Appointment of a Receiver After the mortgagor has defaulted, the mortgagee may ask court to appoint a receiver for mortgaged property If appointed, the receiver takes possession and control of the property, pursuant to court s receivership order Receivership is an equitable ancillary remedy that mortgagee can seek in an action for (1) foreclosure of the mortgage, (2) for a judgment on the debt, or (3) for specific performance of an assignment of rents Appointment of a Receiver: Pro Gets the mortgagor out of possession of the land (and out of control of rents), but without making the lender a mortgagee in possession This is of particular value in states with long foreclosure timelines Receiver, as an agent for court, can manage property and enter into new leases pending foreclosure Mortgagee, as mortgagee in possession, couldn t effectively enter into leases w/out the consent of mortgagor Appointment of a Receiver: Con Con: receivership is costly, particularly by comparison to direct collection of rent by notification to tenants Attorneys fees for court process (pleadings, hearing) Receiver has to post fidelity bond Receiver gets a fee (typically higher than a regular property management fee) If the property is no longer generating enough cash flow to pay operating and carrying costs, mortgagee will have to fund the additional cost of the receivership Note: in Missouri, receivership is very uncommon in cases of financial defaults on mortgage of completed project Nonjudicial foreclosure happens very fast (45-60 days) The risk of losing the small amount of rent that would accrue in such a short period of time may not justify the expenses of a receivership By contrast, receivership is more likely in the case of a failed development (e.g., where mortgagor goes into default before construction is completed) Receiver could supervise completion of construction and eventual sale of the property or foreclosure of the mortgage
Receivership: Discretionary, or Mandatory? Traditionally, appointment was in discretion of court Today, receivership clauses in commercial mortgages provide mortgagor s consent to appointment of a receiver after default (e.g., Fannie multifamily mortgage) Should such a clause bind the court? Appointment of Receiver. Beneficiary, separately or in any action to foreclose this Deed of Trust, shall be entitled (without notice and without regard to the adequacy of any security for the Note, the absence of waste or deterioration of the Property or other arguments based in equity) to the appointment of a receiver of the Rents of the Property who shall have, in addition to all the rights and powers customarily given to and exercised by such receiver, all the rights and powers granted to Beneficiary by the covenants contained herein. Once appointed, at Beneficiary s option, such receiver may remain in place until all amounts secured hereby are paid in full. Dart case (p. 414) reflects the traditional judicial approach Receivership is an equitable remedy, not a contract right (parties cannot contract to control a court s equitable discretion) Court won t appoint a receiver if mortgagee s legal remedy is adequate In Dart, mortgagee was oversecured (value of land >>> mortgage debt), and there was no evidence of waste or threat to value of the land Restatement 4.3(b): mortgagee entitled to receiver after default, if mortgage explicitly so provides, w/out regard to adequacy of security [p. 418, note 2] Uniform Assignment of Rents Act is similar [p. 405] Some states (NY, MN, IL, IN) have statutes making appointment mandatory upon mortgagor default, where mortgage contains consent to appointment Foreclosure: Real vs. Personal Property Under Article 9, secured party can sell personal property collateral in a private sale, as long as sale is commercially reasonable in all respects [ 9-610(b)] Under real estate law, foreclosure sale is ALWAYS a public auction sale on courthouse steps This is true whether the foreclosure is a judicial foreclosure or (as in Missouri) a nonjudicial foreclosure
Private Sales UCC rationale for allowing private sales: they frequently will result in higher realization [i.e., higher sale price] on collateral for the benefit of all concerned. [ 9-610, comment 2] Why doesn t real estate law permit foreclosure in private sales? Can the Receiver Sell the Property? Traditionally, equity or general receivers (appointed to take over all assets of the debtor) had the power to sell receivership property (subject to court approval) By contrast, custodial or special receivers (appointed for specific property) were viewed as having only the power to preserve the property, not to sell it Under this view, receiver could not sell property free and clear of liens (i.e., with same impact as a foreclosure sale) Shubh Hotels Boca LLC Bank made $28.8MM mortgage loan to Shubh to renovate Doubletree Guest Suites in Boca Raton Bank obtained receiver, but in receivership, hotel was still losing $28,000 per month May 2010: upon motion by Bank, court authorized receiver to sell the property in a private sale June 2010: receiver signed contract to sell property to new buyer for $9 million, court approved sale terms Shubh (mortgagor) objected Should the court be able to empower the receiver to sell the property free and clear of the borrower s redemption right, or should sale be permissible only in a foreclosure sale (that would trigger borrower s redemption right)?
