Commercial Foreclosures in Lien-Theory States – Pre-Trial
By Thomas P. Wert[1]
The judicial mortgage foreclosure process is a central fact of life in a little less than half of the states in the U.S., the so-called “lien-theory” states. In lien-theory states, the lending institution receives a mortgage on real property as collateral for a loan. The other half of the Nation, in which the lender holds title to the property in the name of the borrower through a Deed in Trust, i.e., “title-theorystates,” usually handles foreclosure through a non-judicial proceeding.[2] In my home state of Florida, a lien-theory state, the process is structured as an ordinary civil lawsuit, which can be very simple or extraordinarily complex, especially in the commercial setting. The following is a summary[3] of some pre-trial considerations for lawyers engaged in commercial foreclosure actions in lien-theory states.
Mortgage Foreclosure Basics
In Florida, like most lien states, a mortgage provides a right of foreclosure rather than a conveyance of legal title or the immediate right to possession of the property. The lender or mortgagee has no right to possess the mortgaged property until actual title is issued in its favor. The mortgage does not create an interest in real property but rather creates a chose in action empowering the holder to foreclose. Therefore, a foreclosing lender must have that chose in action adjudicated in order to “foreclose” on its collateral.
“Foreclosure” is the act of terminating all rights to a particular piece of real property, including the equitable right of redemption,[4] of the owner/mortgagor and any interests inferior to the foreclosing mortgagee, e.g., junior encumbrances or liens. In Florida, a successful foreclosure action results in a final judgment of foreclosure which orders the property to be sold at public auction. All rights of the mortgagor and junior lienholders are extinguished after the foreclosure sale.[5]
The Right to Foreclose: Default and Acceleration
The right to foreclose a mortgage is triggered by a default under the mortgage. What constitutes a default is defined by the terms of the mortgage and defaults are typically categorized as either monetary defaults or non-monetary defaults. Monetary defaults are simply the failure by the borrower or mortgagor to make payments under the note underlying the mortgage when due. In the case of a fully matured note or a demand note, the obligation is typically absolutely and unconditionally due, so if demand is made and the borrower does not pay, a default is pretty cut and dry. But, disputes frequently arise when defaults are called and the obligation accelerated before maturity. Acceleration provisions, which permit a lender to accelerate the entire balance due when a default occurs before maturity, are certainly enforceable under constitutional protections safeguarding the right to contract. A valid acceleration, e.g., filing a foreclosure action, can even occur prior to the lender giving notice to the borrower of such a demand. A borrower can prevent acceleration by tendering arrearages prior to acceleration of a mortgage. Tender requires actual monies delivered by the borrower to the lender and not merely an offer to pay.
Lenders must remember that a foreclosure action is usually an equitable proceeding. Therefore, acceleration can be defeated where equitable circumstances or unconscionable actions warrant a denial of foreclosure. For example, a judge’s denial of foreclosure of a mortgage where the mortgagor was on military deployment overseas has been upheld where the mortgagor suffered personal hardship of his daughter’s need for hospitalization in the U.S. and the mortgagor was only one month behind in payments. Embezzlement of a mortgagor’s payments by a third party has been seen as an adequate excuse to deny acceleration. Defenses such as waiver and estoppel are also a basis for denying acceleration. Where a mortgagor’s understanding that late payments will be accepted is induced by the representation or conduct of the lender, acceleration may be denied. Similarly, where a lender accepts substantially all of the arrearages, the lender may waive the right to accelerate. As a result, it is probably prudent for a lender to give notice and an opportunity to cure before instituting a foreclosure action based upon accelerated indebtedness.
Most mortgages also impose numerous provisions which do not involve the payment of money, which if violated entitle the mortgagee to accelerate the debt and foreclose, i.e., non-monetary defaults. Provisions requiring that insurance bemaintained upon mortgaged property, that property taxes be paid or that the mortgagor stay current in payment upon prior mortgages fall into this category. With such non-monetary defaults, there looms the possibility that a court may find that the borrower’s breach is not sufficiently material to warrant foreclosure. For example, where only a small portion of a property was taken in an eminent domain proceeding, a Florida court held that the resultant breach was merely technical, the security was not impaired and, as a result, foreclosure was not warranted.
Priority of Interest
One of the initial considerations in determining whether a foreclosure action will benefit a lender is priority of interest. Simply put, it makes virtually no sense for a junior lien holder to foreclose on a property unless it is willing to make arrangements to make arrangements with the senior lien holder so that its interests will be protected from foreclosure itself. Generally, lien priority of interest is determined by the maxim “the first in time is the first in right.” Thus, priority of a lender’s mortgage is determined by the date the mortgage is recorded in the public records. The priority of judgment liens is established by the time of recordation in the public records, although judgment-lien priority can be superseded by a bona fide purchaser for value. Mechanic’s liens or construction liens usually attach on the date the Notice of Commencement is recorded on the construction project. Federal tax liens do not supersede prior recorded mortgages but take priority as of date of recording.
