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Real Estate: Rights and Duties Prior to Foreclosure


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The Title Theory
1) Legal title and right of possession in ME until mortgage has been satisfied or foreclosed.
2) ME has the right to collect rents and profits until the mortgage debt is paid or foreclosure has occurred.
3) BUT: ME will usually not take possession until default occurs.
4) 6/7 states (East and South)-->New England: Massachusetts, Vermont, Connecticut
The Lien Theory
1) Restatement theory.
2) MR has legal and equitable title until valid foreclosure.
3) ME has only a lien (a security interest) on the mortgaged premises.
4) MR has right to possession and to rents and profits.
5) Adopted by about 40 states: CA, most of West and Midwest
6) ME cannot use a provision in the mortgage to give the ME possession upon default b/c it is against public policy for debtor to contractually give up right of possession
· Probably under the mirage of hope or acting under false pretenses
The Intermediate Theory
1) Lien theory applied until default and the title theory thereafter.
2) So, MR has right to possession until default.
3) Little difference from title theory b/c MEs don't usually take possession until default.
4) 2/3 states
When does a ME become a ME in possession?
1) Let into possession by MR.
2) Takes possession after MR abandons property.
3) In good faith after purchasing at an invalid foreclosure sale.

Once in possession can remain in possession until mortgage is satisfied or foreclosed.

Mortgage law is more likely to give ME possession when the MR gave up possession at default rather than ex-ante (in an agreement in the mortgage contract).
General duties of ME in possession
Duty of a provident owner-->manage the property in a reasonably prudent and careful manner so as to keep it in a good state of preservation and to use the rent collected for no other purpose than to credit to the debt.
Specific duties of ME in possession
1) Rents
2) Maintenance and Repairs
3) Improvements
4) Compensation for Services
5) Liability for Tort
ME in possession: Rents
Reasonable diligence to keep property rented for a reasonable amount. Rents applied to mortgage debt.
ME in possession: Maintenance and Repairs
Limited to the greater of the rents and profits the ME actually receives or such rents as a reasonably prudent ME should have collected.

ME had no obligation to be out of pocket to make repairs.
ME in possession: Improvements
ME can usually not make improvements.

Protects MR b/c such improvements would add to the mortgage debt and thus make it more difficult for the MR to redeem.
ME in possession: Compensation for Services
Most jurisdictions: Cannot do the services or repairs himself and obtain compensation for doing so.

Some: allow reasonable compensation
ME in possession: Liability for Tort
Liable in tort for injuries to TPs arising through negligence in the use of the property or in failure to carry out duties normally imposed on the owner or possessor of RE.
Ancillary Remedies
Used incident to foreclosure to prevent MRs from milking the property or entering into sweetheart deals during prolonged foreclosure period.

1) possession
2) assignment of rents
3) receiver

It is extremely rare that these remedies would ever be sought on a mortgage on a single family dwelling. These remedies mainly apply to commercial real estate.
Assignment of Rents
This is like a mortgage on the rents; the lender takes a separate security interest on the rents.
Rents from RE are deemed realty and are governed by the law of real property security. UCC 9-104(j) says code is inapplicable to a lien on these rents.

This is used in all states, including title theory states where they should theoretically already own the rents.
Valid between MR and ME
Valid against TPs
Right to collect
Absolute assignment
1) Eff upon execution
2) P upon recording
3) En upon default

Can't have in CA post 1997
American Common Law/Inchoate
1) Eff: all that exists is a lien until there is affirmative action
2) P: all that exists is a lien until there is affirmative action
3) En upon affirmative action
Restatement/Middle Ground (CA)
1) Eff upon execution
2) P upon recording
3) En upon affirmative action
Affirmative action requirement
Varies by jurisdiction and can include appointment by a receiver, impounding rent, taking possession, mailing notice, or just requesting a receiver.