Waste Tort law restrains the owner of a present estate in land from changing its physical characteristics in a way that reduces the value of another person s interest in that land Landlord-tenant Life tenant-remainder Mortgagor-mortgagee E.g., Uphoff sets his house on fire (arson), reducing its value from $350,000 to $50,000 If Uphoff s home was subject to a mortgage held by Bank, Uphoff s act = legal waste Bank s mortgage on Uphoff s home secures Uphoff s obligation to repay the loan secured by the mortgage So why would Bank sue Uphoff in tort, for waste? If Uphoff hasn t paid back the loan, why not just sue him in contract, for a judgment for the unpaid balance of the mortgage loan? Why Sue for Waste? Problem: Bank may not have an enforceable claim against Uphoff under contract law Example: Some mortgage debts are nonrecourse, either by contract or due to state anti-deficiency legislation Example: Uphoff may have acquired the land from the original mortgagor, but without assuming personal liability on the mortgage debt (Spencer s Kenosha Bowl, p. 404) In these situations, bringing a waste action in tort would be the only way Bank could recover from Uphoff for the economic harm occasioned by his wasteful conduct Waste (Review) Mortgagee has cause of action in tort, for waste, for conduct that changes the land in its physical characteristics in a fashion that reduces its value Waste liability doesn t matter if defendant has contractual liability on the debt Waste liability matters where (1) mortgage is nonrecourse, or (2) defendant has no personal liability on debt (e.g., 3d party)
Problem 2: Waste or Not? Mortgagor does not replace roof of mortgaged premises Mortgagor fails to pay real estate taxes ($150,000) when they become due Mortgagor enters into a 10-year belowmarket rent lease with a new tenant Mortgagor increases casualty insurance deductible from $10,000 to $1MM Roof Replacement? Traditional rule: ordinary wear and tear waste Common law drew a distinction between active waste (actionable) and passive waste (not actionable) [p. 431, Spencer s decision] Modern rule: Waste occurs when... [the mortgagor] fails to maintain and repair the real estate in a reasonable manner [Restatement 4.6(a)(2)] Property Maintenance/Repair Mortgagee can avoid any ambiguity as to whether failure to maintain/repair constitutes actionable waste by imposing an express affirmative covenant upon the mortgagor to maintain and repair mortgaged premises E.g., Fannie Uniform DOT 7 ( Borrower shall maintain the Property in order to prevent the Property from deteriorating or decreasing in value due to its condition... Borrower shall promptly repair the Property if damaged to avoid further deterioration or damage. ) [p. 1445] Problem 2: Waste or Not? Mortgagor does not replace roof of mortgaged premises Mortgagor fails to pay real estate taxes ($150,000) when they become due Mortgagor enters into a 10-year belowmarket rent lease with a new tenant Mortgagor increases casualty insurance deductible from $10,000 to $1MM
Nonpayment of Real Estate Taxes Older decisions: nonpayment of taxes was not waste (b/c land is unchanged in its physical character) E.g., State v. Kaye (Mo.Ct.App. 1900) ( The nonpayment of taxes was not damage or waste to the lands. ) Nearly all recent case law (e.g., Spencer s) and Restatement 4.6(a)(3) holds that nonpayment of taxes = legal waste Rationale: failure to pay taxes harms mortgagee s security, b/c local government s lien for unpaid taxes has priority over mortgagee s lien! Mortgagor fails to pay real estate taxes ($150,000) Unpaid mortgage balance owed to Ætna = $6,000,000 FMV of mortgaged land = $7,000,000 How much can Ætna recover from Mortgagor in an action for waste based on nonpayment of taxes? Problem 3 Answer depends on what theory the state follows Title theory states = Ætna could recover $150,000 Mortgagee is title holder, and is thus entitled to damages for full reduction in value of land Ætna has to apply damages to reduce unpaid debt! Lien theory states = Ætna can recover no damages Under lien theory, mortgagee can recover damages equal to the amount by which its security is impaired Here, no security impairment (even after tax lien arises, land is still worth $6,850,000, more than the $6,000,000 balance) Problem 2: Waste or Not? Mortgagor does not replace roof of mortgaged premises Mortgagor fails to pay real estate taxes ($150,000) when they become due Mortgagor enters into a 10-year belowmarket rent lease with a new tenant Mortgagor increases casualty insurance deductible from $10,000 to $1MM
