Due on Sale Real Estate

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Due on Sale Real Estate document sample

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Document Sample

Note and Mortgage

• The typical ―mortgage‖ transaction
involves two separate documents:
– 1. A note
– 2. A mortgage.
• We have been considering some of the
variables in notes.
• We now turn to take an even longer look
at the variables among and within
mortgages and mortgage substitutes.

1 Donald J. Weidner
DRAGNET CLAUSE IN MORTGAGE
(Text p. 416)

• A dragnet clause in a mortgage uses a
single property to secure the original
debt and any other debt owed, or to be
owed, by the mortgagor to the
mortgagee.
– The clause ―drags‖ other debts into the
mortgage

2 Donald J. Weidner
DRAGNET CLAUSE IN MORTGAGE
(Cont‘d)
• Courts vary in approach to dragnet clauses
• Some ―interpret‖ dragnet clauses narrowly,
holding, ex., that dragnet clauses will only
secure subsequent debts directly related to the
property.
• Or, a court may ―presume‖ that a future
advances clause only covers advances of the
same quality or relating to the same transaction,
– perhaps unless the documentation concerning
the subsequent advance refers to the original
mortgage as providing security.

3 Donald J. Weidner
State Bank of Albany v.Fioravanti
(Text p. 416)
• 1966: Fee Owner executed $2,500 Note #1 and
Mortgage #1 on Lot 1.
– Mortgage #1 had a dragnet clause providing that
additional subsequent debt would be secured by
the mortgage, but no more than $2,500.
– Lender recorded Mortgage #1.
• 1973: Fee Owner executed $6,800 Note #2 &
Mortgage #2 on Lot 2 to same Lender.
– No reference was made to Lot 1.
• Fee Owner conveyed Lot 1 to Grantee who
assumed ―the payment‖ of Mortgage #1 on Lot 1.

4 Donald J. Weidner
Fioravanti (cont‘d)
• Fee Owner paid in full the 1966 Lot 1 Note#1 in
connection with which Mortgage #1 (with the dragnet
clause) was issued and recorded on Lot 1.
• Fee Owner defaulted on the 1973 Note#2, causing
Lender to foreclose Mortgage #2 on Lot 2.
– Lender got a $3000 deficiency judgment in the
foreclosure of Mortgage #2.
• L sued Grantee of Lot 1 to foreclose Mortgage #1 on
Lot 1 to recover $2,500 of the $3,000 deficiency from
the foreclosure of Mortgage #2 on Lot 2.
– Recall, the dragnet clause in Mortgage #1 had a
$2,500 limit on the additional debt that could be
dragged in.

5 Donald J. Weidner
Fioravanti (cont‘d)

• HELD: ―payment of the 1966 note [secured by
Mortgage #1 on Lot 1] could not terminate the
bank‘s right to foreclose the mortgage[#1].‖
– To decide otherwise would defeat intent.
• TO EMPHASIZE: The note and mortgage are two
separate instruments. One can survive the other.
• Dissent: Lender‘s document did not specify that
the Lot 1 Mortgage would survive the payment of
the Lot 1 Note
– Construe a document that is at best ambiguous against
the person that drafted it.

6 Donald J. Weidner
Note 1 to Fioravanti
• In Florida, dragnet clauses are construed
against the drafter.
• Wrinkle: pre-existing debt.
– United Nat’l Bank v. Tellam, 644 So.2d 97 (FL
3d DCA 1994)(invalidating attempt to drag in
pre-existing debt rather than future debt).
Court forces existing debts to be specified
and prevents dragging in future debts that
were never anticipated at making of the
Mortgage.

7 Donald J. Weidner
Note 2 to Fioravanti
(p. 416)
• The Restatement of Mortgages permits
dragnet clauses only (a) if the future debt
is incurred in a transaction similar to the
original mortgage; (b) if the original
mortgage described with adequate
specificity the additional types of loans that
will be secured by the mortgage; or (c) if
the parties expressly agreed at the time of
the future advance that it would be
secured by the original mortgage.

8 Donald J. Weidner
AFTER ACQUIRED PROPERTY CLAUSE
(Text p. 416)

• Secures a single debt with a mortgage
that purports to encumber both the
property originally mortgaged and all
future property the borrower will acquire.
• Attempts to bring future property under
the mortgage rather than future debt.
• However, real estate lenders only get
limited benefit from after acquired
property clauses in mortgages.
9 Donald J. Weidner
AFTER ACQUIRED PROPERTY (Cont‘d)
• A mortgage with an After Acquired Property clause
will be outside the chain of title of the property that is
acquired later.
• Subsequent purchasers or mortgagees of a second
parcel will not find the After Acquired Property clause
in the recorded chain of title of the second parcel.
– Hence they will not be bound by that clause.
• The purpose of the recording acts is to allow buyers and lenders
to rely on the instruments properly recorded in a particular
parcel‟s chain of title.
• In sum: a subsequent purchaser or mortgagee of the
second parcel will defeat the lender-mortgagee of the
first parcel who is trying to rely on the After Acquired
Property clause in the mortgage on the first parcel.
– This is true whether a tract or a grantor-grantee
index is used.
10 Donald J. Weidner
EVOLUTION OF PROTECTION OF MORTGAGORS
(Text p. 367)

The ―mortgage deed,‖
says the legal historian Maitland,
―is one long suppressio veri and
suggestio falsi.‖

11 Donald J. Weidner
Stages in Evolution of Mortgage Law
1) Defeasible fee enforced according to its terms

Deed
Borrower Lender Lender‘s estate ends ONLY
if borrower pays everything
Fee simple subject to
off exactly on time.
condition subsequent

2) Equity relieved Borrower in special circumstances
3) Special circumstances were always found
• The equity of redemption came to be called an
estate in land.

