This DD was contributed by Jack Murray, and is replete with Jack's characteristically exhaustive citations of authority that he provides on issues of concern to him.  Way down at the bottom I manage a puny little response.  Ed.


Daily Development for Tuesday, April 23, 2002


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


MORTGAGES; DEED IN LIEU; MERGER: Debtor's grant of security interest in its personal property (including "instruments") to corporate parent  did not result in "transfer" of mortgage, which thereafter was extinguished when mortgagor issued quitclaim deed in lieu of foreclosure notwithstanding anti-merger language in deed.


United States Leather, Inc. v. Mitchell Mfg. Group, Inc., 276 F.3d 782 (6th Cir. 2002)


Courts generally will not enforce a non-merger provision in a deed in lieu of foreclosure where the rights of innocent third parties may be affected - or even lost - because of fraud or inequitable conduct by the parties to the deed.   Here, the Sixth Circuit held that under the facts of the case, allowing an exception to the merger rule (based on the intention of the parties stated in the quitclaim deed in lieu of foreclosure that no merger of the mortgage and fee would occur) would not be enforced because to deny merger would inequitably permit the mortgagor to void its obligations to an intervening judgment creditor to the sole advantage of the mortgagor's corporate parent.


This decision involved a very complicated factual situation. The case arose out of the efforts of the plaintiff, United States Leather, Inc. ("USL"), to enforce a judgment of approximately $1.5 million against Mitchell Automotive, Inc. ("Mitchell Automotive"), which owned personal property and a manufacturing facility in Clare, Michigan. Mitchell Automotive was in the business of manufacturing and selling leather products for use in automobile interiors.


Over time, Mitchell Automotive built up a substantial debt to USL (as a supplier of finished leather), as well as to its parent corporation, Mitchell Corporation of Owosso ("Mitchell Corp.").  Mitchell Automotive eventually succeeded in finding a buyer, Lamont Group, Inc., and Lamont Group Acquisition Corp. (collectively, "Lamont Group") to purchase Mitchell Automotive's real and personal property. Lamont Group paid $6.5 million in cash to Mitchell Automotive and gave two promissory notes for the balance of the purchase price of $27.5 million. To secure the indebtedness, Lamont Group granted Mitchell Automotive a security interest in the purchased assets and a mortgage on the real property.  Shortly thereafter, Mitchell Automotive granted its parent, Mitchell Corp., a security interest in all its personal and intangible property (including all "instruments") to secure any and all existing and future indebtedness to Mitchell Corp. According to the court, "It is undisputed that Mitchell Corp. obtained a security interest in the Lamont Group's mortgage and promissory notes through their agreement."


The Lamont Group subsequently defaulted, and agreed to surrender all the personal property collateral and deliver a deed in lieu of foreclosure to the secured real property to Mitchell Automotive.  The quitclaim deed to the real property contained language stating that it was the intention of the parties that the deed did not constitute "a merger with or extinguishment of the indebtedness secured thereby."  (The deed also provided that the recourse obligation of Lamont under the Asset Purchase Agreement for the purchase of Mitchell Automotive's assets would be reduced by $6 million). As a result of the conveyance, Mitchell Automotive held title to both the mortgage and the fee interest in the real property.


Shortly thereafter, USL obtained a consent judgment against Mitchell Automotive and Lamont Group in the amount of approximately $1.5 million, and levied on the personal property of Mitchell Automotive at its offices in Owosso, Michigan.  The levy officer did not take actual possession of the property, based on the agreement of Mitchell Automotive's attorney that the property would not be moved, sold, or disposed of and that Mitchell Automotive's remaining personal property was not sufficient to satisfy the judgment.


Mitchell Corp. then advised USL that it claimed priority against the assets of Mitchell Automotive by virtue of its prior security agreement and that it had "peaceably repossessed" the personal property of Mitchell Automotive in accordance with its rights under that agreement. USL responded to this development by filing a formal Notice of Levy against the manufacturing facility  owned by Mitchell Automotive (which was the property previously conveyed by the deed-in-lieu from Lamont Group to Mitchell Automotive), and served a garnishment on the tenant of the property - eventually collecting $46,000 in lease payments before the lease was terminated.


USL then filed a "motion for determination of interests in the property of Mitchell Automotive," arguing that "Mitchell Corp.'s security interest was extinguished by merger, was not perfected, was fraudulent, and that the corporate form should be disregarded."  Id. at 786.  The district court adopted the findings of the magistrate judge, who held that the mortgage was extinguished by merger notwithstanding the non-merger language contained in the deed in lieu of foreclosure. The district court further ruled that the question of whether Mitchell Corp. had to perfect its security interest until after USL's garnishment and levy of Mitchell Automotive's personal property was irrelevant.