Insurance Deductible Change in deductible threatens Lender s security, but it is not waste (no physical change to land and no immediate impact on the land s value) Mortgagee must address this threat by covenant (contract) E.g., Fannie DOT 5 [p. 1443]: insurance shall be maintained in the amounts (including deductible levels) and for the periods that Lender requires Failure = default; Mortgagee can accelerate In economic terms, a below-market lease reduces the land s value to Landlord (land s value is a function of net rentals the land generates) The longer the term of the lease, the greater the financial impact It is not waste, however (as there s no physical damage or change to land) Lenders address this risk by contract (e.g., Assignment of Rents: entering into belowmarket lease w/out Lender s prior consent = default) Sweetheart Lease? Nonrecourse Loans On nonrecourse commercial mortgage loan, the Lender often requires a guaranty agreement from one or more principals of the Borrower Typically, a guarantor takes on personal liability for repaying the guaranteed debt, or some portion of it How is the guaranty agreement in Problem 4 different from a typical guaranty? Nonrecourse Carveout or Bad Boy Guaranty Under the Guaranty in Problem 4, the guarantor takes on personal liability, not for the debt itself, for certain bad acts or bad conduct, including: Waste [ 1(f)] Nonpayment of taxes or charges that would result in mechanics lien [ 1(j)] Misappropriation of rents [ 1(c)], insurance proceeds [ 1(b)], condemnation awards [ 1(b)], or tenant security deposits [ 1(e)] Uninsured portion of casualty loss [ 1(i)] Loss due to criminal forfeiture of mortgaged property [ 1(g)]
Uphoff owns a home, subject to a mortgage held by Bank Uphoff carries fire insurance on the home with State Farm Bank is not carrying a separate policy on the home; Uphoff s policy says nothing about Bank s interest as mortgagee Uphoff s house is struck by lightning and it burns to the ground Does Bank have any claim to the insurance proceeds payable under Uphoff s fire insurance policy? Insurance Problem Casualty Insurance: Realty Mortgagor and mortgagee each have insurable interests in the mortgaged property Either (or both) are capable of insuring those interests Problem: if both parties carry duplicative insurance vs. casualty, it s a waste of resources Thus, mortgage forms customarily require the mortgagor to insure both parties interests E.g., Fannie/Freddie DOT [p. 1245, 5] Common law: casualty insurance contract is between insurer and insured party; mortgagee has no claim against insurance proceeds payable under mortgagor s policy, unless either: (1) the policy expressly insures the mortgagee as well, or (2) the mortgage by its terms expressly obligated mortgagor to insure the property for the mortgagee s benefit In situation (1), Bank would have claim as insured party In situation (2), courts treat mortgagee as having an equitable lien on insurance monies [p. 453] As a result, mortgage documents impose this obligation expressly [Fannie/Freddie DOT, p. 1442-1443, 5] Restatement 4.7(a)(1) confirms this result Casualty Insurance: Personalty Compare Article 9: Insurance monies for damage to personal property collateral constitute proceeds of collateral [UCC 9-102(a)(64)(E)] Security interest in original collateral automatically extends to proceeds [UCC 9-315(a)(2)] Thus, under Article 9, a secured party has lien on insurance proceeds from damage to collateral, without regard to: Whether the policy expressly insured the secured party s interest, or Whether the security agreement obligated the debtor to insure the collateral for the secured party s benefit
Insurance Clause in Mortgages [Fannie 5, p. 1442] Policy must include standard mortgage clause Insurer can t deny coverage vs. mortgagee, even if it could ve denied coverage vs. the mortgagor (e.g., arson by mortgagor) Policy must name mortgagee as an additional insured (proceeds jointly paid to both parties) Policy must provide that insurer can t cancel the policy without prior notice to mortgagee Mortgagee can force-place coverage (and add that cost of that coverage to the unpaid debt) if mortgagor s insurance lapses Problem 1: Control of Insurance Proceeds 1994: Bailey bought home for $100K Bailey borrowed $90K from Bank, 30-year mortgage, 10% interest 2014: Fire occurs; Insurer pays $50K (cost to repair) Balance due on mortgage loan at time of fire = $63K Bank wants to apply insurance $$ to reduce debt to $13K Bailey wants to use proceeds to rebuild the house If mortgage is silent, who gets to control the proceeds? Why Should Bailey Get Proceeds to Rebuild? Bailey expected to have 30 years to repay the loan, unless he defaulted He wasn t responsible for the fire If home is rebuilt, Bank will be more than fully secured, so its security isn t really threatened Contract should be enforced in accordance with reasonable unexpressed expectations, so court should allow Bailey to rebuild (if mortgage contract doesn t prohibit that result) Why Let Bank Apply Proceeds to Debt? Monitoring reconstruction of mortgaged property involves risk to mortgagee Bailey might divert funds, or might fail to pay contractors who might obtain mechanics liens Bank may not like Bailey s rebuilding plans Bailey s financial condition may have changed At this point, the interest rate on Bailey s loan may no longer be favorable to Bank (it may now be below-market if rates have increased)!
