Daily Development for Friday, January 21, 2000

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

MORTGAGES; BANKRUPTCY; DEEDS IN ESCROW: Illinois Appellate Court denies second mortgagee right to cure or redeem after mortgagor places deed in escrow to first mortgagee pursuant to Chapter 11 reorganization plan.

Klein v. DeVries, 1999 WL 1259899 (Ill.App.2nd Dist).

Metropolitan Life Insurance Company ("Metropolitan") held a first mortgage on Mr. DeVries' property. In 1986, DeVries filed for bankruptcy. Pursuant to the confirmed reorganization plan, which plan was recorded with the county Recorder of Deeds in 1987, DeVries delivered a quitclaim deed to the property to Metropolitan's attorney. T

he reorganization plan further provided that upon any future default by DeVries under the mortgage loan or the plan, Metropolitan was to give notice thereof to DeVries and to any junior lienholders, as well as to all other creditors and parties in interest. The parties so noticed - but not DeVries - would then have the opportunity to either cure the default or "obtain Metropolitan's position as first mortgage holder by making certain payments to Metropolitan." If none of the noticed parties elected these options, the deed was immediately to be delivered to Metropolitan and title would "pass free and clear of liens and encumbrances, unpaid real estate taxes, and mechanics' liens excepted."

In 1989, DeVries executed and delivered to plaintiff (Klein) a note secured by three mortgages on the property secured by Metropolitan's first mortgage. These mortgages were recorded with the county Recorder of Deeds on March 27, 1989. DeVries subsequently defaulted on the Metropolitan mortgage, and Metropolitan sent the required default notices to DeVries and other creditors - but not to the plaintiff. On December 7, 1989, Metropolitan recorded the escrowed quitclaim deed. Metropolitan then sold the property to an entity that in turn subdivided it and sold it in various parcels to other parties

In September 1997, plaintiff filed a complaint for foreclosure and requested a declaratory judgment seeking to have his mortgages declared valid and to foreclose on the mortgages he held on the property. The trial court denied plaintiff's requests for relief.

The appellate court, in affirming the holding of the trial court, first noted that "[i]n general, a mortgagee can have no greater rights than his mortgagor." The court then turned to the issue of what rights DeVries had when he entered into the mortgages with the plaintiff. The plaintiff argued that at the date of execution of the subordinate mortgages, DeVries still had equitable and legal title to the property and since no default had yet occurred under the first mortgage, he was entitled to cure the default and redeem the property. The appellate court disagreed, finding that DeVries' interest in the property had been irrevocably "altered," i.e., his agreement with Metropolitan that he had no right to cure any future default under the first mortgage converted his fee simple estate in the property to a fee simple defeasible (which the court described as "an estate that may last forever but that may end upon the occurrence of a specified event"). Therefore, the court ruled, this was the only estate that DeVries could convey to the plaintiff, and "when DeVries defaulted under the Metropolitan mortgage, both DeVries' and the plaintiff's estate in the property ended."

The appellate court refused to consider the issue of the lack of notice to the plaintiff as required by DeVries' reorganization plan, ruling that because it had concluded that the plaintiff had no right to cure DeVries' default under the Metropolitan loan, "we need not address plaintiff's argument that he should have been notified of the default."

Reporter's Comment 1: This result, given the particular facts of the case, seems rather harsh. Metropolitan specifically agreed, in the bankruptcy reorganization plan filed by DeVries and approved by Metropolitan, that it would give notice and an opportunity to cure to "each junior lien or mortgage holder." For Metropolitan to then in fact give notice to all creditors except the plaintiff certainly is suspicious, and perhaps even deliberate. The reorganization plan was recorded, and subsequent lienholders should be able to rely on the provisions contained therein. The court gave short shrift to the plaintiff's contentions in this regard, but its ruling on this issue - at least from an equitable standpoint - is somewhat disturbing.

Reporter's Comment 2: This appears to be a case of first impression in Illinois, and perhaps in the United States. Interestingly, the Illinois appellate court cites no case law, from Illinois or any other state or federal jurisdiction, in support of its holding. The court's ruling that a fee simple estate can be converted into a fee simple defeasible because the owner agrees, in a separate instrument arising out of the owner's bankruptcy proceeding, to waive certain cure rights under a mortgage on the fee estate, seems somewhat strained and does not appear to be supported by case or statutory law in other jurisdictions. .