In upholding the ruling of the district court, the Sixth Circuit first stated the general rule in Michigan regarding the merger doctrine


"The general rule in Michigan is that when a holder of a real estate mortgage becomes the owner of the fee, the mortgage and fee are merged and the mortgage is extinguished. . . This rule is, however, subject to the exception that when it is to the interest of the mortgagee and is his intention to keep the mortgage alive, there is no merger, unless the rights of the mortgagor or third persons are affected thereby.'" (citations omitted)


The Sixth Circuit rejected Mitchell Automotive' argument that there was no merger because it did not hold both the title to the real property and the mortgage.  The court reasoned that although Mitchell Automotive had granted a security interest in the Lamont Group's mortgage and promissory notes to Mitchell Corp., it "did not assign, transfer, or convey Lamont's mortgage to anyone."  Id. at 787.


The court then ruled that because of equitable considerations involving the conflicting rights of USL as an intervening third party, it would not enforce the express non-merger intent of the parties as set forth in the deed in lieu of foreclosure from Lamont Group to Mitchell Automotive. According to the court


"Allowing an exception to [the] merger rule in this instance would do grave injustice. Such a finding would permit Defendant [Mitchell Automotive] to avoid paying an uncontested $1.5 million debt to [USL] in favor of its parent corporation, Defendant [Mitchell Corp.].  The fact that these two corporations share the same office space, computers, employees, and are run by the same President who originally incurred the debt to [USL] only highlights the inequity of applying the exception."


The court found that this case was distinguishable from other Michigan cases where non-merger language contained in a deed in lieu of foreclosure had been enforced, as this was not a situation where the mortgagee was trying to protect itself from the claims of junior lienholders of the mortgagor.  As the court stated "[Mitchell Automotive] is not in the position of a mortgagee trying to protect itself from junior lienholders of the Lamont Defendants; it is attempting to protect itself from having to pay a debt it acknowledges owing to Plaintiff. We agree that equitable considerations preclude Mitchell Automotive from avoiding merger when the effect is not to protect its own interests from the creditors of the Lamont Group (the mortgagor), but rather to prefer the debt of its parent corporation over the debt owed to USL as a third party."


The Sixth Circuit further noted that unlike the Michigan cases cited by Mitchell Corp., USL did not expressly acknowledge the priority of Mitchell Corp.'s mortgage and its judgment was not expressly made subject to Mitchell Corp.'s mortgage.  The court also rejected Mitchell Corp.'s argument  that it was itself a third party whose rights were "most affected by merger or non-merger."   The court held that USL was equally affected by the merger issue.  The court further denied Mitchell Corp.'s claim that it was unfair to "lump" Mitchell Corp. and Mitchell Automotive together without first determining whether the corporate veil could be pierced.  The court was greatly influenced by its finding (as stated earlier) that both corporations shared the same office space, computers, employees, and officers.


The court reasoned that because USL had abandoned any claim against Mitchell Corp. for the indebtedness owed to it by Mitchell Automotive, it was not necessary to make a determination as to whether the facts of the case justified piercing the corporate veil.  The court noted that the district court had instead been "called upon to weigh the equities between USL and Mitchell Corp. as secured creditors competing for the sole asset of the debtor," and in this regard "it was proper to consider the relationship between Mitchell Automotive and its respective creditors."  Id.  The court found that the equities of the case prevented Mitchell Automotive from relying on the exception to the merger rule "to favor the debt owed to the parent company over USL's judgment lien."  Id. at 789.


Reporter's Comment 1:   The Sixth Circuit's ruling effectively employed the "balancing of the equities" doctrine to thwart what appeared to be an attempted preferential transfer or fraudulent conveyance of mortgaged property by a deed in lieu of foreclosure (although the court never decided this precise issue) to avoid an obligation to an innocent third-party judgment creditor. This case has complicated and unusual facts, and the Sixth Circuit was careful in its opinion to limit its holding to the facts presented.  The court expressly acknowledged and confirmed that the generally permitted exception to the merger rule - i.e., that the mortgage would not be extinguished if the parties expressed their intention in the deed not to terminate the mortgage- would be valid and enforceable in those situations where the mortgagee's reason for keeping the mortgage alive was for the purpose of preserving its rights (including foreclosure) against subordinate lienholders of the mortgagor.


As evidenced by  other cases and applicable state statutes (see below), the unique facts of this case should not prevent the parties to a more conventional deed-in-lieu transaction from entering into a deed containing specific non-merger language, or prevent the owner-mortgagee from subsequently enforcing its rights under the preserved mortgage.


Reporter's Comment 2:.  Many states rely (at least in part) on the intention of the parties, either express or implied, to determine whether a merger occurred as the result of a deed-in-lieu transaction. In Tidwell v.

