Daily Development for Thursday, October 9, 2008
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri

MORTGAGES; CHARACTERIZATION; EQUITABLE MORTGAGES: Sale/leaseback involving distressed homeowner may be recharacterized as an equitable mortgage notwithstanding extensive language in the documentation of the transfer denying that a mortgage relationship exists. 

Bernstein v. New Beginnings Trustee, LLC, 988 So. 2d 90 (Fla. App. 2008)

Bernsteins, who alleged that they had fallen behind in their mortgage payments due to illness, were facing foreclosure of their property.  The accelerated claim of the mortgagee was $88,000, but under the terms of their mortgage, the Bernsteins retained a right to cure and reinstate the mortgage for $32,000.  They alleged that their property was worth $250,000 at this time. 

A few weeks before the foreclosure sale, Bernsteins were approached by New Beginnings New Beginnings,  which offered to buy the property by paying the reinstatement monies, $32,000 to the lender, and to give Bernsteins a one year lease with option to repurchase their home for $125,000.  During the terms of the lease, Bernsteins alleged, New Beginnings was to pay the mortgage payments. 

The documentation of the transaction acknowledged that the sale price might not reflect the market value of the property, because it was a “distress sale.”  The documentation also stated that the Bernsteins were not acting under duress and was at “arms length.”  Indeed, the Bernsteins, at the trial court, acknowledged that they had full knowledge of their actions and had the advice of legal counsel.  (They alleged, however, that the lawyer given to them was counsel to New Beginnings.) 

The lease provided that the rental payments would be used to pay the existing mortgage on bgehalf of the Bernsteins and that any additional funds “will be deemed to cover administrative and overhead costs and time and efforts expended [by New Beginnings.]” Under the lease, the Bernsteins undertook all responsibility for maintaining and repairing the property, even, specifically, structural repairs.  Bernsteins were responsible for special assessments, insurance and tax increases (presumably the base property taxes were covered in the mortgage payments) and the condo association fees.  (Note that the agreement to maintain and repair likely was inconsistent with New Beginnings responsibility under the implied warranty of habitability, assuming Florida, like most states,  would apply that doctrine to townhomes.)  There is no indication from the court report that New Beginnings even recorded the deed, or that it notified the lender of the transfer.  (Likely, of course, the transfer wo
uld have given the right to the lender to accelerate again under the due on sale clause.)

The court concluded that “all indicia of ownership” remained with the Bernsteins, and that Bernsteins didn’t even give New Beginnings a set of keys.

Notwithstanding all of this, when the Bernsteins later failed to pay rent, alleging that New Beginnings was not maintaining payments on the mortgage, the trial court rendered partial summary judgment for New Beginnings, finding that the sale and leaseback were valid and granting New Beginnings a writ of possession of the property. 

The appeals court reversed and remanded for further proceedings, finding that this transaction was in fact an equitable mortgage, and that therefore Bernsteins’ interest could be terminated only through a foreclosure action.  It found it unnecessary to reach at this point the intriguing other issues raised by Bernsteins - that this was a residential mortgage as to which TILA applied, justifying rescission of the transaction by the borrowers and damages (and, presumably, attorney’s fees) as none of the federally required disclosures were made. 

Comment 1: The only remarkable aspect of this case was that the trial court judge didn’t recognize an equitable mortgage arrangement when it stood up and crowed like a rooster.  Classically, self serving language in the instruments of these disguised mortgages does not avail the “lender.”  What is far more significant is the fact that the borrower has sold the property for substantially less than its value and also has a right to reaquire the property for substantially less as well, indicating an “economic compulsion.”  Here, the $125,000 option price was much lower than the alleged $250,000 value of the townhome, but also gave the lender a return of around 300% on the $32,000 it “loaned” to the Bernsteins at the outset. 

Of course, since the original determination by the trial judge was summary judgment, we haven’t yet had a trial of the facts, and it may be that Bernsteins won’t be able to prove the values that they allege.  Nevertheless, the fact that this deal was made under economic stress and that New Beginnings did not in any way accept the responsbilities of being a landlord are likely to carry the day in establishing finally that we had a mortgage here.

Comment 2: Although the outcome is unremarkable, the setting of the case as part of one of the many spurious “home foreclosure” rescue schemes now being perpetrated on homeowners during the current crisis makes the case noteworthy.

Comment 3: Note that in a commercial sale/leaseback transaction, it would not be uncommon for the transferor to retain possession and undertake all “indicia” of ownership, executing a triple net lease imposing all responsibilities on the tenant.  In such a case, the court would likely look much more carefully at the economics of the transaction - the sale price and the option price, to determine whether it ought to recharacterize a deal as a mortgage.  In fact, in the area of synthetic leases, recharacterization is so common that the parties in fact rely upon it and get title insurance to protect the alleged “buyer/landlord’s” status as an equitable lender, which is a status it would prefer in the event of the “seller/tenant’s” bankruptcy. 

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