Daily Development for Tuesday, October 19, 1999

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

MORTGAGES; FUTURE ADVANCES: Additional construction funds advanced by beneficiary to trustor pursuant to a separate agreement were secured by the subject property under the original deed of trust and were not unsecured "additional loans."

Harrington Properties, Inc. v. Peterson, 973 P.2d 1004 (Utah App. 1999)

A builder gave a purchase money mortgage (deed of trust) to a seller to finance the acquisition of a building lot on which the builder would construct a luxury home for resale. The purchase payment was deferred nine months pursuant to a note secured by the mortgage. This mortgage was subordinated to a construction loan from an institutional lender entered into at closing on the lot. The purchase money mortgage provided, among other things, that it secured:

"[T]he payment of such additional loans or advances as hereafter may be made to Trustor, or his successors or assigns, when evidenced by a promissory note or notes reciting that they are secured by this Deed of Trust;"

The mortgage contained a covenant against waste that was rather specific as to construction on the property. The borrower agreed:

"To keep said property in good condition and repair; not to remove or demolish any building thereon; to complete or restore promptly and in good and workmanlike manner any building which may be constructed, damaged or destroyed thereon; to comply with all laws, covenants and restrictions affecting said property; not to commit or permit waste thereof; not to commit, suffer or permit any act upon said property in violation of law; to do all other acts which from the character or use of said property may be reasonably necessary, the specific enumerations herein not excluding the general; and, if the loan secured hereby or any part hereof is being obtained for the purpose of financing construction of improvements on said property Trustor further agrees:

(a) To commence construction and to pursue same with reasonable diligence to completion in accordance with plans and specifications satisfactory to Beneficiary. (b) To allow Beneficiary to inspect said property at all times during construction. ....

Note that the last two items apply only if the loan is made for construction. The original purchase money loan, of course was not made for construction.

The deed of trust further provided that if "Trustor fails to make any payment or to do any act as herein provided, then Beneficiary ... without obligation so to do and without notice to or demand upon Trustor and without releasing Trustor from any obligation hereof, may: Make or do the same in such manner and to such extent as [Beneficiary] may deem necessary to protect the security hereof .... [a]nd in exercising any such powers, incur any liability, expend whatever amounts in its absolute discretion it may deem necessary therefor..."

Subsequently, the builder went over budget on the house, and was unable to complete it with funds available from the institutional lender. When the time came for payment of the purchase money note, the home was still unbuilt and unsold, and the developer could not pay the note. The developer subsequently declared bankruptcy. Six months after the bankruptcy filing the purchase money lender and the builder entered into an agreement that the purchase money lender would advance up to an additional $75,000 to complete construction, as it appeared unlikely that in its present state the house would return enough to pay off the purchase money note.

The loan agreement providing for the $75,000 in advances did not indicate that advances pursuant to this agreement were to be secured by the original mortgage.

The trial court held that the advances were not secured by the deed of trust because they did not fit within the future advances provisions in that the loan agreement providing for them did not refer to the earlier deed of trust.

The Court of Appeals "end ran" the trial court's conclusion because it found the construction funds advanced to the trustor were advanced under the provision of the deed of trust allowing beneficiary to make expenditures to protect its security interest. The court stated that the trustor was obligated to repay all sums expended by the beneficiary regardless of how such advances were memorialized. The construction advances were necessary since without the advances by the beneficiary, construction on the property would have stopped.

Critical to the court's conclusion was the first sentence of the waste clause, above, by which the borrower agreed to "complete . . . any building which may be constructed, damaged or destroyed [on the property]."

Comment 1: The court has turned the covenant against waste and the general covenant to protect security into a virtually unlimited right on the part of the mortgagee to advance funds to complete construction notwithstanding the very specific language of the deed of trust restricting future advances. Despite the language of the waste covenant requiring the borrower to complete construction of buildings constructed on the property, the court still had to deal with the "protection of security" clause. Although the clause vested absolute discretion in the mortgagee, one would assume that Utah courts, which have applied "good faith and fair dealing" concepts to real estate cases in the past, would restrict such language to authorize expenditures truly designed to "protect security."

When otherwise the property would lack sufficient value to pay off the mortgage, an advance to complete construction, the editor proposes, ought to satisfy the test, at least in cases like this one, where the parties clearly intended that the mortgagor construct a building on the property that would enhance its value. Although one could argue that the advance may or may not increase the value of the property beyond the value of the property with a partly completed building,, the mortgagee ought to be entitled to the benefit of the doubt. After all, the mortgagee, by making the advances, is taking a risk that the property will not even return the amount of the original value plus the advances, and thus is making a financial commitment to its judgment that the advances are worth the money.

It should be pointed out that these advances may in fact take the mortgage amount beyond the original face amount of the secured note. They would not be covered by the typical future advance agreement, but as efforts to protect security, they are valid advances anyway. Mortgagees who take positions junior to loans for property on which construction is occurring should be aware of this danger.

Comment 2: But where the economics of the original mortgage agreement did not contemplate the construction of buildings, it seems more of a stretch to permit the mortgagee to advance money to complete unfinished construction following default and to add the cost to the mortgage debt. Obviously, any construction project involves risk, and the mortgagee should not be able to subject the mortgagor (and the mortgagor's other creditors) to the gamble that additional funds will add value to the property when construction was not part of the original scheme.

Comment 3: There has some uncertainty in the cases over the extent to which advances to complete or advance construction constitute advances to protect security that properly are added to the mortgage debt. Of course, where the mortgage instrument addresses the issue, the task of the court ought to be simply to discern that intent as it applies to the facts at hand. But what about where the instruments are silent?

The Restatement of Mortgages, in Section 2.2, takes the position that "advances to protect security" may be added to the mortgage lien with the original priority of the mortgage whether or not the mortgage provides for them if the advances are "reasonably necessary for the protection of the security . . . (1) to protect the value of the mortgage real property and the improvements on it; or (2) to protect against the assertion of liens having priority over the mortgage."

Of course, if the debtor stops construction, leaving the property exposed to weather and vandalism, one assumes that this is an act of waste, and the mortgagee ought to be able to respond by stepping in and expending money to "button up" the property, and to preserve it in its present state.

But this is a far cry from actually continuing construction on the argument that later completion of construction will only be more expensive. The debtor, presumably for economic reasons, has determined it doesn't make sense to pour more money into the project. Should we view the lender as accepting the risk of such a decision if the lender hasn't bargained for more in the mortgage?

In the reporter's notes, the Restatement cites to relatively scant authority dealing with advances to complete construction. But the reporters indicate, in Comment a, that advances to cover "costs of completion by the mortgagee of improvements which the mortgage was obligated to make but failed to complete" do satisfy the test This clarifies the reporter's intent in the main language of the section, even though it violates the Strunck & White "which/that" rule, a rule with which the editor also struggles from time to time.

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

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