Daily Development for Thursday, March 8, 2001

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

This case was in fact the DD for March 2, and the comments discussed the liklihood that parties who engaged regularly in practices such as those undertaken by the equitable mortgagee here probably were subject to federal regulation. But I have received an extensive set of comments by Burt Rush and Jack Murray of First American Title Insurance Company that give a name to this kind of person a "foreclosure consultant." These comments provide a lot more discussion of the issue, and since it may be a developing phenomenon, I am reposting the item with the comments by Jack and Burt and then adding the original comments, many of them from Howard Lax in Michigan.

Finally, because I'm busy on another project today, and you've kept me from that project these two days with your flood of messages on various valuable topics, I'm going to "cheat" and make this case, with the new comments, the DD for tomorrow.

MORTGAGES; EQUITABLE MORTGAGES: Mortgagor's transfer of statutory redemption rights followed by transferee's redemption and subsequent lease/option arrangement with mortgagor constitutes an equitable mortgage.

London v. Gregory, http://www.michbar.org/opinions/home.html?/opinions/appeals/2001/0 22301/9475.pdf

Gregory deeded her home to London two days prior to the end of a foreclosure redemption period. London redeemed the property from foreclosure for $38,000. Then London gave Gregory an 18 month lease and option to repurchase the home for $48,000. The lease payments were $400 per month, presumably fair market value, and the option was exercisable only at the end of the lease term, with closing to occur on December 17, 1997. The purchase option was exercisable only if all the rent payments were made on time.

Gregory only made one of fourteen scheduled lease payments, and that one was late. Apparently London tolerated all the missed payments, and finally, on December 16, 1997, served 30 day notice to quit in an eviction action.

The district court, in the eviction proceeding, found that the deed was really an equitable mortgage as a matter of law. It refused to accept any evidence of the actual intent of the parties.

The court of appeals upheld the decision, citing two similar cases where a property owner, under financial stress, deeds a property to an investor and receives a lease and/or option to repurchase the home. In both cases, the conveyance was held to be an equitable mortgage securing a loan and not a true conveyance. The court also held that the trial court properly excluded evidence of the parties' conscious intent.

Comment by Burt Rush: This is a classic case illustrating how far some (if not most) courts will go to protect parties facing foreclosure, especially where they stand to lose substantial equity. Such cases are rarely "published."

While this decision doesn't tell us how Ms. London was put in touch with Ms. Gregory, it's common for public foreclosure notices to be followed by opportunists looking for easy profit.

In California, lawmakers have responded with legislation strictly controlling activities of "Mortgage Foreclosure Consultants," a group broadly defined to include anyone who offers to help parties in foreclosure in exchange for compensation. (See, California Civil Code sections 2945, et seq.)

Even without such laws, judges find ways to protect owners who may have been prey in foreclosure. This may show itself as greater willingness to entertain claims of fraud, forgery, undue influence, duress, want of advice oras in the London caseunequal bargaining power coupled with inadequacy of consideration.

For escrow/closing and title folk, the moral of the story is that we should be very careful when asked to work with known 'foreclosure consultants.' They may charm your socks off...but then you won't have socks.

Comment 1 by Jack Murray: Courts generally will not permit a mortgagee to evade the requirement of foreclosing a mortgage, and deprive the mortgagor of its right of redemption, by subterfuge; e.g., by taking a deed to the property and granting the mortgagor the right to repurchase the property upon payment in full of the debt. This same equitable principle would apply where a thirdparty "foreclosure consultant" obtains a deed to the property from the mortgagor in exchange for the consultant's agreement to redeem the property from foreclosure and lease it back to the mortgagor with an option to purchase (usually at an inflated price).

Many states have enacted statutes specifically addressing whether a deed given by a mortgagor to a mortgagee may constitute a continuing security device. Some states' statutes make it difficult to challenge a deed that is absolute on its face. In Minnesota, for example, there is a statutory presumption that a conveyance, if absolute in form, is not given as further or new security for the debt. See MINN. STAT. ANN. 559.18 (West 1990 & Supp. 1996). See also GA. CODE. ANN. 441432 (1997) (prohibiting use of parol evidence to show that deed absolute on its face is a mortgage, unless there has been fraud in the procurement); MISS. CODE. ANN. 89147 (1997) (precluding use of parol evidence to prove that an absolute conveyance or other writing is a mortgage in the absence of fraud).

Other states have enacted statutes that expressly permit a party to prove by other written evidence (or, in some cases, parol evidence if necessary) that a deed absolute on its face was in fact a mortgage. See, e.g., ARIZ.

