase leverage; but if close to or 100% finance then lender may require personal guarantor other than the borrowing entity. iii. In quasi equity, Lenders usually restrict prepayment rights since that will lessen the value of kicker. 1. Lender also restrict ability to sell; right to disapprove sale; no sale to affiliates- sell cheap to associates and eliminate kicker provision and financing from someone else 2. Basically lender wants more of a say iv. Why would a borrower enter into Participating Mortgage? 1. Borrower does this in a tight money market; also worried about negative leverage from high rate: high rate also increases the cap rate which reduces multiple and thus valuation of property and loan amount 2. Hedge against recession if the rates go down then rent goes down reducing cash flow. d. Alternatives Participations: i. Piece of Refinancing: If building has gone up in value. The MR will pay a percentage of proceeds of a new financing to the priority ME. This = gross amount of new loan, less reasonable costs for closing + balance of the participating mortgage. ii. Piece of Sale: MR will pay a percentage of the remaining principal balance and future profits interest 1. Lender must guard against the borrower who will sell the property cheap to an associate. T/f Lender will require: a. Right to disapprove of the sale, no sales to associates, arms length negotiations, and a bona fide sale 2. Must watch out because lending partners don’t want to becomes general partners when participating in profits e. Participating Mortgages: Risks and Rewards: i. Developer gives up: cash flow, refinancing proceeds, sale proceeds, or a combo of them. He does this in exchange for obtaining a below market fixed note of interest and an amount of cash flow at the beginning of the project. ii. W/out a participating mortgage the project might have to be abandoned if there is not enough cash flow iii. Note: higher cap rates = reduced value f. g. h. i. iv. Hedge Against Inflation for Lender: If rates go up, lender can’t reinvest that money in something more profitable. T/f by participating in the venture, lender takes piece of profits which are increasing in inflationary environment. % profits v. % cash flow i. Borrower prefers % of net income b/c this takes into account expenses netted out such as increased in taxes or operational expenses or cost of living ii. Lender prefers % of cash flow (gross income) b/c any increase in income will result in more $ to the lender Convertible Mortgage: Borrower gets a lower interest rate and lender gets option to buy after X years in exchange. i. This means that lender can convert from a debt position to being a part owner. The formula says that the purchase right is less than the amount of money earned on the interest rate. 1. Lender would exercise option to buy if the option price is lower than FMV ii. Problem of ―clogging the equity of redemption‖ : CL doctrine that prohibited ME option to purchase upon default of MR: 1. MR can not waive their right to equity of redemption in advance 2. But if MR is already in the deal, and is in trouble w/ the mortgage, MR can do a deal where he exchanges the property w/ the ME in return for discharging the MR’s obligation. This is a good thing b/c alternative is foreclosure. 3. Issue: Opinion letter stating that convertible mortgage is enforceable on its terms is dangerous, b/c it won’t always be b/c of clogging the equity of redemption. Equity: Joint Venture: usually avoided i. Conflict of interest: lender may have a different fiduciary duty than borrower: when borrower wants to refinance- does lender go along? Lender owes duty to borrower and to its own stockholder Usury: Taking too much interest for the use of borrowed funds i. Must know when usury law will come down on a loan ii. Elements: (1) Agreement to lend or forbear; (2) Borrower has duty to pay debt; (3) Rate exceeds allowed rate; (4) With intent to violate usury law 1. Obligation to repay is what separates a loan which creates debt from contingent obligations or investments a. Ex: Loan w/ Debt = Note for $100K plus 5% of equity b. Ex: Contingent Obligation = 20% of the equity iii. Exemptions From Usury Laws: Commercial, Corporate, Transactions over certain $ amount (PA $50K) iv. Bankruptcy will not enforce default rate that is excessive. (i.e. a jump in interest rate from 8% to 25%). Only reasonable rate is allowed. v. Typically: Individuals making individual transactions in personal matters worry about usury. Limited to interpersonal transactions where it is not residential property that is at issue. j. Wraparound Financing and Usury i. Ex: A has a loan of $150K at 6% and wraparound lender loans $50K at 9%. The applicable usury rate is 9%. So the wraparound lender says, I’ll loan you $200K at a rate of 9% and whatever you pay me, I’ll apply it to the $150K loan. 1. T/f lender is paying $150K loan at 6%, but taking 9%, giving him an extra 3% profit. k. Late fees: i. Must be reasonable and within industry custom ii. Late fee: admin cost iii. Default rate: increased risk and lost opportunity cost: has to be watched for unenforceable penalty l. Index rates: for const loan not perm loan: because lender and borrower like the certainty of permanent - Borrower wants stability. Lender can match yield to the Borrower’s payment obligation i. Bullet loan: short term w/ 25 yr amortization or even interest only. 1 or 2 indexed rate adjustments. Benefit is that the shorter term brings a lower rate. The borrower may refinance at the call date to a fixed rate ii. Mini perm: const lender agrees to convert to a short term fixed rate: refinance after the project is seasoned- 7 to 10 yrs; initial construction loan is interest only then change to perm loan with fixed rate once construction is done: benefit: more time to negotiate the perm loan and without prepayment fee; and with the finished building as collateral can get a larger loan iii. Bowtie loans: indexed short term loan- 7 to 10- with deferral of interest in excess of base amount; cap on interest payments iv. Rollover Mtg: amortized at 25- 30 yrs with 3 yr call date: renegotiate at the call with a new 3 yr deal 4. Amortization: Need More Notes Here a. Traditional loan is: 30 yr fixed. An Alternative is: balloon b. Balloon: 15 year maturity w. monthly payments calculated at 30 year amortization schedule. This leaves a large balance at the end of year 15. You then refinance the balloon. i. Problems with balloon: (1) Refinancing may not be available b/c rates are high. (2) High interest rate at that time may lower the value of the building and the subsequent lower value of the building when refinanced, may be less than the owed balloon. ii. Hope is that inflation or success will increase rent and the value of bldg and refinance a bigger loan than balloon and ―mortgage out‖ the excess as tax free profit c. Call provision and partial amortization: i. Makes prospective buyers of that mortgage wary ii. Borrower should get notice of call so that they can refinance iii. Making the playing field level would mean- there would have to be prepayment privilege given the call provision iv. Lender will make the call when the rates go up v. If the rate is same and the term is same, but if one has call provision and interest only payment- that one has less monthly payment. The downfall will be if interest rates rise, the lender will call. 1. Ex: 10 yr fixed, interest only payments, callable at end of 5 yrs a. Balloon: Entire Amount b. Advantages: More cash flow b/c only paying interest c. Potential Disadvantages: If interest rate goes up, lender calls, you’re screwed b/c you haven’t amortized anything 2. Compare: 10 yr fixed, no call, 20 yr. amortization a. Balloon: remaining balance b. Advantages: Less to refinance at end of 10 years, c. Potential Disadvantage: Interest Rates go down, you’ve paid more money AND refinance anyway d. Debt Coverage Ratio: Yearly Free Cash Flow before Debt Service/Yearly 5. Non-Recourse: Carve-Outs and Exploding or Springing Guarantees a. Entities: i. LLC – No liability – Could be a personal guaranty somewhere ii. GP, LP – Joint and several liable – could be personal guarantee somewhere b. Types: Parent companies come in to guarantee and they are non-recourse subject to certain carve-outs. What is individual responsibility of certain partners of guarantors i. Non-recourse to entity ii. Non-recourse to partners iii. Non-recourse to guarantors c. General Concept: Borrower is not liable on the note. Lender only has recourse against the collateral (the property) i. Carve Out: But, if X happens, then you lose your non-recourse ability ii. Exploding Guaranty: Borrower is a single-purpose entity w/ no assets beyond the mortgaged property. On day 1 there is no guaranty. Lender will demand ―exploding or springing‖ guarantee whereby individuals or entities in control of the borrower agree to assume personal liability upon the occurrence of event X. 1. This is b/e a carve-out would be useless as against the entity. 2. Matter of whether you start out with liability of after a certain event happens 3. Focusing on creating the possibility of some liability and motivating people to act iii. There are tax reasons for non recourse instead of recourse d. Morrison Reading: i. If building is sold w/ in X years, the non-recourse provision won’t apply e. f. g. h. i. j. k. l. m. ii. Other Issue: If you had a 15 yr lock-in provision, and you get out in 5, this might also trigger the prepayment penalty. Largely carve-out is not to really seek recovery but to provide incentive for full effort to make it a success: ex: first 3 years it is recourse then it becomes non-recourse i. Carve-out- manages risk not punish failure- seeks guarantee from other than the borrowing entity: a member of LLC or general partner Carve Outs: Full Liability: Contingency of full liability if: i. There is a sale: any material change in ownership excluding estate planning changes (so long as same folks are essentially there) ii. Junior financing iii. Could exclude financing for improvement of property Bankruptcy and Borrower Claims or Defenses i. If the borrower defends foreclosure action, asserts a lender liability claim, or flies bankruptcy case, then the lender’s documents may provide that some or all of the debt becomes recourse ii. Springing Guarantees: Bankruptcy could go against bankruptcy codeso substitute Springing guarantees wherein the key shareholders, and not LLC itself, become personally liable- a non debt party- If A happens, then recourse liability springs to a third party Environmental Risk: lender doesn’t want to own contaminated property: but non-recourse will make the lender the owner upon default thus if contamination contingency of recourse guarantee springs; or a separate indemnity agreement; borrower will resist if the contamination is small and remediated; lender makes borrower guarantee that the property is not contaminated Fraud: if non recourse was gotten on fraud: then it changes to recourse Carve-Outs for Damages: tests good faith of borrower: imposes duty, and provide liability arises against the entity when there is a breach: i. Breaches include Failure to properly use insurance proceeds, taking of a security deposit or prepaid rent, post default taking of rent. ii. Lenders don’t usually have to worry about this because the lenders get casualty insurance Carve-Outs for Waste: failure to pay insurance: remedied in residential situation by the escrow fund, failure to comply w/ laws, failure to discharge a mechanic’s lien, must remove all equipment and furnishings, failure to pay taxes i. Situations in which the lender may be out money Litigation: i. Basic risk allocation is Lender assumes economic risks of the project while Borrower bears all other risks. The carve-out negotiations strikes a dividing line b/w these 2 concepts. Implied carve outs: not explicit in the document: but just because it is non recourse doesn’t meant I cant sue you if you don’t pay real estate taxes i. There is case law on implied carve-outs. Basic notion is that these are negotiated as part of the transaction. Lender begins with a big list and you push them down. 6. Prepayment Privilege: a. No common law right to prepay: (PA there is a right). T/f you have to negotiate the right to prepay b. Context in which liquidated damages would be used (where people are setting out in advance penalties for breach): default…there is no breach c. In residential setting: Fannie Mae form allows prepayment-without penalty, thus encourages refinancing d. In commercial setting: i. People argue it is an unenforceable penalty, and it isn’t a liquidated damage because there is no breach (you don’t default if you pay ahead of time) ii. There is a ―lock in‖ period 1. Better than common law because you can prepay after the lockin period…But sometimes you have to pay a penalty to pre-pay iii. Lazzareschi: 1. Held in dicta that charge shouldn’t be palpably exorbitant (similar to unconscionability common law test) to be enforceable- but held that the reasonable charge is not a simple calculation. 2. Can substitute for compensatory damages a reasonable estimate because you don’t know what the actual amount will be 3. You are charged an additional fee for prepaying early b/c you are foreshortening the income stream payments that the lender will get for the life of the loan. So you compensate the lender for that. e. The Prepayment Charge as a Penalty (TAKE NOTE ON PAGE 246) i. Any time a developer is stuck with a large prepayment penalty, and litigation is the best option, their litigation theory will be that the penalty was disproportionate ii. Bringing argument back into liquidated damages arena…This is similar to a breach. Setting a fee and the fee should be tested like a liquidated damages provision. (IL recent case saying prepayment penalties must be paid under liquidated damages test) iii. Generally, lenders aren’t trying to charge you a whole lot, but they are trying to keep their deal. We don’t know what the relationship with the rates will be. When prevailing rates are low, you want to redeploy the $ lower and take a loss. Banks want to take benefit of their deal here. Prepayment penalties are unnecessary when the prevailing rate is higher than the contract rate, because the lender could take the money and redeploying it at higher rates. Since lenders don’t know what rates will be in the future, they will establish reasonable penalties today. 1. Yield maintenance provision is designed to be the solution to the whole problem. f. Critical terms: lock out period: i. Longer term of loan the longer lockout period ii. Shorter lockout period may be higher interest rate g. Standard: was 6% interest + remaining balance h. Yield maintenance: i. Only works to impose a pre-payment penalty when the current rate is lower than the contract rate ii. Goal is avoid litigation over prepayment penalties iii. Calculate interest rate loss and reduce it to present value: 1. The amount is that of excess to the remaining balance that would be required to produce the same amount of yield when the mortgagee buys a US T bonds. 2. If you give me back the balance of $100K and I could take the $100K and re-invest it and make less money than I would have on your mortgage. T/f you owe me the difference b/w what I am making and what I would have made. iv. Process: Figure out remaining term of years. Calculate what investment on orig rate would be. Calculate what investment on T bill rate would be. Then the charge is the additional amount needed to match the orig rate. 1. Ex: orig term: 8% for 30 years: 15 yr remaining: amount of interest: 25000 lets say; if T bill rate is 6 % then my interest is 25% less at 20000. You have to give me 5000 more to make me whole. This make prepayment bulletproof: 2. Must have a component of present value: the interest difference between orig rate and T bill rate was simply added on an annual basis for the remaining years; thus didn’t take present value discount: if they projected 25000 over the next 10 years, I may only need 20000 now to get that amount. Thus I shouldn’t be asking 25000. v. Borrower says it shouldn’t be T bill rate but the going rate at that time for the remaining term of years: vi. In residential this is not an issue: simply have the client ensure that they are using Fannie Mae form i. Bankruptcy: Bankruptcy adds requirement that all fees and charges have to be reasonable. The yield maintenance clause will have a built-in present value. Also, in bankruptcy, the re-investment rate must be reasonable. It can’t be something that is consistently lower than mortgage loan yields. j. READ SKYLER RIDGE p.246 and TEACHERS p.179 7. Prepayment of Tax and Insurance a. In residential setting, the monthly payment is made up of principal, interest, tax and insurance. b. At foreclosure, tax liens take priority thus lender acts like financial planner by requiring escrow account into which owner must pay enough money to cover tax and insurance. Lender protect their interest since (1) tax lien will reduce their collateral value, i.e. the property won’t sell for as much w/ liens on it. Or under (2) insurance, if the property isn’t insured and there is a catastrophic event, the lender loses substantial value. i. This is Fannie M standard requirement ii. It is like an involuntary savings plan (escrow account) where the lender will require you pay 1/12 of the estimated taxes each month. That way you have prepaid your insurance and taxes. You send your money to the lender and bill to the lender, they pay, and the risk is taken out. iii. If you are a big bank with a lot of money, escrow collections are a large source of income…you make money on it. c. Contention: some owners complain that mortgage service companies who manage the escrow accounts and invest their money owe these owners interest under the ―fiduciary trust‖ theory. d. In some states, they must give a small portion of interest, but most don’t require. In PA no definitive ruling. e. RESPA limit the amount of cushion for tax increase that lenders can gather at 1/6 max of current rate of tax. Although lenders say this pays for admin costs, this is profit generator for them. When fed rates are high, people scream about these f. Insurance i. Note: You are insured for the value of your home. So you only get compensated for the value of the construction costs to replace your home to that value. Meaning, you might not get the same house if costs for construction, etc., go up. 1. T/f amount of insurance for the building needed should be enough to cover inflation costs and new construction cost: ii. If you put an addition on the house, you need to raise your insurance. iii. If lender hasn’t increased their debt, lender wants you to increase your insurance to cover the addition because it would cost more to rebuilt the home iv. Extended coverage Policy‖ Insured against loss by fire, hazards, earthquakes, floods v. Replacement endorsements – appraiser comes to house, then they determine whether current coverage is adequate, then ask you to raise your insurance to cover the entire piece of property. 