Dasher, 152 Mich. App. 379, 393 N.W.2d 644 (1986), the court dealt with the issue of whether a deed in lieu of foreclosure created a merger that would affect the priority of an intervening lien. The court stated that "[t]he question of intention of a mortgagee or vendor is a question of fact which must be developed from evidence produced to show what the intention was at the time the acts were done."  Id., 152 Mich. App. at

385, 393 N.W.2d at 647. In Weitzki v.Weitzki, 437 N.W.2d 449 (Neb. 1989), the court noted that the intention of the mortgagee is controlling as to whether the mortgage is kept alive. The court held that when the mortgagee becomes the owner of the fee, and there is no expression of intention as to whether the mortgagee wished to keep the mortgage alive, it will be presumed that the mortgagee intended to do what would prove most advantageous to himself in the absence of circumstances indicating a contrary purpose. 


The court then found that in this case no merger of title and lien occurred in light of the mortgagee's intent to retain the priority of his lien against the subordinate lien.  See also FDIC v. Lee, 988 F.2d 838, 843 (8th Cir. 1993) ("[t]he doctrine of merger is not favored and will not be applied in the absence of an intent on the part of the mortgagee, or unless the application of the doctrine is require by equities of a particular case" [quoting Construction Machinery v. Roberts, 307 Ark. 252, 819 S.W.2d 268, 270 (1991)] ); Sylvania Savings Bank v. Turner, 27 Mich. App. 640, 645, 183 N.W.2d 894, 896-97 (1970) ("whether [merger] occurs depends fundamentally on the mortgagee's intention. If it is in his interest to preserve his lien separately from the fee, it will ordinarily be concluded that he did not intend to merge the lien into the fee"); Long Island Lighting Co. v. Commissioner of Taxation and Finance, 652 N.Y.S.2d 640, 641, 235 A.D.2d 637, 638 (N.Y.A.D., 3rd Dept. 1997), leave to appeal denied, 90 N.Y.2d 801, 660 N.Y.S.2d 554, 683 N.E.2d 19 (1997) (noting that "the doctrine of merger is disfavored," the court stated that "the determinative issue is whether the owner intended there be a merger, which must be discerned from all the circumstances"); Nancy J. Appleby, Negotiating and Structuring a Friendly Foreclosure or Deed in Lieu of ForeclosureA Lender's Perspective," Negotiating and Structuring a Friendly Foreclosure or Deed in Lieu of Foreclosure, American Bar Association Section of Real Property, Probate and Trust Law, New York, NY (August 10, 1993), Tab 8.


The section of the Illinois mortgage foreclosure statute that deals specifically with deeds in lieu of foreclosure, 735 ILCS 5/15-1401, states (with respect to the issue of merger) that "A deed in lieu of foreclosure, whether to the mortgagee or mortgagee's nominee, shall not effect a merger of the mortgagee's interest as mortgagee and the mortgagee's interest derived from the deed in lieu of foreclosure."


Reporter's Comment 3:   A deed in lieu of foreclosure does not "wipe out" any subordinate liens, and the grantee takes subject to all existing liens, whether known or unknown.  To attempt to eliminate these liens, the lender still must foreclose the mortgage or otherwise deal with each of the existing encumbrances.  (The lender actually may have an incentive to pay something on lien claims to avoid a contested foreclosure proceeding; after all, the primary purpose of a deed-in-lieu transaction usually is to avoid foreclosure).


