Daily Development for Monday, January 31, 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; MORTGAGEE IN POSSESSION; WAIVER OF LIABILITY: Mortgagee is possession has duty of care toward property and management of income and leases, but can rely upon general exculpatory language in assignment of rents to avoid such liability.

Singh v. FDIC , 241 B.R. 484 (Bkrtcy D. Mass 1999)

For five years following debtor default, mortgagee, through a managing agent, was in possession of income property. During that period of time, no one paid the taxes on the property, and substantial penalties accrued as first liens on the property in addition to the taxes themselves. The penalties and accruals exceeded the interest charges on the loan, some of which were paid with rents that could have been used to pay taxes. In addition, it was alleged, some tenants were permitted to pay below market rents, some rents were never collected, tax escalation rights were never invoked, and collected rents were not invested in an interest bearing account, although they were not in some instances applied immediately to reduce the mortgage debt.

The debtor's trustee in bankruptcy attempted to hold the mortgagee in possession liable in negligence for breach of a duty of care based upon all of the above problems.

At trial in the Bankruptcy Court, the court had imposed a "reasonable care" standard and had found mortgagee in violation of that standard. The mortgagee appealed to the Federal District Court, acknowledging that the standard applied but arguing that the provisions of the assignment of rents executed by the borrower exempted it from liability for diversion of money to principal and interest payments and away from taxes. The District Court remanded for a determination of the relationship of the language of the exculpatory language of the assignment of rents to the statutory provisions in Massachusetts dealing with the duties of a mortgagee in possession.

This is the remand opinion in the Bankruptcy Court.

Under the assignment of rents, the lender had the authority to enter and take possession of the premises and to use the income to maintain it, pay expenses and taxes, and to "rent or lease the whole or any part of the Premises for such term or terms and on such conditions as to [sic]the said LENDER shall deem proper."

In addition, another paragraph of the assignment provided discretion in allocating rent monies:

"The LENDER, in its sole discretion, shall from time to time, determine to which one or more of the purposes aforesaid the said rents and revenues shall be applied and the amount to applied thereto, except that payment of principal and interest on all mortgages shall be paid first."

The court first held that there is nothing in the language quoted above, or anywhere else in the assignment of rents, that diminishes the duty of the lender to take "reasonable care" in preserving the collateral and managing the leases. Hence, the court reinstated its decision that the lender was liable for failure to properly invest collected rents and to invoke the tax escalator provision.

The court studied the language indicating that the lender had the power to pay expenses such that the lender deemed proper, and concluded that such language did not operate as an exculpatory provision where the lender paid commissions to the managing agent for rents not collected. This was simple negligence, not a choice.

With regard to the lender's failure to charge market rates to certain tenants the issue was more difficult. The court concluded that the decision to accept leases at low rents was a manifest decision that was covered by the exculpatory language of the assignment of rents. Consequently, it concluded that the language ought to apply. Then, in a dramatic judicial tour de force, after it concludes that the contract insulates the mortgagee from liability, it concludes that the mortgagee nevertheless is liable because it failed to preserve the issue of the exculpatory clause in the present case. So the lender had to pay anyway.

With respect to the failure to pay taxes, however, the court took another look at the language of the assignment. Although it concluded that the language quoted above gave to the mortgagee "sole discretion" to determine for which of the various management purposes rents could be applied, the court went on to conclude that the lender never exercised such discretion. It just let the payments flow into the rent funds. In fact, the tax bills were never sent to the mortgagee or the manager. Consequently, the court concludes that the assignment language does not insulate the mortgagee from liability.

The court does make an important ruling that a properly drafted exculpatory clause of which a mortgagee takes proper advantage can provide protection from liability in these circumstances. Massachusetts enforces contractual waivers of liability for negligence. The court concludes that even if the duty of the mortgagee to pay rents was a statutory duty (which the court concludes it's not), the lender is protected because the public policy of the states permits waivers of statutory duties when health and safety are not involved. Comment 1: There really aren't many cases on these important issues, and it is a shame that this one is so caught up with procedural hair splitting. Further, it's a shame that the court indicates no understanding of the difference between collecting rents as an assignee of rents and collecting rents as a party in possession of the premises. In the former case, the bulk of the cases would hold that an assignee has no liability for care of the premises (for an exception to this rule, see Touma v. St. Mary's Bank, 712 A.2d 619 (N.H. 1998) (the DIRT DD for 1/20/99) (assignee liable when rents diverted from roof repairs)). But where a mortgagee actually takes possession of the premises, it undertakes a duty of care to manage the premises with the objective of preserving its value for its own benefit but also for that of the mortgagor and others with an interest in it. See Nelson & Whitman, Real Estate Finance Law Sections 4.244.31 (3rd Ed. 1994)

The consent to permit the mortgagee discretion to divert monies away from the costs of maintenance and other expenses appears in the assignment of rents, and it is unclear whether this consent ought to apply under all circumstances or only when the mortgagee has seized the rents but has not yet taken possession.

Comment 2: Where the mortgagee has taken possession, the normal restrictive reading of clauses granting immunity from negligence ought to apply, and the editor would prefer a ruling that the waiver of negligence would not be effective. In fact, there is at least an argument that for the mortgagee to take complete possession and control of the premises and have no duty to maintain it pending foreclosure amounts to a clogging of the equity of redemption, as mortgagors are not supposed to lose control of the property until foreclosure. The equity of redemption can't be waived, and agreements to clog it are unenforceable. (It is more difficult to make this argument in title theory states like Massachusetts.)

Comment 3: Clearly it was a negligent decision to permit penalties to build up on a prior tax lien that exceeded any benefit resulting from paying interest on the debt. Although the assignment required that payments be made first on "all mortgages," this term could have been used to include prior tax liens, as that appears to be the purpose of the phrase, even if it applied in the mortgagee in possession situation.

Comment 4: Note that the court is concluding that the waiver of negligence, if properly drafted and properly pleaded, could have insulated the mortgagee from liability for all of the alleged acts here diverting money, underrenting the premises, and failure to pay taxes even failure to require the lessees to pay their pass through obligations. If the mortgagee can do all of that, isn't the mortgagee in every real sense behaving as an owner, and not as a temporary custodian for security purposes?

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

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