Title Theory of Mortgages In medieval times, mortgage instrument conveyed to the mortgagee a legal estate in fee simple subject to condition subsequent Mortgagor retained future interest (right of entry) If borrower timely repaid, borrower could re enter property and terminate mortgagee s estate Upon default, mortgagee s estate became absolute! Thus, mortgage was a conveyance of title Some Implications of Title Theory Unless the parties agree otherwise, during the mortgage term: Mortgagee is entitled to possession of the land Mortgagee can collect rents and profits from the land and apply them to the debt NB: during medieval times, lenders collected rents and profits in lieu of charging loan interest (prohibited by religious laws on usury) Foreclosure/Equity of Redemption Historically, there was no foreclosure process; upon default, mortgagee s defeasible fee simple title became fee simple absolute (forfeiture) This worked great inequity, esp. where value of premises >>> unpaid mortgage balance Equity jurisprudence developed foreclosure to ameliorate this inequity Over time, foreclosure evolved to require that mortgagor s interest could only be extinguished by a foreclosure sale after default Until then, mortgagor remains equitable owner of the land and retains the right to redeem complete ownership by paying off the balance of the debt Mortgagor s equitable interest became known as the equity of redemption Mortgagee s interest was thus acknowledged to be an interest for security purposes only 1
Lien Theory of Mortgages Mortgage does not convey title to mortgagee, but grants only a lien (security interest) to secure repayment of debt Mortgagor retains both legal and equitable ownership, and the right to possession, until a foreclosure sale occurs Missouri Deed of Trust Page 3: Borrower irrevocably grants, bargains, sells, conveys and confirms to Trustee, in trust, with power of sale, the following described property [property description]. 25: In turn, Trustee hereby leases the Property to Borrower until this Security Instrument is either satisfied or released or until there is a default. Do these provisions mean Missouri follows the title theory? 25. Trustee hereby leases the Property to Borrower until this Security Instrument is either satisfied and released or until there is a default under the provisions of this Security Instrument. The Property is leased upon the following terms and conditions: Borrower, and every person claiming an interest in or possessing the Property or any part thereof, shall pay rent during the term of the lease in the amount of one cent per month, payable on demand, and without notice or demand shall and will surrender peaceable possession of the Property to Trustee upon default or to the purchaser of the Property at the foreclosure sale. Missouri courts have consistently held that Missouri is a lien theory state [I]t is settled in Missouri that a grantor in a deed of trust does not convey the title to a trustee, but creates a lien on the land to secure the payment of debt, and that the grantor continues the owner of the land until entry for breach of the condition of the deed of trust. R. L. Sweet Lumber Co. v. E. L. Lane, Inc., 513 S.W.2d 365 (Mo. 1974). 2
So what is 25 trying to accomplish? It provides a formal explanation for borrower s right to possession during loan term (borrower is a tenant and thus has legal right to possession) However, lien theory makes clear that formal location of title is not controlling If parties are using borrower s title to land to secure payment of a debt, then lender has only a lien, and equitable title remains in the borrower pending foreclosure after default (substance over form) So what is 25 trying to accomplish? If mortgagee foreclosed and bought the land at a foreclosure sale, mortgagee could then bring an unlawful detainer action to evict mortgagor (based upon mortgagor being tenant under language of 25) This is no longer necessary; Missouri unlawful detainer statute now allows foreclosure sale buyer to bring unlawful detainer action w/out regard to status of mortgagor [RSMo. 534.030] Problem 3 Client holds mortgage on brother in law s rental home (rented to T) to secure repayment of $300K loan; brother in law has missed 3 straight monthly payments Client wants to start a foreclosure, but also wants to immediately change the locks (to prevent her brother in law from gaining access) and to instruct T to begin paying rent directly to her Implications of Lien Theory If jurisdiction follows lien theory, mortgagee cannot obtain legal possession of the land until acquiring that right at a foreclosure sale Until that time, lender cannot bring an action to recover possession of the land, or take possession by self help, unless the borrower either: 1) consents, or 2) abandons the land 3