1. Borrower subject to Lender’s right to disapprove borrower’s choice, which right shall not be exercised unreasonably 8. Satisfactory Hazard Insurance: a. Standard mtg : i. Commercial: MR, as assignee, may either (1) apply the insurance towards payment of the mortgage or (2) pay for repairs on the building. It is at the discretion of the lender. 1. Proceeds Payable to Lender: lender has a choice about whether to pay the debt or fix the premises with the proceeds; and b. c. d. e. Carrier waives the defenses against the policyholder- Act or Neglect; 2. Note: If Borrower gets insurance not required – still must assign Lender as being payee. Otherwise, if the prop gets damaged by a type of loss that is covered by B’s insurance that wasn’t assigned to Lender, that is breach of mortgage condition, and L can sue B. ii. Residential Mortgage: Opposite of Commercial As long as it is (1) economically feasible and the (2) lender’s security isn’t impaired, then the proceeds will be applied to repair or restore 1. When is lender’s security impaired? i.e. if property is FMV $300K before incident, and it is FMV $210K post. As long as the debt does not exceed the FMV, everything is OK. 2. Who has burden of proof to show isn’t econ feasible? Lender has burden. 3. Lender has to show above or else he MUST rebuild. Coinsurance provision: not in standard docs like mtg agrm- but in policy: i. Must carry 80% of FMV; you are allowed to not have 20%; you could be underinsured if there is appreciation ii. If underinsured, less the 80% the Calculation is: 1. Amount of Insurance / 80% of FMV of Property (x) loss = reimbursable loss iii. Ex: FMV = $34M (minus $4M for ground) = $30M. Insurance coverage = $20M, which is less than 80% coverage since .8 * 30 = 24. Loss = $4M. 1. Calculation: $20M / $24M (i.e. 80% of 30) (x) $4M = $3.33M in reimbursable loss. iv. Note: Ground is not included in FMV READ SAVARESE AND BRIEF p.251 i. Purpose of this provision is so, if event of a loss, lender has direct contract rights to sue, equity/debt. ii. Dispute about who has the coverage and what the amount of the coverage is. iii. Carrier says there is no loss because iv. There is a direct loss, and they are entitled to be paid even if the homeowner fixed it up themselves already. Mortgage Language Disposition of the proceeds i. Highly favorable to borrower ii. Insurance proceeds shall be applied to restoration of the property. Presumption in favor of homeowner for restoration iii. Lender’s security must not be lessened (Not losing value): If debt has been paid down a lot or value of property has gone up a lot, there is rarely a problem…But we could see some litigation over the speculation. Condemnation proceeds: Same debate here as to what to do w/ proceeds i. Total Condemnation: All of MR’s property is condemned. ME has right to apply the proceeds to satisfaction of the mortgage loan ii. Partial Condemnation: Pro-Rata distribution of the condemnation award calculated on pre-taking total value. 1. Ex. If debt is 75% of fair market value, then 75% of the condemnation value shall go to discharge the mortgage. This 75% discharges the debt because it increases equity in the property by 75%. Question of whether the lender is going to get a share of the condemnation proceedings to reduce the debt…Lender had a security interest in the debt, and the formula is the best way to provide a fair resolution of the dispute for residential homeowners 2. Ex: If debt is $500K and the total value is $1M, then the ME gets 50% of the partial condemnation proceeds, whatever they are. 3. Fully Secured Partial: If you have plenty of collateral, the lender gets what they are owed. Excess to borrower. 4. Unsecured Partial: Lender gets since not enough collateral. iii. Condemnation award is assigned to the lender: 1. If owner-borrower gets the money from the condemnation provision, it is unlikely that the lender sees any money to help pay down the debt. 9. Junior financing: a. In residential, this is encouraged; statutorily protected to allow junior financing. FNMA has no restriction on jr. borrowing. Congress has barred due on encumbrance clauses in residential transactions. b. Commercial: Lender will have a ―due on‖ encumbrance clause i. Lender does not want borrower to have ability to obtain jr. financing. 1. Second loan leverages the property, increasing the risk of default. Traditionally, not problematic (Secondary financing useful to redeem the property and to protect mortgage interest in senior loan)(Equity buildup over time is protective of first mortgage). Do you pay secondary loan first because it may be recourse? The junior financing may be recourse because it takes on more risk because of their subordination. Issue of fairness concerning recourse; borrower will pay recourse lender first. ii. Ex: Debt is reduced from $25M to $20M. FMV of building is now $40M. If borrower obtains a second mortgage for 75% or $30M, borrower can pay off debt and have an extra $10M that goes into their pocket tax free. 1. This is a problem for the 1st Lender b/c: a. Borrower could now loan out $10M themselves, thus creating a competitor b. If the 1st loan is non-recourse and 2nd is recourse, then borrower will seek to pay 2nd first c. 1st lender now has loss of total control over project d. Jr. Lender might complicate foreclosure proceedings c. Commercial Jr. Financing: i. There is an Outright prohibition; similar to prepayment lockout. ii. Now there is a qualified right to have a junior if: 1. Tenants are protected from being made defendants 2. There is coordination w/ the first mortgage foreclosure by ensuring all proceeds go to the first ME and the to any subordinate if there is surplus 3. Notice of foreclosure shall be given to the ME d. LaSala: Held: Jr. Financing clauses are enforceable in some instances. If there is a concrete likely event of dissipation of your assets if there is jr. financing, then they are enforceable. (this is not easy to prove). Reasonable restraints on alien nation…Only reasonable to borrow junior financing if it won’t endanger the first security. Not a significant limitation on junior financing. 10. Right to sell – Due on Sale Clause: a. Due on Sale Clause is just an acceleration of the mortgage that is due in the event of a sale that is not authorized by the lender. Also, due on sale gives lender the power to require that any buyer will assume the mortgage. b. Originally: Purchaser could acquire property subject to mortgage; L could upon default have recourse against property or B#1, but not B#2. i. Purchaser#2 could personally promise to pay and thus assume mortgage also. ii. MR’s argued that due on sale clauses were not a restriction against alienation- just restrict ability to profit of B from depreciation or higher market interest rate: If rate is higher, then the existing mortgage at lower rate looks more attractive to other purchasers of mortgageincreased cap rate also decreases value; but B could sell the building at a higher cost because of low mtg rate c. Novation: O2 takes a new Note and O1 has no responsibility re: property d. Subject to mortgage: This just means that you abide by the priority of the recording but you are not making any promises for personal liability e. Assumption: O2 promises O1 to pay O1’s debt; but O1 is not off the hook quite, and this gives L the right to come in and sue O2 upon default f. Due on Sale clause was invented by Lender to stop the practice that in the high interest rate market, O2 assumed O1 mortgage and thus avoided paying higher interest rate and split the money O2 saved on the interest rate with O1. i. Statutory exceptions to due on sale triggering event: inheritance, joint tenancy, death of borrower, gift to children, present revocable trust, transfer in divorce, separation, lease with option to purchase for less than 3 years g. Pre-Payments w/ Due on Sale Clause i. Commercial: 1. L gets both lock in period (protection from lower interest rate) and due on sale clause (protection from higher interest rate) 2. L cannot prevent transfer during lock in period b/c that is a restraint on alienation. But L protects by preserving the right, in case of transfer during lock in period, to due on sale clause, and if I trigger the due on sale ( I don’t like the new owner as a credit risk) then you pay prepayment penalty 3. Prepayment penalty could be challenged ii. Residential: Unlike commercial, prepayment penalty is not allowed by statute when you call due on sale. But due on sale clauses are valid in almost all transactions. h. ARM Due on Sale Clauses – Need Notes Here i. Double Whammy: When mortgage contains BOTH a prepayment clause and a due on sale clause, lender can’t have it both ways. i. If lender is going to invoke due on sale b/c lender won’t allow an assumption of the mortgage he can’t then decide to invoke the prepayment clause as well. Only one at a time can be invoked. Chapter 6. Construction Lending 1. Prior issues: a. Before construction starts, there are two other liens that could already exist: Land lien, and infrastructure lien b. Const L agrees to make loan if those preexisting liens agree to subordinate to Const Loan: c. Lien holders should get B (developer) to specify what the const Loan is for: what type of project in details: d. The flow of cash from Construction Lender Owner/Developer Contractors Sub Contractors is an issue if money doesn’t flow the way it is supposed too. 2. Priority against Mech Liens: a. Liens Are Available to: i. Prime contractor, subs, and suppliers (in most states) ii. If owner advances money to prime, and prime doesn’t pay his sub, the sub can put a lien on the building b. Payment and Amount of Lien: i. Majority: When a lien is filed, it attaches against the property in an amount that is capped at the remaining funds due to the prime contractor 1. In other words, the monies advanced are ok, but the lien that goes on the property is only to the extent to the yet unadvanced money from the prime contractor. ii. PA: You risk everything. There is no credit for advances. 1. In theory you could advance all $ to the prime and if the prime takes off leaving you in the lurch, you would owe all the money to pay for a full second time. c. CL Ordinarily, a construction mortgage will take priority over subsequently filed mechanic’s liens. i. But Mechanic’s lien will relate back to the start of construction ii. Note: At this point must pay attention to Optional/Obligatory Rule d. Const L requires B to produce a list of mechanics who could claim lien, or B must notify L upon notice of nonpayment by a sub or subs e. Commencement of Construction: Mech L relates back to the date of commencement. i. Commencement of Construction: when the work begun is conspicuous and substantial enough to make it reasonably apparent that improvements are intended to be constructed on the site ii. Counsel for Lender should make sure that construction does not begin before recordation of the client’s mortgage to avoid issues. f. Timing Issues: i. Claimant (Contractor or Sub) must file MechL w/in 4 months (check this number it says 6 in materials but that doesn’t make sense using the 3 month number below) of the completion of his work on the job. Additionally a claimant must give notice of his intent to file a claim one month before filing ii. This creates the timing problem: If I did title search 1 month after completion, this lien may not show up, but I could own the property subject to lien. 1. Or conversely for the claimant, if it is 3 months out and he hasn’t done anything, he is in trouble. B/c he must give 1 month notice BEFORE filing, which puts him outside the 4 month requirement. iii. Due diligence: must ask the subs who finished- whether they were all paid- or could demand to see lien waivers that has a date after the date of completion g. Perspective of Permanent Lender i. Competitive Success of the Rental Program 1. Tend to focus first on the back end – will the building rent up at the right % and right rents 2. Main risk is the interest rate risk on the long term loan 3. Quality of construction and design are important because the ultimate risk of foreclosure and even lender ownership ii. Need to manage the construction loan – file when no one is on the site. When is the commencement of work? When they start digging on the job? Would a reasonable person drvigin by the site conclude that there was new construction going on? iii. If the owner is giving more than the minimum to the contractor and nothing to the subcontractor. Predicate for distinction: Where advances are optional, even though the construction loan is filed first, the mechanic’s lien has priority. 3. Optional v Obligatory: a. Rule: If the future advance was optional (at the discretion of Const L) and was made w/ notice of the intervening mechL, then mech L has priority against the future advance. If the future advance was obligatory (there could be certain objective conditions that L imposes that must be satisfied for future advance), then the advance wins i. Note: Constructive notice is not good enough for notice requirement. In PA act, must give written notice complying w/ subsection ―d‖ (is or isn’t constructive notice good enough??) ii. Irwin Concrete: Held: The mere fact that there are conditions which need to be satisfied before the lender must advance does NOT render the future advances optional. There must be some request method, but the Lender did NOT have discretion. iii. Nat’l Bank of Wash: Held: the disbursements were up to the total discretion of the bank. They were advanced in amounts and at times the lender determined. No advance shall be due unless, in the judgment of the lender all work for which the advance had been made had been done in a good and workmanlike manner, and unless the construction be approved by the architect 1. ―where the advances of promised loan moneys are, under an agreement to lend money, largely optional, that is, where the time and amount of the moneys are to be largely discretionary in the lender, the legal effect of such provisions is to bring the transaction under the rule for optional advances rather than the rule governing mandatory advances for the purpose of determining lien priorities. Optional advances under a construction loan agreement attach when the advances are actually made. Any liens attaching prior to an optional advance would thus be superior to it, and attaching afterwards , junior to it.‖ b. Dispute: Const L wants both ways: draft so that they have discretion but not appear discretionary so that it wins against mech L. c. Completed advances are protected; Const L must be recorded prior to start of construction otherwise the mech L wins since it relates back 4. Const L: or Open End Mortgage Future Advances a. Open-ended Mortgage: i. A mortgage which secures advances, up to a maximum amount of indebtedness outstanding at any time stated in the mortgage, plus accrued and unpaid interest. Such a mortgage shall be identified at the beginning thereof as an ―open-ended mortgage‖ and shall clearly stated that it secures future advances, which in the case of a home equity plan, the lender has a contractual obligation to make on the terms and conditions set froth in the mortgage and the open-end loan agreement with borrower. b. Issue: Ex The job is struggling and the prime contractor is struggling to get the money he needs to complete the job b/c the job is costing more than he thought. OR, there is a hard deadline in the construction documents that is not met and the job goes into default i. In both instances, the ConstL no longer has to advance, it is optional if he does. T/f he would lose his priority if he did. Is there a solution? c. Open End Mortgage Secures Present and Future Advances: i. In most states, future advance clauses are subject to the optional obligatory doctrine. 1. In residential setting, dragnet clauses are barred for public policy ii. Must Label the OE per PA§ : ―This is Open End mortgage that secures future advances made after record‖ 1. In order to get the benefit of the PA statute, you must label and record iii. Residential: PA Act was primarily directed towards construction mortgages, but reaches home equity loans. 1. For home equity loans – both future and present advances are secured and take priority over all. This eliminates any disputes w/ intervening liens or encumbrances iv. Construction: In PA, intervening liens must make sure that there is notice in order to get the benefit of the statute. 1. Note: Advances are still subject to the (1) ―optional/obligatory rule‖ and the (2) statutory rule that if the money is advanced to pay for all or part of construction … see below statutory rule. d. Important Statutory Rule: If you have an optional advance the mechanic’s lien takes priority unless the advance is made to pay for or get funds to the owner, when the funds are for the completion of construction, erection, alteration, or repair i. T/f if you’re a const lender and you have notice of a mechanic’s lien, you won’t lose priority as long as you’re confident to a high degree that you can demonstrate the money was delivered to the borrower to pay legit amounts in completion of the structure whether optional or not ii. This protects lenders; but this is good because if no money, then project stops and everyone really loses; it is in the interest of mechanics to go along with this because it is better to have the project come out as a success for them as well. iii. In effect, this rule means that every disbursement is going to be protected b/c no one will advance money to a construction borrower for anything other than construction! 1. This holds true as long as the lender advances for this purpose, even if the borrower takes the money and uses it for something else. Lender doesn’t have to track the money. 