Daily Development for Thursday, October 4, 2001

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

MORTGAGES; ACCELERATION; NOTICE: Ninth Circuit rules that notice of acceleration is not valid unless notice of acceleration is communicated to mortgagor, and prior to such notice default can be cured and default interest that is contingent upon acceleration cannot be collected. In re Crystal Properties, Ltd. 2001 WL 1117543 (9th Cir. 9/25/01)

This case could easily have been resolved by resort to the language of the instruments, but, as you will see, the court ranges far beyond that quick solution.

The mortgage instruments provided as follows:

"Should default be made in any payment provided for in this note, ... at the option of the holder hereof and without notice or demand, the entire balance of principal and accrued interest then remaining unpaid shall become immediately due and payable, and thereafter bear interest, until paid in full, at the increased rate of five percent (5%) per annum over and above the rate contracted for herein. No delay or omission on the part of the holder hereof in exercising any right hereunder, ... shall operate as a waiver of such right or any other right under this note...."

In 1995, mortgagors began missing payments, and negotiated with the lender to accept a fifteen percent discount in a payoff of the loan balances. The lender went into receivership soon thereafter, and mortgagors began bargaining with the FDIC. In early 1995, the FDIC sent mortgagors a letter indicating that the loans were in default "which involks (sic) the default interest clause." But it never indicated what the default interest was nor provided any formal notice of acceleration to the borrower.

Later, when the mortgagor transferred the security given for some of the loans, the FDIC sent a letter indicating that it had "triggered the default intere provisions of [the] Deeds of Trust," but again gave no formal notice of acceleration and thereafter provided calculations of accrued interest based upon the contract rate, not the default rate.

Although negotiations continued for a reduced payoff, the mortgagor never produced the payoff funds, and the loans were transferred about two years after the first default to Beal. About three months later, Beal sent notices of default, and, apparently, of acceleration and invocation of the default interest clause, to the mortgagors.

Soon therafter, mortgagors transferred all their mortgaged properties to a corporation they controlled and promptly threw that corporation into bankruptcy. Beal appeared in the banktruptcy with a creditor's claim for default interest running all the way back to 1995.

The court noted that the default language quoted above specifically required an election on the part of the mortgagee to accelerate the debt, and indicated that there could be no default interest without such election. Thus, although the court acknowledged that the language also provided that default would be regarded as having occurred "without notice or demand," this did not mean that acceleration could occur automatically.

Beal then argued that there was evidence that it's predecessors had treated the loan as accelerated, even if they did not communicate that fact to the mortgagors. They noted that there is no express requirement for notice of acceleration to be sent to the mortgagor, and that the authority provides that such notice is not required where not compelled by contract or statute. Only an "affirmative act" is needed.

The court cited authority that countered this argument, indicating that in its view the weight of authority indicated that there could be no acceleration without notice to the lender, although the notice need not be formal.

Some of the authority cited by the court indeed states such a requirement, although much of the authority, including that collected in the Annotation at 5 A.L.R.2d 968 (1949) (as updated by A.L.R.) states only that there be "some affirmative act," and that acceleration cannot occur wholly within the mind of the mortgagee. By the end of its recitation of authority, however, the court concluded that not only is "some affirmative act" required but that the affirmative act must be notice to the mortgagor.

The court characterized acceleration clauses as a "penalty, and inserted for the benefit of the creditor," and hence conduct and communications very clear in order for acceleration to be deemed to have occurred.

Against this background, the court had little difficulty disposing of the various claimed "notices" mustered by Beal as evidence that acceleration had occurred.

A special issue arisen as to certain of the mortgaged properties that that had been transferred to other parties, triggering the due-on-sale clause.

Most such clauses state that acceleration occurs automatically upon such event. But the court, although acknowledging that this happened, did not deal with these loans separately. Presumably it would have held that there was no declaration of default interest in these cases, whether or not acceleration had occurred.

There were several loans that had in fact matured by their own terms during the period between the original default and the bankruptcy. The court concludes, basically, that the terms of the default interest clause, quoted above, permit the imposition of default interest only upon acceleration. Since these already matured loans could not be accelerated, there could be no default interest levied upon them. The court does concede that the documents might have provided differently, accruing default interest automatically when default has occurred, even if it consists of nonpayment of a matured.

Comment 1: Is acceleration a penalty, as the court suggests? If so, then presumably a California court would deny enforcement entirely, since nothing is more certain under California mortgage law than that penalties are unenforceable (this isn't to say that anything is particularly certain in California in this area).

The fact is that acceleration is a necessary first step in collecting an unpaid installment debt, particularly through a foreclosure. Without acceleration, the lender might be required to "use up" the foreclosure right in collecting only the payments then unpaid. The alternative of waiting until all payments were unpaid is not only impractical, but runs afoul of statutes of limitations on the first defaults.