Wheeler v. Community Fed. Sav. & Loan Ass n, 702 S.W.2d 83 (Mo. Ct. App. 1985) Because mortgagor neither consented nor abandoned property, mortgage s self help action in changing locks was unlawful entry Court awarded $100,000 in punitive damages In Problem 3, brother in law has not abandoned the home (rent paying tenant in possession); lock out is not available relief Problem 3: Collecting Rent? Can Client direct T to pay rent directly to Client rather than to Brother in Law? Under title theory, mortgagee can collect rents and apply them to debt Under lien theory, mortgagee s status as mortgagee does not allow mortgagee to collect rents prior to completion of foreclosure sale Q: Did Brother in Law assign his lease with T and the right to collect rents to Client as additional security for the loan? [More on Wednesday] Mortgagee in Possession If Mortgagee legally takes possession (i.e., by consent or after actual abandonment), it becomes Mortgagee in Possession [Note 4, p. 378] Consequences? Mortgagee becomes subject to owner tort liability (not imposed on mortgagee out of possession) Strict duty to maintain and preserve property for benefit of mortgagor (can t just act to preserve its own interest as mortgagee) [Compare U.C.C. 9 207] The distinction between title theory and lien theory is not as significant today; either (1) The mortgagee contractually agrees that mortgagor will have right to possession until foreclosure sale, or (2) In lien theory states, applicable law prevents mortgagee action to recover possession prior to foreclosure sale Still matters in cases where the court must resort to a default rule b/c the parties agreement is silent E.g., X and Y own land as joint tenants with the right of survivorship Without X s knowledge, Y mortgages Y s interest to Bank. Did that sever the joint tenancy and make X and Y tenants in common? In title theory states, yes (unity of title broken); in lien theory states, no 4
Lender s Underwriting/Due Diligence Mortgagee s investigation prior to making a mortgage loan focuses upon key criteria: Borrower s creditworthiness (i.e., can the Borrower make the mortgage payments?) The value and character of the mortgaged land (Mortgagee may have to buy the land at a foreclosure sale, if Borrower defaults!) For residential loans, Mortgagee s investigation focuses primarily on: 1) Borrower s creditworthiness (can he/she make the monthly payments given income and other debts?) 2) Borrower s title (does Borrower have marketable title?) 3) Value of collateral (e.g., appraisal, usually based on prices of recent sales of comparable properties) Similar criteria used for commercial mortgage loans on mortgagor occupied land (i.e., company headquarters) Lender s due diligence for income properties (e.g., office, apartments, retail) differs, b/c these are occupied by third parties under leases or other occupancy contracts Further, the owner of these projects is usually a single asset entity (i.e., a limited liability entity that owns NO assets other than the mortgaged property) Thus, the income to pay mortgage will come solely from property operations (i.e., rents paid by tenants) These loans are often nonrecourse, i.e., borrower has no personal liability to repay debt, and mortgagee s recourse is to the land (foreclosure) and any personal guarantees Commercial Loans Thus, on these transactions, lender s due diligence focuses heavily on the leases or other occupancy contracts of the mortgaged property Borrower will repay the loan using cash flow from the property (e.g., net rentals paid by tenants) Lender: If I have to foreclose, I may become the owner of the Property (thus the Landlord under the leases). Will the leases generate enough cash flow (rents) to allow me to recover the loan amount (either through operations or resale to buyer who can collect rents)? 5
Concerns for the Mortgage Lender 1) What rights does the mortgagee have versus the tenants, before and after a foreclosure sale? 2) What rights does the mortgagee have in rents from the property, and what priority does it have in those rents versus other creditors (such a junior mortgagees, judgment lien creditors, or the bankruptcy trustee if borrower goes bankrupt)? 6