5. Mechanics Liens in PA a. Statutory – Protect mechanics. Comes out of a generally notion of fairness and unjust enrichment. b. §1301 – Right to lien i. Every improvement and the estate or title of the owner in the property shall be subject to a lien, to be perfected as herein provided, for the payment of all debts due by the owner to the contractor or by FINISH c. §1508 - Priority of Lien d. e. f. g. h. i. The lien of a claim filed under this act shall take effect and have priority as follows 1. Except as set forth in subsection c, in the case of the erection or construction of an improvement, as of the date of the visible commencement upon the ground of the work of erecting or constructing the improvement 2. Except as set forth in subsection c, in the case of the alteration or repair of an improvement, as of the date of the filing of the claim (Helpful at sale of an existing house because BFP takes property free and clear of any mechanics liens that haven’t been filed. Want to look to see if the house had construction that is less than 6 months old that could relate back) 3. Any line obtained under this act by a contractor or sub shall be subordinate to: a. Purchase money mortgage b. An open-ended mortgage, the proceeds of which are used to pay all or part of the cost of completing erection, construction, alteration or repair of the mortgaged premises secured by the open-ended mortgage Contractor means: i. One who, by contract with the owner, express or implied, erects, constructs, alters of repairs. ii. An architect or engineer who, by contract with the owner, express or implied, in addition to the preparation of drawings, specifications and contract documents also superintend or supervises any such erection, construction, alteration or repair. Subcontractor: i. One who, by contractor with the contractor, or pursuant to a contract with a sub in direct privity of a contract with a contractor, express or implied, erects, constructs, alters or repairs an improvement of any part thereof; or furnishes labor, skill or superintendence thereto; or supplies or hauls materials, fixtures, machinery or equipment reasonably necessary for and actually used therein Owner’s primary concerns with contractor i. On time + under cost ii. Organizational skills iii. Honesty about flow of funds and construction contract Owner’s primary concern with subcontractors i. Owner’s can require subs to sign affidavits saying that they have been paid the necessary increments on time. ii. When people are buying new houses, the banks usually save the homeowner by their requisites Even though mechanics lien is subordinate to construction lender, mechanics lien is a lien on real estate…and if the owner wants to make his building functional then he’s have to deal with it. i. Were generally no mechanics liens in PA because, many times, owners and contractors agreed that there would be no mechanics liens. Contract waiver invalidates this law. j. Only go three tiers of ability to get mechanic’s liens. If the duct contractor buys his sheet metal for the job, they aren’t covered. Someone below the third tier is not covered. k. What is a mechanic’s lien? i. A statutory lien that arises in favor of a defined class of contractors and others who work on new construction projects. ii. Lien serves as an unjust enrichment cure. iii. With the mass of people who start on the job…between foundation diggers and painters, owner could be in trouble and someone files a judgment lien on the property. If you buy a house from Toll Brothers, they won’t guarantee that there are releases of mechanics liens. l. How do you know there is a mechanic’s lien on property? i. The claimant must file with the prothonotary a claim within six months of the completion of his work on the job. m. Is that it? i. No. A subcontractor must give notice of his intent to file a claim one month before filing. This is tricky. That means if you are three months after completion of your work and have not done anything, you are in trouble n. Are mortgages and other liens which are prior in time to the filing of the claim protected? i. Not always. The mechanic’s lien for new construction relates back to the first date of visible work on the job site. o. If a claim is filed, what can the owner do? i. If it is a sub’s claim, the owner may hold back from the contractor. p. Who gets a mechanic’s lien? i. First Level: those who deal with the owner. They include the general contractor, the architect and the engineer, and anyone else who contracts directly with the owner to work on the project. ii. Second Level: Subcontractors of the general contractor and suppliers to the general contractor get mechanic’s liens. iii. Third Level: Subcontractors to subcontractors who have contracted with the general contractor. ONE Owner Developer ↓ ↓ Pri mary General Contractor Design Professional ↓ ↓ ↓ ↓ TWO Landscape Architect Parking Lot Specialty THREE HVAC MECH STEEL ↓ ETC ↓ Duct K (sub of sub) Trane (supplier to sub) Note: Under the act subcontractors is broadly defined and includes suppliers. Q. A. How much risk does the owner have? Quite a bit. There is no credit for amounts paid by the owner to the general contractor. So if the general contractor does not pay the subs and runs off the owner is stuck. The owner is subrogated to the subs’ claims, but that is of little help if the general contractor is in chapter 7 or 11. Does this present a risk to a buyer of new construction? Yes, because the mechanic’s relates back to the beginning of work as long as the notice of lien is filed within 6 months of the end of the job.. What do you do if you are a buyer? Delay closing until six months after the job is complete! Obtain little insurance. Be sure the developer has the ability to refund part of the price if a lien is filed. What about the owner developer? The amendments have made life more complicated for the developer. (i) It is universal practice to require that when the general contractor requests a progress payment from the owner, the general and any sub whose work is included in the progress payment request must sign an affidavit that states that it has been paid for all work completed before the period covered by the progress payment request. This is OK under the amendments. Q. A. Q. A. Q. A. Q. (i) An advance waiver by a sub of its right to a mechanic’s lien is permitted if the general contractor has posted a payment bond. (iii) In commercial work, an advance waiver of a contractor or sub of its right to a mechanic’s lien is void and the same is true for residential jobs where the ownergeneral’s contract price is $1,000,000 or more. (iii) In residential jobs under $1 million the general contractor and subs may waive their lien rights in advance. - Usually, the contractor pays out 90% of the contract to the sub until everything is all set. See the chart below. Commercial Residential Less $1 Advance Waiver Advance Waiver mill Permitted NOT Permitted $1 mill Advance Waiver or more NOT Permitted EXCEPT SUBS May Advance Waive if General Has Posted a Payment Bond -Advance waiver permitted in residential work less than $1million…hurts the small subs…very difficult. Smallest workers have no rights at all -In theory, owner could pay the entire contract price to a general contractor, he could not give a nickel to the subs, and the owner would owe the subs the entire amount. -If the subs have knowledge of the contract price and disbursement mechanisms, their claims are limited to the remaining balance -When you are buying a brand new house, you are relying upon authenticity and representation of the builder…new statute may encourage big homebuilders to put waivers in Q. A. Complicated. How about this issue of double payment? The owner pays the general but does not get a credit for the payment. The owner can cut down his liability to the unpaid balance. If sub has knowledge of contact price and the terms of disbursement before the sub starts work, the sub is limited to a pro rata share of the balance under the contract. Or, if the contract is filed before any work starts, all subs are so limited. Q. A. Do the amendments have any new provisions that benefit the developer or the construction lender. Mechanics liens are always subordinate to Purchase Money Mortgages and to advances to fund construction under an Open End Mortgage. Q. Are home owners treated the same? A. Yes, except in one particular. A BFP takes free of liens for alterations or repairs unless there are of record before the sale is closed. 6. Advance Waiver: a. Advance Waiver: i. Ex: It used to be that owners, if they had enough clout, could get the general contractor to agree that he would not file a MechL. In advance, they would advance their right to a MechL. ii. Current Law in PA 1. Commercial Construction: Advance waiver is not permitted 2. Residential: Less than $1M, advance is permitted. Over $1M, it is not permitted. a. Exception: Subs may advance waive if the general contractor has posted a payment bond. iii. Why Advance Waiver: This way a buyer of the property won’t be afraid that a sub contractor or other qualified person is going to file a mechanic’s lien on their property after they buy it. (MechL can be filed up to 6 months after construction is already complete) b. Retroactive Waiver: i. The sub acknowledges receipt of money due on a given date in exchange for the owner’s making another progress payment. ii. So, before owner advances payment 9, he will require the contractor or sub to say that he was paid payment number 8. This isn’t advance waiver, it is waiver as work progresses. iii. This way, the most the owner is ever on the hook for is one month’s payment. c. Another Option: Owner will require sub to have knowledge of the contract price and terms of disbursement before the sub starts work. T/f the sub is limited to his pro rata share of the balance under the contract. i. If the K is filed before work starts, even better, b/c all subs will be so limited. 7. Payment Bonds and other methods: a. Surety Bonds: Protect the builder when they bid too low for a project or if there are unexpected building conditions to raise the cost of construction, or if people in the deal are stealing money. Instead of issuing a policy, they issue a bond. i. Payment bond: guarantees payment of the bills of the supplier of labor and material. ii. Performance bond: The bond company agrees that if work is not completed as in the K, it will come back to the job and employ such resources as necessary to complete the building in conformity w/ the K. If the job isn’t finished, they will finish it. Only used regularly in public work. Idiosyncrasy of tax payer expenditures. Contractors have to get the bond…but ultimately the consumer does. Public work has a slightly higher expense. Not everyone can get bonded. Only those which have the cash flow to make the job work. Track record or capital can justify a performance bond. 1. These are very expensive and only for huge players: b. Ways to avoid getting a performance bond i. The lender will release funds by check jointly to the owner and the contractor in order to insure against diversion of funds. 1. The contractor agrees that on the request of the lender, the contractor will complete the project if the owner goes into default. ii. Letter of credit: Owner/Developer gets these instead of cash escrow of the funds that they are obliged to invest in the project. Generally collateral must be posted. A not from the bank (clean letter of credit – on demand from the lender, bank x will deliver on behalf of the borrower $2 million, unconditional promise). Bank must treat letter of credit as a loan. Sometimes it is secured. To get a letter of credit, smaller companies post collateral. 1. The owner is obligated under the loan agreement to have sufficient funds in escrow or covered by a letter of credit to complete the project. Thus, if the project cost has increased, the increase must be pre-funded by the contractor to avoid being in default. iii. Holdback: Owner/Developer holds back 10% of owed total from GC as a guarantee that GC will finish the job; GC does the same for subs: 10% is substantial portion for GC that it does the job; they get the remainder upon completion. It is like an escrow account. GC and subs are often left 10% short because of the holdback. Chapter 8. Defaults, Workouts, and Foreclosures A. Working Out Defaults by Private Agreement 1. If the parties can’t reach an accommodation then their options are: a. Chapter 11- This is the debtor’s choice i. This will keep the debtor out of foreclosure just by filing. But, this costs time and money and the results are unpredictable. ii. Debtor could have lost 1 big tenant, bankruptcies of tenant’s, bad market conditions, and poor mismanagement iii. However, You can mold the sale method to suit better. You can have a public or private sale. If you do private sale, you then go to Bankruptcy Court and ask if anyone has a higher bid. That way, you are ensured of a good price. 1. Note: If you are highest bidder prior to Bankruptcy Court approval and someone outbids you there. What protections do you have? a. Ask for a breakout fee which will say if you sell it for more, you owe me a fee. b. Foreclosure: This is the ME’s choice i. Risks for ME – doesn’t get his money back (public sale doesn’t result in enough $), there may not be recourse (even if recourse is available it may be irrelevant if developer doesn’t have any funds as the reason he defaulted), there is no private sale context (it is just the highest bidder at the time), bad public image c. The primary benefit of a private resolution is elimination of the ―worst case‖ for either side by settling on something in the middle. Often, this happens because the Mortgagor offers a ―quick‖ deal which has important economic implications because of the time value of money. 2. Accommodation to Avoid Foreclosure: Work-out defaults by private agreements; viewed as a Win-win: a. renegotiate terms; maintain management- give a chance to turn around; avoid foreclosure b. Cardinal Rule that any loan modification agreement contains an estoppel clause, to the effect that the borrower has no claim, offset or defense against the lender or with respect to the collateral. c. Lender and Borrower will try to restructure by means of a work-out agreement which might include: i. Renewing the loan or forbearing from exercising remedies 1. Could use notes here ii. Reducing the Interest Rate 1. This isn’t very common iii. Deferring Interest for some period 1. This is common. Interest simply isn’t collected and is accrued on the principal. The amortization schedule is kept, resulting in a balloon at the end, which is then refinanced. 2. Since interest is much greater earlier, this will be a huge reduction in payment iv. Redoing the amortization schedule 1. Amortize on a longer or same term, but have a balloon at the end b/c monthly payments are reduced. A simply re-finance is done. 2. Alt: Instead of redoing the whole lump, leave the remainder intact and agree that the payments will be 60% of the total for say 4 years, 70% for 4 more, and 85% for last 4. This will leave a balloon at the end, which is then refinanced. v. Alternative: Define expenses to our mutual satisfaction and you’ll agree to pay debt service up to X$. i.e. just pay up to a certain amount in excess of what you are earning. The leftover that you owe will be accrued and will end up as a balloon to be refinanced at the end of the term. 1. Lender does this b/c if you are struggling, the building isn’t worth very much b/c there is no income. T/f lender is willing to wait and see if building increases in value before foreclosing. vi. Lender Gets a Kicker vii. Finally – Deed in Lieu – discussed later d. Real World Situation i. Default before completion 1. Recourse against individual guaranator of the construction loan generally is unlikely because the project would instigate a fight and most real estate assets are hidden everywhere. Pain inflicted by the controversy will be great, because of all the costs and fees 2. Bidding by third parties at a sale of a partially completed project always fetches a fraction of the actual value because the project is full of risks. 3. If there is competitive bidding, a higher price for the uncompleted project is more likely upon foreclosure. The price may be equal to the amount footed by the construction lender. ii. Default after Completion and Closing of Take Out Loan Typically, the take out lender does not want to foreclose because income from the building is low when there is a default and, therefore, the foreclosure sale price will probably be LOW Accommodation to Avoid Foreclosure a. Renew loan or forebear from exercising remedies; b. Reduce interest rate; c. defer interest for some period; d. redo the amortization schedule—a longer term, or same term but have a balloon because monthly payments are reduced; and e. if others fail, a deed in lieu deal that offers quick control of property to mortgagee and benefits to mortgagor—waiver of the deficiency or carve out from nonrecourse. 2. Roberts, Some real estate defaults are simple to solve, while others are beyond hope. Most are in between and the skill and know-how of the developer must be evaluated in the context of a default. Questions that must be asked by lender about the deal: a. Asset: i. Title Search? ii. What is the revenue streams? iii. Physical condition of the property? (New construction of finished? Engineering study?) b. Owner: Who is the owner? Is this the only one in default? Single-purpose entity? Who’s behind them? And what’s going on in general? v. Are there corporate entities that are general partners? vi. What resources do they have? If they have a lot of money, you can do a good workout and save the building? c. Economy i. Our availability of funds? ii. The state of the market? iii. National and regional economic issues? iv. How is the rental market in the city? d. Project i. What is the business problem? ii. Is the project misconceived? iii. Did they take too many risks? e. Time Span i. If I was to get the building in 2 years, how successful would I be? The more unknown the ability to be successful, you may be happy to see whether you can do a work-out 3. Lenders have a simple solution to avoid having the loan officer who initially approved the loan and administered it also determine the workout terms. The solution is to perform due diligence and careful scrutiny of all elements of the old and new deal 3. What does bank have to determine about Developer before it makes any decisions to refinance or make a work-out deal? a. Assess risks of foreclosure; is the D victim of bad market; delay in notifying lenders of problem could look bad for D but there is also risk that L will act adverse anyway b. assessment of collateral: building c. assessment of revenue source: tenants and leases d. assessment of management: owners e. If debt svc is larger than cash flow; (usually vacancy or discount rent) then ask for workout 4. Human Nature Part of Work-Outs a. The person who approved the loan shouldn’t have a vote on approving the deal. b. There needs to be a control mechanism b/w the lawyers, client, and the bank officer. So you have an outside (still in the firm/company, but outside the deal) experienced officers review and approve i. ii. iii. iv. 5. Best way to avoid foreclosure: You forgive former defaults, you have a forebearance agreement, and going forward you don’t have any basis to accelerate because payment obligations were adjusted. Match available cash with what is required to pay to get the contractor back on his feet. 6. Ideal solution for many owners is to bring in a partner. 