DD 10/6/06 Automatic default plus automatic activation of rents interest causes conversion conundrum.


Daily Development for Friday, October 6, 2006

by: Patrick A. Randolph, Jr.

Elmer F. Pierson Professor of Law

UMKC School of Law

Of Counsel: Blackwell Sanders Peper Martin

Kansas City, Missouri

dirt@umkc.edu <mailto:dirt@umkc.edu>

MORTGAGES; ASSIGNMENTS OF RENTS; MISDISTRIBUTION OF RENTS: Even where lender has not declared a default and has made no effort to activate its rents interest, parties receiving distributions from the borrower that constitute rent monies are liable in tort to the lender for conversion of the lender's property.

Wells Fargo v. Diamond Point Plaza, L.L.P. 2006 Westlaw 2788385 (Md. App. 9/29/06)

This "target rich" case has been discussed in the two previous DD's. The facts are discussed generally under the headings "Mortgages; Waste" and "Landlord/Tenant; Commercial; Radius Clause." In this discussion, we will focus on the court's ruling on the mortgagee's rights to collect rents in the hands of the mortgagor or transferees of those rents - some of the principles of the mortgagor.

The court had already found that the mortgagee was in default from the moment that it came into existence due to the borrower's failure, in representations contained in the mortgage, to disclose what it knew about the imminent "dark" status of Sam's Club at the shopping center. The court detailed the express representation in the mortgage that borrower had no knowledge of "any tenant's intention of notice to vacate the premises," and that, in fact, borrower's principles did know of Sam's Club's intentions, if for no other reason than that a prior mortgage broker it had spoken to, Lehman Bros., discovered these intentions and reported them to principles of the borrower.

The mortgage contained a relatively standard assignment of rents clause for major commercial mortgages, providing inter alia:

                Upon an Event of Default (as defined in the Mortgage), the license granted to Assignor herein shall be automatically revoked by Assignee and Assignee shall immediately be entitled to receive and apply all Rents, whether or not Assignee enters upon and takes control of the Mortgaged Property. Assignee is hereby granted and assigned by Assignor the right, at its option, upon the revocation of the license granted herein to enter upon the Mortgaged Property ... to collect the Rents. Any Rents collected after the revocation of the license herein granted may be applied toward payment of the Debt in such priority and proportion as Assignee, in its discretion, shall deem proper.

The false statement in the mortgage that there were no problems with the tenants put the mortgage immediately into default:

                The Debt shall become immediately due and payable at the option of Mortgagee, without notice or demand, upon any one or more of the following events ("Events of Default"):

                * * * (e) If any representation or warranty of [Mortgagor], . . . of any of the terms of this Mortgage ... made herein or in an [sic] such guaranty, or in any certificate, report, financial statement or other instrument or document furnished to Mortgagee shall have been false or misleading in any material respect when made; . . .

After the mortgage was entered into, the on site manager transferred the sum of $633,000 as an "advance." These funds later showed on the books as repaid, but apparently were immediately transferred to the partners as a partnership distribution. It appears that the court viewed the "advance" as in fact a payment of the funds to the first recipient, and a conversion of funds properly allocable to the mortgagee. Consequently, the recipients were liable to pay them over to the mortgagee.

Readers will not be surprised to know that the borrower had a very different view of what was disclosed to the lender prior to the loan and of the circumstances surrounding the $633,000. The court simply didn't believe their story, and the appeals court affirmed this ruling..

What makes the case interesting, however, from a legal standpoint, is the court's ruling that immediately upon default (which happened without notice or declaration as of the time of the mortgage), all rent monies collected by the mortgagor were automatically owned by the mortgagee (to be applied, apparently to the mortgage debt) and that the mortgagee had this right without any prior notice or demand.

Many jurisdictions take a different view of this situation. Although frequently default without notice is recognized, default normally does not trigger an activation of the assignment of rents, perhaps for the kinds of concerns raised here. The mortgagor may not have known in fact that the mortgagee viewed it as in default (in fact the mortgagee probably didn't, since it didn't know yet of the Sam's Club problem) and the mortgagor therefore treated the funds in its possession as within its control, as did it's principles. It's a pretty tough rule to hold that any time a party expends funds that it believe in good faith it has a right to expend is guilty of conversion due to unknown and unstated claims of third parties to the funds.

It is true that the mortgage language supported this result, but most courts take a special view of language like this, because very often the parties to a mortgage include this language, but really don't mean it. Mortgages frequently are in default for one or more technical reasons, such as failure to provide insurance certificates or a minor delay in payment. The parties commonly don't treat these problems as significant enough to cut of the mortgagor's control over its rent flow. Consequently, many courts take the view that the proper interpretation of the assignment of rents clause is that it must be "activated" by some affirmative action of the lender. That, the editor believes, is the position taken by the Restatement of Mortgages and backed up by sound reasoning in a majority of the courts considering the issue.

Not so here. Automatic is automatic. Whether or not the mortgagee knew of the default, the rents, or the payment over of the rents, a tortious conversion occurred. Even though the party receiving the "advance" later paid back the funds to the mortgagor, this was no defense to his tort, because he owed the rents to the mortgagee, not the mortgagor, and the mortgagor later redistributed the monies to other partners. Consequently, this recipient had to pay $633,000 to the mortgagee even if he indeed had already repaid the "advance" to the mortgagor.

It is likely that the court would not have made this finding had the recipient been completely innocent of any knowledge of the misrepresentation concerning Sam's Club. But that's not really clear from the holding. Innocent recipients of the personal property of others sometimes are held liable for conversion if they treat that property as their own, however ignorant they are of the true circumstances.

Comment 1: Does the above analysis suggest that trade creditors or others dealing in good faith with the mortgagor might have to disgorge monies paid to them and hand them over to the mortgagee, even without any bankruptcy? If not, judge, why not?

The editor believes that the court really didn't mean it when it suggested that repayment of the rent money to the mortgagor would not have absolved the defendant of conversion. It was reasonable, under the circumstances, for most parties who repaid advances to the lender to believe that this was a way to put the rents back into a money flow that would wind up with the mortgagee. Here, the court suggested that there was something suspicious about the repayment transaction, and that in fact the party repaying the money expected that it would bounce back out to other partners in the mortgagor's deal.

Comment 2: Although the editor is reasonably confident he has faithfully rendered the court's analysis of the rents issue in the opinion, he must admit that the court's discussion of the pleadings earlier in the opinion indicate that the lender characterized the "advance" as a fraudulent transfer, made at a time when the borrower was insolvent. Of course, since the loan had already been automatically accelerated, the borrower certainly was insolvent, if the payment was a fraudulent transfer, it would have been "cured" by a repayment back to the debtor. So the court apparently analyzed the problem a different way - as a conversion - in order to discount the alleged repayment to the debtor. But the editor admits that the court's analysis of this issue is almost conversational, and gives us very little useful basis to evaluate the facts any more than has been done here.

Comment 3: What's important about this case is Maryland's rejection of the "activation" requirement imposed in many other jurisdictions. In the editor's view, the "activation" requirement is a sound requirement, and in fact derives in part from the philosophy of the equity of redemption. When a lender seizes the rents, this is very close to interfering with the possession of the property, since the rents are the "fruits of possession." Although we may no longer want to require that the lender go through a complete foreclosure to interfere with the borrower's possession, isn't a little judicial imposed process still appropriate here?

Readers are encouraged to respond to or criticize this posting.

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