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Donald J. Weidner 1 Construction Lender vs. Permanent Lender (Text p. 728) Construction lender usually a commercial bank primarily interested in making.

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Presentation on theme: "Donald J. Weidner 1 Construction Lender vs. Permanent Lender (Text p. 728) Construction lender usually a commercial bank primarily interested in making."— Presentation transcript:

1 Donald J. Weidner 1 Construction Lender vs. Permanent Lender (Text p. 728) Construction lender usually a commercial bank primarily interested in making short term, floating rate loans Construction lending is labor-intensive and construction loan departments are usually well-staffed with loan administrators, architects, engineers and inspectors to monitor loan disbursements at every stage of a construction project.

2 Donald J. Weidner 2 Construction Lender vs. Permanent Lender (contd) Permanent lender– usually an insurance company primarily interested in a long term loan, possibly with an equity participation feature. Although two separate sets of instruments... may be used, the terms of the permanent loan are often embodied in the construction note and mortgage so that, when construction is completed, the original note will pass from construction lender to permanent lender with no need for execution of a new note by a possibly recalcitrant borrower.

3 Donald J. Weidner 3 Some Lender Liability Issues Construction Lender as the disburser of funds is expected to assure the project is being constructed as planned and that those contributing services and materials are being paid as agreed. Construction Lender Its Draw Inspector Monitors Construction Landseller Mechanics Lien Claimants Members of public Fixture financers Borrower Permanent Lender – classically, drafts itself as a notepurchaser who takes free of most defenses

4 Donald J. Weidner 4 Rice v. First Federal S & L (Text p. 238) Borrowers are appealing from a judgment of foreclosure on a mortgage they gave on a building. BCL Note for $12,000 M on bldg. to be constructed partly with loan proceeds BCL CL charges B a fee for inspection and supervision [1% of loan proceeds ] Building begins to crumble (shortly after completion) BCL Defaulted on note BCL Sued to foreclose BCL Counterclaimed for damages for negligent inspection [the building began to crumble because of construction defects]

5 Donald J. Weidner 5 Rice v. First Federal (contd) Court: a construction lender has an interest in the progress and quality of the construction of its security proportional to the amount of the money invested and would reasonably be expected to inspect the construction and be entitled to additional compensation for its additional costs in making such inspection. Does this cut for or against imposing a duty on the lender in favor of the borrower? –Courts apparent rationale: it is not necessary to impose liability to induce the lender to prevent losses because the lender is already under an economic incentive to engage in loss-avoiding behavior. –Here, the Lenders agent did inspect the project.

6 Donald J. Weidner 6 Rice v. First Federal (contd) Did Lender, by undertaking the inspection of the construction site and requiring [borrowers] to pay a fee therefor, impliedly [contract] with [borrowers] to make such inspection for their benefit? If a Lender has a duty to its own shareholders to behave a certain way, should that duty extend to others who may suffer from its breach? –Such as Borrowers If you expand the beneficiaries of the duty, the shareholders lose, at least in the short run.

7 Donald J. Weidner 7 Agency Court assumed that the Lender was not acting as an agent of the Borrower. –Rest. Agency (3d)(2005) suggests the court was correct: Agency is the fiduciary relationship that arises [a] when one person (a principal) manifests assent to another person (an agent) [b] that the agent shall act on the principals behalf and [c] subject to the principals control, and [d] the agent manifests assent or otherwise consents so to act.

8 Donald J. Weidner 8 Fiduciary vs. Contractual Duties The overarching mandatory obligation in contract is to act in good faith. –Stated somewhat differently, contractual provisions must be carried out in good faith –In general, the UCC defines good faith as honesty in fact –In the case of a merchant, however, the UCC states that good faith requires both: [a] honesty in fact and [b] the observance of reasonable commercial standards of fair dealing in the trade.

9 Donald J. Weidner 9 Fiduciary vs. Contractual Duties (contd) The primary fiduciary duties are (a) care and (b) loyalty, with loyalty being very powerful. It is often easier to establish a breach of a fiduciary duty than of a contractual duty –Burdens are often shifted against those who are classified as fiduciaries There may be greater remedies for breach of a fiduciary duty than of a contractual duty –Tort remedies, and not merely contract remedies, are often available for breach of fiduciary duties Including punitive damages.

10 Donald J. Weidner 10 1.In Kham & Nates Shoes (Text p. 236), Judge Easterbrook stated: Firms that have negotiated contracts are entitled to enforce them to the letter, even to the great discomfort of their trading partners, without being mulcted for lack of good faith. Although courts often refer to the obligation of good faith that exists in every contract... this is not an invitation to the court to decide whether one party ought to have exercised privileges expressly reserved in the document. (emphasis added) Good Faith as Gap-Filler Only

11 Donald J. Weidner 11 Kham & Nates Shoes (contd) Kham & Nates Shoes (continuing the Easterbrook quote): –Good faith is a compact reference to an implied undertaking not to take opportunistic advantage in a way that could not have been contemplated at the time of drafting, and which therefore was not resolved explicitly by the parties. When the contract is silent, principles of good faith…fill the gap. They do not block use of terms that actually appear in the contract. (emphasis added) 2. See also Penthouse (Text p. 744).

12 Donald J. Weidner 12 Jeminson v. Montgomery Real Estate (Text p. 239) Lender (mortgage corporation) in 1970 loaned a member of the urban poor the $11,800 purchase price for a home. Lender knew she was on welfare and uneducated. She gave Lender her note and mortgage, which the Federal Housing Administration insured. Shortly after she moved in, she realized that the seller had fraudulently misrepresented the condition and value of the property. She abandoned the house as uninhabitable, stopped paying on the mortgage, whereupon the mortgage was foreclosed.

13 Donald J. Weidner 13 Jeminson v. Montgomery Real Estate (contd) She then sued Lender, arguing she was unemployed and uneducated, and that Lender knew or should have known of the sellers notorious and unscrupulous business practices. She argued two lines of authority: 1. The precedent of the Connor case; and 2. The cases that denied holder in due course status to parties who accepted notes either in bad faith or when a legal defect appeared on the face of the instrument Some of these are known as the close connectedness cases.

14 Donald J. Weidner 14 Connor v. Great Western S & L ( 1968 California case discussed in Jemison at pp. 240 ff.) Homebuyers purchased new homes from a Developer and the homes started to crumble. Homebuyers sued the S & L that provided the construction financing alleging, inter alia, negligent supervision of construction (the design of the homes was inadequate for the soil conditions). S & L was not the seller of the homes but provided Developer land acquisition financing, construction financing and permanent financing for the home buyers. Developer had no large-scale tract experience. S & L inspected the construction site at least once a week

15 Donald J. Weidner 15 Connor v. Great Western S & L (contd) S & L had many sources of return from financing this new development: –Sale/buyback of property by developer to and from the S & L gave the S & L a return on the site acquisition financing –Developer paid S & L a financing charge on the site acquisition loan and interest on the site acquisition loan –Developer paid S & L a financing charge and interest on construction loan. –Homebuyers paid S & L origination fees and interest on the permanent financing (the purchase money mortgages on their homes) –Developer paid S & L penalties from the developer if the home buyers obtained their permanent financing elsewhere

16 Donald J. Weidner 16 Connor v. Great Western S & L (contd) Court concluded that the Lender had a duty to the homeowners to properly supervise the construction (unlike Rice). Which the Lender breached. Connor was an outlier case. Jemison said that liability arose in Connor because lender voluntarily assumed the duty to inspect, and had become involved in the overall transaction to a far greater extent than the usual lender of money....

