Daily Development for Friday, January 31, 2003

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; DEED IN LIEU OF FORECLOSURE; CLOGGING EQUITY OF REDEMPTION: A deed in lieu of foreclosure given as part of original transaction in which mortgage loan is created is invalid as a clog on the equity of redemption notwithstanding the stated fact that the deed is given to induce a third party to purchase the mortgage note from the original mortgagee.

Panagouleas Interiors., Inc. v. Silent Partner Group, Inc., 2002 WL 441409 (Ohio App. 3/22/02)

This little tale of low level wheeling and dealing is a pretty good example of the kinds of situations in which courts are inclined to be protective of mortgage borrowers, a solicitude that led to the creation of the "clogging" doctrine in the first instance. A "clog" is basically an invalid waiver of the equity of redemption. A mortgagor who purports to waive the right to have an equity of redemption following default, which can be terminated only by a lawful foreclosure, is said to have "clogged" the equity of redemption. Clogging is prohibited, and the waiver is void.

Historically, precedent has been reasonably uniform that a mortgagor who gives to the mortgagee a conditional deed to the mortgaged property that can be enforced and recorded upon default in the mortgage loan has unlawfully waived, or "clogged" the equity of redemption. There have been recent assaults on this concept in recent years. In fact, the court here cites a Ninth Circuit decision, Guam Hakubotan, Inc. v. Furusawa Inv. Corp., 947 F.2d 398 (9th Cir. 1991), which apparently upheld such an arrangement. But in the Guam case, the conditional deed was executed long after the original loan agreement and at a time when it was anticipated that the mortgagor was likely to default in the near future.

The rule against clogging has been softened, and courts, though still carefully scrutinizing the transaction, will permit "deeds in lieu of foreclosure," which basically are waivers of the right to demand an equity of redemption, when such deeds are entered into after default. In these cases, the courts reason, the imbalance in bargaining position that existed at the time the loan was entered into is not as severe. Although, admittedly, the borrower is in default and therefore possibly desperate, the borrower at least is properly focussed on the consequences of the action with regard to the potential loss of ownership of the property, and in fact by recognition of the validity of these transactions the courts give the borrower an additional "bargaining chip" - the ability to "sell" to the lender a cheaper and faster security realization process for something the borrower is likely to value, such as a waiver of any deficiency claim.

The thinking behind this exception may in fact explain the somewhat aberrational result in Guam.

In the instant case, the mortgagee attempted to argue that, like Guam and other situations involving valid deeds in lieu of foreclosure, the conditional deed/waiver of equity of redemption entered into by the mortgagor here was not done as part of the funding of the original loan, but rather to induce a third party to "take out" the original mortgagee, who was the seller of the mortgaged property. The court, however, cut through this analysis when it observed that the "take out" agreement really was part of the original acquisition arrangement, and the conditional deed was therefore basically part of the same transaction, even though given to the "take out" lender rather than the original seller.

Comment: Some legal rules have survived the test of time because they really are good ideas that recognize practical realities in the financial affairs of the human species. In the view of the editor, the recognition of the equity of redemption and the protection against waiving it in fact are as valid today as when they were developed five or six centuries ago. The fact that the term "clogging" has an antiquated feel to it doesn't mean it reflects an outdated concept.

Borrowers at the time of entering into a secured loan remain attentive primarily to the "live" terms of the borrowing - interest rate, term, control of the property, etc. They rarely think seriously about what will happen if they default. If they really expected to default, they'd probably not do the deal in the first place.

Lenders, on the other hand, are very risk averse and focussed intently on default remedies even at the time the loan is initiated. It is this imbalance in focus, rather than any imbalance in power, that the recognition of the equity of redemption addresses. And consequently the concept is applied whatever the size of the deal or sophistication of the borrower. (The deal in this case, it can be noted, was commercial in character, but apparently involved a very unsophisticated buyer and a quite canny lender which, allegedly, came to repossess the property pursuant to its conditional deed literally with guns at ready.)