12 Donald J. Weidner
Stages in Evolution of Mortgage Law (cont‘d)

4. Lenders were permitted to strictly foreclose
the borrower‟s equity of redemption
• Lenders were permitted to end the borrower‘s right to
redeem the land from the mortgage
• Strict foreclosure decree states: pay up now or be
barred from asserting any interest in the future.
5. Lenders were required to foreclose by Judicial
Sale
• The proceeds of a foreclosure sale are distributed:
• First, to the lender, to pay what is due to the lender (principal,
interest and costs)
• Second, any surplus is paid to the borrower.
• Thus, the lender gets what was promised to the lender,
repayment, and no more.
13 Donald J. Weidner
Stages in Evolution of Mortgage Law
(cont‘d)
6. Legislatures in roughly half the states
supplement the judicial protections of
borrowers with an additional right in the
borrower: a Statutory Right to Redeem
from a Foreclosure Sale
• In short, the mortgagor (and, often, a junior
lienor) is permitted, for a specific period of time,
to redeem ―from the sale‖ by paying, to the
foreclosure sale purchaser, the foreclosure sale
price plus, in some cases, certain additional
amounts.
• There are many approaches to the
consequences of nullifying the foreclosure sale.

14 Donald J. Weidner
Stages in Evolution of Mortgage Law
(conclusion)
Where that leaves us.
1. Leading Rule today: There may be no
contemporaneous (with the loan origination)
waiver of the equity of redemption.
– No matter how clearly stated, understood and
agreed to, a contemporaneous waiver of the
equity of redemption is unenforceable.
2. However, in many states: Powers of sale,
authorizing a sale out of court, whether they
are contained in mortgages or deeds of
trust, are enforceable and hence popular.
– In these states, the only two necessary steps to
foreclose are notice and sale.
15 Donald J. Weidner
THE PRACTICAL REALITY OF CHOICE OF
SECURITY INTEREST
1) A Mortgage
2) A Deed of Trust
3) An Absolute Deed Standing by Itself
4) An Absolute Deed with Collateral
Documents
• Collateral documents such as a lease back or an
option to repurchase
5) An Installment Land Contract
• Also called ―contract for deed‖ or ―bond for title‖
6) A Negative Pledge
7) A Lease
8) A Proprietary Lease in an Cooperative
16 Donald J. Weidner
Sample Mortgage
(Supplement p. 28)

• ―This Mortgage Deed‖
• ―Mortgagor hereby grants, bargains, sells,
conveys and confirms unto Mortgagee, in
fee simple‖
• Legal description of the land conveyed
• Mortgagor covenants that it ―is
indefeasibly seized of the Premises in fee
simple and has full power and right to
convey . . . And does hereby fully warrant
title and will defend the same‖
17 Donald J. Weidner
Sample Mortgage
(Cont‘d)
• ―CONDITIONED, HOWEVER, that . . . If
Mortgagor shall fully perform all the
covenants, conditions and terms of this
Mortgage, then these presents shall be
void, otherwise to remain in full force and
effect.‖
• The mortgagor also covenants
– To pay the principal and interest ―according to
the terms of the Note and this Mortgage.‖
– To pay all taxes and assessments.
– To keep the buildings and improvements
insured
18 Donald J. Weidner
Sample Mortgage
(Cont‘d)
• Further covenants by mortgagor
– to give the mortgagee the right to spend money to cure
defaults and add the amount to the mortgage
– to give the mortgagee the right, on default, to declare
the ―whole of the indebtedness . . . due and payable‖
and proceed to foreclosure
– ―all rents, profits, incomes . . . are hereby assigned and
pledged as further security for payment of the
indebtedness hereby secured with the right on the part
of the Mortgagee at any time after default hereunder . .
. to demand and receive the same and apply the same
on the indebtedness hereby secured.‖

19 Donald J. Weidner
Sample Mortgage
(Cont‘d)
• Further Covenants by the Mortgagor
– ―Receiver. In the event suit is instituted to foreclose this
Mortgage or enforce the payment of the Note . . .
Mortgagee shall be entitled to the appointment of a
receiver to take charge of the Premises, to collect the
rents, issues and profits . . . and to . . . care for the
premises, and such appointment shall be . . . as a matter
of right to the Mortgagee.‖
– ―Subordination. This mortgage‖ shall be ―subject and
subordinate to the lien of any and all institutional
mortgages that may now or hereafter affect the
premises,‖ provide they are in connection with the
property and not more than $500,000.
20 Donald J. Weidner
Tahoe Nat’l Bank v. Phillips
(Text p. 369)
• B was in a real estate development partnership
that was overdrawn on its account with L bank. L
agreed to lend $34,000 to B, who transferred the
funds to her partnership‘s account.
• B gave L a single-payment demand note.
• B also executed an ―Assignment of Rents and
Agreement Not to Sell or Encumber Real
Property‖ (also known as a ―negative pledge‖)
• The property described in the negative pledge
was B‘s residence.
• 6 months later, B filed a Declaration of
Homestead.
• L sued to declare the negative pledge an
equitable mortgage on the residence and to
foreclose on it.
21 Donald J. Weidner
“Assignment of Rents and Agreement Not to
Encumber Real Property”—Negative Pledge
1. ―In consideration and as security for a loan‖
2. Certain real estate [B‘s residence] was described
3. Borrower ―hereby assigns to Bank all monies due . . . on
account of such real property reserving unto Borrower
the right to collect and retain any such monies prior to
Borrower‘s default‖
4. Borrower ―will not create or permit any lien or any
encumbrance to exist on said real property.‖
5. Borrower ―will not transfer, sell, assign or in any manner
dispose of said real property . . . without the prior written
consent of Bank.‖
6. Bank is authorized to record [which Bank did]
7. Agreement is intended to benefit all subsequent holders
of the note.