17 Donald J. Weidner 17 Jeminson (Court of Appeals on Connor) The Court of Appeals distinguished Connor as follows: –Because Lender in Connor had become an active participant AND either knew or should have known certain facts, Lender came under a duty to the individual purchasers to exercise reasonable care to prevent them from damages caused by major structural defects. Connor sought imposition of a duty at the point of effective financial control.

18 Donald J. Weidner 18 Jemison (Court of Appeals on Connor Contd) Connor imposed liability because the lender voluntarily assumed the duty to inspect, and had been involved in the overall transaction to a far greater extent than the usual money lender in such transactions. Connor, in effect, held the Lender liable as a principal Interestingly, Connor rejected the idea that the Lender was a partner (or joint venturer) with the Developer –There was no division of profits.

19 Donald J. Weidner 19 Jeminson (Court of Appeals on Connor Contd) There are no facts in Jeminson that suggest that the Lender took an extraordinarily active part. Indeed, the Jeminson Lender never inspected. Lender had no incentive to inspect: –[The mortgagee had no real interest in the actual sales transaction. The mortgagee was merely a source of funds, and in the usual course of prudent business practice took a mortgage for the sole purpose of securing its monetary advance to the [borrower]. Given the existence of an FHA insurance policy, the value of the collateral was inconsequential. –The lender did not retain any riskit had no skin in the game. Should the court impose tort liability to give Lenders an incentive to inform themselves?

20 Donald J. Weidner 20 Legislative Response to Connor See the California legislatures response to Connor ( Text p. 245 ). –A lender who makes a loan... to finance the... improvement of... property for sale or lease to others, shall not be held liable to third persons for any loss or damage occasioned by any defect in the... property... unless such loss or damage is a result of an act of the lender outside the scope of the activities of a lender of money or unless the lender has been a party to misrepresentations with respect to such... property.

21 Donald J. Weidner 21 Jeminson (Court of Appeals on whether Lender was on Notice of Sellers Conduct) The foreclosed homeowner asserted many allegations that the Lender knew or should have known, including the facts that –Seller had a notorious reputation for unscrupulous practices; and –Seller charged more than twice what Seller had recently paid for the property. In holding for the Lender, the Court of Appeals stated: [T]he transaction in this matter was not unitary, but binary: there were two transactions, not one: a sale followed by a mortgage. –Recall Professor Barnetts Bifurcated Transaction analysis of Tufts

22 Donald J. Weidner 22 Jeminson (Court of Appeals on whether Lender on Notice of Sellers Conduct) Given that the sale and the mortgage are separate, any fraud or unconscionability attributable to the purchase agreement cannot be ascribed to the subsequent mortgage agreement. The mortgage itself is neither fraudulent nor unconscionable; for good and valuable consideration, defendant mortgage corporation took a mortgage equal in value to the money advanced to the plaintiff.

23 Donald J. Weidner 23 Jeminson Ct. App. Rejects Close-Connectedness Analogy to Put Lender on Notice Recall that a Holder in Due Course is a holder who takes an instrument: –(i) for value, and – (ii) in good faith, * * * and – (vi) without notice that any party has a defense or claim in recoupment. UCC 3-302(a)(2) (Supplement p. 47) Arguably, knowledge of shoddy business practices of the seller means that you either –fail to take in good faith or –you take with notice that [a] party has a defense.

24 Donald J. Weidner 24 Jeminson Ct. App. Rejects Close-Connectedness Analogy to Put Lender on Notice (contd) It is possible to argue that a holder who takes an instrument is so closely connected with the payee that the holder either does not take in good faith or takes with notice of a defense. Jeminson cited authority that, to prevail against the holder under the close connectedness doctrine, two things are necessary: –(1) an extraordinary discount; and –(2) knowledge by the holder such as through an infirmity on the face of the instrument.

25 Donald J. Weidner 25 Jeminson Ct. App. Rejects Close Connectedness (contd) Jeminson said that there was no allegation that the lender was so intimately affiliated with the real estate company that the real estate companys fraud could be chargeable against the lender. There was no allegation that the Lender 1.Acted as a subsidiary of the [seller], or 2.Was the Mortgagee of all property sold by the [seller], or 3.Was otherwise somehow viewable as the alter ego of the [seller].

26 Donald J. Weidner 26 Jeminson Ct. App. Rejects Close Connectedness (contd) Finally: It might be argued that, if the [Lender] did not extend a loan to the plaintiff because she was an uneducated black person, buying a house in an allegedly deteriorating neighborhood, it might incur some legal liability under the Federal Housing Administration Act. Recall the more recent (2001) Associates case. Is this predatory lendinga loan that is not suitable for the borrower because there is little chance the borrower will be able to repay?

27 Donald J. Weidner 27 The Dissent in Jeminson and On Appeal The Dissent made two Major Points: 1. There were allegations that Lender knew, as a result of repeated dealings with the seller, that the seller had a reputation for unscrupulous practices –suggesting a duty to warn or at least to refrain from taking action that would increase the plaintiffs peril

28 Donald J. Weidner 28 The Dissent in Jeminson and On Appeal 2. Because there was a subject to financing clause, it was impossible to conclude that the transaction was binary, not unitary. Citing the reasons in the dissent, the Supreme Court of Michigan in 1976 reversed the award of summary judgment for defendant and remanded.

29 Donald J. Weidner 29 Jeminson on Remand From FSU Law Student Mike Fidrych, 2/12/09: I spoke with the attorney who argued the case for the lender (Albert Holtz) earlier today. He explained that the Michigan Supreme Court remanded for fact finding, basically to see "if plaintiffs unsupported allegations were true" and capable of establishing a "close connectedness" style relationship between the lender and the seller of the property. On remand the judge ruled that plaintiff did not establish facts to support the alleged relationship between the lender and seller, and subsequently dismissed the case. Mr. Holtz said "the only evidence the plaintiff had to offer were a few loans made by the lender to the seller over a period of several months." That was the end of the line for Jeminson v. Montgomery Real Estate and Co.

30 Donald J. Weidner 30 Jeminson Court of Appeals: Right Result? If the court should not impose tort liability on lenders to give them incentives to monitor, should regulators provide the incentive to Lenders by requiring them to have some skin in the game? –Recall the misaligned incentives that gave rise to the mortgage crisis –Risk retention may be part of the FNMA, GNMA reform package (if there ever is one)

31 Donald J. Weidner 31 Shorthand Liability for Construction Defects Connor and the Supreme Court remand in Jeminson are exceptional cases. In general, the Lender is liable for defects in the premises only in limited circumstances ( see Text p. 246 ): 1.If Lender and Developer are joint venturers 2.If a construction lender continues to disburse funds after receiving complaints about defects 3.If Lender takes over construction upon a default and completes the project The lender will not become liable for defects in construction simply by taking a deed in lieu of foreclosure and then selling the property.