7. Another solution that would be a decent result (less time and money) is a deed-in-lieu B. Deed in lieu 1. Sometimes a work-out is not appropriate solution from Lender’s perspective. This could be b/c of economic conditions or loss in confidence in the MR’s management a. Rather than initiate a foreclosure, the lender may propose that the MR convey the property in exchange for: i. Cancellation of all (or most) of the mortgage debt and ii. Sometimes the payment of additional consideration b. The basic trade-off is that the lender benefits by i. Gaining control and use of the property quickly, no litigation ii. Cooperation w/ new owner taking over, EE’s keep jobs iii. Avoid bankruptcy b/c lender will have title c. Essentially, the lender rips up the note, cancels the deficiency, and receives the deed. 2. Legal issues: a. Clogging: CL doesn’t allow waiver of eq of redemption if it was part of the initial loan transaction i. However, post-default deed-in-lieu transactions are not subject to the clogging rule b/c the conveyance (which in effect waives equity of redemption) is after the original transaction closed. ii. If deed in lieu looks involuntary- CL may be more enforced b. Merger: CL says that if the ME obtains title to the mortgaged property, the lien and the fee merge and the mortgage is extinguished. i. Problem: This will mean that the ME owns title subject to any jr. liens ii. To prevent1. Convey title to subsidiary; who preserves priority because the ME doesn’t get the fee. The owner of the loan (the ME) and the owner of the fee (the sub) are two different entities. 2. Say it is not a merger 3. Give B covenant not to sue 3. Fraudulent transfer: a. If the amount of debt extinguished is substantially less than the FMV of the property conveyed, the deed in lieu may be set aside as a fraudulent transfer i. Ex: If FMV is $1M and debt is $500K. Borrower gives lender property in exchange of discharge of debt- to the other creditors it looks like you shortchanged the value of bldg. 1. The other creditors will say that you shortchanged $500K worth of value which could have gone to them to discharge debts 2. If, at the time of transfer, the debtor was insolvent or the transfer made him insolvent, the transfer would not be allowed. Because of insolvency question, as a pre-requisite to doing a deed-in-lieu-of-foreclosure you need to do due diligence on solvency, and at least get to a good level of comfort, and then you have to go out and get appraisals. Want to prove bona-fide status. b. To prevent get an appraisal and keep in file; i. require % (60-80% minimum) of appraised value for discharge of indebtedness c. If there is a foreclosure action, no matter how low the price, it can’t be attacked as fraudulent b/c there is an open bidding process. 4. Recording Act: a. Must be BFP: some evidence of hard cash transfer is needed to get protections of RA. b. Workout agreements change the terms of note: if there is junior lien; there are issues i. Increased interest rates: higher rate for senior means less money available to pay junior. Increase in principal due: higher amt for senior means less money for junior. Extension of Time for Repayment. Etc. 1. Both cases, junior will argue the change in terms, especially the change in the amt due amounts to a new note- old note has a fixed amt that is secured. ii. What can the junior lien do to protect its interest? Priority ME must follow law (set forth below) c. Priority Issues: To retain priority of senior lien i. CL: If you toy w/ the note at all, the first mortgage loses it’s priority. 1. Not generally good, because workouts would be impossible if other 1st lien knew his priority would be extinguished 2. Anything that increases the risk to the second and third lien causes the 1st lien to lose its priority ii. Rst and Majority: The priority of the first ME will be affected if the second ME (jr. lien) is materially and adversely affected. 1. If the 1st lien priority was help, maybe the second and third lien priorities were helped as well. iii. Changing amortization schedule (extend term of the note and defer interest for a while) to have as longer is ok- more money available to pay junior iv. Might shorten the maturity date – people have to refinance earlier, so it might be more difficult to pay the balloon payment v. Increase the interest rate d. releasing guarantor: e. Doing a workout also impact a guarantor: guarantor only bound by the terms of the note; if the workout is seen as a new note agreement then guarantor can back out; f. In practicing in a transaction setting, the problem becomes ―do we ever want to have a mortgage that does not allow any further encumbrances?‖ Ordinarily, the senior lender would be nice and cordial to liens 2 and 3 because they want a workout agreement and they want to give the other lenders notice to determine quickly whether there is an adverse issue in this case. g. Solutions i. Make sure junior liens and guarantors do not adversely affect workout agmt ii. This is why loan docs say due on sale if junior encumbrance (because junior line didn’t take subject to the changes in the financing structure) iii. Have a provision that says ―guarantor waives right to discharge because of the result of workout‖ iv. Have a provision that says ―no further encumbrances‖ 5. Tax: a. The source of the tax problem is depreciation taken on property. Basis is reduced by depreciation taken. It is appreciating pursuant to market forces. If the reduction of the debt is slower than the depreciation, you may owe more. The depreciation of the basis brings it down. i. Ex: If you have $900K in debt and $700K in basis (after taking depreciation deduction), you won’t get any cash if you give a deed in lieu. But you are treated as if you have $200K in realized gain 1. $900K in debt discharged pursuant to deed in lieu, basis is only $700K. T/f $200K in gain. (Taxable gain)(Phantom Gain because there is no real cash gain) B1 Acceleration 1. Installment notes contain acceleration clause because otherwise you are under CL only entitled to payments past due; a. W/out an acceleration clause, in the event of foreclosure, you would only get those payments that have happened up to the foreclosure date. All future payments would be lost. b. Also, you lose your lien on the property. 2. Acceleration Clause Components: a. Acceleration should be contingent upon (1) Notice and (2) ability to cure i. PA: requires notice of intent to accelerate, not notice of acceleration ii. PA: Must let defaulting party know what the cure is, and what they have to do to cure it b. Conversely: Rst: States that you can enforce a default and defaulting party can’t argue that it is a penalty. If defaulting party didn’t pay on time, well, the made an agreement to pay on time and didn’t. c. Borrower: will always want to condition the right to accelerate on a default that is legitimate. Not mistake or accident 3. Acceleration is bad for the borrower only if the rate on loan is lower than market rate. 4. 5. 6. 7. a. Thus L conditions the acceleration with prepayment fees: (there is always the issue of unenforceable penalty) FNMA Mortgage: a. Typically there are 3 schools of thought w/ default: And these only arise if there is NOT an effective notice and opportunity clause written into a K: i. Majority/Rst/Traditional Rule: Enforce acceleration if default. It is a fair bargain when you agree to pay it back. Default is always your fault ii. Equity: Default caused by actions beyond your control. It wasn’t defaulting party’s negligence, accident or mistake, won’t enforce accelerations iii. Defacto: Need to show some reason to declare default if there was simply a matter beyond the control of the defaulting party b. However, FNMA: Although it has an acceleration clause, it gives: i. Right to pay accrued arrearage up to the time of foreclosure judgment, which will take away acceleration (Don’t hear about average Americans complaining to pull the trigger quickly. Open-ended right to pay arrearage instead of balance if they pull the trigger) ii. Also has the notice + right to cure provisions iii. People losing their houses is generally bad thing, and the best way for FNMA to get paid is to allow borrowers some leeway in making payments c. The big difference between FNM and other commercial residential agreement? i. Paragraph 19: Ability to pay accrued arrearages and cure default up until 1 hour before sheriff sale, as if no acceleration had occurred; must also pay expenses including attorney fees d. Most jurisdictions have the notice + opportunity to cure language though. In arguing oppressive and unconscionable, you always also argue that there is no material harm to L. L wants to provide that accepting late payment is not a waiver of L’s rights to terminate and declare default. There might be something about avenues a ME can pursue or something…Arrearage legislation in PA – can only cure default 3 times a year. B2 Possession by Mtgee 1. Lien Theory Jurisdiction: ME has no legal right to obtain possession of the premises. Only has right to foreclose on the lien. Since a mortgagee takes possession by consent not by legal right, the mortgagee’s rights are those of the mortgagor and the mortgagor has no right to terminate the lease a. BUT: i. (1) If the MR relinquishes possession to the ME voluntarily AFTER default or ii. (2) The MR abandons the property and the ME enters to protect the collateral, iii. Then the ME may take possession as a ME in possession. b. Rst: Most lien theory jurisdictions do not enforce a ―consent‖ in the mortgage to the ME taking possession. c. If the jurisdiction does enforce a ―consent‖ then it switches from a lien to a title jurisdiction b/c the ME then has an absolute right of possession b/c of MR consent and does not need to satisfy either of the above 2 qualifications 2. Title Theory State: ME can take possession before or after default. If a mortgagee takes possession, the mortgagee may terminate leases that were entered into before the mortgage but may terminate leases that were entered into after the mortgage was recorded. 3. Intermediate Position: ME can take possession after default if provided for in the mortgage B3 Impact on leases 1. Title: If a ME takes possession, the ME may terminate subordinate leases, but not leases that were entered into before the mortgage. 2. Lien: ME takes possession by consent, not by legal right, the ME’s rights are those of the MR and the MR has no right to terminate the lease. B4 Mtgee in possession is a fiduciary for Mtgor and Jr Lien holder 1. Must manage prop prudently in a quasi fiduciary manner 2. New York & Suburban Federal Savings & Loan Association v. Sanderman: ME in possession must act as a prudent owner and give notice at least to a holder of a jr. encumbrance. a. The court found that hiring an around the clock guard to patrol the property for over one year was not a situation where the ME acted in good faith on a temporary basis in order to secure time to find out what to do w/ the property. b. They didn’t need the security guard that long. c. Have a court of equity, if collateral in current condition is not worth current debt. Looking for accessory complementary relief. The ultimate case is getting to foreclosure. Interim relief can be attained in the form of RECEIVERS. 3. But conversely ME while in possession may be liable to third parties for torts, so they have to protect themselves. a. T/f ME does not like to ME in possession b/c they have duties B5 Appointment of receiver: 1. Difference between trustee and receiver a. Trustee has title and capacity to transfer title b. Receiver is an appointee of equity court who has control to preserve the asset value, but has no disposition ability. 2. Any unnecessary diminution in the value of the property hurts the lender even more, particularly if the property is under secured, there is waste, and there is a default. 3. Hard burden of proof – Need to prove that you have a loan is underwater; not something you want to have to prove to the world. Have a range of values and it could be litigated. Lawyers often look at the issue, decide who you represent, and if you control the documents you advance your client’s interest in the documents. If you wanted to enhance the likelihood of an equity court to appoint a receiver, you put a provision that says “on default, I consent to the appointment of a receiver.” 4. In most states, no rents can be possessed by Lender until foreclosure: a. Risk: Borrower may be irresponsibly spending that money while in default 5. Solution: A receiver is appointed by the court presiding over a foreclosure. The receiver is an ―agent of equity‖ who is generally appointed to preserve the property and the rents from waste or dissipation by the MR and preserve the interests of the ME. a. This is as opposed to having a ME in possession 6. Traditional Criteria in both Lien and Title Jurisdictions: (if these are met, the receiver clause will kick in) a. Default b. Inadequate security (debt is greater than the value of the property) and, c. The MR is committing waste by not maintaining the property, failing to pay taxes or properly insure the premises, or collecting rents but not making the mortgage payment. 7. Agreeing to the Appointment of a Receiver: a. Mortgages often provide that on default, a ME may have a receiver appointed, i.e. ―consent‖ provisions. State courts will treat these in the following ways: i. Court of equity is not bound by a consent to a receiver provision in a mortgage ii. Consents are generally enforced w/ a receiver routinely appointed. (this is sometimes governed by a specific statute) 1. Rst: Consents are enforceable iii. The consent is treated as creating a presumption that a receiver should be appointed even in the absence of proof of inadequacy of the security or waste. b. Concept of Waste: This goes to the integrity of the building or the insurance. c. Solution: receivership: an agent of equity: no title but manager- collects rents and hold for the payments due; 8. Impact on Tenants of a Receiver: a. Receiver may terminate leases subordinate to the mortgage b. Ordinarily, appointment of a receiver is not a basis for a tenant to leave. There is no breach of the landlord’s covenant of quiet enjoyment until foreclosure is completed. 9. Possible Alternative to Receivership: a. § solution could be: automatic right to rents if default – skip receivership; if default there is presumption that rents are important: thus it becomes mortgaging rents: Shifting burden by §: like power of sale: B has to prove that he can cure it 10. A receiver has duties, risks, and the right to compensation. The ME is not responsible in any way for the mistakes of a receiver. Thus, ME’s prefer the receiver approach over the ME in possession. a. Also the receiver can manage and improve property and get new Ts B6. Assignment of rents and leases: mortgaging rents 1. Rents are produced from the real estate, and the fact that a real estate is leased changes collateral. Once those moneys are earned it isn’t real estate, it’s personal property. Article 9, UCC, security interests in personal property gives an exclusion for rents 2. All transfers of intangible assets are assignments 3. Need to appoint a receiver until you can take the assignment to the courthouse and gte it approved. 4. A mortgage creates a security interest in the premises. Rents derived from the premises are not real property. Thus, MR’s took steps to obtain an interest in rents. a. Leases are contracts that produce rents. Thus, an assignment of leases by a landlord transfers the right to rents under the lease to the assignee. b. The practice is to assign both the leases and the rents to the ME. 5. Tenant is not bound by assignment until Tenant is notified by assignee a. *This assignment of leases and rents must also be recorded with the mortgage as being included (what is the legal consequence in enforcing the rents assignment if it is not recorded) 6. Forms of assignment: a. Pledge of rents: Conditional interest in the rents that is only triggered by default. Courts have required that the conditional interest be activated by the taking possession of the premises by the ME or receiver. i. Basically: ME must obtain possession or have receiver appointed to get rents. b. Absolute Assignment: ME is entitled to rent immediately. Default is not required and language will not refer to it. Rents are immediately payable and may be collected by the ME w/ the ME applying the rents to pay installments. Surplus goes to MR. All you need is notice to Tenants. c. Present assignment with License for Mortgagor to Use Rents: MR retains control to collect rents and L has the title and the right to those rents first to pay debt service: i. Most Title and a Few Lien States: say that this version of assignment becomes self activated on default and if ME serves notice to Tenants 7. Most Lien theory jurisdictions do not recognize the ME’s interest in the rents until an affirmative action is completed. i.e. ME obtains possession and a foreclosure is initiated OR a receiver is appointed. 8. Restatement position – Pro-lender 9. Ganbaum (P. 388): Present assignment, automatically effected; rents are incident to title: mortgage does not convey title: thus rents cannot be assigned through mortgage; B was sued by L for not using rents to pay tax and debt. 10. Issue: What does the ME have to do to get the rents? a. Rents on default provision that will work automatically b. Take possession or have a receiver appointed SEE p. 114 PROVISION…SEE HOW IT HELPED LANDLORDS If I have a security interest and an interest in the rents, and you file bankruptcy before I can go to the state courts, then I have to re-evaluate how much money and at what interest rate do I need to lend money. B7 Bankruptcy 1. Landlord’s have more special interest amendments than any other interest groups 2. When an affirmative act of getting an receiver is caused in order for the ME to perfect/mature the ME’s right to collect rents, a problem will arise if bankruptcy is filed a. On filing of the bankruptcy case, the lender is barred statutorily (a stay) by the bankruptcy code § 362 from seeking to complete the necessary actions to get the right to collect rents. b. Thus the lender had no right to rents b/c Bankruptcy Courts tended to find that the required affirmative acts had not been completed 3. Then, in 1994, § 552(b) said security interest extends to rents: ―if I perfected my security interest- by filing and recording the mortgage or assignment on rent then in Bankruptcy I get the rents‖ a. In other words, this clause perfects assignment of rents to the ME as long as the assignment of rents is recorded in public record b. This section preempts absolute assignment/ license concepts; MR goes to default then ME get rents b/c ME recorded that MR agreed to it. c. Advantage of bankruptcy: sell the collateral in an orderly way 4. Then, once this has been completed, ME must look at mortgage to see what it says about assignment of rents and look at lease to see what it says about lien on rents; 5. Prepayment by T to L does not bind ME; prevent abuse in times when borrower is tight on money C. Rights and Duties of the Parties at Foreclosure 1. Overview: Strict foreclosure has been abandoned. Instead public sale of foreclosure, etc. has been adopted. Lender’s only interest is in getting paid. a. Traditional Power of Sale tend to realize less than the ―value‖ of the property resulting in large deficiencies. Responses have been: i. Restrictions on deficiency judgments. Judgment is only available to the extent the lender proves the value of the collateral, as distinct from foreclosure price, was less than the debt. ii. Confirmations of foreclosure sale by the court iii. Setting of upset prices below which the property won’t be sold iv. Statutory rights of redemption, where MR can repurchase for foreclosure price. 