Due on Sale Real Estate

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					            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

				
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Description: Due on Sale Real Estate document sample