32 Donald J. Weidner 32 Buy-Sell Agreements between Construction Lender and Permanent Lender ( Text p. 743 ) Buy-sell agreements usually provide: Construction lender agrees to sell to the permanent lender, and permanent lender agrees to purchase from the construction lender, a Note and a Mortgage. Permanent Lender consents to the assignment by the borrower to the Construction Lender of the proceeds to be forthcoming under the permanent loan commitment; Construction Lender agrees to sell the Note and Mortgage to no one except to the Permanent Lender and to refuse to accept prepayment; Permanent Lender agrees to buy the Note and Mortgage at par, subject to compliance with the commitment;

33 Donald J. Weidner 33 Buy-Sell Agreements Usually Provide (Contd) The remedies in the event the borrower defaults under the construction loan agreement or under the permanent loan commitment; and Borrower agrees to comply with the permanent loan commitment and to amend the Mortgage documents if the Permanent Lender requests it, –and the Construction Lender agrees to obtain such amendments from the borrower.

34 Donald J. Weidner 34 Penthouse Intl, Ltd. v. Dominion Federal S & L (Text p. 744) Overview Suit is primarily by the Developer, Penthouse, against a participating lender, Dominion, and the Law Firm that represented the participating lender. Dominion refused to fund a loan and Penthouse sued to enforce Dominions loan commitment. 6/01/83Penthouse had invested at least $65 million of its own money in a hotel and casino project that was 40% complete. 6/20/83Queen City S&L agreed to loan Penthouse $97million for construction and permanent loans, for a ten year term, provided it could get other lenders to participate to the tune of $90 million. –Commitment Expiration Date and Latest Closing Date: in 120 days 10/20/83Queen Citys Commitment Expiration Date and Latest Closing Date passedyet no closing. 11/21/83Dominion S & L decided to participate to extent of $35M.

35 Donald J. Weidner 35 Penthouse Overview (contd) November 21, 1983Penthouse and Queen City agree to extend the Commitment Expiration Date to 12/1/83 [for only 10 days?], stating also that the loan Closing Date shall be no later than March 1, 1984 (in a little more than three months) –The court was required to interpret the meaning of a Closing Date that was later than the Commitment Expiration date. February 9, 1984Preclosing Meeting: The Melrod Law Firm, acting through its partner, Gorelick, represented participating lender Dominion S & L in a gratuitously caustic way. March 1, 1984The Extended Final Closing Date agreed to by Penthouse and Queen City the previous November passed without a closing (well after the extended Commitment Expiration Date had passed) Nevertheless, the parties kept trying to work things out. Court Below held: Dominions conduct after the February 9. 1984 Preclosing Meeting and before the March 1, 1984 Final Closing Date constituted an anticipatory breach of the loan commitment.

36 Donald J. Weidner 36 Penthouse –The Project Penthouse assembled 5 contiguous parcels: (a) a fee in each of 3 parcels (subject to a declaration of encumbrances that needed to be modified or removed); and (b) a leasehold in each of 2 parcels. 1. The first leased parcel had a Holiday Inn on it. It was obtained from a Harry Helmsley Corporation (the Helmsley lease). 2. The second leased parcel had a Four Seasons Hotel on it. It was obtained from the Rothenburgs (the Rothenburg lease). Penthouse was going to use the Holiday Inn structure, rebuild the Four Seasons structure, and construct a 7-story building between these two towers.

37 Donald J. Weidner 37 Initial Commitment Expiration and Closing Initially, the Commitment Expiration Date was in 120 days, Oct./20/83, unless mutually extended in writing. The Closing was to have been held on or before the Commitment Expiration Date. If no Closing by the commitment expiration date,Lender shall have no further obligation to Borrower. Para. 17 said Lenders obligation to close the loan [is] contingent upon the satisfaction of 20 Preclosing Conditions. Para. 19 of the Preclosing Conditions said: Lenders obligation to [close] is also contingent upon execution of a participation agreement between Lender and other lenders pursuant to which said other lenders will participate in making the loan... at least to the extent of $90 million on terms... satisfactory to the Lender. Borrower was responsible for obtaining participating lenders satisfactory to Lender.

38 Donald J. Weidner 38 Loan Participation Agreement Lenders who wished to participate in the syndicate (participants) would enter into a Loan Participation Sale and Trust Agreement under which the participants would purchase from Queen City (the Lead Lender) undivided participating ownership interests in the mortgage loan. Lead Lender was to act, not as an agent, but as an independent contractor for the participants and would serve as a trustee with fiduciary duties in connection with protecting the rights of the participating lenders.

39 Donald J. Weidner 39 Dominions Participation November 21, 1983, Dominion decided to participate in the $97million loan syndicate of 12 financial institutions to the extent of $35million. Dominion accepted all of the terms and conditions of both the Loan Commitment and the Participation Agreement except that the Participation Agreement was amended to include Dominion as co- lead seller for the syndicate. Although Dominion never directly entered into a written agreement with Penthouse, Penthouse paid Dominion an up-front fee of $175,000 for Dominions agreement to participate as a Co-Seller.

40 Donald J. Weidner 40 Confusing Extension of Commitment Expiration and Closing Date[s] On Nov. 21 st, Penthouse and Queen City mutually agreed to extend the Commitment Expiration Date to Dec. 1, 1983. * * * In addition, [Penthouse and Queen City] agreed that we shall close the loan no * * * later than March 1, 1984. –How could the opportunity to close the loan continue after the commitment expired? 2d Circuit concluded that not only was March 1 st the closing date, but also that the commitment was extended to and expired on that date,

41 Donald J. Weidner 41 Unsatisfied Preclosing Conditions Once the syndicate was complete, Penthouse tried to avoid some of the preclosing conditions. Nevertheless, Lead Lender Queen Citys attorney thought that the loan could close. Lead Lender Queen City did not ask Dominion or other participating Lenders to waive compliance with the preclosing conditions. Instead, Lead Lender Queen City sent the participating lenders a letter declaring substantial progress toward meeting the preclosing conditions and scheduled a preclosing meeting for Feb. 9. Meanwhile, Dominion was having trouble selling sub- participation interests in its $35million share. –It could not legally lend a single borrower more than $18.5million. And, prior to the preclosing meeting, the title insurer raised several objections to title on the Helmsley lease.

42 Donald J. Weidner 42 To Secure the Loan Court: Penthouse was required to deliver to Queen City a mortgage on the hotel and casino and the underlying properties. –How could Penthouse give a mortgage on the two underlying properties it did not own? –Or, is a leasehold an underlying property? Penthouse was required to deliver a note secured by a valid first mortgage lien on all real estate owned by [b]orrower covering the project site and all improvements thereon and was required to provide a valid first leasehold interest in the Rothenburg and Helmsley leases and a first mortgage covering the improvements thereon. Penthouse also was required to provide assignments of its interest in the leasehold estates to be effective in the event of Penthouses default. Para. 6 required Penthouse to certify at closing that there were no violations of the Helmsley or Rothenburg leases.

43 Donald J. Weidner 43 The Helmsley Lease 1. The Helmsley lease parcel, with a Holiday Inn on it, was subject to two mortgages, the McShane mortgage and the Chase mortgage, which needed to be discharged or subordinated before Penthouse could furnish the required security. FO 1M McShane FO 2M Chase FO Lease Penthouse, who promised lenders a 1 st M Court : Unless the McShane and Chase mortgages were discharged or subordinated, if foreclosed upon, they potentially could wipe out the Helmsley lease and any security interest in that lease.

44 Donald J. Weidner 44 The Helmsley Lease (contd) 2.Further, unless the Helmsley lease was modified, the closing of the loan would itself violate the lease terms (ex., if there was a clause in the lease prohibiting further encumbrances). But the closing commitment required Penthouse to certify to no violations of the lease. 3.In short, there could be no closing without first negotiating with 1.the 1 st Mee, 2.the 2 nd Mee and 3.the Fee Owner as Lessor (unless the closing conditions were changed).

