Note and Mortgage

1. 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. • We’ll then take up the law of the notes. Donald J. Weidner

2. 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 Donald J. Weidner

3. 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. • Some “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. Donald J. Weidner

4. 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 clauseproviding 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. Donald J. Weidner

5. 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. • Lender 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. Donald J. Weidner

6. 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. Donald J. Weidner

7. Note 1 to Fioravanti • In Florida, dragnet clauses are construed against the drafter. • In particular, pre-existing debt must be specifically included. • United Nat’l Bank v. Tellam, 644 So.2d 97 (FL 3d DCA 1994) (invalidated attempt to drag in pre-existing debt rather than future debt). Existing debts must be specified and future debts may not be dragged in if they were not anticipated at making of the Mortgage. Donald J. Weidner

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

9. 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. Donald J. Weidner

10. AFTER ACQUIRED PROPERTY (Cont’d) • The reason: A mortgage with an After Acquired Property clause will be outside the chain of title of the after-acquired property. • 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. Donald J. Weidner

11. AFTER ACQUIRED PROPERTY (Cont’d) • 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. Donald J. Weidner

12. EVOLUTION OF PROTECTION OF MORTGAGORS(Text p. 367) The “mortgage deed,” says the legal historian Maitland, “is one long suppressio veri and suggestio falsi.” Donald J. Weidner

13. Borrower Deed Lender’s estate ends ONLY if borrower pays everything off exactly on time. Lender Fee simple subject to condition subsequent Stages in Evolution of Mortgage Law • Defeasible fee enforced according to its terms • Equity relieved Borrower in special circumstances • Special circumstances were always found • The equity of redemption came to be called an estate in land. Donald J. Weidner

14. Stages in Evolution of Mortgage Law (cont’d) • 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 (foreclosed) from asserting any interest in the future. • 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, interest and no more. Donald J. Weidner

15. Stages in Evolution of Mortgage Law (cont’d) • Legislatures in roughly half the states supplement the equity of redemption and other judicial protections of borrowers with an additional Statutory Right of the Borrower 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. Donald J. Weidner

16. Stages in Evolution of Mortgage Law (conclusion) Where that leaves us. • 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. • However, in many states: Powers of sale, authorizing a sale out of court, whether they are contained in mortgages or in deeds of trust, are enforceable (and popular). • In these states, the only two necessary steps to foreclose are notice and sale. Donald J. Weidner

17. THE PRACTICAL REALITY OF CHOICE OF SECURITY INTEREST • A Mortgage • A Deed of Trust • An Absolute Deed Standing by Itself • An Absolute Deed with Collateral (accompanying) Documents • Collateral documents such as a lease back or an option to repurchase • An Installment Land Contract • Also called “contract for deed” or “bond for title” • A Negative Pledge • A Lease • A Proprietary Lease in an Cooperative Donald J. Weidner

18. Sample Balloon Mortgage(Supplement p. 31) • “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” Donald J. Weidner

19. Sample Balloon 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 Donald J. Weidner

20. Sample Balloon Mortgage(Cont’d) • The mortgagor also covenants • to give the mortgagee the right to spend money to cure defaults [ex., to pay real estate taxes if the mortgagor does not] 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 [the “acceleration” clause] Donald J. Weidner

21. Sample Balloon Mortgage(Cont’d) The mortgagor also covenants that • “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.” Donald J. Weidner

22. Sample Balloon Mortgage(Cont’d) • The Mortgagor also covenants • “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.” Donald J. Weidner

23. Sample Balloon Mortgage(Cont’d) The mortgagor also covenants • “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. Donald J. Weidner

24. Deed of Trust • From Klem v. Washington Mutual, 2013 Wash. LEXIS 151 (Feb. 28, 2013): • A deed of trust . . . Is a statutorily blessed “three-party transaction in which land is conveyed by a borrower, the ‘grantor,” to a ‘trustee,’ who holds title in trust for a lender, the ‘beneficiary,’ as security for credit or a loan the lender has given the borrower.” • If the trustee acts only at the direction of the beneficiary, then the trustee is a mere agent of the beneficiary and a deed of trust no longer embodies a three party transaction. Donald J. Weidner

25. 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. Donald J. Weidner

26. “Assignment of Rents and Agreement Not to Encumber Real Property”—Negative Pledge • “In consideration and as security for a loan” • Certain real estate [B’s residence] was described • 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” • Borrower “will not create or permit any lien or any encumbrance to exist on said real property.” • Borrower “will not transfer, sell, assign or in any manner dispose of said real property . . . without the prior written consent of Bank.” • Bank is authorized to record [which Bank did] • Agreement is intended to benefit all subsequent holders of the note. Donald J. Weidner