22 Donald J. Weidner
Tahoe (cont‘d)
• Majority: ―the assignment cannot reasonably
be construed as a mortgage at the instance
of the party who drafted and selected it.‖
• Note the court emphasized:
– (1) Lender‟s superior bargaining position and
– (2) Lender‟s use of Lender‟s standardized
form.
• As in Goebel v. First Federal (Text p. 403—the ―how to
implement the interest rate increase‖ case)
• Consider the majority‘s 4 reasons for not
finding a mortgage and ask whether each is
persuasive.

23 Donald J. Weidner
Tahoe (Cont‘d)
Majority‘s Reasons Why No Mortgage
1. The instrument contains no words of
hypothecation
• Except perhaps the assignment of monies due on
account of the property.
• Compare our Balloon Mortgage: ―Mortgagor hereby
grants, bargains, sells, conveys and confirms unto
Mortgagee, in fee simple, all those certain lands‖ etc.
2. The instrument includes language inconsistent
with a mortgage, that is, a prohibition on junior
liens (which the court said might be an invalid
restraint on alienation).
• But see Smith & Lubell (Text p. 712): A prohibition on
junior financing is one of the ―safeguards now
frequently . . . found in the promissory note.‖
24 Donald J. Weidner
Tahoe (Cont‘d)
Majority‘s Reasons Why No Mortgage
3. The instrument lacks an acceleration
clause.
• Is an acceleration clause necessary in a
demand note?
4. The subject property was not to be
improved by the loan.
• Similar to what some courts say in the case
of a dragnet clause in a mortgage.
• However, many mortgages secure advances
of funds that are not spent on the property
mortgaged.
25 Donald J. Weidner
Tahoe (cont‘d)
• Some lenders use a negative pledge to avoid a
prohibition against extending loans that are
secured by second mortgages (see Fn. 8).
• Some lenders use a negative pledge to preserve
their right to a direct action on the debt.
• In general, a Lender has a choice of remedies
under the note or under the mortgage.
• However, some states have a ―one action‖ rule.
The Lender‘s only remedy on default is to
foreclose.
– Theory is that, because the mortgaged property is
the primary fund for the repayment of the debt, the
Lender must exhaust it first, then seek deficiency.
– Further, the rule is said to protect the mortgagor
from a multitude of suits.
26 Donald J. Weidner
Tahoe (cont‘d)
• Compare our balloon mortgage paragraph
entitled ―Remedies Cumulative‖:
– ―In the event of default in payments due under the
Note . . . Mortgagee shall have, in addition to the rights
and remedies specified herein, all other rights and
remedies provided . . . in the Note.‖
• Recall, Tahoe said even though the Lender did
not have the benefit of a mortgage, the Lender
still had its remedy on the note
– Including the right to proceed against the property in
satisfaction of the note, to the extent there was value in
excess of the homestead exemption (see text p. 374)
27 Donald J. Weidner
Tahoe Dissent
• The dissent said the borrower did breach the
covenant prohibiting assignment:
―[D]efendant has also breached the Assignment
by declaring a homestead on her property. A
declaration of homestead is neither a conveyance
nor an encumbrance for other purposes but it
does exempt the property from execution or
forced sale. Since the purpose of an agreement
not to encumber is . . . To acquire a ‗guarantee
that property in which the debtor has an equity will
remain unencumbered and unconveyed, and thus
available for levy and execution should the
creditor reduce his debt to judgment,‘ a
declaration of homestead effectively frustrates the
clear purpose of the agreement.‖
28 Donald J. Weidner
Tahoe National Bank v. Phillips
HYPO # 1

Sale
Alleged Borrower Alleged Lender
2 year option to repurchase

Permits 2 years to pass
Borrower
without exercising option

What Kind of Evidence Might Borrower Want to Introduce to
Establish that the Sale Coupled with an Option to Purchase Was
Intended and Should Be Treated As a Mortgage?

29 Donald J. Weidner
Factors to Consider whether there is an
―Equitable Mortgage‖
(Text p. 377)

“[1]Side agreements providing for reconveyance will
readily be connected to the deed to support a finding
that the deed and agreement formed a single security
transaction. Nor is a written agreement essential.
Among other facts that will be considered are:
[2]„declarations of the grantee; [3] the relations
subsisting between the parties at the time the deed
was executed; [4] the retention by the grantor . . . of
possession . . . and [5] the exercise of dominion over
it in making improvements and repairs, [6] paying
taxes and the like, [7] the value of the property
compared with the consideration actually paid . . . .‟ . .
..”

30 Donald J. Weidner
Equitable Mortgage
(Text pp. 377-78)

• The ―putative deed will probably have been
recorded.‖
• ―Because a bona fide purchaser from the
grantee will generally not be bound to the
mortgage transaction, the grantee-lender has
good reason to sell or encumber his title as
soon as he can, leaving the original grantor
with only a personal action against him.‖
– A subsequent grantee with notice will be bound by
the equitable mortgage.
• Deeds absolute are also often used by
grantors trying to hide assets from other
creditors.