2. Methods of Foreclosure: a. Judicial: this is complex, expensive, and time consuming i. See p. 108-9 for things L must do in judicial sale ii. Judicial is good for small time owner, b/c it gives them time to do something about it. b. Power of Sale: Less expensive, speedier, less complicated i. Conduct by a private person, but the sale is done by a public auction methodology. They don’t have a complexity of dealing with sheriff’s sale and implications ii. There is no sale pursuant to a state statute, no judicial proceeding, you can have either a public auction or a private sale, and the trustee sells pursuant to the terms of a deed of trust in a deed of trust PoS. iii. Drawback: Title is less certain, but you can obtain title insurance. iv. The burden is on the MR to prove that a PoS should not go through v. Proper Notice Must be Given in PoS 1. Otherwise, sale is voidable 2. T/f if you represent the owner, and before a 3rd party buys at the PoS, you can void the PoS c. Karontas v. Home Fed Bank: Seller must disclose knowledge of defects in the property and residence if material facts are known to the seller and the seller knows the buyer does not know and can’t reasonably discover. 3. Three Categories of Innovation a. Restrictions on deficiency judgments b. Confirmation of the foreclosure sale by the court c. Setting of upset prices below which the property cannot be sold d. Statutory rights of redemption under which the borrower can repurchase the property for the foreclosure sale price during a specified period of time following the sale. 4. Steps a lender follows in judicial foreclosure P. 395 FILL IN BELOW a. Lender must obtain title search to determine who has an interest in the property. Junior interests must be joined as parties defendant or they will not be cut off by foreclosure b. Lender must file lis pendens notice to prevent bona fide purchasers and other form acquiring c. The lender must file its foreclosure complaint and serve the summons and complaint on the necessary parties to the action – those whose interests are to be affected by the foreclosure d. A hearing will be held, perhaps before a master in chancery who will prepare and submit a report to the judge regarding the status of debt, the debtors, and the security, following which there will be a court judgment that a sale will be held and setting forth its terms e. The sale is advertised to the public pursuant to statutory requirements f. A court official conducts a sale. Th lender will attend and must be prepared to bid to protect its interest. g. After the sale, a report of sale is made to the court and a determination is made as to borrower’s and borrowers’ creditors’ rights to surplus h. Lender may petition for a deficiency judgment decree if the borrower is personally liable on the note and if such a judgment is permitted in the applicable jurisdiction i. In states that have enacted legislation giving the borrower a right of redemption after foreclosure, the purchaser cannot possess the property until that period has expired 5. Rules: a. Rule: Mortgage foreclosure does not cut off any interests (mortgages, easements, or leases) senior to (recorded before) the foreclosed mortgage b. Rule: A mortgage foreclosure cuts off interests that are junior to the foreclosed mortgage, only if, the junior interest holder is joined and served in the action. c. Problem 8.2: Ace Ins is foreclosing i. Paula: not affected b/c prior to Ace ii. Ace: recorded its mortgage here iii. Fuller: discharged b/c below Ace but must be joined iv. Mechanic: Relates back prior to Ace, so not affected v. Widget: has non disturbance K w/ Ace, so not affected vi. Sans Argent: can cut off if joined. vii. Amer Tele: can cut off, but may not want to b/c of strength of company even though it is below market 1. Sidenote: foreclosure might be breach of Quiet Enjoyment viii. Sam: can be cut off if joined 6. Cutting of Juniors: If junior is not joined in action, they must accept the buyer as the new owner/lessor. a. In some jurisdictions, if Junior in not joined, Taggart believes they may quit anyway b/c foreclosure is a breach of quiet enjoyment b. Problem 8.4: Property valued at $18M, but no buyers i. Ace: Debt of $15M ii. Fuller: Debt of $10M iii. $1M priority real estate tax lien iv. Total: $26M c. Solution: Ace will only bid up to $17M b/c that is $1M less than the value. This is b/c Ace will then be able to recoup their debt, plus pay off the lien, plus cut off Fuller, and t/f break even. d. What is highest Fuller would bid? 7. Circular Priorities: Two sources of law cause conflicting priorities in example RE primes first lien as matter of law, and Tax Lien has priority over RE as matter of law a. Ex: Ace: $15M, Fed Tax Lien: $2M, Real Estate Tax Lien: $1M i. Ace is before Fed Tax ii. Fed Tax is before Real Estate iii. Real Estate is before Ace b. Solution: RE Lien, Ace, then Fed Tax i. Why? Fed Tax is ALWAYS junior to Ace, it will always have $15M in front of it. ii. T/f Fed Tax is treated appropriately, RE gets its priority, and Ace is treated relatively appropriately. c. To cure the subprime crisis, you can abrogate deficiency judgments i. Some statutes have tried to deal with claims for more efficient foreclosure by prohibiting deficiencies. ii. Most of the time, the lenders are regulated by the government. iii. You either ban deficiency judgments completely (not common) 8. Protection of Borrower/Regulation of ME remedies a. Severe and prolonged economic downturns, whether caused by drought, flood, or other natural event, or by more subtle market factors result in real estate owners losing their properties to foreclosure. A compounding loss is the possibility of a deficiency judgment b. Deficiency Judgment: If foreclosure doesn’t bring a fair sale price, the ME can obtain a deficiency judgment against the ME for the remaining amount of debt. c. Ex: Debt is $500K. At the sale, property is bought for only $200K by ME. Deficiency judgment of $300K against MR is entered. i. If bank sells a year or two later for $400K, they don’t really earn money. So no problem. But the mortgagor finds the results unfair ii. Problem arises if they sell for anything above $500K b/c that will be harsh to the MR. iii. Question: Isn’t is unfair no matter what b/c ME gets the deficiency judgment PLUS can resell? Isn’t that double dipping so to speak? d. Carve-Outs and Exploding Guarantees may eliminate or reduce the benefit of a non-recourse mortgage loan. Conversely, not all ME’s will ignore a deficiency judgment i. Maybe this explains, if MR has non-recourse, even w/ deficiency judgment, there is nothing for ME to get? e. Examples of Who Could be Barred in Obtaining a Deficiency Judgment in a Judicial Proceeding: i. Vendor ME, Vendor or Third Party PMM, Vendor or 3rd Party PMM of residential only, 3rd Party Institutional Lenders f. Some Jurisdictions prohibit a deficiency judgment if there is a deed of trust or MR’s PoS. But allow it under judicial proceeding 9. Private Sale a. Some jurisdictions allow deficiency judgment if there is a judicial sale but not if the sale is under a trust deed or mortgage power of sale. 10. Trade-Offs: a. Trying to give the creditor something in order so they don’t have a deficiency judgment b. Some states say that in exchange for allowing a PoS proceeding which is quicker, you must give up your right to deficiency judgment c. Some states say that if you want a shorter period of statutory redemption, then you must give up right to deficiency judgment. 11. Trading off Shorter Post-Sale Redemption Real estate industry is trying to extract a price or give you an incentive to give up your deficiency judgments. In the short term, deficiency judgments have to significant economic value because you can’t collect on them. 12. Fair Market Value Legislation: a. The example of the bank bidding in a small part of its lien and still suing for the balance led depression era legislatures to try to fix the problem by substituting the ―fair value‖ of the property for the ―sale price‖ in calculating the deficiency. Even in these states ―fair value‖ did not necessarily mean ―fair market value.‖ i. Difference between debt and fair market value ii. Economics don’t like this because the economists feel like the public auction IS fair market value and the statute ruins that. Sympathy though, for notion that foreclosure market is a limited market. iii. Applies not to every buyer but only to foreclosing mortgagee because the PMMortgagee is going to get a windfall because it is a bad sale. Trying to prevent the windfall to the bank. Theory is that it should create an incentive for the bank to bid a larger percent of its lien than it might otherwise do. 1. Critical detail in a FMV statute. Counteract bias and presumption by burden of proof. Presumption is that the debt is the FMV and the burden is upon the ME to come in and make a case that the FMV is in fact something less than the debt. b. CL: court will not set aside a sales price b/c it is too low unless it is so low as to ―shock the conscience‖ of the court. i.e. 40-50% below market c. How did the Montana Supreme Court deal with the issues in 1989 in the Gallerian Partnership case (p. 410)………………….. d. Evolved CL & Statutes: i. Use minimum bids ii. Procedure that looks at difference b/w Debt and Fair Price, instead of debt and price. Fair price is left to experts e. Farm States: There is right to redemption (which is ability to buy back at purchase price), so ME will buy, then offer opportunity for farmer to redeem. T/f the assumption is that ME will bid up the price to reduce their deficiency f. One Form of Action Rule – Foreclose the Mortgage First i. California and some other jurisdictions require a mortgagee to first foreclose on the property and only after the sale may the mortgagee sue the mortgagor for the balance due. ii. Must pursue real estate collateral once. iii. A variation is an election of remedies rule that provides that once you start either a personal action on the debt or a foreclosure action you must complete that litigation first. iv. In most jurisdictions a mortgagee may sue on the debt for a personal judgment and foreclose the mortgage at the same time. a. g. The Daily case, which is discussed at p. 419, illustrates the severity of the penalty under California law for seeking relief on the note (the personal obligation) before foreclosure. The facts of the problem are as follows: —$25 mill commitment for take out —fund $23 mill and hold back $2 mill because work not complete —owner does not complete the job and defaults on the payments ---issue: what is the status of the $2 mill. —lender applies $2 mill to reduce the $25 mill loan to $23 mill 13. Bankruptcy Impact a. In residential Mortgages: Individual has right to pay arrearages to prevent foreclosure. T/f Chapter 13 is available, which allows you to finance your arrearages. Assumption that MR will be able to resume payments. b. Chapter 11: You get additional time to negotiate to keep your property and possibly even get a lease (for commercial RE) and thus improve your building’s worth. Plus Chapt 11 forum for private sale. Foreclosure is stayed. c. Vacancies b/c of Tenant Bankruptcy: Tenant has ability to disaffirm the lease, which allows them to make the landlord an unsecured creditor. Landlord can no longer accelerate on them. i. Also tenant will be allowed to assign his lease in bankruptcy, whereas otherwise he wouldn’t be able too. 14. Letters of Credit a. Letters of credit can be obtained to cover certain obligations b. Dual-note (one secured by real estate and letter of credit) i. Problems: potential compliance problems with respect to investment statutes affecting the availability of certain usury and shared appreciation exemptions under CA law and potential defenses of marshalling of assets, applications of proceeds and certain bankruptcy issues 15. Sale confirmation: Equity and Individual Justice a. Borrower protection may be direct as well as indirect and may or may not be effective. b. Slow and Difficult Procedure c. Rules to protect common folks from the ―cold hearted‖ bank. d. ―Super‖ Efficient Power of Sale e. Courts and legislatures have been reluctant to void sales merely because of price. But in some jurisdictions, the practice is to set an ―upset price.‖ 16. In re Krohn (p.421) is an example of the extension of equity’s protection to deed of trust sale. The common law approach applicable in judicial foreclosures is summarized by the court as follows: foreclosure sales are set aside when the inadequacy of price of so great so to shock the conscience. Judicial foreclosure sales have been set aside in absence of gross inadequacy when there has been an irregularity. Where there is an inadequacy in price which in itself might not be grounds for setting aside the sale, slight additional circumstances or matters of equity might so justify. a. The purchaser argued three reasons why the court should not even entertain actions that seek to challenge the amount paid at a trustee’s sale. i. The court rejected the ―chilled market‖ argument because they weren’t presented with evidence or data indicating that prices paid at sales made under power of sale bring an appreciably higher percentage of fair market than prices bid at judicial foreclosure sales. A chilled market is a market that has some irregularity in some way (blizzard during sale) ii. The court dealt with the quality of title - BFP argument this way – Price paid within purchaser’s control. Purchasers can make a reasonable bid that is not grossly inadequate iii. The difficulty in establishing the fair market value was dismissed because Section 8.3 of the Restatement takes the position that if the sale price is less than 20% of FMV the court is warranted in invalidating the sale because of gross inadequacy iv. Working theory is that we know that the foreclosure process is not going to bring anywhere near FMW. 17. Post-Sale Statutory Redemption.(p. 427). a. Many states in the mid-west have adopted post-sale redemption statutes. These statutes are very complicated. They share two goals: i. provide an opportunity for the crop and weather cycle to turn favorable allowing the farmer to save the farm, and ii. Reduce the deficiency judgment by encouraging higher bidding iii. A Second Chance. Farm sold for $150,000. Buyer does not take possession for one year. Owner or any junior may ―redeem from the sale‖ by paying the buyer $150,000. Can reacquire the property not for the debt but for the price paid by the buyer. 1. GOALS a. Keeping property in hands of farmer b. Incentive for buyer to bid higher to make it less likely that they will exercise their right to redeem. 2. What happens to the mortgage? a. If there is $ of the mortgage unpaid. The net result is that, when you reacquire the property, the $ lien comes back. Creates an incentive to bid to minimize deficiency, but also that, if I do reacquire it at an attractive price, you don’t abrogate the lenders’ loans. That ensures that farming lenders would want to continue to lend to farmers. iv. Another option: when bank is trying to decide whether to stop the bidding at a certain level or go higher, the bank looks at all the different mortgagees, and the mortgagees only have incentive to redeem if they are getting more value. Farmers had multiple liens. The goal is to have an ongoing process that is self-correcting. Deficiency goes away when you have a post-sale re-sale to the various mortgagees. b. If there is a mortgage you don’t know about upon sale, then the seller has been overpaid. Disaster scenario Omitted Juniors Hypo 1. Owner Mee 1 $10,000 Mee 2 5,000 Sale at foreclosure in which both mortgagees are joined $20,000 sale price: Mee 1 received $10,000 Mee 2 receives 5,000 Owner receives 5,000 Buyer has fee clear of all liens Mee 1 receives $10,000 Mee 2 receives 2,000 and has a deficiency judgment of $3,000 against owner Buyer has fee clear of all liens Mee 1 receives $ 7,000 and has a deficiency judgment of $3,000 Mee 2 lien is discharged and he has a deficiency judgment of $5,000 Buyer has fee clear of all liens Mee 1 Mee 2 $10,000 5,000 $12,000 sale price: $ 7,000 sale price: Hypo 2. Mee 2 is not joined but the buyer knows of Mee 2 existence. Therefore, assuming a fmv of $20,000, the sale price should be not greater than $15,000 $15,000 sale price: Mee 1 receives $10,000 Mee 2 not involved Buyer has fee subject to $5,000 lien. Buyer may prepay the $5,000 if permitted, and if the lien is in default the Mee 2 may foreclose, or Mee 2 may try to redeem Mee 1 lien. In the later event, the $10,000 would be paid to the buyer and the lien would be reinstated. The net result would be: Buyer paid $5,000 for a $20,000 property which is subject to $10,000 and $5,000 liens held by Mee 2. Hypo 3. Owner Mee 1 Mee 2 $10,000 5,000 Mee 2 is not joined and the buyer does not know of the Mee 2 lien. Therefore, the price paid is $20,000, and the price is distributed as follows: Owner $10,000 Buyer owns fee subject to Mee 2 $5,000 lien On discovery that Mee 2 was omitted, the buyer may try to prepay Mee 2 lien. If this occurs, then he has paid $25,000 for a property worth $20,000, but the Buyer may have a common law action against the owner for $5,000. Moreover, in this situation, absent third party rights created by reliance on the satisfaction of Mee 1 mortgage, Buyer is considered to hold Mee 1 mortgage under an equitable subrogation theory, and buyer may reforeclose the lien with Mee 2 named as a party. If that occurs and the property sells for $15,000 to a new buyer, the distribution would be as follows: Buyer as subrogee of Mee 1 $10,000 Mee 2 5,000 New buyer holds fee clear of liens. The Buyer would then have paid $20,000 and received $10,000 as subrogee. He has lost $10,000. Five thousand of the loss resulted from the fact Mee 2 was recorded but not found and $5,000 resulted from the fact the second sale brought $15,000 or $5,000 less than what the Buyer paid. Another remedy for the Buyer in this situation is to seek an order of strict foreclosure against the omitted Mee 2. Of course, the Mee 2 has the right to so redeem. If there is a redemption by Mee 2, the following happens: Mee 2 receives Mee 1 $10,000 lien. Mee 2 has his original $5,000 lien. Buyer as equitable subrogee received the $10,000 payment. Thus for $10,000 the buyer has bought a property worth $20,000 that is subject to a total lien of $15,000. The loss is $5,000. Buyer may then take the $10,000 redemption money, add $5,000 to it and pay both liens. If this occurs he has paid $25,000 for a $20,000 property Chapter 10: Commercial Lease Transactions 1. Ways to adjust rents a. CPI b. Long term you can have an appraisal and adjust the rent c. Adjust rent to go up with other indices – Porter’s wage (link between wage increases in union contract and lease adjustments) 2. In what ways does landlord contribute to your success? a. The landlord in a mall is selling buyers (location, ambience). Landlord might want to profit with retail tenants, a percentage rent. b. Inflation hedge plus getting a piece of the yield c. Some small retail tenants in Bryn Mawr may only own one store, so the fixed rent may be given. d. Does the volume you’ll get at the mall generate more income when you factor in percentage rents than small volume areas with fixed rents? Mostly yes. e. Generally, the fixed rent base you’d pay in a percentage rent lease will be less than what you might pay to open a store in a strip mall. Inducement to come in, then get a target hit point for the percentage rent to kick in. For base rent, you cede a certain amount of gross rent i. If the mall is a success…synergism of tenants essential ii. Having stores dark is not a good thing. 