45 Donald J. Weidner 45 Other Title Problems/Lack of Progress There were other title problems with respect to the Rothenburg lease (the Four Seasons Hotel parcel) and with respect to the parcels that were owned in fee (a declaration of encumbrances). Penthouses outside counsel knew that there would need to be negotiations on the title problems, but no negotiations had begun prior to the February 9 th pre-closing meeting. The day before the pre-closing meeting, the Melrod firm, through Gorelick, was contacted to represent Dominion (the participating lender with a $35 million share).

46 Donald J. Weidner 46 Feb. 9 th Preclosing Meeting and Beyond Lipari, representing Lead Lender Queen City, circulated a Blumberg form for a plain language mortgage. The draft mortgage included a rider requiring Penthouse to satisfy each of the preclosing conditions. Gorelick, representing Participating Lender Dominion, called the documents idiotic and said the transaction was not in a position to close. –To satisfy Gorelicks concerns, Queen City and Penthouse agreed to allow Gorelick and his firm to prepare documents and to review condition compliance –they also agreed to pay his firms fees. Gorelick started requesting documents and information. March 1 (the commitment expiration and closing date) passed, but the parties kept trying to work things out. –Did this result in an implied extension of the loan commitment?

47 Donald J. Weidner 47 The Final Unraveling and the Lower Court Dominions Chairman of the Board said Lead Lender Queen City was in over its head. Other loan participants started to say their commitments had expired. Court below: Dominions conduct during February and March was an anticipatory breach of the loan commitment. Court below: the lease and title problems were minor and could have been worked out, in part through a waiver of conditions. –It found a waiver of some key conditions.

48 Donald J. Weidner 48 The Lower Court/Second Circuit Court below awarded Penthouse $128,000,000 against Dominion and its lawyer,Gorelicks law firm, who were held jointly and severally liable. –The judgment included 10 years of lost profits on the hotel and casino project In addition, $7,000,000 was awarded to Queen City. On appeal, the Second Circuit reversed, taking a philosophically different approach than the lower court: –In the guise of construing the terms of an agreement, court[s] will not make a different or better contract than the parties themselves have seen fit to enter into[.] March 1 was the final closing date and was the date on which the commitment expired. –even though the parties conduct in continuing to negotiate after March 1 st may be consistent with an implied extension of the expiration date.

49 Donald J. Weidner 49 The 2d Circuits Reversal 1.The parties bargained for a loan commitment that remained open only for a stated duration [unless mutually extended in writing] and we are not at liberty to construe that agreement in a manner inconsistent with its clear language. 1.Recall Kham & Nates Shoes (Easterbrook) (Slides 10-11, this set). 2.It does not matter that the parties conduct in continuing to negotiate after March 1 st may be consistent with an implied extension of the expiration date. The agreement required a written extension, not an implied extension.

50 Donald J. Weidner 50 The 2d Circuits Reversal (contd) 2. To determine whether there was an anticipatory breach, only conduct prior to March 1 is relevant. –On March 1, the Lenders commitment expired and there was no further commitment for Lender to breach. 3. The only example of a change requested prior to March 1, which was not required by the commitment, was Gorelicks demand concerning amendments to the Helmsley lease. –It was proper for Dominion (through Gorelick) to insist on eliminating the title and lease problems.

51 Donald J. Weidner 51 The 2d Circuits Reversal (contd) 4.It is arguable that Gorelicks demands at the February 9 th preclosing meeting were sufficiently clear and unequivocal to give rise to an anticipatory breach if his refusal to proceed was unjustified. Although closing was scheduled in just a few weeks, there were no active negotiations to resolve the title and other problems with the Helmsley lease. Milbank Tweeds Nelson testified there was no way the loan could have closed by March 1.

52 Donald J. Weidner 52 The 2d Circuits Reversal (contd) Gorelicks insistence on marketable title in the face of the objections reported by the title company by itself would justify his position that the deal was in no position to close and thus, cannot, as a matter of law, constitute an anticipatory breach. Grouping the title and lease problems with Penthouses failure to establish that it was in a position to fully satisfy all of the preclosing conditions, we conclude that Gorelick properly refused to proceed unless his concerns were addressed.

53 Donald J. Weidner 53 The 2d Circuit (contd) 5.Even if Dominion had refused to perform on time, Penthouse can not recover because Penthouse was unable to perform on time. 1.Penthouse could not perform on time unless the pre-closing conditions were waived, and 2.Queen City did not have the authority to bind Dominion to a waiver of the conditions. 6. Note the FHLBB urged as amicus that a Lead Lender should not have the authority to waive or modify significant conditions of a loan to the detriment of participants.

54 Donald J. Weidner 54 Lead Lender Authority to Waive Conditions? Does the Lead Lender have the authority to waive conditions in a way that binds participating lenders? –Court says must look both to the A. loan commitment and to the B. participation agreement. A. The Loan Commitment. Court said: under the loan commitment, Lead Lender Queen City was not empowered to waive Penthouses compliance with the pre-closing conditions. B. The Participation Agreement provided: Lead Lender was to act, not as an agent, but as an independent contractor for the participants and would serve as a trustee with fiduciary duties in connection with protecting the rights of the participating lenders.

55 Donald J. Weidner 55 The Participation Agreement The Second Circuit said that Queen City was an independent contractor, not an agent. As to its discretion: –Queen City was given discretion as to the means and manner of contractual performance, but was not empowered to make material changes that rendered the participants less secure. Even if Queen City were authorized to act as an agent for the other participants, the waiver would have been outside the scope of its authority: it would not have been authorized to waive or alter material terms or otherwise to diminish or discharge the obligation of the third person.

56 Donald J. Weidner 56 The Participation Agreement (contd) And even if Queen City had been an agent who had been delegated that authority, the authority was revoked and the revocation was communicated to Penthouse. –As a result of the communication, there could be no implied waiver. Note, even the FHLBB admitted that its policy consideration (loan participants must satisfy themselves that the participation is a loan that the participating association would make itself) is not binding if the parties agree otherwise.

57 Donald J. Weidner 57 To Summarize: Lead Lender Had No Authority to Waive Pre-Closing Conditions Lead Lender was not an agent of the participating lenders Even if Lead Lender was an agent, it did not have this authority. –It could only waive means and manner of borrower performance –It could not make participating lenders less secure Even if Lead Lender was an agent and had been given this authority as an initial matter, that authority had been effectively revoked.

58 Donald J. Weidner 58 SPECIFIC PERFORMANCE of TAKE OUT SELECTIVE BUILDERS INC. v. HUDSON CITY SAVINGS BANK (Text p. 775) PL Bank 3/11/74 Developer Permanent loan commitment in base amount of $1,200,000 which provided that it would automatically expire unless the loan was closed by January 1, 1975. Proceeds of the loan would be disbursed only upon final inspection. PL Nov. 74 Proposed closing with a holdback of $20,000, an amount the court said is the approximate dollar amount of all the unfinished work. This type of closing is not uncommon in mortgage loan transactions where new construction is involved. Took the matter under consideration. PL 12/24/74 Christmas eve notice that all must be completed and closed by January 1, 1975 (per the Permanent loan commitment). PL Time for automatic expiration passes. Carpeting, tiling was not done, primarily in non-rented apartments. Heat was not yet on in those, and developer did not want to put the heat on (which was, as a practical matter, needed to complete the unfinished work) until the units were rented. 1/1/75 PL

59 Donald J. Weidner 59 Specific Performance for Borrower? The casebook cites Selective Builders for this proposition: Courts have specifically enforced mortgage loan commitments against hesitant lenders on the theory that money damages are inadequate [as a remedy for the developer] because of the unavailability of other funding or the time required to obtain a substitute loan. However, a leading text states: (a) Manifold authorities hold that [specific performance] is unavailable [to the borrower] for breach of a loan commitment, the remedy at law being fully adequate.... (b) Selective Builders is apparently the only American case granting specific performance when no mortgage had been executed to the lender.