31 Donald J. Weidner
Tahoe National Bank v. Phillips
HYPO #2
Loan
Definite Borrower Definite Lender #1
Note
Negative pledge [Say identical to Tahoe]
Records
Lender #2 Applies for loan
Borrower
Insists on 1M

1) If Lender #2 records a mortgage, will it be the first
mortgage?
2) Would Lender #1 be able to get an injunction to prevent
borrower from making an outright conveyance?
• Tahoe: ―Specific performance of the covenant against
encumbrances might create an invalid restraint against alienation.‖
3) Would it be easier for Lender #1 to enjoin Borrower from
giving a mortgage to Lender #2?
• Tahoe: ―Under these circumstances, enforcement as an equitable
mortgage, which permits the property to be conveyed subject to the
lien, is the only alternative to invalidation of the instrument.‖
32 Donald J. Weidner
Due-on-Sale & Due-on-Encumbrance Clauses
• Prior to 1982, due-on-sale clauses were frequently invalidated
by the courts as unreasonable restraints on alienation.
• Several state legislatures imposed restrictions on the
enforceability of due-on-sale clauses--commonly prohibiting
enforcement in residential mortgages unless the mortgagee
could establish that a transfer would impair mortgage security.
• The majority judicial approach held due-on-sale clauses
enforceable unless the borrower could show the lender
engaged in unconscionable conduct.
• The minority judicial approach generally only held due-on-sale
clauses enforceable if the mortgagee established
reasonableness by showing that the transfer would result in
security impairment or an increased risk of default.
• Due-on-encumbrance clauses were rarely litigated and the few
reported cases permitted enforcement of the clause only when
reasonably necessary to protect the lender‘s security.
33 Donald J. Weidner
Due-on-Sale & Due-on-Encumbrance Clauses (Cont‟d)
• The enforcement of due-on-sale clauses by lenders
enabled them to force repayment of lower-than-market
interest rate loans during periods of rising interest rates
upon the sale of the property by the mortgagor.
• Judicial and state legislative restrictions on the
enforceability of due-on-sale clauses imposed severe
economic burdens on depository institutions during a
period of high inflation.
• In response, Congress passed the Garn-St. Germain
Depository Institutions Act of 1982. 12 U.S.C. § 1701j-3.
• Garn-St. Germain preempts state laws that restrict due-on-
sale clauses, and makes these clauses generally
enforceable. 12 U.S.C. § 1701j-3(b)(1).

34 Donald J. Weidner
Due-on-Sale & Due-on-Encumbrance Clauses (Cont‟d)
• Garn-St. Germain covers any ―person or
government agency making a real property loan.‖
12 U.S.C. § 1701j-3(a)(2).
• Due-on-sale clauses are defined broadly as any
―contract provision which authorizes a lender, at
its option, to declare due and payable sums
secured by the lender's security instrument if all
or any part of the property, or an interest therein,
securing the real property loan is sold or
transferred without the lender's prior written
consent.‖ 12 U.S.C. § 1701j-3(a)(1) (emphasis
added).
– Thus, the Act defines due on sale clauses to
include due-on-encumbrance clauses.
35 Donald J. Weidner
Due-on-Sale & Due-on-Encumbrance Clauses (Cont‟d)

• Garn-St.-Germain, as a general rule, says that due
on sale clauses and due on encumbrance clauses
are enforceable.
• However, in a certain limited number of situations
involving residences, due-on-sale and due-on-
encumbrance clauses are not enforceable.
• The biggest exception is, that in the case of a
single family residence, a due on encumbrance
clause is unenforceable.
– For example, a home equity loan to finance college.
• There are other instances in which due-on-sale
clauses in residential loans are unenforceable.
See12 U.S.C. § 1701j-3(d)(2-9).
36 Donald J. Weidner
Florida Statute: Substance Not Form
Determines Whether Mortgage Exists
• Fla. Stat. sec. 697.01(1) (Similar to the Balloon
Mortgage provision at Supp. 25):
• ―All conveyances, obligations conditioned or
defeasible, bills of sale or other instruments of
writing conveying or selling property, either real or
personal, for the purpose or with the intention of
securing the repayment of money, whether such
instrument be from the debtor to the creditor or
from the debtor to some third person in trust for
the creditor, shall be deemed and held mortgages,
and shall be subject to the same rules of
foreclosure and to the same regulations, restraints
and forms as are prescribed in relation to
mortgages.‖
• Is a negative pledge within 697.01(1)?
37 Donald J. Weidner
Installment Land Contracts as Mortgage
Substitutes
H & L Land Co. v. Warner, 258 So.2d 293 (Fla. 2d DCA 1972):
• ―An installment land sale contract, or so-called contract for
deed, evidences a sale of the land and an obligation of the
seller to convey and of the purchaser to pay the purchase
price in installments . . . and is essentially a security
instrument taking the place of a purchase money mortgage.
– ―The doctrine of equitable conversion is established in Florida. * * *
if a land sale contract is specifically enforceable, and is free of
equitable imperfections, the vendee becomes the equitable owner of
the land and the vendor holds legal title as security for the vendee‘s
performance.‖
• ―[A]n installment land sale contract is in essence a
mortgage, and pursuant to Fla.Stat. s 697.01, F.S.A., the
safeguards for the debtor and the remedies for the creditor
are the same as those between a mortgagor and
mortgagee.‖

38 Donald J. Weidner
Three Basic Theories of Mortgages

1. Title. Mortgage passes title at outset.
2. Lien. Mortgage is nothing but a lien.
3. Intermediate. Mortgage is a lien at the
outset, but passes title upon default.
• In general, the theories have low predictive
value.
• However, the theories have some predictive
value on issues concerning the lender‘s
right to rents after default and prior to
consummation of foreclosure proceedings.

39 Donald J. Weidner
Commercial Mortgage Variations
• Call provision: permits lender to call in the note for
complete repayment at specified intervals before the
loan has been fully amortized.
• Participation: gives lender a share in property‘s
income and/or appreciation in value.
• Convertible mortgage: analogous to a convertible
bond—provides that the lender‘s interest can be
converted into an equity interest.
– Ex., ―a fixed rate loan that entitles the lender at a specified
point to convert the unamortized portion of the loan (say,
70% of the property‘s initial value) into an equity interest
(again 70%) in the property. Frequently, a convertible
mortgage will give the lender the right to buy out the
mortgagor‘s remaining equity interest (here 30%) at a
predetermined price or at a price calculated on the basis of a
predetermined formula.‖
• Personal liability: most loans on income-producing
property are nonrecourse.
40 Donald J. Weidner
USURY VARIABLES

• Variations Among State Usury Laws
– Range in rates
– Range in penalties
– Range in what is deemed to constitute
interest
– Range in exemptions
• Because of the above variations, do not
assume that the usury case law of one
state is persuasive in another state.