3. Percentage Rent a. Gross sales formula favored by landlords because it is less manipulable by tenants than a net income index 4. Covenant of Continuous Operation a. Lagrew Properties holds Beaumont Plaza and SupRex is leasing space in the plaza. Pharmacy closed its doors after anchor tenant left, exercised its options and landlord appealed to pharmacy trying to sublease to a discount store. b. ―Courts will declare implied covenants to exist only where there is a satisfactory basis in the express contract of the parties which makes it necessary to imply certain duties and obligations in order to effect the purposes of the parties to the contract made, Such covenants can only be justified upon ground of legal necessity arising from the terms of the contract hereof. The implication from the words must authorize the inference or an imputation in law of the creation of the covenant c. To determine whether to imply a covenant of continuous operation, take these factors into account: i. Whether rent is below market value ii. Whether percentage payments are substantial in relation to base rent iii. Whether term of the lease is lengthy iv. Whether tenant may sublet 5. 6. 7. 8. v. Whether tenant has rights to fixtures vi. Whether the lease contains a noncompetitive provision d. Application of factors to case i. Shopping centers are designed for going concerns, not empty store fronts ii. The fixed base rent alone provides no hedge against inflation iii. Lease’s base-plus-percentage rent term is strong evidence in favor of finding an implied covenant of continuous operation e. The presence of a right to assign or sublet is not necessarily inconsistent with an implied covenant of continuous operation Implying covenants of continuous operation a. Commercial leases often contain use clauses so that shopping center may have exclusive rights to certain tenants to conduct their business free form competition Remedies a. Landlord may suffer monetary loss and loss of percentage rentals from smaller tenants in the complex whose sales decline due to decreased shopper traffic the draw left b. Courts refuse specific performance here Restrictive Covenants a. Exclusive clauses, use clauses, radius clauses b. Herman Miller v. Thom Rock Realty Co. i. Was to have been a showroom building being exclusively devoted to contract furniture trade. Furniture industry fades, tenant seeks damages and to released from the lease because landlord rented to non-furniture tenants ii. Lease between parties contained covenant restricting landlord to lease premises only to contract furniture showrooms. Assignments and sublets a. In commercial tenancies, landlords have employed limitations on assignments and sublets to both protect financially unstable or otherwise unsuitable tenants and hedge against inflation to recapture some of the appreciated rental value of the premises b. At common law, a tenant could assign or sublet freely unless the lease prohibited such transfers. Recent trend to apply the contract principle of good faith and fair dealing in interpreting transfer clauses in leases c. Newman v. Hinky Dinky i. Lease says that tenant may not assign or sublet lease without written consent of landlord. ACS asked to assign to Hinky Dinky. Newman didn’t consent and assign was done anyways ii. ―where a lease contains an approval clause, such as a provision stating that the lease cannot be assigned without the lessor’s prior consent, a lessor may only withhold consent only when lessor has a good faith reasonable objection to assignment of the lease, even in the absence of a lease provision stating that the lessor’s consent will not be unreasonably withheld iii. Factors to determine whether lessor has acted in good faith in withholding consent to an assignment of a commercial lease 1. financial responsibility of the proposed assignee 2. assignee’s suitability for the property 3. legality of the proposed use 4. need for alteration of premises 5. nature of occupancy iv. Landlords respond by inserting recapture clauses or profit sharing 1. Recapture clauses allow landlord to terminate lease at its option on tenant’s request to assign or sublet 2. Profit-sharing clauses require tenant to share with landlord some or all profit received from any substitute tenant v. Ilkchooyi v. Best 1. Lessor of shopping center refused to allow assignment unless transferring tenant paid it a portion of the purchase price a. Court held that profit-sharing clause in lease not authorized by statute and has not been sanctioned by Supreme Court 2. How to escape from bad bargain in commercial deal: a. Doctrine of adhesion b. Unconscionability i. Includes absence of meaningful choice on part of one of the parties together with contract terms unreasonably favoring other party ii. FACTORS: 1. oppression from unequal bargaining power 2. hidden surprises in the document in a prolix in a form 3. Terms that are one-sided, lacking in jurisdiction, and reallocate risks in a bargain unreasonably 9. Repairs and compliance with Liens a. Under common law, a commercial landlord has no duty to maintain or repair the premises absent a statutory or contractual obligation to the contrary b. Brown v. Green i. Long-term lease of an entire warehouse by business partners who were on written notice of potential asbestos contamination prior to leasing…Repair clauses required tenant to make all repairs, structural or otherwise…lessor intended to transfer major burden of ownership to lessee ii. FACTORS whether parties intended that the lessee assumed certain risks despite unqualified language 1. The relationship of the cost of curative action of rent reserved 2. Term for which lease was made a. Short term – unlikely lessee would have been expected to assume responsibility of capital improvements to property to benefit owner b. Long term – lessee has more time to amortize the cost of the improvement 3. The relationship of the benefit ot the lessee of that of the reversioner 4. Whether curative action is structural or non-structural in nature 5. Degree to which lessee’s enjoyment of the premises will be interfered with when curative action is being undertaken a. More interfering, the more substantial, the more lessor’s paying 6. Likelihood parties contemplated application of particular law or order involved iii. Where short term commercial lease is at issue ad cost of compliance is more than a small fraction of the aggregate rent reserved over the life of the lease c. Dennison v. Marlowe i. Lessees rented 2-story building and parking area for 5 years…building was later found to be in violation of fire safety code. Lessee’s accepted ―as is‖…expecting no problems ii. Most jurisdictions held that, where tenant agrees to comply with government authorities and alterations or improvements ordered by public authority are substantial, landlord is liable for repairs iii. Intention is determinative iv. Lessee shouldn’t bear alteration costs where: 1. improvements are substantial and structural 2. improvements will survive term of lease 3. Improvements not required because of particular lessee use 4. cost of improvements substantial 5. unusual event that led to need for repair…not in contemplation at beginning of lease 10. Commercial landlord remedies a. Trend on tenant’s abandonment of leased premises to apply the mitigation of damages b. Austin Hill Country Realty v. Palisades Plaza i. Palisades and Hill Country executed 5-year commercial office lease for suite in palisades office complex. Improvements agreement signed to have palisades convert shell office space to working space. Members of Hill country gave palisades conflicting instructions and palisades sued for anticipatory breach. c. d. e. f. g. ii. Traditional common law rule regarding mitigation dictates that landlords have no duty to mitigate damages. iii. Requiring mitigation in the landlord-tenant context discourages economic waste and encourages productive use of the property iv. Mitigation rule helps prevent destruction of or damage to the leased property. v. Mitigation rule consistent with trend disfavoring contract penalties vi. Reasonable efforts to mitigate doesn’t require that landlord accept replacement tenants who are financial risks vii. Replacement tenant must be suitable under the circumstances Four causes of action against a tenant for breach of contract i. Landlord can maintain lease, suing for rent as it becomes due ii. Treat breach as anticipatory repudiation, repossess, and sue for the PV of future rentals reduced by reasonable cash market value of the lease iii. Repossess, release the property, and sue tenant for difference between contractual rent and amount received form new tenant iv. Declare lease forfeited and relieve tenant of liability for future rent Damages in mitigation jurisdictions i. Multiple cause of action approach 1. limits damages to those accrued at time of trial ii. Retained jurisdiction 1. Court retains jurisdiction to enter new damage award as additional rents accrue in excess of mitigation iii. Anticipatory breach approach Percentage Rent i. Obligation on part of tenant to devote premises to its retail business and with all due diligence Security Deposit Agreements i. Landlords require tenants with low to medium credit risks to put down a security deposit, and these tenants may not get into their leases if the deposit isn’t returned, tenant may continue in possession of the property without rent until deposit is recouped Purchase Options i. A right in the tenant to purchase must be subordinated to the mortgage even if fo a price which would pay off the mortgage Ground Leases: Leasehold Versus Fee Mortgage Financing a. Prefinancing decision: whether to purchase or lease the underlying land on which on which the newly constructed improvements will be situated b. If decision is made to purchase the land, developer can obtain a regular fee mortgage loan to cover both the purchase price of the land and cost of developing and improving the land c. Developer can also decide to a. Lease the underlying fee from the fee owner under a long-term leasing arrangement known as a ground lease. Fee mortgage, lender’s security is mortgage lien on mortgagor’s fee title to improvements and mortgagor’s fee title in the land. b. Obtain a leasehold mortgage to find the costs of developing land and constructing improvements. Security for loan is mortgagor’s defeasible leasehold. d. The Ground Lease a. Reasons for owner to lease i. Emotional ties to property ii. Avoid cap gains tax iii. Faith in potential long-term income b. Reasons for developer to lease i. Reduces front-end investment ii. Tax deductions for depreciation apply only to buildings iii. Return of developer’s cash investment is higher iv. Annual cost of ground lease easier to bear e. Subordinated and unsubordinated ground lease a. Sub ground leases are ground leases under which the landowner agrees to execute one or more mortgages of his land to secure loans made to developer by 3rd parties b. Unsub ground leases do not require landlord to execute mortgages to secure the developer-tenant’s loans. Developer may have difficult time securing loan c. If debt is secured only by developer’s leasehold estate, institution can levy on leasehold estate only. Developer may fail to meet institutional mortgage loan payments, it will default. Landlord may be in a position to cancel lease before institutional lender has a chance to preserve leasehold estate by curing the default Legal, Tax, and Business Consideration a. In leasehold mortgage financing, initial outlay is less, but developer loses interim land appreciation and any leasehold improvements made. b. Leasehold financing used to leverage investment costs and increase rate of return on equity capital invested by developer c. IRC – ground lessee must recover the cost of leasehold improvements over applicable cost recovery period, regardless of term d. In leasehold financing where lien on leasehold mortgage doesn’t cover the underlying fee, security is merely mortgagor’s defeasible leasehold estate Basic Problems in Leasehold Financing - Where leasehold estate may be mortgaged some time in the future, insert lease provisions for protection of prospective mortgages - Length of initial term Some statutes authorizing investment in leasehold mortgages provide that the term of the lease shall not be less than for a given number of years, including enforceable option of renewal. Trustee of a bankrupt Lessor may reject an option of renewal. 5. Assignability of Lessee’s Estate a. Prime condition precedent to acceptability of the Lease for mortgage purposes is unrestricted right of lessee to transfer leasehold estate by assignment, without consent of lessor b. Lease acceptable to leasehold lender must provide absolute and unrestricted assignability of the Lessee’s estate, free and clear of lessor control c. Another Lessor’s suggestion to avoid is an offer of a covenant by the Lessor not unreasonable to withhold consent of assignment of lease 6. Notice of Default and New Lease a. Unless lease provides protection against defeasance it isn’t a valid security instrument b. Necessary for lender to receive notice of Lessee’s default c. Lease provision should state that, despite bankruptcy the lease cannot be terminated as long as rent is being paid d. Provision that, following termination of lessee’s estate following a default, Lessor will enter into an exact lease with the mortgagee with the exact same provisions and term e. ―Non-disturbance clause‖ i. So long as lessee isn’t in default under lease possession will not be disturbed in event of foreclosure on lessor f. Are there non-economic defaults? Triggered if tenant no longer belongs to a certain association…how do I cure that? here, sign a new lease g. Need a generic savings clause 7. Insurance a. Leasehold mortgagee wants to be named insured on hazard insurance policies pursuant to standard mortgage clause, and to have the option to apply insurance proceeds to mortgage debt 8. Condemnation a. Use Taking – Taking of use of premises without vesting title in condemning authority. b. Leasehold mortgagee will be interested in being protected against total or partial taking…Lease should provide that leasehold mortgagee s expressly authorized to participate in condemnation proceeding 9. Sub-Leases a. Leasehold mortgagee would insist upon sub-tenant being of good credit rating and suitable for the property b. To protect itself from loss of rental income after it has signed a new lease, ground lease should have a covenant requiring all subleases to attorn leasehold mortgagee if it becomes holder of a new ground lease 10. Estoppel a. Obtain from lessor statement that lease is in full force and effect and that lessee isn’t in default - 11. Ground Rent Escalation Clauses a. Hedge against inflation in long initial terms of lease (CPI or percentage rent evaluations) 12. Streamlined Mortgages a. Where fee owners agree to subject subordinate fee interest to the line of a leasehold mortgage by joining the mortgage b. Developer could anticipate larger financing, construe more expensive improvements on the land and pay a higher ground rent to fee owner c. Advantages i. Initial cap requirements are less and full yearly rental payments deductible ii. Lender can value property a higher amount since value attributable to land AND improvements d. Provisions i. Term of ground lease at lease equal to mortgage term ii. Provide for attornment with sub-leases e. Fee owner runs risk of losing property in event lessee defaults Ground Leases - Traditional Fee Mortgage Financing o Developer acquires land, with or without financing o Construction lender demands first priority – PMM on land must be subordinated or paid off from construction loan proceeds o Developer owns subject to construction M followed by take M - Lease without Major Construction o Owner has fee free to subject to M o Developer wants land to complement project but O won’t sell o Developer leases land for minimum term of 10 years with options for another 30 years - Lease with Major construction o What issues arise if a small shopping center is to be constructed: Subordinated ground lease or Unsubordinated ground lease Long-term nature of the lease (How the rent increases over time) - Lease Term and Follow-up issues o Useful life of structure is important in deciding on the term One story moderate priced office space vs. gaming hotel or urban office building Initial term is determined by the term of the construction take out lender…lose security if term is shorter than financing duration Followed by options – generally in 5-year increments - What is security for the construction M? o Developer has lease – property interest that can be security for the debt o Construction lender is secured by the lease o Take out lender has the lease and for the term of the lease the possession and use of the improvement - What do you think of leasehold M? - - - o If there is a default under the lease and lease is terminated, what happens to leasehold Mee? o In a fee arrangement if developer falters early, Mee can take over and attempt to salvage the project or at least get to 50% to ?