Under the restatement, the affirmative action required is delivering demand to MR and others holding mortgages on the real estate.
In the Matter of Millette
1) Highlights the importance of determining which theory the states follow.
2) Eastover Bank (E1) clearly had an assignment of rents recorded before Steel (E2) sought garnishment, but Eastover Bank did not take affirmative action until after Steel perfected judgment.
3) Under the American Common Law, E2 would be senior to E1.
4) Under Restatement, E1 would be senior to E2.
5) Result: Restatement view
Is the AOR consistent with the lien theory?
Yes: Gives MR right to give the ME the right to possesion upon MR default-->so enforecement of AOR clause follows logically
Is AOR a clog on the EOR?
No: Even after assignment is enforced, the MR has the right to redeem the debt at any time until a valid foreclosure has taken place.
Why is the AOR used?
1) Enhances ME's security position by allowing it to reach the rents and profits w/o actually incurring many of the responsibilities of a MIP.
2) Presence of the clause may enhance the ME's ability to have a receiver appointed.
3) May give the ME an enhanced claim to rents vis a vis the MR's subsequent creditors or trustee in bankruptcy.
What is a receivership?
An official receiver is appointed by the court to take possession of the mortgage real estate and make repairs on it, applying rents to the debt after the cost of repairs and cost of receivership are satisfied.
Why is a receivership used?
1) Less responsibility than under MIP.
2) Lien Theory states: beneficial b/c of doctrinal roadblocks to ME possession
3) AOR is of little value if property is vacant or onmly partially rented.
Rights of receiver
1) A receiver can rent out open spaces, but new tenants will typically want non-disturbance or subordination agreements since they are otherwise junior to the mortgage and will be destroyed upon foreclosure.
2) With respect to sweetheart deals/leases:
§ If a lease is senior to the mortgage, the receiver can’t normally do anything to it
§ If a lease is junior to the mortgage (either signed after mortgage or has been subordinated to the mortgage), the receiver can usually deal with them (terminating the leases or an amendment thereto)
3) The receiver can undo junior leases in title theory states. In lien theory states, the general rule is that receivers cannot undo a junior lease but generally there are provisions in mortgage agreements allowing receivers to set aside commercially unreasonable agreements, such as post-default, prepayment agreements.
· The Restatement says that post-default prepayments by lessees are per se unreasonable but cheap rents for open space is not necessarily so.
What is required for receivership?
Dart v. Western Federal as well as the restatement say that the default rule is that receivers are only appointed when lender can show DEFAULT + IMPAIRMENT OF SECURITIES + WASTE
Significance of a Receivership Clause
Restatement: Where there is an actual receivership clause or AOR clause, all that is required is default. Other states don’t allow receivership clauses.
Ex-Parte Receivership
1) Ex-parte receiverships take place without the presence of the MR.
2) There is a presumption against them because of the lack of due process, but when a strong enough reason is presented, they can be considered constitutional. 3) Courts will usually allow them when there is 1) legitimate reason + 2) written waiver.
4) Lenders prefer ex parte receiverships because the element of surprise can prevent MR’s from committing waste or entering into sweetheart deals.
Dueling receivers
§ If neither E1 nor E2 has a receivership clause, E2 has a better chance at getting a receiver assigned because E2’s security is more impaired.
§ If they both have receivership clauses, E1 is more powerful because E1 is senior to E2. The restatement says (and the general rule is) that if E2 gets a receiver appointed first, it can keep all rents received until E1 intervenes. After E1 intervenes, future rents go to E1.
Is self-help repossession allowed?
No, as in in Wheeler v. Community Federal Savings and Loan, it is not allowed. In Wheeler, punitive damages were assessed.
What is cherry-picking?
1) The ME’s decision to pick and choose what leases to keep.
2) In a judicial foreclosure state, any party not made a part of a judicial proceeding is not bound by the proceeding. This gives E1 the incentive to only make lessees parties to lawsuits if they want to get rid of the lessee.
3) The Uniform Act and the majority of states favor cherry picking because tenants are on notice that new landlords have the right to determine whether or not to terminate the lease.
4) When dealing with a power of sale foreclosure this issue is a real mess. Some states require very little notice in power of sale foreclosure and some states require a lot of notice to all the affected parties (i.e., mailed notice). They may give a notice of preservation, “effectively excluding that party from the effect of the foreclosure even though the party is given notice of the foreclosure.” This institutionalizes cherrypicking.
5) Others consider this unfair manipulation.
How do you get around cherry-picking?
1) Subordination agreements
2) Non-disturbance agreements
3) Attornment