41 Donald J. Weidner
FOUR ELEMENTS THAT MUST BE MET BEFORE A
LOAN CAN BE CONSIDERED USURIOUS:
1) An agreement to lend money
2) Interest in excess of that allowed by statute
3) An absolute, not contingent, obligation to
repay the principal
4) An intent to violate the usury laws

NOTE: Intent, #4, is usually presumed if the other 3 elements are
shown.
NOTE: An absolute obligation to repay, #3, is difficult to avoid
without defeating the lender‘s business objectives.

42 Donald J. Weidner
McElroy v. Grisham
(Text p. 714)

• Builder bought 104 acres for $238,000 and spent
$19,200 on site preparation.
• Builder experienced financial difficulty and went
shopping for a $100,000 loan.
• Agreement #1:
– Builder conveyed property to Partners for $80,000
– Builder was ―to receive a contract for deed allowing
[requiring?] him to repurchase the property from
Partners for $120,000‖
• $40,000 to be paid in one year
• $80,000 balloon at the end of year two.
• Attorney, consulted to ―complete the necessary
paperwork‖, suggested reworking the contract.
– Attorney also was made a partner
43 Donald J. Weidner
McElroy v. Grisham (cont‘d)
• Agreement # 2:
– Builder conveyed the land by warranty deed to the
Partnership
– Partnership paid Builder $80,000
– “At [the attorney‟s] suggestion, the contract for deed
was changed into an option contract” (Text p. 715).
Accordingly:
– Partnership gave Builder an Option to Purchase
• Exercisable within one year
• $40,000 to be paid at the time of exercise
• Plus $80,000 to be paid within two years
– No interest
– Builder was required to release $120,000 in liens against
the property (presumably, by using some or all of the
$80,000 proceeds)
44 Donald J. Weidner
McElroy v. Grisham (cont‘d)
• Agreement # 3:
– The parties ignored the option (Partnership later
claimed Builder let it lapse) and entered into a
“contract for deed” under which Builder agreed to
purchase most of the parcels (the Partnership
was going to keep three parcels) back for
$125,0000 (slightly more than the option price but
getting back less of the property).
• Builder defaulted after paying for a while and
sued to have the transaction declared a usurious
loan.
• Is there ―an agreement to loan money‖ with an
―absolute obligation to repay the principal?‖
45 Donald J. Weidner
McElroy v. Grisham (cont‘d)
• The case involves what texts call a Deed Absolute
(on its face) with Collateral Documents.
• The initial collateral document was a
―Contract for Deed‖
– another term for an Installment Land
Contract
• The Contract for Deed was replaced with an
―option to purchase‖
• Why did the Attorney replace a warranty deed
coupled with a ―contract for deed‖ with a warranty
deed coupled with an ―option to purchase?‖

46 Donald J. Weidner
McElroy v. Grisham (cont‘d)
• A specific intent to violate the usury laws is
not necessary to find a violation:
– All that is necessary is an intent to enter a
transaction that charges interest that exceeds
the maximum rate.
• The question: is there, in substance, a
loan secured by a mortgage?
• Substance will control form--the law will
―discard the shell and keep the kernel‖
– Just like in Florida
47 Donald J. Weidner
McElroy v. Grisham (cont‘d)
• What factors indicated that, behind the form of a
sale, there was the substance of a loan?
1. Purported borrower had approached other
institutions and individuals for a loan and was
rejected.
2. Purported borrower was in dire financial trouble
• And the purported lenders were aware of the
trouble
3. Purported borrower approached purported lender
seeking a loan.
4. There was a gross disparity between the
purported “purchase price” and both
• Historical cost and
• Appraised value

48 Donald J. Weidner
McElroy v. Grisham (cont‘d)
5. There were collateral documents:
• Providing for a payment of monies back to the
“buyer” (either under the Contract for Deed or
upon exercise of the “option” to purchase), and
• Providing for a reconveyance to the “seller”
upon the repayment of those monies (when
“seller” performed under the Contract for Deed
or “optionee” exercised the “option” to
repurchase).
6. The purported borrower never intended to
relinquish ownership.
7. Even after the “option” lapsed, discussions
continued to get the money back to the “buyer”
and the property back to the “seller.”
Conclusion: “none of the parties intended for the
property to come into the hands of the [partnership]
any more than was necessary to secure the loan”
49 Donald J. Weidner
Interest Contingency Rule
• Assume the loan in McElroy v. Grisham was risky.
An investor has a legitimate right to expect a
return that reflects that risk
– How might the loan be structured?
• The casebook suggests one possible solution:
provide the lender a share of the profit on the sale
of residences, even if that share of profits
ultimately pushed the lender‘s total return above
the usury level.
• This type of solution is possible because of the
interest contingency rule, which is a fundamental
principle in the case law of usury.
50 Donald J. Weidner
Interest Contingency Rule (Cont‘d)
• One statement of the interest contingency rule:
– ―[A] promise to give the lender a greater profit
than the highest permissible rate of interest
upon occurrence of a condition, is not
usurious if the return promised on failure of
the condition is materially less than the
amount or debt with the highest permissible
rate of interest.‖
• Note: there may be a legal risk to the lender
who takes a profit share, as opposed, for
example, to a share of gross receipts
– Profit sharing is a great indication of partnership

51 Donald J. Weidner
Interest Contingency Rule (Cont‘d)
• A second statement of the interest
contingency rule:
– From Golden State Lanes v. Fox, involving
a sale-leaseback
– ―in a loan the lender does not share in the
profits of the enterprise, nor does he run
any risk of the loss of his capital other than
that of the insolvency of the borrower,
attendant upon all loans.‖
– However: in a nonrecourse loan, the
lender may experience a loss of capital
even if the borrower is solvent
52 Donald J. Weidner
Corporate Borrower Exemption
• The most common statutory exemption from
usury laws is for loans made to corporate
borrowers.
• Text (p. 721): ―The central question . . . concerns
the extent to which, to qualify, a corporation must
have a life and business purpose independent of
usury avoidance.‖
– ―New York and several other states take the view that
any corporation, even one formed exclusively for the
purpose of avoiding usury limitations, qualifies for the
corporate exemption.‖
– Courts are split.