Recent case law (Professor Randolph's protestations to the contrary) generally supports the ability of a mortgagee to foreclose its mortgage after acceptance of a deed in lieu of foreclosure. See, e.g., PNC Bank, Delaware v. Philben, Inc., 1997 Del. Super. LEXIS 467 (Del.Super.Ct. 1997) (not reported in A.2d) (holding that where the deed-in-lieu documents contained an anti-merger provision, the owner-mortgagee could subsequently commence foreclosure proceedings; the court noted that "where the mortgage includes an anti-merger provision to protect an existing mortgage balance, the deed is merely additional security for the mortgage debt" and that "[the mortgagee] preserved its right to foreclose"); GBJ, Inc. v. FirstAvenue Investment Corp., 520 N.W.2d 508, 511 (Minn. App. 1994) (ruling that "[the mortgagee] did not forfeit its rights as mortgagee when it took the deed in lieu of foreclosure.  To the contrary, the doctrine of merger presumes that the mortgagee retains all rights"; the court further stated that "[the mortgagee] therefore retained the right to foreclose"); Runge v. Runge, 1999 Minn. App. LEXIS 1187 (Ct. of Appeals of Minnesota) (unpublished)(stating that "[the mortgagee] did not forfeit his rights as mortgagee when he took the deed in lieu of foreclosure"; and noting that deed  contained "an unambiguous anti-merger clause evidencing [mortgagee's] intent not to merge his interests"); Olney Trust Bank v.Pitts, 200 Ill. App.3d 917, 926-27, 558 N.E.2d 398, 403-04 (5th Dist. 1990) (holding that "because there is no merger, the mortgage debt is not satisfied or extinguished"; the court permitted the lender, who had obtained a deed-in-lieu, to foreclose but prohibited it from pursuing an action for a deficiency judgment)  In re Estate of Ozier, 225 Ill. App.3d 33, 36, 587 N.E.2d 77, 80 (4th Dist. 1992) ("In the absence of evidence to the contrary, the law presumes that a mortgagee intended to keep his mortgage alive, when such course was essential to his protection against an intervening title or for other purposes of security"); Zubrys v. Harbor Country Banking Co., Docket No. 192822 (unpublished opinion per curiam of the Michigan Court of Appeals, December 19, 1997) (holding that where the first mortgagee took a deed in lieu of foreclosure and subsequently foreclosed its mortgage after discovering the existence of a second mortgage, there was sufficient language in the deed-in-lieu documents to prevent a merger of the security interest and ownership interest; the court also held that the second mortgagee did not have standing to challenge the adequacy of the consideration given to the mortgagor for the deed in lieu); Union Bank & Trust Co. v. Farmwald Development Corp., 181 Mich. App. 538, 547, 450 N.W.2d 274, 278 (1989) (ruling that junior mortgagee's objection to entry of foreclosure of mortgages of first mortgagee was unfounded, because first mortgagee's interest was not extinguished and discharged by mortgagor's conveyance of the secured property to the first mortgagee); Clark v. Federal Land Bank, 167 Mich.App. 439, 444-45, 423 N.W.2d

220, 222 (1988) (refusing to permit a subordinate judgment lienholder to have bank's foreclosure on property subject to lien declared invalid; and stating that "the quitclaim deed executed by the [mortgagors] to the bank manifested unequivocally an intention that the mortgage not merge with the fee.  Additionally, plaintiff's rights were not affected by the intention to keep the mortgage alive, for she knew her judgment lien was subject to a first mortgage pursuant to the judgment of divorce"); 55 Am.Jur.2d Mortgages,  1345, Intervening or Junior Claims or Liens.


Editor's Comment: Because Jack Murray was generous enough to donate this DD, and because anything he writes is worth reading, I've gone ahead and printed his entire piece, including his voluminous citations.


Jack indicates that he has a disagreement with me on this issue.  Our disagreement is somewhat narrow.  It relates to situations in which a mortgagee takes a deed in lieu of foreclosure with actual knowledge of the existence of other interests junior to the mortgage.  These interests are not foreclosed away, of course, and are still binding on the property. Jack has argued that courts should preserve the mortgagee's rights against these parties, notwithstanding the probable merger that results from the transfer of the fee to the mortgagee.  I have argued that although this result may be  appropriate where a mortgagee was unaware of the competing interest, even though it was recorded, it is not appropriate where a mortgagee deliberately seeks the advantage of a deed in lieu with actual knowledge of the existence of other interests.


I have not before seen Jack emphasize the argument that the result is affected by "anti merger" language in the deed in lieu.  I have understood him to argue that, even absent such language, the court should set aside the merger.


I have acknowledged the authority supporting Jack's result in the past. For instance, the DD of 8/11/00 reported the case of  Miller v. Martineau, 983 P.2d 1107 (Utah App. 1999), where merger was not found when there was an intervening leasehold interest.


I don't know how many of the cases that Jack cites indeed deal with the situation of the known intervening interest, nor how many also involve the feature of an express reservation denying merger.  If they all directly support Jack's position on the point, that indeed is persuasive.


My view in the past has been based upon the notion that parties ought to live with the consequences of their actions.  They have the device of foreclosure to clear the title.  If they choose not to use it, then they should abide by the consequences of that choice, which is that title is not cleared.


Jack's position here has driven me to rethink the issue.   What harm results by denying merger?  The best scenario that I can think of that raises a question would be where the mortgagor believes that the mortgagee is taking title subject to the other interests, and thus does not appreciate that it has much of a bargaining position in the deed in lieu negotiations.  Courts are careful in reviewing such deals, since they do involve a waiver of the equity of redemption.  If the mortgagor believes that the mortgagee is taking title subject to other interests, and this is not the case, the mortgagor may be giving up more than it should.   This is particularly true if the mortgagor thinks that the mortgagee would have no right of recourse if liens attached to the property foreclosed.


This problem is avoided to a certain extent if the parties stipulate in the deed in lieu that the mortgagee continues to assert its priority position as against the existing liens.  Since that's the only scenario I have been able to come up with so far, I will withdraw my general view in favor of merger where the parties have so stipulated.  I'm not sure that general boiler plate "anti merger" language is such a stipulation.


The Reporter for this case is Jack Murray of First American Title in Chicago.

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