60 Donald J. Weidner 60 Specific Performance for Borrower? (contd) If you assume that a lender must act in good faith, does that mean that, in order to insist on the borrower meeting the deadline, the lender must have a reasonable belief that the lenders security might be impaired? –Do you look at lenders motive? What would Judge Easterbrook say? Recall the Penthouse language: The parties bargained for a loan commitment that remained open only for a stated duration and we are not at liberty to construe that agreement in a manner inconsistent with its clear language. –Any distinction here?

61 Donald J. Weidner 61 No Specific Performance for Lender Both the casebook and the leading text agree that specific performance has generally been denied to the lender on the ground that the lenders damages can be ascertained with reasonable precision based on the difference between the commitments interest rate and the current interest rate. –Even though one could argue that the lender had bargained for an interest in real property, a mortgage. Real estate historically is presumed unique. However, the lenders interest in property is only as security What of a lender who was promised an equity kicker?

62 Donald J. Weidner 62 Subordination Agreements A. In one category of cases, a seller has signed a contract to sell in which the seller has agreed to take back a purchase money mortgage for some or all of the purchase price. The contract also contains the sellers promise to subordinate the purchase money mortgage to the mortgage of the buyers construction and/or permanent lender. The seller subsequently refuses to close. In this class of cases, the question is whether the buyer may obtain a court order specifically enforcing the sellers promise to sell. Consider the language of subordination used in 4 cases in this first category:

63 Donald J. Weidner 63 Subordination Cases 1.Buyers agreed in writing to purchase from seller- defendants a parcel of raw land for subdivision purposes. The Seller agreed to subordinate the Deed of Trust which will become a second deed of trust to a first trust deed to be filed concurrently... and said first trust deed not to exceed in the amount equal to $6.50 per square foot exclusive of garages, stairways and porches. May the Buyer force the Seller to close? One way to approach the question: what further language might have been added to the Subordination Agreement to further protect the Seller?

64 Donald J. Weidner 64 More Subordination Cases There are two alternative rationales for letting sellers off the hook on account of the subordination agreement: a) uncertainty and b) unfairness. 2. Seller agreed to the following subordination clause: In the event the [buyer] should erect a building on subject property at a total building cost of not less than $75,000.00 or more than $300,000, then Beneficiary [seller] agrees to subordinate said Trust Deed to the lien of a first trust deed not to exceed 60% of the true building cost. In the event of such subordination then the payments on said Second Trust Deed loan to be $400.00 or more per month, including 5% interest.

65 Donald J. Weidner 65 More Subordination Cases 3. Seller agreed to subordinate to a mortgage from A S & L Association with specified debt service variables. Buyer got a mortgage from B S & L. Recall Kovarik v. Vesely ( Text p. 99 ), involving a buyer under a contract that provided that his financing was to be through a $7,000 purchase-money mortgage from the Fort Atkinson S & L. When Fort Atkinson denied the loan, the question was whether the buyer could be forced to close the acquisition by accepting financing from the seller.

66 Donald J. Weidner 66 More Subordination Cases 4. Seller agreed to subordinate to a Savings and Loan construction loan mortgage in an amount not greater than $500,000 at a rate of interest not to exceed 10%. B.In a second category of cases, after the construction loan is closed, something goes wrong (usually, a portion of the construction loan proceeds is diverted away from the project) and the landseller who subordinated wants its junior purchase money mortgage declared to be a first mortgage. Middlebrook-Anderson is one of the best-known cases in this area

67 Donald J. Weidner 67 Landseller/ ?Subordinator? Developer Agrees to pay over time: gives Note and Mortgage Contract to sell land on credit Agrees not to record mortgage until after construction loan mortgage is recorded (subordination agreement?) DeveloperCL Construction Loan Agreement for the benefit of construction lender and developer only Note and Mortgage Landseller/ ?Subordinator? CL Records Construction Loan Mortgage Records Purchase Money Mortgage CL Developer Disburses $1,500,000 [$300,000 is used for something other than construction] Developer defaults; project is thrown into foreclosure; foreclosure sale proceeds will not be sufficient to satisfy both the CL and the landseller. To what extent does CL have first mortgage priority? Middlebrook-Anderson v. Southwest S&L (Text p. 777)

68 Donald J. Weidner 68 Middlebrook-Anderson (contd) Construction Lender disbursed $1,400,000 into a construction loan account. Most of it went into construction but $300,000 of it disappeared. Landseller, who recorded his purchase money mortgage after the construction loan mortgage was recorded, nevertheless sued to obtain mortgage priority over the construction lenders prior recorded mortgage. Landsellers claim was based on the failure of the [construction] lender to limit the use of the loan funds for construction purposes.

69 Donald J. Weidner 69 Middlebrook-Anderson (contd) Buyer (Developer) represented to the Seller that the funds received from the construction loan would be used exclusively to construct improvements on the property. Did the Buyers (Developers) representation to the Seller bind the Lender? That is, did it become a condition precedent to the Lenders first lien priority? –If Buyer (Developer) is not an agent of its Construction Lender, how is the Construction Lender bound by Buyers (Developers) promise?

70 Donald J. Weidner 70 Middlebrook-Anderson (contd) What were the arguments that the law of subordination agreements should not apply? –There was no document called a Subordination Agreement that could be interpreted or applied; and –Subordination involves converting a senior lien into a subordinate lien whereas here the Landseller never had a senior lien to convert into subordinate status.

71 Donald J. Weidner 71 I. Is there a Subordination Agreement? Court applied the law of subordination: Subordination is, strictly speaking, a status, not a form of litigation. It refers to the establishment of priority between different encumbrances on the same parcel of property, by some means other than the basic priority involved in the concept of first in time, first in priority, or the automatic priority accorded purchase money liens. By statute, a purchase money deed of trust is prior to other liens on real property. Landseller recording second reflects a typical automatic subordination arrangement, which Lenders prefer to written agreements because of the reluctance of courts to enforce written agreements that are deemed to be unfair to the seller.

72 Donald J. Weidner 72 II. Assuming the Law of Subordination Agreements applies, what Duty, if any, Does a Construction Lender Owe to a Subordinator? A.One Possibility: A duty is imposed as a matter of Tort law. As in Connor, a lender who actively participates in a project has a duty imposed by tort law, in this case a duty to the seller- subordinator. A.Because the construction lender is the best person to avoid the lossthe person who has effective control (even if there is no active involvement beyond the Lenders usual role)? B.Does the construction lender already have an incentive to avoid loss? C. What would the tort duty bereasonable care?