53 Donald J. Weidner
Time Price Doctrine
• Is a Seller‘s agreement to provide Buyer
purchase money financing an ―agreement to
lend money‖ within the meaning of the usury
law?
– Stated differently, is a seller-provided purchase
money financing a loan?
• The ―time-price‖ doctrine says that a seller
has a right to charge more for a sale on credit
than for a cash price.
• What if the seller sells on credit at the cash
price but explicitly charges ―interest‖ at a rate
in excess of the maximum rate?
– See Mandelino v. Fribourg (Text p. 721)

54 Donald J. Weidner
Heller Financial Inc. v. Lee
(Text p. 722)

• Florida Limited Partnership with a Sole
Corporate General Partner took out two loans to
purchase an Orlando hotel. This case concerns
the smaller and junior of the two loans.
• The $9,900,000 junior loan was made both to
the Limited Partnership and to its sole corporate
General Partner. The loan was secured by the
equity interest in the limited partnership and by
the equity interest in its General Partner.
• After the closing of the loans and acquisition, an
unrelated corporation managed the hotel.
55 Donald J. Weidner
Heller Financial Inc. v. Lee (cont‘d)
• At issue was Section 11(b) in the Note, which
made the borrowers‘ obligation to repay
nonrecourse:
– ―Subject to the provisions set forth below, no Maker
shall be personally liable to pay the Loan . . . and
Holder agrees to look solely to the Assignments and
any other collateral . . . pledged . . . to secure the
loan. Notwithstanding the foregoing, each Maker
(excluding Robert Ahnert), . . . shall be personally
liable for . . . (b) repayment of the Loan and all other
obligations of the maker under the loan Documents in
the event of [any breach of certain covenants].‖

56 Donald J. Weidner
Heller Financial Inc. v. Lee (cont‘d)
• The referenced covenants said that each borrower
agreed not to permit the filing of any
encumbrances on the Hotel other than those
provided for in the senior loan documents.
• Approximately $821,212 in encumbrances were
filed (4 tax liens and 2 mechanics liens).
• Issue: Do the Makers of the note become
personally liable on the full $9,900,000 loan
because they permitted $821,212 in
encumbrances to be filed?
• Held: Yes. ―Section 11(b) is not a liquidated
damages provision because it provides only for
actual damages.‖
– Which the court said was payment of the
unamortized loan balance.
57 Donald J. Weidner
Junction Bit & Tool Co. v. Village Apts., Inc.
(Supp. p. 22)

• In an earlier case, the Supreme Court of Florida
had said that an election to sue on a note at law
acted as a bar to any subsequent suit for
foreclosure of a mortgage standing as security
for the note.
• Here, the Court reversed its earlier decision:
• If the earlier judgment on the note leaves the
creditor unsatisfied
– that unsatisfied judgment was no remedy and
– hence, does not bar the remedy of foreclosure
on the mortgage.
58 Donald J. Weidner
Gottschamer v. August, Thompson et al.
(Supp. page 23)

• $165,000 note was executed by a corporation and
guaranteed by its principals.
• Upon default, the holder of the note and mortgage filed a
foreclosure action against the corporation and included a
count against the guarantors.
• The foreclosure action was stayed but the trial court
determined that $197,671 was due on account of the note.
• A foreclosure sale was held and the noteholder was the
successful bidder for $195,000.
• There was a subsequent hearing to determine the value of
the property and the amount of the setoff to which the
guarantors were entitled.
– It concluded the property was only worth $186,500.
• Issue: Do the guarantors get credit for the $195,000 the
noteholder bid at the foreclosure sale or for only the
$186,500 value of the property?
59 Donald J. Weidner
Gottschamer v. August, Thompson et al.
(cont‘d)
• ―Where the amount bid at the foreclosure
sale is higher than the fair market value of
the property subject to the mortgage, the
amount bid must be applied to the debt as
fixed by the final judgment.‖

60 Donald J. Weidner
Notes Under the Uniform Commercial
Code: A Quick Overview
(Supplement pp. 39-41)
• Caveat about the Smith & Lubell statement at text
p. 710: ―Since the note is evidence of a debt and
is a negotiable instrument, only one copy of it
should be signed by the borrower.‖
– Not all notes qualify as negotiable instruments under the
Uniform Commercial Code
• Rights of a holder in due course (UCC 3-305)
– In general, a holder in due course takes free of
―personal defenses‖ but takes subject to ―real defenses‖
(see next slide)
– Breach of warranty is a personal defense to which the
HDC is not subject.
• Who qualifies as a holder in due course (UCC 3-
302, 3-104, 3-106).
61 Donald J. Weidner
UCC § 3-305 DEFENSES AND CLAIMS IN RECOUPMENT
A holder in due course is only subject to the
following “real” defenses:
”(1) a defense of the obligor based on
(i) infancy of the obligor to the extent it is
a defense to a simple contract,
(ii) duress, lack of legal capacity, or
illegality of the transaction which, under other
law, nullifies the obligation of the obligor,
(iii) fraud that induced the obligor to sign
the instrument with neither knowledge nor
reasonable opportunity to learn of its
character or its essential terms, or
(iv) discharge of the obligor in insolvency
proceedings;”

