The Clogging Rule. Contemporaneous Option as Clog

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1 Uphoff borrows $200K from Lambert to pay his gambling debts Lambert takes a mortgage on Uphoff s home (worth $300K) Lambert also has Uphoff deliver a deed conveying the home to Lambert Side agreement by Lambert: Lambert will only record the deed and assert title if Uphoff defaults; if Uphoff repays, Lambert will tear up the deed Is that a valid deed in lieu? The Clogging Rule Deed by mortgagor, delivered simultaneously with execution of a mortgage, is an invalid clog on the mortgagor s equity of redemption 1) Deed intended only to circumvent the foreclosure process and the mortgagor s right to redeem the property prior to sale 2) The deed was not intended to effect a transfer of full title at time it was executed/delivered Thus, Lambert would have to foreclose the mortgage Contemporaneous Option as Clog Common law: option in favor of mortgagee to buy mortgaged land, taken contemporaneously with the mortgage, is a clog on the equity of redemption [p. 286] Concern: exercise of option may circumvent mortgagor s right to redeem and circumvent foreclosure process Restatement 3.1: option taken contemporaneously with the mortgage is not an invalid clog unless its effectiveness is expressly dependent on mortgagor default. Why limit the common law rule this way? 3.1. The Mortgagor s Equity of Redemption and Agreements Limiting It (a) From the time the full obligation secured by a mortgage becomes due and payable until the mortgage is foreclosed, a mortgagor has the right to redeem the real estate from the mortgage. (b) Any agreement in or created contemporaneously with a mortgage that impairs the mortgagor s right described in Subsection (a) of this section is ineffective. (c) An agreement in or created contemporaneously with a mortgage that confers on the mortgagee an interest in mortgagor s real estate does not violate this section unless its effectiveness is expressly dependent on mortgagor default.

2 Problem Lambert loans Strong $50,000 Strong executes a deed of the home to Lambert Strong remains in possession of the home Agreement: if Strong repays $50,000 + interest to Lambert within 2 years, Lambert will deed the home back to her Two years later: Strong does not repay, Lambert brings unlawful detainer action to recover possession. Does Strong have a valid defense? Absolute Deed or Equitable Mortgage? Did Lambert really buy ownership of the land (was this an actual sale ), or was he just using title to the land to secure Strong s obligation to repay the money? If it is the latter, and this fact is proven by clear and convincing evidence, then Lambert s deed is deemed in equity to be a mortgage He would have to foreclose (by judicial foreclosure, since the deed would not have a power of sale in it) What info is relevant in making this judgment? Relevant Restatement factors [p. 301] Statements of parties ( This is a loan. ) Substantial disparity between loan amount and the fair market value of the land Grantor (Strong) remained in possession of the land even after deed was executed/delivered to Lambert Grantor (Strong) paid taxes or made improvements after delivery of deed to Lambert Nature of the parties and their relationship prior to/after the deed Case law factors: Was Strong in financial distress at the time of deed? Did Strong have legal counsel? If Strong kept possession, and FMV of land = $200,000, the argument to re-characterize the deed as an equitable mortgage is compelling The parties are using title to the land to secure repayment of Strong s debt (substance over form) Why would Strong rationally sell the land for $50,000? Argument is particularly compelling where borrower is in financial distress (as in Perry, p. 292), where the grantor of the deed was looking for a rescue from imminent foreclosure action

3 Lambert signs installment contract to buy a flat-screen TV (12 $350 each) from Tiger John Cleek at Aaron s K: Aaron s retains title to the TV until all payments are made by Lambert Lambert makes first 11 payments, but he misses the 12th payment Can Aaron s take back the TV, terminate the contract, and keep all of Lambert s past payments as damages for breach? UCC: Security Interest 1-201(b)(35) defines a security interest as an interest in personal property... which secures payment or performance of an obligation (b)(35) also provides that... [t]he retention or reservation of title by a seller of goods notwithstanding shipment or delivery to the buyer... is limited in effect to reservation of a security interest. UCC Installment Sale Contracts Under the UCC, Aaron s is deemed to have a security interest in the TV, which it must foreclose by sale Balance of debt = $350 (remaining payment) + any costs of collection incurred by Aaron s Before sale, Lambert can redeem TV from the security interest by paying off remaining balance of the debt If sale price >> balance of debt, any surplus must be returned to Lambert [ 9-610, 9-615, 9-623] Sometimes, an owner of land sells it to buyer by installment land contract or contract for deed Buyer agrees to pay purchase price in monthly installments over time (perhaps as long as years) By terms of ILK, even though Buyer typically takes immediate possession of the land, Seller is not obligated to deliver a deed to Buyer until Buyer has paid all installments ILK typically provides that if Buyer defaults, Seller retains title to land AND may retain all of Buyer s prior payments under the ILK as liquidated damages for Buyer s breach!