73 Donald J. Weidner 73 Duty of Construction Lender to Subordinator (contd) B. Another Possibility: A Duty is imposed as a matter of Contract law. 1st Argument in Contract: Seller-Subordinator is a third- party beneficiary of the Construction Loan Agreement between developer and construction lender. --However, the Middlebrook Construction Loan Agreement stated that it was for the benefit of borrower and lender only. What did court say in response to that language? 2nd Argument in Contract: Construction lender is a third- party beneficiary of the Subordination Agreement between seller and Developer and must perform its part of the agreement before it can enforce it. --However, there was no document called a subordination agreement. What did the Middlebrook court say in response to the absence?

74 Donald J. Weidner 74 The Agreement in Middlebrooks- Anderson Court implied an agreement of subordination from the Lenders actual knowledge of the... sellers lien... and of the subordination....(factors always present?), under which the Lender had a duty to satisfy before it could enforce the Sellers promise to subordinate) Court gave the following reasons for the implication: 1.Lender is in a better position than the Seller to control the use of the loan proceeds to prevent misappropriations by the Developer. 2.Lender can require documentary evidence that expenses have been incurred and can corroborate this by on-site inspection. 3.If Lender loses priority as a result of improper disbursements, it can redeem the Sellers purchase money mortgage and thereby own the property for a price presumably less than fair market value.

75 Donald J. Weidner 75 Reasons for Implying An Agreement Conditioning Subordination on Lenders Performance of Duty (contd) 4.By contrast, if the Sellers mortgage is junior to the construction loan mortgage, the Seller is not normally in a position to protect itself by redeeming the larger construction loan mortgage. 5.A construction Lender has the additional remedy of a deficiency judgment whereas a purchase money mortgagee does not (in California). 6.The Lender is in a better position to avoid loss.

76 Donald J. Weidner 76 Reasons for Implying An Agreement Conditioning Subordination on Lenders Performance (contd) 7. Allocation of loss to the lender gives the lender incentive to contract to cover the contingencies. –Doesnt the lender already have an incentive to exercise care (recall the Rice case)? Does this sound like contract or tort? –Court said it was deciding the case as a matter of contract law

77 Reasons for Implying An Agreement Conditioning Subordination on Lenders Performance (contd) If it is a matter of contract law: –Presumably, punitive damages are not available in the event of breach of the duty. –If the contractual promise is a warranty, then the Lender has no defense on the ground that it exercised reasonable care If this is a contract rule, is it a default rule or a mandatory rule? Donald J. Weidner 77

78 Donald J. Weidner 78 Cambridge Acceptance Co. v. Hockstein 246 A.2d 138 (N.J. Super. Ct. 1968) I. Fee Owner, Hockstein, entered into a ground lease with Tenant, American, under which: Fee Owner leased vacant land to Tenant. Tenant agreed to construct a 52 unit motel. Fee Owner agreed to subordinate his interest to a construction loan mortgage and a take-out thereof –mortgage not to exceed 25 yrs. or $5,500 per motel unit. Fee Owner was to receive the improvements at the end of the lease.

79 Donald J. Weidner 79 Cambridge Acceptance Co. v. Hockstein (contd) II. Fee Owner, Tenant and Construction Lender entered into an Agreement: Construction Lender agreed to advance construction monies. Tenant agreed to deliver its mortgage on the land. (how does that happen?) Fee Owner agreed to subordinate his fee title (what does that mean?) to a construction loan mortgage and take-out loan.

80 Donald J. Weidner 80 Cambridge (contd) The Construction Lender disbursed monies into the Developers Master Account and none of it was applied to construction. Does Lender still have 1 st mortgage priority over subordinator? For some or all of the reasons articulated in Middlebrook-Anderson, a variety of doctrines have been used to dislodge Construction Lenders from their first lien positions.

81 Donald J. Weidner 81 Cambridge (contd) Theory # 1: Middlebrooks conditional subordination theory. In Middlebrook, $300,000 of the $1,400,000 in loan disbursements disappeared. The result of the application of the theory of conditional subordination was that lender had a first mortgage only to the extent the disbursements went into the improvement: 1) Lender got a $1,200,000 first mortgage to the extent the money disbursed went into improving the property. 2) Seller got a second mortgage for the amount of his purchase money. 3) Lender got a $300,000 third mortgage for the amount of the loan proceeds that went somewhere other than into construction.

82 Donald J. Weidner 82 Cambridge (contd) Theory #2: Landsupplier-subordinator is a third- party beneficiary of the construction loan agreement. The courts have said different things. Middlebrooks suggests that, even if the construction loan agreement provides it is for the benefit of buyer and lender only, there may nevertheless be a cause of action on this theory –Middlebrooks said there is wide latitude to admit evidence to explain what the parties intended by this language. However, in Brooklyn Trust, the landsupplier-subordinator was not permitted to claim to be a third party beneficiary of the construction loan agreement.

83 Donald J. Weidner 83 Brooklyn Trust Co. v. Fairfield Gardens 256 N.Y.S. 719 (N.Y.A.D. 1932). sued to foreclose its mortgage. Dev Fairfield Gardens Lender Prudence Company Building Loan Agreement All advances made hereunder to be secured by valid first lien. Dev did not yet have title. As of here, Dev must either pay off landseller or get him to subordinate, OR, no construction loan. RHB Landseller Riverdale Home Builders Dev Title $96,400 PMM RHBDev Additional M for $47,500 for loan and consolidated this with PMM RHB Dev got RHB to Signs a subordination agreement After examining Building Loan Agreement that specified apartments with garages. Lender 7/13/28 8/22/28 Contd…

84 Donald J. Weidner 84 Assigned Note and Mortgage RHBDev Lender Loan $ 1 st Mortgage that expressly incorporated terms of the Building Loan Agreement and the Subordination Agreement Lender Dev Defaulted Dev Accelerated and sued to foreclose s right to foreclose was clear. What was not clear: Does /Lenders Assignee or landseller/subordinator RHB have first Mortgage Priority Because the Project was Changed (the garages were not built)? Cont… The building was constructed without the garages that were specified in the Building Loan Agreement Brooklyn Trust (contd)

85 Donald J. Weidner 85 Brooklyn Trust (contd) After a loan is closed and a lender disburses money and receives its mortgage, it is more difficult to argue that the subordination agreement is unenforceable either because of a) vagueness or b) unfairness. –Because the lender has closed the loan in reliance on the subordination agreement. Did Subordinator in Brooklyn Trust lose because he did not rely on the terms of the building loan agreement? –No, some degree of reliance appears to be presumed Or, did Subordinator in Brooklyn Trust lose because, independent of his subjective intent, his subordination agreement failed to condition itself on the building loan agreement? –Yes

86 Donald J. Weidner 86 Brooklyn Trust (contd) In Brooklyn Trust, the construction lender never told the subordinator that a decision had been made to continue the project without the garages. –Should that have mattered? Court said that construction lender has only a duty of good faith. –The problem would be different if the lender cooperated with the borrower in diverting monies advanced from the purposes of erecting the building described in the building contract. This is the third theory that could be used to provide a remedy in Cambridge.

87 Donald J. Weidner 87 More Possible Theories in Cambridge Theory #3: Construction lender owes the subordinator the duty to perform its obligations in good faith. What does the duty of good faith require the construction lender to do in this context? Brooklyn Trust suggests a minimalist test for good faith: The construction lender has a duty to refrain from cooperating in the diversion of construction loan monies. –Does this duty lie in contract or in tort? UCC: in the case of a merchant, good faith requires honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.