Frequently, all three of these clauses are added. Many of their provisions will cancel each other out. However, if there are contradicting terms in the different agreements, the subordination agreement would make E1’s agreement senior and it would trump.
What are subordination agreements?
1) Tenants agree to subordinate to E1’s mortgage, flipping the priorities between them.
2) This can be an agreement between T and E1, or an agreement between T and MR in which T agrees to subordinate to any current and future mortgage on the property.
3) In Dover, the subordination clause worked to the disadvantage of E1 because the court determined that it extinguished the junior lease. Fiber Form was liable for rents only on a month-to-month basis after the foreclosure sale rather than being liable for its former 5-year lease.
What is a non-disturbance agreement?
T and E1 enter into an agreement which says that if there is a foreclosure, the new P (usually E1) must agree to allow T to stay on the premises as long as T continues to pay rent.
What is an attornment?
In the event of foreclosure and new owner, T agrees to attorn to the new owner and become liable to all terms of the original lease to the new P.
What is the purpose of the waste doctrine?
To protect the value of the RE security from harm due to the MR's acts or failures to act.
What is waste?
Waste is a tort committed by the holder of a present possessory interest of land (MR) that unreasonably harms the holder of a future interest (ME). Waste can sometimes be considered a contract violation as well when mortgages use language specifically prohibiting waste and requiring reasonable repairs. Because it is a tort, punitives are sometimes available. The two main categories of waste are:
· voluntary waste: active waste, such as tearing up a building before foreclosure
· permissive waste: passive waste; failing to act when a reasonable possessor would have, such as not making repairs or paying taxes
What are the five categories of waste under the restatement?
(1) Negligent and Intentional Physical Changes to Real Estate that Reduce Value: all courts recognize this as waste.
(2) Failure to Maintain and Repair Real Estate in a Reasonable Manner (except for failure to repair “acts of God” damages or acts of third parties not the fault of MR): this is widely accepted as waste--Prudential Insurance Co. v. Spencer's Kenosha Bowl, Inc.
(3) Failure to Pay Property Taxes: this is waste in 50% of courts
(4) Material Failure to Comply with Covenants on the Mortgage Respecting Physical Care, Maintenance, Etc.
(5) Waste of Rents; Retaining Possession of Rents to Which ME has Right of Possession
Remedies for waste
Damages, an injunction and foreclosure
Limitations of recovery for waste
1) Loan balance: full payment of debt is the only purpose of holding the security and all recoveries for waste must be applied to the mortgage debt.
2) Amount of waste: The actual harm or damage suffered by the RE forms a ceiling on the amount of waste recovery.
3) Impairment of Security
Methods for valuing impairment of the security
1) Hard-nosed debt equivalency value-->no impairment unless value is reduced below the balance owing on the debt-->no cushion for ME
2) Reasonable margin of security rule-->more pro-ME
3) Scheduled LTV ratio (Restatement)
Scheduled LTV ratio
Can recover damages to bring LTV ratio to the same level that would have existed if all payments on the loan had been made on time and if the property's value had remained stable.
Preclosure waste actions
Uncommon and treated differently in different jurisdictions:
1) Title theory state: damages for reduction of security value to reduce debt-->LTV changes
2) Lien theory state: No recovery until security is impaired
Restatement rule: Restore the lender to the scheduled L/V ratio
Is recovery allowed for waste on non-recourse loans?
CA: antideficiency statute also bars recovery of damages for waster unless it was committed in bad faith. (Cornelison)
Waste actions at foreclosure
1) When foreclosing, the waste amount should be subtracted from the potential bid. If there is a “full credit” bid, then ME will not be able to recover.
2) In Prudential Insurance v. Spencer’s Kenosha Bowl, the Wisconsin court held that 1) permissive waste was a form of waste and 2) “subject to” grantees (who are not personally liable on a debt) can still be held liable for waste
3) In California, even though deficiency judgments are not allowed on residential real estate, waste judgments are still allowed if made in bad faith. (Cornelison) This reasoning was also used in Nippon Credit Bank when a promissory note stated that there was no personal liability but there was liability for waste and the debtor did not pay taxes. Failure to pay taxes was considered waste and because the debtor had kept 1.7 million for the family trust, this waste was considered “bad faith.”
What is rent skimming?
Buy RE subject to an existing mortgage and then rent it, intending to retain all of the rents and pay nothing on the mortgage or for the maintenance of the property.