There are exceptions to “first in time, first in right.” Unrecorded interests can take priority over a mortgage if the mortgagee has prior notice of the unrecorded interest, i.e., a purchaser in possession of the property at the time of the mortgage may have a superior interest over the mortgagee. Another exception is liens created by real property taxes, which are often granted super priority regardless of when a mortgage is recorded. A practitioner should check the rules of priority in the forum jurisdiction to ensure that his or her client is in a place in the priority chain where the client can benefit from a foreclosure action.
Foreclosure Alternatives
Even where a default is clear, most lenders in today’s foreclosure glut must consider foreclosure alternatives. Lenders must first evaluate the collateral to determine if the cost and delay of a potentially long foreclosure action will ultimately be the most economical choice. This determination requires an appraisal confirmation that the value of the property is sufficient to cover costs of litigation, plus marketing and selling the property, plus the expense of carrying the property until sold. Typically, the commercial lender with the aid of an appraiser is best suited to perform this analysis, rather than the attorney. Regardless, somebody needs to conduct such an analysis before the foreclosure process begins because, needless to say, the process is expensive.
A quick inspection of the property should also be made to ensure it is secure from theft, vandalism and possible waste by the borrower or tenants. Confirmation should be made promptly that adequate insurance coverage is in effect and that real property taxes are not seriously delinquent. If the property is in immediate risk of harm for any reason, the lender should consider the appointment of a receiver for the property. The lender may also need to front the funds necessary to insure the property or to keep the taxes relatively current in the interim (most mortgages allow these amounts to be added to the underlying debt). Consideration should also be given as to whether the lender is entitled to have any rents on the property paid into the registry of the court or into a designated account, pending adjudication of the lender’s right to the rents, to ensure they are not wasted or misappropriated by the borrower. Many states, such as Florida, have statutory procedures for such remedies.
A frank assessment of likely defenses must also be made to determine the possible length of the proceedings and the potential liability for the lender. If delay or exposure to liability are a significant risk, there are various work-out mechanisms available. The parties can always renegotiate the terms by postponing payments, lowering interest rates or adding collateral. Under such circumstances, a lender should always seek a written acknowledgement of the debt, including principal, interest, attorneys’ fees and other costs. The modified agreement should confirm that these obligations are unconditionally due without claims, defenses or offsets of any kind and all claims should be expressly released.
The sale of the property is commonly the first alternative sought by the borrower, whereby the mortgagor’s obligations are satisfied by the proceeds from the sale. However, in commercial cases in today’s market, lender’s do not frequently possess the patience or the flexibility necessary to facilitate such a sale. After all, if the property could be sold for a price that would pay off the lender, the borrower would probably not be in default in the first place.
Frequently, a take-out by a new lender or note buyer is another alternative to foreclosure. This is usually accomplished by the lender accepting a discounted payoff of principal and/or interest. The new lender or note buyer will take an assignment of the original loan documents so that the new lender will enjoy the original lender’s priority over inferior interests.
Deeds in lieu of foreclosure are commonly the preferred work-out solution for lenders. The lender receives a deed of the property in lieu of foreclosing the mortgage and, thereby, avoids the cost and delay associated with the foreclosure process. By granting a deed in lieu, a borrower forgoes any equity the borrower believes it may have in the property in exchange for saving the expense and avoiding the exposure of litigation. The borrower will typically ask for a release from any deficiency between the value of the property and the amount of the debt and a release of any personal liability of any guarantors. Obviously, a lender must analyze the financial ability of the borrower and the guarantors before agreeing to such an arrangement. But, the reality is that chasing individual guarantors is a time-consuming and predominantly fruitless endeavor. Most likely, the savings of time and expense gained through a deed in lieu will outweigh the likelihood of collecting on a deficiency judgment from the borrower or guarantors.
There are pitfalls with deeds in lieu. In particular, junior liens and encumbrances must be considered when analyzing the prospect of a deed in lieu. Non-merger language must be included in the deed which expressly disclaims any merger of the mortgage with the fee-simple interest of the prior mortgagor and preserves the rights of the mortgagee under its mortgage. Otherwise, the priority of the lender’s mortgage theoretically could be eliminated and the mortgagor’s new deed will be subject to the junior encumbrances, without any right to foreclose them.