A holder in due course is not subject to
“personal defenses” (such as breach of
warranty). 62 Donald J. Weidner
Official Comment to Revised 3-305

• The Official Comment to the revised 305
states that the holder in due course
doctrine:
– ―applies only to cases in which more than two
parties are involved. Its essence is that the
holder in due course does not have to suffer
the consequences of a defense of the obligor
on the instrument that arose from an
occurrence with a third party.‖

63 Donald J. Weidner
UCC § 3-302 Who is a Holder in Due Course
”(a) [With very limited qualification], „holder in due
course‟ means the holder of an instrument if:
(1) the instrument when issued or negotiated to the
holder does not bear such apparent evidence of forgery
or alteration or is not otherwise so irregular or
incomplete as to call into question its authenticity; and
(2) the holder took the instrument
(i) for value,
(ii) in good faith,
(iii) without notice that the instrument is overdue
or has been dishonored . . . ,
(iv) without notice that the instrument contains an
unauthorized signature or has been altered,
(v) without notice of any claim to the instrument . .
. , and
(vi) without notice that any party has a defense or
claim in recoupment . . . .”

- § 3-104 (b) provides: “Instrument means a negotiable
instrument.”
64 Donald J. Weidner
UCC § 3-104 When Instrument is Negotiable
”(a) [With minor exceptions], „negotiable instrument‟ means an
unconditional promise or order to pay a fixed amount* of money, with
or without interest or other charges described in the promise or order,
if it:
(1) is payable to bearer or to order at the time it is issued or first
comes into possession of a holder;
(2) is payable on demand or at a definite time; and
(3) does not state any other undertaking or instruction by the person
promising or ordering payment to do any act in addition to the
payment of money,

but the promise or order may contain (i) an undertaking or power to
give, maintain, or protect collateral to secure payment, (ii) an
authorization or power to the holder to confess judgment or realize on
or dispose of collateral, or (iii) a waiver of the benefit of any law
intended for the advantage or protection of an obligor.

* The old language requiring a “sum certain” was removed. New Section
3-112(b) was added.
65 Donald J. Weidner
New UCC Section 3-112(b)
• Section 3-112(b) now provides:
– ―(b) Interest may be stated in an instrument
as a fixed or variable amount of money or it
may be expressed as a fixed or variable rate
or rates. The amount or rate of interest may
be stated or described in the instrument in
any manner and may require reference to
information not contained in the instrument.‖
• This language was added in 1990 to dispel any
doubts about the negotiability of variable interest
rate notes.

66 Donald J. Weidner
UCC § 3-106 When Promise or Order Unconditional
―(a) [With minor exception], for the purposes of Section 3-104(a), a
promise or order is unconditional unless it states (i) an express
condition to payment, (ii) that the promise or order is subject to or
governed by another record, or (iii) that rights or obligations with
respect to the promise or order are stated in another record. A
reference to another record does not of itself make the promise or
order conditional.

(b) A promise or order is not made conditional (i) by a reference to
another record for a statement of rights with respect to collateral,
prepayment, or acceleration, or (ii) because payment is limited to
resort to a particular fund or source.”
What result in the 1975 Florida case in which a note stated it was “secured by
a mortgage on real estate . . . The terms of said mortgage are by this
reference made a part hereof?”
- See Holly Hill Acres, LTD. V. Charter Bank of Gainsville, 314 So. 2d 209 (Fl.
App. 1975).

67 Donald J. Weidner
Notice

• A person has notice of a fact if the person,
―from all the facts and circumstances
known to the person at the time in
question, has reason to know that it
exists.‖ UCC 1-202(a).

68 Donald J. Weidner
UCC § 3-203 Transfer of Instrument; Rights Acquired
by Transfer
(a) An instrument is transferred when it is
delivered by a person other than its issuer for
the purpose of giving to the person receiving
delivery the right to enforce the instrument.

(b) Transfer of an instrument . . . vests in the
transferee any right of the transferor to enforce
the instrument, including any right as a holder
in due course, but the transferee cannot
acquire rights of a holder in due course by a
transfer, directly or indirectly, from a holder in
due course if the transferee engaged in fraud
or illegality affecting the instrument.

69 Donald J. Weidner
UCC § 3-203 Explained
Official Comment:
2. . . . Under subsection (b) a holder in due course
that transfers an instrument transfers those rights
as a holder in due course to the purchaser. The
policy is to assure the holder in due course a free
market for the instrument.

There is one exception to this rule stated in the
concluding clause of subsection (b). A person
who is party to fraud or illegality affecting the
instrument is not permitted to wash the instrument
clean by passing it into the hands of a holder in
due course and then repurchasing it.

70 Donald J. Weidner
UCC § 3-203 Explained (Cont‟d)

Official Comment
4. The operation of Section 3-203 is illustrated by the
following cases. In each case Payee, by fraud,
induced Maker to issue a note to Payee. The fraud
is a defense to the obligation of Maker to pay the
note under Section 3-305(a)(2).
Case #1. Payee negotiated the note to X who took as a
holder in due course. After the instrument became
overdue X negotiated the note to Y who had notice
of the fraud. Y succeeds to X's rights as a holder in
due course and takes free of Maker's defense of
fraud.
Case #2. Payee negotiated the note to X who took as a
holder in due course. Payee then repurchased the
note from X. Payee does not succeed to X's rights
as a holder in due course and is subject to Maker's
defense of fraud.
71 Donald J. Weidner
Associates Home Equity Services, Inc. v. Troup
(Text p. 427)
• Classic type of civil rights case.
• Elderly, minority, inner-city resident Troup signed
contract to purchase home improvements.
• Home improvement company steered her to
defendant lender to finance their contract.
• In 1996, Defendant lender provide her a loan:
– $46,500 amount
– 11.6% interest (plus 4 points at closing)
– 15 year term
– $41,600 balloon (due at end of 15 years)
• Defendant lender sold her note and mortgage to
defendant Associates, who paid a premium for it
because of its high interest rate.
72 Donald J. Weidner
Associates Home Equity (cont‘d)
• Borrower defaulted on note.
• Notepurchaser (assignee of note and mortgage)
filed an action to foreclose on the mortgage
• Borrower asserted defenses to the foreclosure
action based on various statutes, including:
– CFA, the Consumer Fraud Act
– TILA, the Truth in Lending Act
– FHA, the Fair Housing Act
– CRA, the Civil Rights Act Sec. 1982
– LAD, the Law Against Discrimination (New Jersey)