Further, even absent foreclosure concerns, acceleration is no more than the a rescinding of the extension of credit originally given to the borrower. In this sense, it is consistent with remedies for breach in other contractual contexts.

Comment 2: Long Island Savings Bank v. Denkensohn, 635 N.Y.S.2d 683 (App. Div. 1995), the DD for 7/18/96, provided expressly that no notice to a borrower was required to trigger acceleration. Many other cases, included many cited in the ALR annotation, indicate that the "overt act" need not be notice to the borrower. In most cases, of course, the overt act will lead ultimately to the borrower's receiving notice that action is proceeding to collect on the loan. But the acceleration itself will be deemed to have occurred earlier, such as upon entry of the accelerated claim in the lender's books, instructions to the trustee under a deed of trust to initiate foreclosure proceedings, or some other unequivocal demonstration that the lender is proceeding to collect.

Comment 3: One court has commented that lenders shouldn't be able to collect default interest indefinitely, and that default interest should be associated with acceleration and resort to remedies. Hence, the "affirmative act" ought to be a step in the direction of collection.

[W]hile the acceleration clause is for the creditor's protection he should not be permitted to divert it to another purpose and that it is to enable him to take steps to enforce payment or prevent further default, not to impose an additional interest burden upon an already distressed debtor, as in the case of notes providing for an increased interest rate at maturity." Wentland v. Stewart, 19 NW2d 661 (Iowa 1945)

Consequently Wentland held that a mere declaration without any affirmative action would not constitute an exercise of the option, since in such event, an acceleration clause might become a device merely to increase the interest rate without the intention of exercising the option to commence suit in advance of the stated maturity date.

Comment 4: In discussing the Denkensohn case in the DD, the editor lobbied in favor of providing notice to the debtor as part of the acceleration. His view was, and is, that the documents ought to require such notice. But others disagreed. Here is my comment, followed by the reactions of others:

It is often said that harsh doctrines in law beget broad exceptions in equity. Although many mortgagees try to bargain for "no-notice" defaults, the editor generally advises against this, even from the standpoint of the mortgagee, since it invites dispute and litigation in many cases and creates the possibility of liability for wrongful foreclosure. A brief notice can clarify misunderstandings before they ripen into disputes.

Other lawyers who have appeared on panels with the editor disagree. They contend that a "no-notice" acceleration is necessary to avoid giving a debtor time to gear up for bankruptcy or to hide assets, squander the rents, or otherwise mess up the security when it appears - through the acceleration notice - that the creditor is "getting serious" and is about to foreclose.

The editor would respond first that acceleration should be an early act in the workout negotiation process, not the last act. It tends to bring an air of reality to the discussions, and can always be dissolved if the parties reach some agreement. As to the "bad actors" who will use the notice of acceleration as a pivot point at which they will engage in fraud - the editor believes that they are out there, but that their presence should not justify an overly harsh contract provision in every mortgage note."

Note that the editor's position dealt only with drafting propriety, and not with legal enforceability.

Comment 5: Dale Whitman and Roger Bernhardt, both more erudite mortgage commentators than the editor, conclude that Crystal is correctly decided, and that, as a matter of law, mortgagees should be required to give notice to a mortgagor in order to accelerate. Here is Dale's answer to the arguments made above:

"When mortgagees "contend that a "no-notice" acceleration is necessary "to avoid giving a debtor time to gear up for bankruptcy or to hide assets, squander the rents, or otherwise mess up the security," they aren't quite speaking to the point. The notice can take instantaneous effect, and the lender can institute foreclosure and seek a receiver one minute later. My point is simply that nobody should, in fairness, have the right to make a "secret" change in somebody else's obligations. If your loan (as a borrower) is accelerated, you have a right to know that from the time it happens. Hardly a radical idea.

It would be different if acceleration occurred automatically as a result of some exogenous fact (e.g., the borrower's filing bankruptcy, failing a net assets test, failing a debt service coverage ratio test, or the like). There, it's not the lender who is making the decision, and I'll agree that the borrower is in a good enough position to know the facts, and hence to know that its obligation has changed, without any special notice from the lender. My argument is simply that when acceleration is discretionary with the lender, the lender ought not be able to accelerate in secret; they gotta tell the borrower it's happening."

Although the editor feels that mortgage documents should be drafted to provide for notice of acceleration, he disagrees with Dale that the law should compel that result, at least in commercial loan documents. This reflects the consistent split between Dale and the editor about whether courts ought to be enforcing concept of overall fairness in loan documents. In general, the editor would prefer that courts stay out of this business, since he has little trust of the judicial ability to do a better job of insuring fairness than the marketplace, and judicial intrusion generally renders the marketplace less effective. Dale has greater trust in the judiciary to draw the line between insuring fairness and meddling in the market.

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

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