4 Russell v. Richards Richards sold land to Buyer via ILK Buyer later resold to Russell (who paid Buyer $11,188 in cash, took possession, took over monthly payments, and assumed liability for balance of ILK = $37,938) Russell made monthly payments for next 6 years, reducing ILK balance to $26,504 ($10,782 principal reduction) Russell then defaulted (FMV of land at time = $82,735) Richards declared forfeiture of ILK Court: contract enforced as written; Russell forfeited her interest, which does not shock the conscience Result: Russell loses her equity in the land She lost the $10,782 in principal payments that she made over past 6 years She lost the $11,188 down payment she made 6 years ago She lost the $34,754 in market appreciation that occurred during the life of the contract Why isn t this magnitude of loss sufficiently shocking to the conscience? $11,188 down payment? Court says it was not appropriate to consider that payment, b/c it was made to the original Buyer, not Richards [p. 312] Huh? Downpayment reflected, in part, prior payments the original Buyer made to Richards! $33,746 in market appreciation? Court: this only belonged to Russell if she performed (her equity was contingent), but she didn t perform, so it wasn t hers to lose [p. 312] Held: trial court appropriately considered loss of $10,782 paid on K, but that loss isn t shocking amount Vendor (Seller) Contract Vendee (Buyer)! Vendee agrees to pay contract price in installments! Vendor does not deliver deed (title) until Vendee pays final installment The Purchase Money Mortgage Compared Purchase Money Mortgagee (Seller) Deed (Title) Note and Mortgage Purchase Money Mortgagor (Buyer)

5 Contrast: If Deal Had Been Structured as a Purchase Money Mortgage After default, Richards (as PM mortgagee) would have had to foreclose the mortgage If land sold for $82,000 at foreclosure: Richards would ve gotten $26,504 (balance of debt), plus any accrued but unpaid interest and costs of collection (e.g., attorneys fees) Balance would have gone to Russell (her equity, not contingent upon her full performance) Watkins v. Eads [p. 329] Any attempt to use title to land as security for a debt should have the same legal effect; thus, ILK should be treated as a mortgage (and must be enforced as a mortgage) Cf. Restatement of Mortgages: A contract for deed creates a mortgage. [ 3.4(b)] Note: many installment land contracts don t contain a power of sale, so in most states following Watkins approach, Seller would have to bring judicial foreclosure action Petersen v. Hartell Seller and Buyer entered into ILK for small plot of raw land Price = $9,162, payable in $50 installments (possible terms of this contract: 40 6%) Buyer makes a total of 58 monthly payments ($2,900 total) but missed a total of 7 payments Buyer tendered a check for $250 for back payments, but Seller refused to accept it and purported to terminate ILK Buyer then tendered the full unpaid balance of the ILK into court, and sued for specific performance of ILK Petersen: Majority Holds ILK is not a mortgage per se If Buyer has not made substantial payments, or if default is nonmonetary (e.g., waste), seller can terminate ILK But, if Buyer has made substantial payments or improvements to the land, and the default is purely financial, the Buyer has a right to specific performance, even after default [p. 319] Court calls this a right to redeem Buyer s interest in land [p. 321]

6 Petersen v. Hartell Note: even the majority calls the Seller s interest a security interest [p. 320], and says Petersen had a right to redeem [p. 321] So why not take the final step (like Chief Justice Byrd), and treat ILK as a mortgage for all purposes? Rose Bird Chief Justice California Supreme Court Chief Justice Pro-Restatement view: ILK buyer and purchase money mortgagor are in essentially the same position and should be treated the same Both purchase money mortgagee and ILK Seller are using title to land to secure payment of a debt Pro-ILK view: ILK buyers are different Often ILK buyers have poor credit, and can t qualify for conventional institutional mortgage financing ILK Buyers are riskier, so ILK Sellers should be able to bargain for a remedy commensurate with transaction risk Displacement of contract remedy should be implemented by legislature, not the court Problem: California Civil Code 2924c gives mortgagors not only a right to redeem, but also a statutory right to reinstate (to cure the default by making only back payments ) The Petersen holding precludes a defaulting ILK Buyer from being able to reinstate Instead, the defaulting Buyer can only protect its redemption right by paying off the full balance of the debt While mortgage law has always recognized an equitable right of redemption, it never granted the mortgagor an equitable right to reinstate Defaulting mortgagor can t reinstate unless (a) Applicable statutes grant such a right (see Cal. Civ. Code 2924c), or (b) The mortgage itself expressly creates such a right (see Fannie/Freddie single-family mortgage form, 19, page 1452)

7 Petersen: The Restitution Remedy If the defaulting Buyer can t pay off the full balance of the contract, then what happens? Seller can cancel ILK, terminate Buyer s equity of redemption (analogous to strict foreclosure) But, Seller must make restitution of Buyer s past payments, to extent they exceeded Seller s actual damages due to Buyer s breach [Freedman v. The Rector, p. 319] This should prevent Seller s unjust enrichment How to Calculate Restitution? Suppose Buyer has been paying on an installment K for 10 years when Buyer breaches and cannot redeem Original ILK price = $57,000; Interest rate = 10% Total installment payments made by Buyer = $60,000 ($500/month) Principal balance due on ILK at time of breach = $51,700 Value of land at time of breach = $65,000 Seller: my damages should be measured by forgone rental value of the land ($500/month); thus, I shouldn t have to make any restitution Is this a sound argument?