73 Donald J. Weidner
Associates Home Equity (cont‘d)

• In short, court allowed the case to move forward
to the discovery stage.
• Borrower could raise overlapping defenses to
establish ―equitable recoupment‖ in the
foreclosure proceeding even if the claims would
be time-barred as an independent matter.
• Borrower asserted predatory lending,
discriminatory lending and unconscionability.
• Borrower asserted that notepurchaser either
acted in consort with the mortgage originator or
controlled its conduct.

74 Donald J. Weidner
Associates Home Equity (cont‘d)

• Predatory lending was defined in terms of
loans that are not suitable for the
borrowers:
– ―In essence, the loan does not fit the
borrower, either because the borrower‘s
underlying needs for the loan are not being
met or the terms of the loan are so
disadvantageous to that particular borrower
that there is little likelihood that the borrower
has the capacity to repay the loan.‖

75 Donald J. Weidner
Associates Home Equity (cont‘d)
• The borrower argued that the loan originator and
notepurchaser were engaged in ―reverse
redlining‖:
– ―Reverse redlining is the practice of extending credit
on unfair terms‖ to specific geographic areas due to
the income, race or ethnicity of the residents.
• The focus was on communities that lack access
to traditional lending institutions.
• Reverse redlining has been held to violate the
FHA (Federal Housing Act), the CRA (Civil
Rights Act) and the LAD (New Jersey law
against discrimination).
76 Donald J. Weidner
Associates Home Equity (cont‘d)

• Court: racial or ethnic factors may be
implicated in reverse redlining:
– A plaintiff may establish a colorable claim of
reverse redlining by demonstrating that
―defendants‘ lending practices and loan terms
were ‗unfair‘ and ‗predatory,‘ and that the
defendants either intentionally targeted on the
basis or race or that there is a disparate impact
on the basis of race.‖
• Discovery may reveal that notepurchaser‘s
guidelines are discriminatory.
77 Donald J. Weidner
Associates Home Equity (cont‘d)

• Court rejected notepurchaser‘s argument
that recoupment is inapplicable because
the foreclosure proceeding is not one to
collect a debt.
• A foreclosure action ―is a quasi in rem
procedure to determine not only the right
to foreclose, but also the amount due on
the mortgage.‖
– Borrower seeks to reduce the amount due

78 Donald J. Weidner
Associates Home Equity (cont‘d)
• The Federal Trade Commission regulates
―consumer credit contracts,‖ which must disclose:
– ―ANY HOLDER OF THIS CONSUMER CREDIT
CONTRACT IS SUBJECT TO ALL CLAIMS AND
DEFENSES WHICH THE DEBTOR COULD ASSERT
AGAINST THE SELLER . . . .‖
• The holder rule ―strips the ultimate holder of the
paper of its traditional status as a holder-in-due-
course and subjects it to any potential defenses
which the purchaser might have against the seller.‖
• A business may not so structure a consumer credit
transaction to separate the consumer‘s duty to pay
from the seller‘s duty to perform.
79 Donald J. Weidner
Associates Home Equity (cont‘d)
• There was an issue whether the originator‘s loan
was a purchase money loan.
• Under the FTC rule, a purchase money loan is a
cash advance received be a consumer to
purchase goods or services from a seller who:
– refers consumers to the creditor or
– is affiliated with the creditor by common control,
contract or business arrangement.
• There was also an issue whether the
notepurchaser was affiliated with the originating
lender or designated from the outset to be the
notepurchaser.

80 Donald J. Weidner
Note 1 to Associates Home Equity
• Nelson and Whitman, Real Estate Finance
Law Sec. 5.30 (5th ed. 2007):
– The FTC‘s rule makes it an unfair trade
practice for a seller of goods or services to
finance a sale without including language that
makes the lender subject to the consumer‘s
claims and defenses.
– In the case of third-party financing, ―the loan
must have been made in connection with a
sale of goods or services and a type of ‗close
connectedness‘ criterion must be satisfied‖
• ―but it is much simpler and looser than the
UCCC‘s.‖
81 Donald J. Weidner
Note 1 to Associates Home Equity (cont‘d)
• ―The lender is brought within the rule‘s ambit if
the seller of the goods or services refers
consumers to the lender or is affiliated with the
creditor by [any] business arrangement.‖
• The FTC rule does not apply to financings or
sales of interests in real estate—it only applies
to sales of goods and services.
• As of 2007, it only applied to purchases of
$25,000 or less.
• If the seller does not include the FTC notice in a
note, its purchaser may qualify as a HDC.
– Although Associates suggests the assignee may be
liable for a failure to include the required language.

82 Donald J. Weidner
Note 2 to Associates Home Equity

• Congress adopted the Home Ownership
and Equity Protection Act in 1994. It
covers ―high cost‖ mortgage loans other
than purchase money loans.
– Special disclosures must be given
– Certain terms are prohibited (negative
amortization, certain balloons, etc.)
– Certain conditions must be met to have a
valid prepayment penalty

83 Donald J. Weidner