% on the $. o To: in the leasehold once the lease is terminated, lender has nothing Mee wants to limit risk of leasehold M o Developer has nothing to give, but owner does o Option A – Ground lease has paper designed to eliminate risk of Lessee’s default o Option B – Owner mortgages the reversion to secure lessee’s mortgage Why Lease? o Owner Like property Avoid cap gains sale Stepped up basis Solid investment return Pass to family o Developer No need to borrow to buy Depreciate building not land Increased leverage Possible rent less $ than finance cost of the land Leverage etc. o Developer’s leverage is higher o Income from project is same whether or not you own the leasehold o Income value $100-80% = $80 million Cost $10 land and $80 construction = $90 cost; that is 88% loan to cost Cost only of $80 and loan of $80; that is 100% loan to cost = infinite ROR since you have no cost. Mortgaging out Tax Implications and Real Estate Ownership Structures 1. Can take depreciation deduction upon Real Estate for tax purposes. a. Commercial = 35 year; Residential = 27 year b. Step 1: Ex: Property worth $100K. Get $10K of income per year. Depreciation = 100/35 = 2.56 annual depreciation. T/f available cash post depreciation is 7.44 (10 – 2.56) i. If tax rate = 40%, then tax = 7.44 * .4 = 2.97 in tax c. Step 2: Depreciation is irrelevant to cash though. i. T/f cash = 10 – 2.97 = 7.03 post tax cash. d. Step 3: T/f your effective tax rate is not 40%, but really 29.7%. e. In essence, you sheltered income. 2. Double Tax: Taxed at 2 levels instead of 1 as in above example. This only happens if you are a Corp. a. Picking up at 7.44…assume tax rate = 34%. T/f tax = 7.44 * .34 = 2.53 in tax b. T/f you have 25% tax rate instead of 34%. c. So you pay dividends to shareholders 10 – 2.53 = 7.47 d. 7.47 is taxed again. e. T/f Real Estate people don’t want to be corporations f. If you want to avoid double tax, you don’t pay dividends to S/H’s 3. Liability Position: a. If you’re a sole proprietor, you are liable in case of injury, but you can ameliorate through insurance and non-recourse loans i. If you’re a small company, non-recourse may be hard to obtain Possible Structures: 1. General Partnership: Each partner can bind the others and are j/s liable for acts of EE’s and other partners. Tax benefit is only taxed once as sole owners. Excess is paid to salary. It is hard to get equity from outside investors though 2. Limited Partnership a. LP’s have no personal liability. Can only lose their investment in the partnership. b. There is a general partner over the limited partners c. Taxation is as individual d. You can treat debt of the partnership as your own and not report it as income. e. Members may deduct the LLC’s losses only to the extent of their tax basis in their LLC interest, which includes their allocable share of LLC debt i. So if your partnership stake is at $250K debt, you can have $250K in income untaxed. You will have to pay it back later though. 3. LLC’s: a. Similar to LP and Corp, but different from Corp at state level. b. LLC’s are agreement driven and look like an LLP c. Taxed at individual level d. There is no general partner, no one has to have liability e. You can elect to disregard the LLC as an entity and you can be taxed as a sole proprietor if you are a single person. i. But if you go to bank to get money, bank will want some guarantee f. You can only shelter your investment income (not this and also your regular income) Condos: 4 Models of Ownership 1. TIC: CL joint ownership. But TIC can fracture ownership 2. Corporation: A co-operative. You give out a proprietary lease. Developer builds building and it is owned by the co-op entity. When you buy your condo, you are really just buying a share of the co-op entity. You can’t own any land/dirt. Co-ops can restrict shares however they want 3. Co-Ownership: Undivided Interest in the common elements. The board manages but does not own anything. You get an easement to use the space. A statute will tell you how everything works. The statute is pro-owner. You get all benefits of ownership, but you have to deal w/ majority rules. If you are co-owner, you are partially liable for all torts. Uniform Condo Act prevents suing individual owners though. You have to sue the association. Association can cover w/ insurance. If insurance runs out, individual unit owners are only responsible for up to the amount of equity they have in their unit. Bankruptcy of Tenant or Landlord - Federal substantive law separate from commerce clause, for congress to make uniform bankruptcy laws. Holds back state law rights - Maximizes potential return for debtors and creditors - Aiming to give people a clean start. As long as you pay an entry fee, you can start free - Credit card industry culprit for many bankruptcy’s - Often, everyone is better off if we can save the business, get value, keep employees, get people through downturns. - Chapter 11 inflicts pain on creditors, but alternative is that, in recessions, vultures who buy things aren’t there - System holds everyone in place and see if we can do better - Two basic choices for individual o Estate: Entry fee is to put anything you own to bankruptcy court in surrender. Adjustments: exemption laws. In some states, money in a bank up to $50,000. Don’t have to surrender on terms different than state laws terms. File a case, creates an estate of all pre-petition property. Here, you avoid pre-petition transfers. Valid liens and security interests are recognized. Time limit for claims to be filed by creditors Objection to discharge (bad actor) Nondischargeable debts Discharged for whatever is included in the pot. Can’t discharge legitimate tax claims. Can discharge very old tax claims. Can’t discharge a spousal obligation o Debtor’s Property Erisa pension excluded along with certain educational IRA’s Exempt property Chapter 11 Concept - Hypo Balance Sheet o Liabilities Secured Debt Trade Debt Wage Claims o Value Liquidation Income $50 $200 $10 $100 $150 (Reorganization value) - - - - A plan might provide that the secured debt remains in place and the priority wages be paid If the income value of the firm is $150, the remaining value of $90 would be absorbed by the new notes for $50 and the issuance of new common stock. The financial soundness of the company depends, to an important degree, on the debt ratio of debt to equity The debt has to be in an amount and with payment terms that there is a high degree of probability the reorganized company can retire the debt in due course. Trade debt would get $50 in notes plus all the common stock. The trade debt may be better off under Chapter 11. In liquidation the trade debt would get $40 (10050 secured and 10 unsecured priority wage claims). Now they get $50 in notes which bear interest and mature over time plus the stock. The firm may now have adequate operating capital and be able to operate at a profit. The unsecured creditors will benefit by any increase in the value of the common stock. There may be another benefit for trade creditors. If the debtor survives, the trade creditor has a customer. o Upside - Preserve jobs, secured creditor taken care of, unsecured creditor gets more than they would have normally gotten o Downside – transaction costs and expenses What of the persons who own the firm’s stock? Even using Procedure o First, stop all creditor claims o Ask if there is something operational about the business that needs to be fixed? Special consultants Amendments to Bankruptcy Code (Mortgagee stayed on filing of Chapter 11) o §362. Automatic Stay (a) Except as provided in subsection (b) of this section, a petition filed under section 301, 302, or 303 of this title, or an application filed under section 5(a)(3) of the Securities Investor Protection Act of 1970, operates as a stay, applicable to all entities, of— o (1) the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title; o (2) the enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the case under this title; o (3) any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate; o (4) any act to create, perfect, or enforce any lien against property of the estate; o (5) any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title; o (6) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title; o (7) the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor; and o (8) the commencement or continuation of a proceeding before the United States Tax Court concerning a corporate debtor’s tax liability for a taxable period the bankruptcy court may determine or concerning the tax liability of a debtor who is an individual for a taxable period ending before the date of the order for relief under this title. o Relief from stay (d) On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay— (1) for cause, including the lack of adequate protection of an interest in property of such party in interest; (2) with respect to a stay of an act against property under subsection (a) of this section, if— (A) the debtor does not have an equity in such property; and (B) such property is not necessary to an effective reorganization; o Special Rules for Single Asset Real Estate Cases (3) with respect to a stay of an act against single asset real estate under subsection (a), by a creditor whose claim is secured by an interest in such real estate, unless, not later than the date that is 90 days after the entry of the order for relief (or such later date as the court may determine for cause by order entered within that 90-day period) or 30 days after the court determines that the debtor is subject to this paragraph, whichever is later— (A) the debtor has filed a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time; or (B) the debtor has commenced monthly payments that— (i) may, in the debtor’s sole discretion, notwithstanding section 363 (c)(2), be made from rents or other income generated before, on, or after the date of the commencement of the case by or from the property to each creditor whose claim is secured by such real estate (other than a claim secured by a judgment lien or by an unmatured statutory lien); and (ii) are in an amount equal to interest at the then applicable nondefault contract rate of interest on the value of the creditor’s interest in the real estate; or o Adequate Protection if not Single Asset Real Estate (§361) (During the period the case is pending, creditor shouldn’t be worst off from mortgagee using the asset. In an office building, not clear that it’s a germane idea.) When adequate protection is required under section 362, 363, or 364 of this title of an interest of an entity in property, such adequate protection may be provided by— (1) requiring the trustee to make a cash payment or periodic cash payments to such entity, to the extent that the stay under section 362 of this title, use, sale, or lease under section 363 of this title, or any grant of a lien under section 364 of this title results in a decrease in the value of such entity’s interest in such property; (2) providing to such entity an additional or replacement lien to the extent that such stay, use, sale, lease, or grant results in a decrease in the value of such entity’s interest in such property; or (3) granting such other relief, other than entitling such entity to compensation allowable under section 503 (b)(1) of this title as an administrative expense, as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property. (if they haven’t been paying insurance on the building)(If everyone agrees that the building is worth 100 units and debt is 80, then you have 20 units of my equity before you need adequate protection) o Special Rules for Single Asset Real Estate Cases (§362) (All interest on all debts stop at date of filing…Only over secured creditors get interest. You have extra collateral, you bargained for it, and will get the benefit of it. Where debt is less than amount of collateral, you aren’t entitled to interest, but if you don’t file a plan within 90 days you have to start paying interest) (3) with respect to a stay of an act against single asset real estate under subsection (a), by a creditor whose claim is secured by an interest in such real estate, unless, not later than the date that is 90 days after the entry of the order for relief (or such later date as the court may determine for cause by order entered within that 90-day period) or 30 days after the court determines that the debtor is subject to this paragraph, whichever is later— (A) the debtor has filed a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time; or (B) the debtor has commenced monthly payments that— o (i) may, in the debtor’s sole discretion, notwithstanding section 363 (c)(2), be made from rents or other income generated before, on, or after the date of the commencement of the case by or from the property to each creditor whose claim is secured by such real estate (other than a claim secured by a judgment lien or by an unmatured statutory lien); and o (ii) are in an amount equal to interest at the then applicable non-default contract rate of interest on the value of the creditor’s interest in the real estate o Leases as Assets Ordinarily, once a case is filed, ―administrative claims‖ (professionals…the people who work on the case, necessary) have first priority over everything. (The Idea that a business may need a leased property to continue to be an operating company drives the idea that ipso facto clauses should not be enforced in bankruptcy. This is just a policy joust between the LL’s property ownership claim and the tenant’s effort to reorganize.) (§365) (1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on— (A) the insolvency or financial condition of the debtor at any time before the closing of the case; (B) the commencement of a case under this title; or (C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement. o What if 20 of the stores need to be closed to concentrate stores at a single supply hub. The leases have value because FMV is greater than the lease rent. Every lease will prohibit or limit assignments. If the provision is effectives the debtor (and its creditors) lose the value of the leases. In preparing individual cases, this gets sliced very thin. o (§365f1) 1) Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of - the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection. o (2) The trustee may assign an executory contract or unexpired lease of the debtor only if— (A) the trustee assumes such contract or lease in accordance with the provisions of this section; and (B) adequate assurance of future performance by the assignee of such contract or lease is provided, whether or not there has been a default in such contract or lease. o (3) Notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law that terminates or modifies, or permits a party other than the debtor to terminate or modify, such contract or lease or a right or obligation under such contract or lease on account of an assignment of such contract or lease, such contract, lease, right, or obligation may not be terminated or modified under such provision because of the assumption or assignment of such contract or lease by the trustee. Drafting technique in single asset real estate cases: use lots of definitions o Entity that owns one asset, but it can’t have more than $4 million in secured debt. Only applies to tiny cases o In a real estate case, only 2 players Chapter 13 - Basic Concepts in Tax System that impact Development of Real Estate - Owners get benefit of the depreciation deduction – added leverage (you get depreciation of mortgage plus the amount of equity entered into the property) - Crane Doctrine o Basis of the property for such purpose of determining the depreciation deduction during ownership and gain on resale will include both the cash (equity) and any mortgage indebtedness whether or not the investor is personally liable on the mortgage loan. - Non-cash depreciation deduction may shelter project income AND personal income - No entities in general partnership - However entrepreneurs divvy their $, that’s how they’re taxed. Gains and losses allocated among the partners. Among the gains, some are capital gains, some are recaptured. - LP - Losses from real estate can offset professional income. Doctor or lawyer or other investors couldn’t afford to have joint and several liability - LP is a registered entity, having 1 general partner and other limited partners who aren’t jointly and severally liable. General partner is liable, and limited partners liable only for their initial investment. How should LP’s be taxed? Looked at setup of LPs. o IRS then said you can choose whatever you want - - - - For single asset cases, LP and LLC primary choices for real estate investment. Pass-through entities with no corporate taxation to pay. However, LLC and membership statutes are more complex. Is there anything over and above the double taxation (getting rid of extra entity) that benefits real estate? Yes Project income shelter vs. personal income shelter Table 13-2 on P. 648 illustrates how tax sheltered investments worked pre 1986 and how that still may be the case for a few active players Basic point o Level 1: Rules applicable to the building; depreciation rates and related rules o Level 2: subchapter K partnership tax rules for allocating income and losses as modified in 1986 Straight line depreciation mitigates the burn out of the shelter and premature sale. Now, you can’t offset passive losses (Real estate) against ordinary income. You can only offset passive losses with passive gains. When depreciable property is acquired for cash and a mortgage loan, the cost tax basis, and basis for depreciation of the property, includes the mortgage indebtedness whether or not the owner is personally liable under the mortgage. The same dollar amount of depreciation will increase the investor’s rate of return on its equity to the extent it is able to reduce its equity and thereby leverage its acquisition costs by means of mortgage debt financing. Amount of tax shelter equals excess of deductible depreciation over nondeductible mortgage amortization Assume that the building is wearing out. Depreciation distributions drive down the basis in the property. Deferring taxes for many years Depreciation deduction converts ordinary income into long-term