27. 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 case on how to implement a note’s provision giving lender the right to increase the rate of interest) • Consider the majority’s 4 reasons for not finding a mortgage and ask whether each is persuasive. Donald J. Weidner

28. Tahoe (Cont’d)Majority’s Reasons Why No Mortgage • 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. Donald J. Weidner

29. Tahoe (Cont’d)Majority’s Reasons Why No Mortgage 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.” Donald J. Weidner

30. 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 being mortgaged. Donald J. Weidner

31. 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 under which 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. • The rule is also said to protect the mortgagor from a multitude of suits. Donald J. Weidner

32. Tahoe (cont’d) • Compare our Sample 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) Donald J. Weidner

33. 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.” Donald J. Weidner

34. Tahoe National Bank v. Phillips HYPO # 1 Deed Absolute with Collateral Documents Sale Alleged Borrower Alleged Lender 2 year option to repurchase Permits 2 years to pass without exercising option Borrower 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? Donald J. Weidner

35. 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 deedwas 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 . . . .’ . . ..” Donald J. Weidner

36. 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.” • However, a subsequent grantee with notice is bound by the equitable mortgage. • See, ex., F.S. 697.01(2). • Deeds absolute are also often used by grantors trying to hide assets from other creditors. Donald J. Weidner

37. Loan Definite Borrower Definite Lender #1 Note Negative pledge [Say identical to Tahoe] Records Tahoe National Bank v. Phillips HYPO #2 • If Lender #2 records a mortgage, will it be the first mortgage? • 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.” • 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.” Applies for loan Lender #2 Borrower Insists on 1M Donald J. Weidner

38. Enforceability of Due-on-Sale & Due-on-Encumbrance Clauses (Text p. 472) • 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 enforcing them in residential mortgages unless the mortgagee could establish that a transfer would impair mortgage security. • The majority judicial approach held due-on-sale clauses were enforceable (presumption of enforceability) unless the borrower could show the lender engaged in unconscionable conduct. • The minority judicial approach generally held due-on-sale clauses enforceable only if (presumption against enforceability) 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 shown reasonably necessary to protect the lender’s security. Donald J. Weidner

39. Enforceability of 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, to protect the lenders, 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). Donald J. Weidner

40. 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. Donald J. Weidner

41. Enforceability of 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 situationsinvolving 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, an acceleration clause triggered by a subsequent home equity loan is unenforceable. • There are other instances in which due-on-sale clauses in residential loans are unenforceable. See12 U.S.C. § 1701j-3(d)(2-9) (Text p. 473). Donald J. Weidner

42. Prepayment Privileges and Penalties (Text p. 474) • Absent a specific provision in a note governing prepayment, the borrower is generally not entitled to prepay whenever the borrower likes • The rationale is that the lender has bargained for a specific debt service schedule • However, a minority of jurisdictions disagree. • In some, statute provides for a right to prepay unless the note provides to the contrary • Some caselaw presumes a right to prepay • Federal law preempts state law in limited residential situations • And prevents a due-on-sale clause from triggering a penalty Donald J. Weidner

43. Florida Statute: Substance Not Form Determines Whether Mortgage Exists • Fla. Stat. sec. 697.01(1) (Similar to the Balloon Mortgage provision at Supp. 36): • “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.” Donald J. Weidner

44. Florida Statute: Substance Not Form Determines Whether Mortgage Exists (cont’d) • Is a negative pledge within FS 697.01(1)? • Is it a conveyance? • Is it a writing selling property? • Reflecting the general rule, FS 697.01(2) provides: “Provided, however, that no such conveyance shall be deemed or held to be a mortgage, as against a bona fide purchaser or mortgagee, for value without notice, holding under the grantee.” Donald J. Weidner

45. 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.” Donald J. Weidner

46. Three Basic Theories of Mortgages • Title. Mortgage passes title at outset. • Lien. Mortgage is nothing but a lien. • 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. Donald J. Weidner

47. 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 as a creditor 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. Donald J. Weidner

48. 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 other states. Donald J. Weidner

49. FOUR ELEMENTS THAT MUST BE MET BEFORE A LOAN CAN BE CONSIDERED USURIOUS (Text p. 720): • An agreement to lend money • Interest in excess of that allowed by statute • An absolute, not contingent, obligation to repay the principal • 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. NOTE: Considerable federal preemption of usury limits in residential mortgages (since Pres. Carter). Donald J. Weidner

50. 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, recommended to Builder by Partners to “complete the necessary paperwork”, suggested “reworking” the contract. • Attorney also was made a partner in Partners Donald J. Weidner