A crime in CA, CO, KS, FL and WA.

CA: when you buy a property and there are rents you have to apply the rents to the mortgage or it is a serious misdemeanor.
Who are the four categories of people potentially personally liable for environmental disasters under CERCLA?
1. Current owner/operator of the waste site – specifically excluding a person who, without participating in management, holds an indicia of ownership to protect a security
2. any person who owned or operated the waste site when hazardous dumping occurred
3. hazardous waste generators
4. hazardous waste transporters
What are the lender concerns over CERCLA?
· pre-foreclosure: Fleet Factors said that if the loan documents gave lenders the power to influence 1) environmental decisions of the debtor or 2) management decisions of the debtor, the lender was participating in management and could be held personally liable.
· post-foreclosure: If ME bought at the sale, most courts would clearly hold that ME became the owner even if they were just protecting security interests. (US v. Martyland Bank and Trust)
1992 EPA response
The EPA passed regulations that largely took lenders off the hook but these were invalidated as being outside of their powers
1996 Congressional response
Codifes the protections of the EPA and allows lenders to have no liability unless they are actually participating. Lenders who are just protecting security interests have no liability.
What can the lender do pre-loan and still not be held liable under CERCLA?
ME may engage in due diligence and even make loans secure by contaminated real estate
What can the lender do post-closing and still not be held liable under CERCLA?
ME may monitor loan and MR activity but still can’t “participate in management” by having 1) decision making control over environmental compliance or 2) control comparable to that of a regular manager, including day to day control
What can the lender do post-default and still not be held liable under CERCLA?
Work-out activities such as renegotiation are still permitted and the ME can take title via foreclosure/deed in lieu as long as the ME seeks to sell at the earliest practicable commercially reasonable time on commercially reasonable terms; this includes the right to continue operations as long as the operations do not further contamination
What rights does the government have under CERCLA?
The federal government can intervene and clean up and in exchange will have a lien on the land for the value of the clean-up while the land still belongs to the person responsible for the damage, for whatever priority the next lienholder would have had; states have the same prerogative but usually will get super-priority liens over the lender and juniors.
Are lenders protected from environmental common law claims such as trespass and nuisance?
No: Edwards v. First National Bank
What is the lender's interest in insurance proceeds?
When damage is caused to the land, the lender has an interest in the insurance up to the amount of the debt.