Another issue may arise if the mortgagor is released from the deficiency. It is axiomatic that the efficacy of a mortgage is dependent on the existence of an underlying debt. If there is no debt, the mortgage is a nullity. If the lender in exchange for the deed in lieu gives an unqualified extinguishment of the debt in releasing the deficiency, i.e., simply cancels the note, a junior lien holder could theoretically contest the foreclosure afterwards contending that the mortgage is no longer valid. This argument can be avoided by simply releasing guarantors and not the borrower and/or by granting the borrower a covenant not to sue rather than a full release. Lastly, the release of the borrower could be held in escrow until the foreclosure proceeding is complete, including any appeals.
Other Pre-Filing Considerations
Other pre-filing considerations include:
Default Interest and Usury Consideration – Analysis of interest claimed is critical because late charges may be deemed as adding interest and placing the loan above the lawful limits under usury laws (Florida law allows for a usury purge where a lender can notify the borrower of an overcharge and refund the amount plus interest, as long as the notice is sent prior to claim of usury);
Analysis of Choice of Law Provisions - The substantive law of the forum state may not be applicable depending upon the terms of the loan documents (although the procedural rules and remedies are controlled by the forum state’s laws), so if the borrower has possible defenses, an analysis of the contractually agreed upon state law should be completed before filing to determine the likelihood of success;
Waiver of Jury Trial Provisions - Mortgage lenders generally prefer bench trials over jury trials and most standard loan documents contain waivers of the right to trial by jury, which are generally enforceable as long as they are conspicuous and unambiguous, although they can potentially be defeated if the borrower was somehow fraudulently induced into agreeing to the provision;
Parties–
Plaintiff - The proper plaintiff is the holder of the note and mortgage at the time the action is filed;
Defendants – include the title holder of the mortgaged property, all parties who are revealed through a title search to have an interest in the property subordinate to that of the foreclosing plaintiff and possibly parties with leases or other contracts, e.g., sales contracts, related to the property.
The Foreclosure Process
Each state has its own unique foreclosure procedure. Attorneys need to be familiar with a particular state’s foreclosure statutes and procedures before filing a foreclosure action in that state because they vary significantly. Despite these variances, in lien theory states, the foreclosure action is typically handled procedurally like any civil law suit. The foreclosure action is instituted by the filing of a complaint in the county in which the property is located and the complaint served upon the defendants. The defendants typically have twenty to thirty days after serviceof the complaint to respond. At the time the lawsuit is instituted, a lis pendens is also usually required to be recorded, which gives notice to the world that the mortgagee intends to foreclose the mortgage.
Answer and Defenses
If the complaint alleges a legally valid cause of action for foreclosure of the mortgage, the defendants will be required to serve an answer to the complaint, in which defendants either admit or deny particular allegation in the complaints and assert any defenses the defendants believe they may have to the relief requested. Defenses available to a mortgagor can be classified into four general categories: contractual defenses, equitable defenses, statutory defenses and lender liability defenses. Contractual defenses may include failure to give notice of default, lack of consideration, accord and satisfaction, payment, fraud, coercion, duress and undue influence. Equitable defenses include waiver, estoppel, laches, marshalling of assets and merger. Statutory defenses include usury, limitations and RICO defenses. Lender liability defenses include breach of the duty of good faith and fair dealing, excessive control by the lender over the borrower, fraud resulting in a breach of a duty to lend, breach of fiduciary duty, equitable liens on undisbursed construction loan proceeds and negligent processing of loan applications. Some of these defenses obviously may also give rise to counterclaims against the plaintiff, e.g., RICO and claims on undisbursed construction loan proceeds.
Discovery
In many mortgage foreclosure cases, it is completely unnecessary for the mortgagee’s attorney to take discovery, e.g., where the answer consists of nothing more than a general denial of the allegations of the complaint. However, if defenses and/or legally sufficient counterclaims are asserted, discovery will almost always be necessary. Lender’s counsel should use discovery to help prove that the facts do not support the defendants’ defenses and, otherwise, limit any remaining issues. Discovery can also be used to gain vital information concerning the condition of the property and to help determine its value. This can be used not only to obtain a foreclosure judgment but also, in the interim, to appoint a receiver to protect the property.
In commercial foreclosures, discovery should also be used by the lender to determine if there is any exposure to liability for hazardous waste cleanup under CERCLA. If a lender acquires title to contaminated property by foreclosing, it may be held liable for cleanup costs even if the contamination occurred prior to foreclosure. Therefore, it is critical to determine the activities of prior owners of the property or to have an environmental survey performed prior on the property before deciding whether to take title through the foreclosure process.