Reporter's Comment 3: Deeds in escrow are often obtained from borrowers by institutional lenders in connection with mortgagor bankruptcies and loan workouts. The documentation usually provides that the deed will be delivered out of escrow to the mortgagee in the event of a future default or other specified event. Mortgagees may try to "bankruptcy proof" a deed-in-lieu transaction by requiring third party indemnifications or "springing" or "exploding" guaranties, or by requiring the borrower to establish a bankruptcy-remote entity to hold title to the property. If a deed is placed in escrow as part of an approved bankruptcy plan, the plan and confirmation order should include specific findings of fact and conclusions of law that the conveyance of the property constitutes an absolute transfer of the property and is not intended by the parties as an equitable mortgage. The escrow instructions should state that, in the event of a subsequent default under the plan or the loan documents - as same may have been revised or restated pursuant to the plan - the title insurance company, as escrow agent, will release the deed and other escrowed documents and deliver them to the designated party.

Since this type of arrangement will have been specifically approved by the bankruptcy court, it should be enforced even if the mortgagee is later the subject of a second bankruptcy case, based on collateral estoppel, res judicata principles, and equitable grounds. In other words, the mortgagee should be entitled to relief from the automatic stay in the subsequent bankruptcy proceeding and to specific enforcement of the escrow arrangement. In In re Howe, 913 F. 2d 1138 (5th Cir. 1990), the Fifth Circuit Court of Appeals upheld the decision of the bankruptcy court that the debtor-mortgagor was precluded, under the principle of res judicata, from filing a lender liability claim against the mortgagee (who was the largest creditor of the bankrupt debtor-mortgagor) five years after the confirmation of the debtor-mortgagor's Chapter 11 bankruptcy reorganization plan. The plan contained a provision that if the debtor-mortgagor failed to comply with the plan, a deed in escrow to the debtor/mortgagor's property would be released to the mortgagee. Because the debtor-/mortgagor had not performed under the bankruptcy plan, the bankruptcy court denied the debtor/mortgagor's motion to dismiss the Chapter 11 proceedings and granted the mortgagee's motion for release of the deed. The Fifth Circuit agreed with the bankruptcy court's holding that because the plan contained "built-in provisions that eliminate default" - if the debtor/mortgagor couldn't pay, the mortgaged property would be transferred to the mortgagee - there was no material default under the plan that would necessitate the dismissal of the Chapter 11 proceedings or prevent the delivery of the deed to the mortgagee. Id. at 1149.

For examples of various forms of deed-in-escrow documents (bankruptcy and non-bankruptcy), see Kenneth M. Jacobson, Michael L. Molinaro, and John C. Murray, Documenting a Consensual Transfer of Real Estate, Consensual Transfers of Real Estate, American Bar Association, Section of Real Property, Probate and Trust Law (1998), p. 129 et seq.

EDITOR'S COMMENT: Jack Murray, our reporter, apparently believes with some passion believes that a deferred deed in escrow as part of a workout arrangement ought not to violate the non-waivable common law concept of the equity of redemption. I'm not sure I don't agree with Jack, at least with regard to big-dollar commercial transactions. But it is difficult to restrict common law jurisprudence to particular categories of borrowers, and without a doubt this kind of device has been used and can be used abusively in sharp practice schemes against ordinary homeowners and low credit debtors.

Where a deed in lieu is given in a default situation, but its effectiveness is deferred until a later time (forget about the self serving language pretending that substance isn't reality), the courts generally find that the deed is the creation of a new equitable mortgage for the period of time covered by the "escrow" or "deferred effectiveness" period, which of course is, in effect, the term of a new loan or an extension of the old loan. Any rights that a mortgage debtor ought to have under state law ought to apply during that period, especially the equity of redemption. And, of course, any junior creditors ought also to have that right.

Jack and I come out at the same point in this case. But we have different ways of getting there. Jack looks to the special language of the escrow agreement providing notice and cure/redemption opportunities to juniors. If there is no state law right to cure, then I would tend to agree with Jack's reasoning that the junior should share this contract right to cure. But with respect to equity of redemption, the junior ought to have this regardless of the language of the senior escrow agreement. The deferred deed in lieu, conceptually, is a new loan, and the equity of redemption ought to apply regardless of any terms of the original escrow. I believe Jack is correct that the court's ruling denying the equity of redemption in such cases is without precedent.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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