88 Donald J. Weidner 88 More Possible Theories in Cambridge Theory #4: The promise to subordinate to a construction loan will be strictly construed, and will not be interpreted to include a promise to subordinate to a loan administered as if it were unsecured. Theory #5: The construction lender owes the subordinator the duty to refrain from gross negligence. –Compare Rice Theory #6: The construction lender owes the subordinator a duty to exercise reasonable care in disbursement. –Compare Rice

89 Donald J. Weidner 89 The Optional/Obligatory Distinction (Text pp. 736-740) Theory #7: Lender is dislodged from first lien priority because and to the extent that, after it had notice of an intervening lienor, it made payments that were optional rather than obligatory. At bottom, a construction loan is secured by a mortgage that embraces future advances. The basic notion optional/obligatory rule: the construction lender will retain lien priority as of the time the mortgage was first recorded, even as to future advances, to the extent those advances are obligatory rather than optional.

90 Donald J. Weidner 90 Optional/Obligatory (contd) On the other hand, if the future advances are optional, they will enjoy priority as of the time the mortgage was first recorded only if the lender made the future advance with no notice of an intervening lienor. Classically, the reason for the rule was to protect the borrower by preserving the borrowers ability to get junior financing from a new lender. Otherwise, a borrower could be trapped by a first lender who can expand its first mortgage security to include future advances it is not obligated to make. –Potential new lenders are less likely to become second mortgagees if the first mortgagee can choose to increase the amount of the debt covered by the first mortgagein effect, making an open- ended first mortgage of limitless size.

91 Donald J. Weidner 91 Optional/Obligatory (contd) Some courts also use the optional/obligatory distinction to protect other kinds of creditors, specifically: 1) creditors who have subordinated and 2) mechanics lien claimants. That is, an important additional reason for the rule is to protect junior lienors and not merely to protect the borrower.

92 Donald J. Weidner 92 Optional/Obligatory (contd) 1. What kind of notice to a lender is necessary to prevent an optional future advance by the lender from taking priority as of the time the mortgage was first recorded? A. Majority rule: the lender loses lien priority as to its subsequent optional advances only to the extent it had actual notice (knowledge) of an intervening lien when it made the subsequent advance. –This rule puts the burden on subsequent lienors to give a senior mortgagee actual notice of their intervening lien (they cannot simply record their junior lien).

93 Donald J. Weidner 93 Optional/Obligatory (contd) B. Minority rule: Lender loses lien priority for its subsequent optional advance if it had either actual or constructive notice of the intervening lien. –This rule puts the burden on the senior mortgagee to search the title before every optional disbursement. –The senior mortgagee also can be put on notice by facts other than those recorded with the land titles. Ex., a lienholder has been held to have been put on notice of an inchoate mechanics lien when the lien holder's site inspector saw a subcontractor on the premises. 2.For those jurisdictions that use the distinction, when is an advance optional rather than obligatory?

94 Donald J. Weidner 94 Optional/Obligatory (contd) Some courts and legislatures believe that lenders acting reasonably should not be punished by an application of the optional/obligatory doctrine. –What if a lender makes a subsequent advance to pay unpaid property taxes (to protect the collateral)? Some statutes protect the lender in this situation. –What if a lender makes a construction loan disbursement prior to the required time in order to salvage the project or keep it moving forward (economic compulsion)?

95 Donald J. Weidner 95 Optional/Obligatory (contd) Some impose on construction lenders a duty of good faith and fair dealing in their disbursement activities. Others say there is no implied duty to monitor disbursements for the benefit of borrower, subordinator or mechanics lien claimant. Some states have cut-off notice provisions that permit the mortgagor to issue a notice that freezes advances having priority under an open-end mortgage at their current amount.

96 Donald J. Weidner 96 Florida Statute on Mortgages for Future Advances (Supp. P. 95) 697.04 Future advances may be secured. -- (1)(a) Any mortgage or other instrument given for the purpose of creating a lien on real property, or on any interest in a leasehold upon real property, may, and when so expressed therein shall, secure not only existing indebtedness, but also such future advances, whether such advances are obligatory or to be made at the option of the lender, or otherwise, as are made within 20 years from the date thereof, to the same extent as if such future advances were made on the date of the execution of such mortgage or other instrument.... Such lien, as to third persons without actual notice thereof, shall be valid as to all such indebtedness and future advances from the time the mortgage or other instrument is filed for record as provided by law.

97 Donald J. Weidner 97 Lender Liability: Originators of Subprime Mortgages Recall Carrick Mollenkamp, James R. Hagerty, Randall Smith, Banks Go On Subprime Offensive, March 13, 2007 Wall Street Journal, p. A3 (Supp. P. 8): Although the specifics vary from deal to deal, repurchase agreements obligate the mortgage originator, under some circumstances, to buy back a troubled loan sold to a bank or investor. That obligation sometimes kicks in if the borrower fails to make payments on the loan within the first few months or if there was fraud involved in obtaining the original mortgage. The total volume of mortgages nationwide that might meet those criteria isnt known, but such agreements cover billions of dollars in mortgages. The materials we have just concluded suggest other theories that might be used to support a claim against the originator.

98 Donald J. Weidner 98 Leasehold Mortgages A Leasehold Mortgagee has a security interest in a defeasible estate –A term of years that can end on any number of contingencies. The leasehold mortgagee must be in a position to control all the contingencies that would end the leasehold estate. Leasehold mortgagee needs both –notice of all defaults and –an opportunity to cure those defaults.

99 Donald J. Weidner 99 Leasehold Mortgages (contd) The leasehold mortgagee seeks all the rights of the tenant. In some states, a leasehold mortgagee apparently is not bound, unless it consents, to a modification or cancellation of the original lease. –In others, it is. Leasehold mortgagee requires warranties by the tenant. Leasehold mortgagee requires the landlord to give estoppel certificates stating that the lease is still in effect and not in default.

100 Donald J. Weidner 100 Leasehold Mortgages (contd) State insurance or banking laws may require different levels of security for regulated lenders who accept leasehold mortgages as security. For example: –Mass. may require that the fee be unencumbered but –N.J. may require only that the lender have a first lien on the leasehold estate itself.

101 Donald J. Weidner 101 Leasehold Mortgages (contd) Even if there is no legal minimum on the length of the lease term, a leasehold mortgagee wants a lease term 1.longer than the life of the loan 2.with no right in the landlord to terminate the lease simply because the improvements are destroyed Recall that both these factors were present in Bolger, in which the rent obligation continued throughout the term of the lease, even if the building was destroyed.

102 Donald J. Weidner 102 Leasehold Mortgages (contd) If a senior fee mortgage is permitted, the tenant should insist that the fee mortgagee should execute protective provisions in a nondisturbance agreement. –The agreement should reserve to the tenant the proceeds of condemnation or fire insurance on the tenants improvements so the tenant can replace them. –The rent should be sufficient to service the mortgage on the fee, and the mortgagee of the fee should give the tenant notice and opportunity to cure any default on the mortgage.

103 Donald J. Weidner 103 Leasehold Mortgages (contd) Bankruptcy law retains the basic idea that a trustee in bankruptcy can assume or reject an executory contract, including an unexpired lease. An executory contract is one in which there are performance obligations on both sides. –The idea is that an executory contract is distinctive because it is both an asset and a liability. If the trustee rejects the lease, the Bankrupt Estate will be liable for the breach.