REV. STAT. ANN. 33702(A) (West 1997); IDAHO CODE 45905 (1997); MD. CODE ANN., REAL PROP. 7101 (1997) (providing that a deed absolute in terms is considered a mortgage when it appears, by any other writing, to be intended merely as additional security for a debt or performance of an obligation); N.Y. REAL PROP. LAW 320 (McKinney 1998) (providing that any deed conveying real property which appears by any other written instrument to be intended only as a security, must be considered a mortgage even though it appears by its terms to be an absolute conveyance); OKLA. STAT. ANN. tit. 46, 1 (West Supp. 1997) (stating that every instrument purporting to be an absolute conveyance of real estate but intended as security for the payment of money, is deemed a mortgage, and must be recorded and foreclosed as such); UTAH CODE ANN. 78408 (Michie 1977) (providing that a mortgage of real property, whatever its actual terms, is deemed a conveyance for the purpose of enabling the owner to avoid the commencement of a foreclosure proceeding to recover possession of the property).

A few states have statutes that provide that no defeasance to any deed of real property that is absolute on its face is effective to convert the document to a mortgage with respect to third parties unless the grantor's defeasance right is in writing and also is recorded in the mortgage records. See, e.g., CAL. CIV. CODE 2950 (West 1993); ME. REV.

STAT. ANN. tit. 33, 202 (West Supp. 1997); PA. STAT. ANN. tit. 21, 951 (West 1997); WYO. STAT. ANN. 341127 (Michie 1997).

Illinois has a statute that states that "[e]very deed conveying real estate, which shall appear to have been intended only as a security in the nature of a mortgage, though it be an absolute conveyance in terms, shall be considered as a mortgage." 765 ILL. COMP. STAT. 905/5 (West 1996).

In Flack v. McClure, 565 N.E.2d 131, 136 (Ill. App. Ct. 1990), the court stated that the burden of proof rests upon the party asserting a mortgage when a deed absolute was conveyed. The court also listed six factors that a court should evaluate in determining the existence of an equitable mortgage: (1) whether a debt exists (which, the court noted, is the essential element to establish an equitable mortgage); (2) the relationship of the parties; (3) whether legal assistance was available; (4) the sophistication and circumstances of each party; (5) the adequacy of consideration; and (6) who retained possession of the property. Based on its analysis of these factors, the court held that the evidence, especially that demonstrating the existence of a debt relationship and grossly inadequate consideration, clearly supported the trial court's finding of an equitable mortgage.

Section 3.2(a) of the RESTATEMENT (THIRD) OF PROPERTY; MORTGAGES ("Restatement") provides that parol evidence is admissible to establish that a deed absolute on its face was in fact intended as security for an obligation and should be deemed a mortgage.

Section 3.2(a) also provides that the parties' intention to create a security device must be proved by "clear and convincing evidence." Section

3.2(b) provides that the parties' intention may be shown by the following:

The statements of the parties.

The existence of a substantial disparity between the value received by the grantor and the actual value of the real property at the time of conveyance.

The fact that the grantor retained possession of the real property.

The fact that the grantor continued to pay real estate taxes.

The fact that the grantor made improvements to the real estate subsequent to the conveyance.

The nature of the parties to the transaction and their relationship both prior to and after the conveyance.

Section 3.2(c) of the Restatement provides that where, in addition to the deed, a separate writing exists indicating that a financing transaction was intended, parol evidence is admissible to establish that the writings, taken together, constitute a single security transaction.

Comment 2 by Jack Murray: Clogging issues may also occur in connection with deedinlieu transactions (or transactions, such as in London v. Gregory, where the property is conveyed to a third party) when the mortgagor retains a residual right (such as an option to repurchase the property or a right of first refusal), with respect to the property after the conveyance, or else retains possession of the property under a lease or occupancy agreement from the mortgagee (or third party). If such a continuing right is granted to the mortgagor, a court could conclude (as it did in London, supra) that a deed was not intended and that the conveyance actually constitutes an equitable mortgage. If so, the court may void the deed.

Section 3.3(a) of the Restatement provides that parol evidence is admissible to establish that a deed accompanied by a written agreement conferring on the grantor the right to purchase the property was in fact intended as security for an obligation, and is therefore a mortgage.

Section 3.3(b) states that such intention must be proved by "clear and convincing evidence," and lists several factors from which such intention may be inferred. Section 3.3(c) provides that the presence of an express negation of the creation of a mortgage in any of the documents is relevant to the parties' intent, but does not preclude a determination that the transaction constitutes a mortgage.

Prior to granting any continuing possessory rights to the mortgagor, the mortgagee (or thirdparty grantee) should consult the title insurer to determine if it will agree to insure title without raising an exception for a possible equitable mortgage claim by the mortgagor. If any such continuing rights are granted, the deedinlieu documents should specifically state that the continuing interest does not transform the deed obtained by the mortgagee into a mortgage and that an absolute conveyance is intended by the parties. In addition, the documentation should provide that the mortgagor will not be entitled to equitable or injunctive relief and that the mortgagor will be limited to an action for damages for breach of contract.