capital gain o Take the benefit on the income side, take the charge on the capital side at a lower tax rate o If taxpayer sells of exchanges real property that has been used in its trade or business and held for more than one year, taxpayer will incur long-term capital gain o Real estate held for personal use or held by a dealer primary for sale to customers is not subject to depreciation o While owning real estate, seller may be entitled to deductions for business expenses for interest and property taxes paid or accrued during ownership period Chapter 14 – Selection of the Ownership Entity Read Steuben, Choice of Entity for Real Estate - 37 Real. Prop., Prob. & Tr. J. 53 (2002) Solo X X Active Group Active & Invest Sole Pro LLC(SingleM) S Corp. C Corp Land Trust TenantComm Gen Partner Limited Partner LLC (Multi) LLP - X X X X X X X X X X ? X (100 sh.) X X X X ? - See Table 14-1, P. 713 Purposes of raising venture capital and securing the debt financing needed to fund acquisition and improvement of real estate Considerations in selecting the ownership entity o Aggregate approach (Pool assets and resources for common purpose) Entity is treated as a nontaxable conduit through which tax consequences flow directly to each constituent member o Entity approach Organization itself is treated as an entity that is separate from its participants; separate tax consequences accrue to entity and members Types: o Sole Proprietor No risk of delegating responsibility to others No liability shield o Tenancy in Common Advantages: Any decision affecting computation of taxable income may be made separately by each tenant No partnership-level tax return required Disadvantages: Requirement of unanimous consent for decision-making too cumbersome except in small groups who passive collect RE income Each tenant must separately report only her proportionate share of net operating income…If one tenant pays a larges amount of expenses she only gets pro rata share for deductions May not reallocate income and deductions such as depreciation in a ratio at variance with their interest in commonly-owned property Partnership defined broadly o General Partnership Not an actual entity that needs registering All partners personally responsible for liabilities occurred within the scope of enterprise o o o o o o Each general partner can bind all the other general partners through the partnership Now, a revised gen. partnership act – adopted in some state that makes positive changes in the model and makes model more friendly. Group getting together for a common economic goal Limited Partnership Can relegate unwelcome management capacity to general partner Revised uniform limited partnership act provides safety valves. Trying to make the LP units more salable: Limited partner not liable for entity debts even if the limited partner participates in the management and control of the LP Little liquidity in LP units. ―Piercing corporate veil‖ – abuse of limited liability privilege Advantage: Continuity of enterprise Disadvantage: Limited partner’s interest isn’t very marketable Corporate Ownership Advantage: Limited tort liability and contract liability available to shareholders Ability to reach wise variety of investors to secure capital Liquidity of publicly held stock and corporation’s exemption from usury laws that restrict interest rates Partnership Ownership Partnership nontaxable conduit by which partner’s share of income and loss funnel directly to partner Ability of partners to deduct their distributive share of partnership’s tax losses Limited partner’s liabilities for increasing his adjusted basis shall not exceed amount of future capital contributions he has to make S-Corporations Nontaxable conduit – pass-through of losses to shareholders – no double taxation Restrictions – can’t have more than 100 shareholders, have a shareholder be a non-individual entity, have a nonresident alien as a shareholder, and have more than one class of stock Originally designed as a vehicle to fund risky oil and gas ventures Cannot obtain stepped-up basis equal to its share of mortgage liabilities…can’t include debt in your basis C-Corporations Useful for holding raw land Limited Liability Corporations Single Member Sole Proprietor can, for a modest fee, can have an LC as a liability barrier Pressure to ―veil piercing‖ in this context. Appealing idea Multi Member Protects even those members who are actively involved with company management Liability equivalent to their contribution. Every member of an LLC is entitled to participate actively in management unless agree says so. No risk if you participate in management. If you run the LLC as a single member, still have liability protection. Few default rules. Everything put into the operating agreement. Disadvantage o Law governing LLCs not well-settled o If you start as an LLC then want to get acquired by a C-Corp, you need to terminate the LLC, have a taxable event. Whereas if you have a C-Corp and a C-Corp. sub, you can merge without tax consequences. Advantage o Not subject to onerous basis rules and S-Corp strict requirements Qualify for taxation as a partnership o Now: Taxed as a partnership or LLC unless you choose to be a corporation. However, partnership tax is not simple. o Situations for LLCs and LPs: Formation and Documentation: high document costs, flexibility in statute, lots of risk. Administration: Need first-class accountant to do partnership returns. Adding members or Partners: Can’t add a member to the General Partnership, old members can dissolve and reform with new members. Add members with consent of other members. LP agreements often restrict limited partners from transferring their stake. Merging or terminating: Can merge LPs, where you want to merge real estate investments and cut operation costs IN LP, GENERAL MANAGER IS THE GENERAL PARTNER. IN LLC, EVERYONE PARTICIPATES IN MANAGEMENT o Sometimes, in practice, what people do in a given jurisdiction is governed by state and local taxation regimes. Overview of Condominiums - Uniform Cooperative Act o Has a lot of consumer protection stuff o Problem with cooperative for middle class people: Fee structure of cooperative, acquisition cost of the units never equaled the construction cost. You’d but the unit for $200,000, but you’d have a percentage of the residual mortgage. That made the - - - - units attractive price-wise, but economic risk of default. If someone stops paying, you look at other people to come up with the money. In the short-term, the risk of default and cash flow problems borne by everyone. In coop, you’re buying stock in a corporation. Condo Association could be incorporated as a non-for-profit, LLC, still is an entity managed for the owners. Joint and several liability. Solve the J+S is insurance. Unit owners can’t be sued Flexible Condominium o Shows 2 buildings, saying that you can withdraw the second one after you start to market the first. o Shows one building as being built, with reservations for building a second. o Declaration had rights if only one building is built, and another is two buildings are built Basic Idea of Condominiums o Take a single family model (horizontal, where 2 neighbors don’t have nay joint economic risk) and change it into condominium act. o When you buy a condo, you buy units, air rights. If you could destroy some of the building, it would hurt everyone else. Everything else is owned by the tenancy in condominium (co-tenant) in the land and the building. However, differs form co-tenancy because you must be able to partition the tenancy o A condominium built on a leasehold is a wasting asset. Normally, you don’t allow people to file a declaration. Declaration doesn’t get filed to fairly late in the process because of the pre-selling going on. The declaration may file once they get a certain number of deposits on hand. When the building is underwritten, they are looking at the condominium a potentially sensible rental product. A high-end product is difficult to lease at high prices. As you go up the economic scale, there is more conflict over declarations. o D wants to build a residential complex. D can build rental units or building units for sale. The sale options are either to build a cooperative or a condominium. o In a condo unit the owner owns to box of space that the unit occupies. The unit boundaries are the lower face of the ceiling, the side face of the exterior walls and the top face of the floor. The rest of the building (common elements) is owned by the unit owners as tenants in common. An Association manages the common elements. o The condo comes into existence when the developer files the declaration of the plots and plans. Once filed, the units are created and the developer then owns and sells the units. The developer controls the board of the Association until a certain percentage of the units are sold. o Is the interest in the unit based upon what it cost you to get in? Size? FMV way? Life in the Community - - o §3208(a) Each unit is assigned voting rights, a percentage ownership of the common elements, and a percentage of the common expense liability. Declaration shall allocate a % of undivided interests in the common elements to each unit and state formulas to establish the allocations. Limit cumulative voting to voting in members of the board. o The Association manages and maintains the common elements. §3307(a) provides that the owner shall afford access through their units for repairs. Owner is responsible for interior partitions unless they are weight-bearing and the interior finishing. To pay for the expense, the Association has the power to tax (§3314). However, the board’s budgets for operations and cap improvements may be rejected by a majority of the owners within 30 days after the approval (§3303(b)). Fixed majority, not quorum. Assumes that voting is being done by 1 unit/1 vote. Statute discouraging participation. Financial Risk o A unit owner finances the purchase of his or her unit and the real estate tax is assessed against each unit. Each unit owner is responsible to pay the assessment or Association fees. Association fees are a first lien on the unit (§3315(b)(2)). o Since the Association manages for the co-tenants who own the common elements, the owners are liable in tort or contract. §3311 reduces this risk by making the association liable for torts alleging wrongdoing by the association or, agents of the association, or contracts made on behalf of the association. Unit owners can’t be sued. Lien on a judgment is pro rata share of the amount of that judgment, including interest (§3311). Hypo: Owner’s share of damages is $345,000. Unit’s FMV is $220,000 and 1st mortgage is $187,000 on the unit – leaving equity of $33,000. Lose $33,000. Stinks from tort claimant’s point of view. o On the tort side, the solution is insurance. §3312 notes that the association shall maintain property insurance on common elements and comprehensive liability insurance. All polices must insure all owners under the policy. Unit owners can get their own independent policies. Must have at least 80% of the cash value of the property insured. 80% is NOT ENOUGH. Balconies, Gardens, and Parking Spaces o §3202 – You own the inside finishings of the box. Shutters, awnings, stoops, porches, and exterior doors and windows are limited common elements allocated exclusively to that unit. Not everyone has balconies. Balcony upkeep may be different than patio upkeep. Limited common element is something assign to you, you can exclude others, you have to pay for your own upkeep. Allows you to tailor common expenses. Parking below is common space. You can sell units of parking. Unit owners vote differently for garage and residence budgets. Could restrict - - - - the sale of parking spaces to people in the condo complex. Can also make parking spaces limited common elements. o It makes sense to have some portion of the common elements dedicated to the use of a single unit. (§3209). Expenses related to a limited common element are charged to the unit owner who has use of the limited common element. Since the unit owner doesn’t own the common elements, the Association may regulate its use. For example, no hanging wash on the balcony. Community Governance o Declarant (developers) has to bear the economic cost of all the units that aren’t sold. Declarant is charged with responsibility for management until they sell 50-75% of the units. o The declaration or By-Laws of the Association setup the mechanics of community government. Central concern is whether and how the declaration may be amended. After a majority of the units are sold the majority of the unit owners might decide to ban dogs. §3219(a) and (d) say that no amendment may increase special declarant rights, increase the number of units of change the boundaries of any unit or common element interest, or increase the common expense liability. Reserve right to maintain the limited common elements to your standards because they belong to unit owners. Can control the space. o Some Association actions require 2/3 and some a majority. If a majority is at a meeting, quorum rules come into play. (§3309(a)). Can make limited common elements transferable, but might want to make it non-assignable with a waiting list. o Frequently have roof damage on townhouse projects that effects only a few people. Sometimes documents say that they allocate the interest among o No-rental provisions are bad…lower price and investors won’t invest. Developer Control o §3303(d) and (e) state that the developer turns over control not later than 60 days after 25% of the units have been sold 25% of the board members shall be elected by owners. Not later than 60 days after conveyance of 50% of the units to owners 1/3 the board members must go to unit owners. Unit owners shall elect an executive board of at least 3 members, a majority of which shall be owners. o Regarding directorship in a board, you first have to ask about liability and coverage. Need adequate insurance for the members of the board. Termination of Contracts and Leases of Declarant (§3305) o If management contracts, employment contracts, or leases were entered into before the unit owners took office, they may be terminated by association within 90 days of taking their positions. Unconscionable contracts created by developer screw over unit owners. Consumer Protection o Disclosure protections the consumer. Requirements in §3402 public statements to the unit owners - - - - - - Cancellation §3406 o Unless purchaser has been given a public offering statement, purchaser, before conveyance, may cancel the contract within 15 days of first receiving the public statement. o A purchaser can cancel a contract by hand delivery or by mailing notice o If a public offering statement isn’t given upon purchase, purchaser can get back up to 5% of the sales price and up to $2000 in damages Escrow §3408 o Any deposit which doesn’t include installment payments are insured until delivered to declarant at closing, or in case of sale of a unit pursuant to an installment sales contract or refunded to purchaser, and delivered to declarant because of purchaser’s default. Want the contract of sale to specify where the money is going and to whom it is going. Release of Lien §3409 o Before conveying a unit, a declarant shall record or furnish to purchaser releases of all liens affecting that unit and its common interest element interest which purchaser does not expressly agree to assume Warranty Against Structural Defects §3411 o A declarant warrants against structural defects in each of the units for two years from the date each is conveyed to a bona fide purchaser, and all of the common elements for two years. Purchasing a ―used‖ unit - §3407. Note cancellation right o Have to get a comprehensive set of documents then, in order to protect you, the association should give you financial information that the outstanding assessment against the unit is X. If they certify that there is no assessment yet there is, and you rely on that information upon sale, then the association is liable. §3410 Condominiums containing conversion buildings o Must get rid of all these tenants. What are the rights of tenant? Regulate conversions. People sometimes feel like they’re being forced into the buy. o Guarantees protections of current owners, deals with people who have infirmities. Social problematic process if unregulated. Some townships refused to issue the building permits. Cooperatives formed under uniform cooperative act have similar provisions. Some states have a uniform statute that governs everything. Concern with agreements of sale - Contingencies. What are the conditions precedent to the buyer having to buy - Do I have to buy the house if it doesn’t have pure public water? No - Radon, lead, water, sewer zoning. Taking all pro cellar caveat emptor and conferring some rights of necessity with options to what kind of rights you want to have. - Pro-buyer format - Normally, a 10% downpayment…Splits pre-paid taxes - LOOK AT DEFAULT PROVISION. RESEARCH ―CHECK THE BOX‖ o Remedies Hold deposit on account of purchase price or as monies to be applied to seller’s damages Liquidated damages should be kept by buyer. Conceivable that you could have had an over 10% drop in the value of the property. By checking the box for liquidated damages you are taking that possibility out. Reorganization and Subprime Issues - Consumers have an option for reorganization o Consumers can keep all their property and use future income to pay prior debts. They only have to pay them to the extent they would have to pay them if they sold all their assets now. o Under current statute, creditors can say if you have more income, you have to use all disposable income to pay your debts. Under this framework, mortgage on the home was not affected unless… o Balance = $100,000 o FMV = $80,000 o Accrued arrearage (payments haven’t made) = $2,000 o Most of the subprime loans didn’t use Fannie Mae instruments because they were sold into investment pools. Chapter 13 case would allow you to leave the mortgage lien in plan, and the mortgage lien system was immune from bankruptcy issues. o Here, creditor is unsecured. Only 80% is secured. In bankruptcy, you can change the payment schedule as long as the end result is you paying $80,000. - Subprime…You take the interest rate down to the prime rate, then bring - Administration trying to get consensus of voluntary program to do workouts on a mass basis. - Consumer interests want to amend the bankruptcy code to say that, if the property was undersecured, you could put part of that on the secured side, redo the interest rate…People need enough income to manage the payment schedule as set forth in the contract. Chapter 13 wouldn’t help the subprime borrower. Refinance the arrearage and reset the balance.