The lender is only entitled to the insurance when the mortgage required the MR to carry the insurance.
What are the two types of insurance policies?
1) Loss payable policy: lender rights derive from MR rights such that if the insurance company has a defense against paying the MR, it also has a defense against paying the lender. Ex. MR torches own building; insurance does not have to pay lender.
2) Standard policy: lender rights are not dependent upon the MR so that the only defense an insurance company has against paying the lender is that the premium for the insurance was not paid. Lenders usually receive notice of default so that they can pay the insurance premiums themselves. More common b/c of lender lobbying.
How is the impairment on security measured?
Same as for waste doctrine.
1) Title theory: ME can recover full amount of proceeds as long as they do not exceed the amount of the mortgage debt.
2) Lien theory: ME's recovery is limited to amount that the casualty has impaired the security. (hard to measure)
3) Restatement: recovery should return LTV to the scheduled level.
Earthquake insurance is generally not required for single family homes. Since lenders do not require the coverage, should they obtain the benefit of the coverage if MR’s choose to get coverage?
1) CA courts hold that whether or not the lender’s name is on the insurance policy, so long as the lender did not require the insurance, they have no right to the proceeds. A MR could even let land foreclose and keep the insurance proceeds because there are no deficiency judgments allowed.
2) Under Freddie Mac and Fannie Mae, if a borrower obtains any form of insurance coverage not otherwise required by the ME, such policy shall include a standard mortgage clause generally assigning the insurance proceeds to the lender up to the amount of the outstanding loan balance.
When a natural disaster occurs and insurance is paid, absent a clause in the mortgage, what are the three approaches for what should be done with the insurance money?
1) The amount shall be applied to restoration and repair if 1) it is economically feasible and 2) the lender’s security will not be lessened. Used by:
o Starkman v. Sigmond/New Jersey
o Restatement
o Fannie Mae and Freddie Mac
2) Majority rule: Lender gets to decide
3) CA Approach: Even if the agreement contracts around the default rule, Approach One is used because the court said in Schoolcraft that the lender has a good faith requirement to only require prepayment where the security is impaired.
o Kreshek went one step further and said that insurance proceeds have to be turned over to MR even though MR does not intend to rebuild, as long as there is security left – but this case was overturned.
What is the effect of ME's purchase at foreclosure sale on the insurance proceeds?
1) Loss Payable Policy: ME cannot recover on the policy
2) Standard Mortgage Policy
a) After purchase: Lender gets all the proceeds from the insurance since they are an insurable interest.
b) Before purchase: Lender is held to have knowledge of the casualty loss and thus, should only bid what the property is worth-->cannot just a windfall if pays full bid and then recovers insurance proceeds.
What choices does a lender have when there is default followed by casualty?
· Foreclose on the real estate and bid in what the property is actually worth, then go after the insurance proceeds for the remainder.
· Take the insurance proceeds and then foreclose for the difference on the property.
What happens if a ME makes a full credit bid at the foreclosure sale?
A lender should not pay the full credit bid; otherwise, the lender cannot collect against the insurance. If a lender does, a minority of courts will allow the bid to be reformed or set aside sale as mistake, but the majority will not.

Courts expect lenders to become aware of any casualty losses before bidding on property.
What are escrow accounts?
Lenders routinely require debtors to pay 1/12 of taxes and insurance each month to the lender, to be held in an escrow account. The lender then pays the taxes and insurance out once a year.
What is the purpose of escrow accounts?
Protects the lender from having a senior lender, because real estate tax liens trump other interests. However, there is also the fear that lenders will use this money as “float.” States have handled escrow accounts differently.
How do legal systems handle escrow accounts?
· Common law arguments against allowing lender to keep interest were overruled (trustee argument, bailee argument).
· Fannie Mae/Freddie Mac contracts specifically state that debtors do not have to be paid interest on the funds unless state law says otherwise
· 15 states forbid escrows or hold that a statutory rate of interest must be paid back to the debtor
· CA: with residential real estate, escrow is usually forbidden and in the minority of instances in which it is allowed, the lender must pay 2% interest. The major exception is institutions supervised by OTS, which have federal preemption.
· RESPA (Real Estate Settlement Practices Act), a federal statute, limits the amount a lender can require a debtor to have in an account at any one time to a 2-month cushion of estimated taxes and insurance.

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