Traditional default rule: if mortgagee has a valid lien against the insurance proceeds, mortgagee can apply them against the debt Mortgagee with valid lien on insurance proceeds does NOT have to make them available for rebuilding, unless mortgage so requires Under this approach, if Bailey wants to rebuild, he can do so, but he d have to go out and get a new mortgage loan (and pay off the $13K outstanding balance on the old mortgage) Fannie Uniform DOT 5 [p. 1444: Unless Lender and Borrower otherwise agree in writing, any insurance proceeds... shall be applied to restoration or repair of the Property, if the restoration or repair is economically feasible and Lender s security is not threatened. [This flips the traditional default rule.] Traditional (majority) rule Starkman rule [Restatement 4.7] Schoolcraft (only in California) Mortgagee can apply proceeds to debt, unless mortgage provides otherwise Mortgagee must make proceeds available for restoration (to extent its security is not impaired), unless mortgage provides otherwise Mortgagee must make proceeds available for restoration (to extent its security is not impaired), EVEN IF mortgage provides otherwise Credit Bidding At foreclosure sales, third parties bidding at the sale typically have to bid/pay in cash By contrast, the foreclosing lienholder can credit bid (i.e., bid against the outstanding debt) E.g., Bank is foreclosing mortgage vs. Debtor s home At time of foreclosure, mortgage balance = $200K Bank can credit bid until the bid amount surpasses $200K Uphoff defaulted on mortgage to Bank (balance = $200K) At foreclosure sale, Bank buys home for a $200K credit bid Unknown to Bank, the home had burned down the night before! State Farm pays Uphoff $200K under his insurance policy (assume this was the insured loss) Does Bank have claim to the money? Problem 2
Effect of Full Credit Bid When mortgagee buys at foreclosure sale by making a full credit bid, the mortgage debt is satisfied in full At time of fire, the Bank s insured interest was as a mortgagee However, Bank suffered no loss as mortgagee, because the debt was repaid in full by virtue of the credit bid! Thus, Bank has no claim against insurance funds, and Uphoff gets the insurance money! Is this a sensible result? Insurance Proceeds for Post-Foreclosure Loss Note 7, page 468: If fire had occurred AFTER mortgagee purchased home at foreclosure by credit bid, mortgagee would have claim against insurance proceeds Note: this is true where (1) policy insured mortgagee as an additional insured or (2) where mortgagor was obligated to provide insurance for benefit of mortgagee Insurance Certificates ACORD 28 (Evidence of Commercial Property Insurance) form distributed in last Tuesday s class This form is commonly provided as proof of insurance Note: if the form is wrong (i.e., if it says the policy covers replacement cost, but the actual policy does not), the policy controls Thus, a lender cannot rely on review of the certificate as a short cut ; must review the policy itself Escrows for Insurance/Taxes Mortgage often requires mortgagor to make escrow payment each month = 1/12 of expected annual cost of taxes, insurance, PMI [Fannie DOT, 3, pp. 1440] Mortgagee uses escrow funds to pay these costs as they come due during the year Escrow is mandatory for residential mortgages (Fannie/Freddie requirement) By contrast, escrow is negotiable (and is often waived) on commercial mortgages
Escrow Deposits: Interest Some state laws require a lender to pay interest on escrow deposit balances (note: no such requirement in Missouri!) Note: OCC regulations [12 CFR 560.2] pre-empt any state laws that would require federally chartered S&Ls to pay interest on escrow deposits Fannie DOT [ 3, p. 1441]: Unless an agreement is made in writing or Applicable Law requires interest to be paid on the Funds, Lender shall not be required to pay Borrower any interest or earnings on the Funds. Waiver of Escrow: Drafting If commercial borrower wanted a waiver of escrow requirement for insurance/taxes, what kinds of protections would you want to draft into the loan documents? Nonpayment = breach/default Borrower will provide Lender proof of payment in advance (in time for Lender to act if proof is not provided) Insurance policy to provide notice to Lender prior to cancellation