The mortgagee in a deedinlieu transaction generally will require that the mortgagor waive any right to control the manner of use, development, operation, or subsequent disposition of the property by the mortgagee after conveyance. If the mortgagee leases the property back to the mortgagor, the rental should be set at or near, but not in excess of, the market rate; and the term of the lease should be relatively short. Title insurers are likely to decide whether to insure these types of transactions against an equitable mortgage claim on a casebycase basis. These considerations become even more important (and problematic) when a thirdparty "foreclosure consultant" takes title to the property and leases it back to the mortgagor with an option to repurchase the property.

In Beeler v. American Trust Co., 147 P.2d 583 (Cal. 1944), the California Supreme Court held that even though the debtor had executed an affidavit contemporaneously with the deed declaring that the transaction was an absolute conveyance and was not intended as a mortgage, a purported deed in lieu of foreclosure would be treated as a mortgage when the borrower leased the property back and retained an option to purchase for the amount of the debt. Id. at 595. In Strike v. TransWest Discount Corp., 155 Cal. Rptr. 132 (Cal. Ct. App. 1979), the California appellate court held that, notwithstanding the delivery of a "grant deed"

to the lender, the borrowers' retention of possession of the property, their payment of all taxes and assessments, and their payment of all insurance, maintenance and utility expenses, evidenced the parties' intention to treat the deed as a security device.

Howard Lax Comment 1: The court reached the correct result. Under Michigan law, a deed can be a form of mortgage, given the circumstances of the conveyance. A transaction may constitute a "loan"

even though it is in the form of a sale. Michigan Law & Practice, Usury, Section 3, citing Abeloff v. Ohio Finance Co., 313 Mich. 568 (1946).

See also Meyer and Perrone, "Usury and Interest," Real Property Law Section Homeward Bound Seminar, October 1988, written materials pages 3334, in which the authors cite five factors that help identify a sale and leaseback as a disguised loan(a) repurchase required; (b) rental geared to amortization of sales price with agreed upon rate of return; (c) Option (or repurchase) price not tied to fair market value at date of exercise; (d) affiliated parties; and (e) sale price significantly lower than the value of the property.

Howard Lax Comment 2: A mortgage lending license is needed pursuant to MCL 445.1651, et. seq., to originate residential mortgage loans. All too often, persons who are not qualified to obtain a mortgage lending license will offer sale and lease back arrangements to distressed homeowners to skirt the law. A mortgage loan is a mortgage loan, regardless of the form it may take. The court and the parties miss the point that the Plaintiff should have been licensed (if he arranged more than ten such transactions in a fiscal year) and subject to Michigan's Mortgage Lending Practices Act (Michigan's AntiRedlining Act). The Defendant should also be arguing that Plaintiff should comply with TILA (five or more transactions in a year is the threshold), ECOA and RESPA.

Of course, we do not know from the court of appeals decision if this was an isolated transaction for Plaintiff or a course of business. If it was discovered that Plaintiff engages in these transactions regularly, Defendant could have sent a letter to Plaintiff rescinding the transaction, and arguing that TILA and ECOA penalties accrue (the statute of limitations may preclude the penalty, but at least the attorney could argue for his or her fees).

Editor's Comment 1: For a more accessible discussion of the standards for flipping a lease option or other "disguised security" arrangement into an equitable mortgage, see Nelson & Whitman, Real Estate Finance Law (3d. Ed. West 1994) pp. 4868. This excellent treatise will come out in a new edition later this year, so just read this one at the library.

Note that the factors set forth in Comment 1 need not all be present. The fundamental question is whether there was some form of "built in"

economic compulsion that would require the party to exercise an otherwise discretionary right to reclaim title to a property transferred earlier. The rest of the considerations tend to suggest that a court ought to be suspicious in evaluating this fundamental question.

Editor's Comment 2: Intent to created a land security interest simply does not matter. Here, the court commented: "Although it was not the plaintiff's intent to make a loan, it was not the defendant's intent to sell her home." But even where the documents state the parties intent, or where testimony would establish that the purported borrower had such an intent, courts will intervene.

Editor's Comment 3: Note that this situation does not arise only in the consumer context. One finds it frequently in informal commercial transactions, often for "bad reasons:" to dodge usury issues, to flip regular income in the form of interest into a capital gain income in the form of exercise of an option, or to disguise true ownership interest in the property from the equitable mortgagor's spouse or creditors (where the option back is unwritten or unrecorded). Some of the licensing issues Howard raises in his comments might also apply to parties who regularly engage in these activities at the commercial level.

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

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1‑6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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