104 Donald J. Weidner 104 Leasehold Mortgages (contd) The more common situation is the one in which the tenant goes bankrupt. –Prior to 1978, a landlord could provide that the lease terminates on the bankruptcy of the tenant. Under current law, a provision that the tenants rights end in the event of bankruptcy is not enforceable. –Therefore, the tenants Trustee in bankruptcy may assume or reject the lease. –If the Tenants Trustee rejects the lease, the landlord has a claim for breach of lease in the tenants bankruptcy proceeding.

105 Donald J. Weidner 105 Leasehold mortgage with 1)promise by Cross Bridge to refrain from collecting rent from subtenants for more than one month in advance 2)rents assigned to, but waived its right to collect rents prior to any default, so the leasehold mortgagor kept collecting. Foreclosure of Leasehold Mortgage SUBORDINATION AGREEMENT IN SUBLEASES Kirkeby Corp. v. Cross Bridge Towers 219 A.2d 343 (N.J.Super. 1966) Foreclosure action brought by a leasehold mortgagee. The defendants are Cross Bridge, the net lessee of a high rise apartment building on the New Jersey side of the George Washington Bridge, and the tenant-occupants. FO Cross Bridge Sub-tenants (occupants) Ground lease Net rent Leases with subordination/ agreements Cross Bridge May, 1963 Kirkeby: LENDER $454,000 loan Records mortgage 6/7/63

106 Donald J. Weidner 106 Cross Bridge Kirkeby LENDER July, 1964 Default on Ground Lease Default on Note Institutes foreclosure and is appointed (on 8/21/64) the mortgagee in possession Sub-tenants (occupants) Sues for rent* When Lender became the mortgagee in possession, he discovered that many subtenant-occupants had prepaid rents; notwithstanding the assignment of rents to in the leasehold mortgage, and notwithstanding the subordination clause in the leases of all the subtenant- occupants. They entered into the 6 for 5 prepayment -- some did so on the advice of counsel! *Discovers that many rents have been prepaid Kirkeby Corp. v. Cross Bridge Towers (contd)

107 Donald J. Weidner 107 Cross Bridge (contd) Tenant Cross Bridge defaulted on the ground lease and on its note to Kirkeby, its leasehold mortgagee. Kirkeby instituted foreclosure and was appointed Mortgagee in Possession. Mortgagee in Possession Kirkeby discovered that many subtenant-occupants had prepaid rents, –notwithstanding the assignment of rents to Kirkeby in the leasehold mortgage and –notwithstanding the following subordination clause in the leases of all the subtenant-occupants: This lease and all rights of the Tenant hereunder are hereby made subject and subordinate to any and all mortgage or mortgages now of record or which may be hereafter placed against the premises and any and all clauses in said mortgage or mortgages contained. Mortgagee in Possession sued subtenant-occupants for rent.

108 Donald J. Weidner 108 Final thought on Cross Bridge Consider: 1. FO enters into a mortgage and records it. 2. FO subsequently leases to tenants. If the mortgagee wants to foreclose, it can add the tenants as additional defendants in its foreclosure action. However, if the mortgagee wants to hold the tenants to their leases (as in Cross Bridge), some jurisdictions (perhaps a small minority) have denied recovery, saying either: a.The leases subsequent to the mortgage can not affect the mortgagee adversely because the mortgagee is not bound to the tenants either by Privity of Estate nor by Privity of Contract. Therefore, the tenants are not automatically bound to the mortgagee who enters possession; or (perhaps another way of saying the same thing), b.There is no mutuality of remedy: if the tenants can not bind the Mortgagee, the Mortgagee can not bind the tenants.

109 Donald J. Weidner 109 Balch v. Leader Federal Bank for Savings (Text p. 828) Fee Owner executed net ground lease of 4 lots to tenant developer. –Tenant intended to construct a hotel building on the 4 lots and to construct a parking garage on 4 adjacent lots Tenant owned (similar to Penthouse). Para. 17 of the ground lease is confusing, said the court: –MORTGAGE OF THE FEE. is the title of Paragraph 17. –Then: The Lessor agrees that this lease will be subject and subordinate to the lien of the first mortgage to be held by Liberty National Life [Tenants Lender # 1]..., the maximum term of said mortgage not to exceed 30 years. –This agreement on the part of the Lessor to mortgage the fee shall apply only to the [Tenants] original construction loan and permanent financing loan and any renewal, extension or refinancing thereof. –Provided, however, that this lease shall be subordinated only for the actual cost of the improvements placed upon the demised premises or the amount of the loan, whichever is less.

110 Donald J. Weidner 110 O DEVELOPER (Ground Lessee) Fee 5/13/70 Net Ground Lease of 4 lots Owns 4 adjacent lots on which he intends to con- struct hotel parking garage Intends to construct a hotel building on the leased parcels Liberty National Life (Lender #1) Loan Signs Mortgage (M on the hotel lot that was signed by both the owner and the lessee.) Signs Mortgage (Mortgage on the hotel lot that was signed by both the owner and the lessee.) Stipulated: the Mortgage to Liberty Natl was effective to encumber the fee in the hotel lots. BalchesCrestwood (New Ground Lessee) Stipulated: the ground lease remained binding on Balch & Crestwood MORTGAGE OF THE FEE. The lessor agrees that this lease will be subject and subordinate to the lien of the first mortgage to be held by Liberty National Life (etc) [T]he maximum term of said mortgage not to exceed 30 years. This agreement on the part of the lessor to mortgage the fee…shall apply only to the original CL and permanent financing loan and any renewal, extension or refinancing thereof. Provided, however, that this lease shall be subordinated only for the actual cost of the improvements placed upon the demised premises or the amount of the loan, whichever is less. Convey Fee O Convey adjacent lots Assigned lease Developer Balch v. Leader Federal (contd)

111 Donald J. Weidner 111 Crestwood (New Ground LesseeNew Tenant) Leader Federal (Lender #2) Liberty National Life (Lender #1) Balches (New Fee Owner) 1987 Loan $ $ to pay off Liberty Natl loan (in default) Note (signed by Crestwood) M on adjacent lots M on lots (only Crestwood [the new Tenant] signed the Ms on the Balches [the NFOs] lots. The Balches did not sign the M. In fact, the mortgage recites that Crestwood had only a leasehold interest in the hotel lots. Estoppel and subordination certificates Releases Mortgage Balch v. Leader Federal (contd)

112 Donald J. Weidner 112 Balch v. Leader Federal (contd) Lender # 2 never asked the New Fee Owners to execute a mortgage in connection with the loan to the New Ground Lessee. Instead, the New Fee Owners executed Estoppel and Subordination Certificates to Lender #2. New Ground Lessees mortgage purported to be nothing more than a leasehold mortgage. When New Ground Lessee defaulted on its loan, Lender #2 attempted to foreclose on the New Fee Owners lots.

113 Donald J. Weidner 113 Balch v. Leader Federal (contd) Lender #2 argued: The Estoppel & Subordination Certificate, when considered with the lease, was tantamount to a lien on the lots of the New Fee Owners. New Fee Owners argued: they were never even asked to be a party to the mortgage and the Certificate only subordinated their interest in the ground lease, and did not mortgage their fee.

114 Donald J. Weidner 114 Balch v. Leader Federal (contd) Key language in the Estoppel and Subordination Certificate: Lessor [New Fee Owner] acknowledges and consents to the loan in the amount of approximately $1,924,000.00 by [Lender #2] to [New Ground Lessee] to be secured by a mortgage on the premises which is the subject of the Net Ground Rental Lease. Lessor recognizes that the proceeds of such loan are to repay the loan to [Lender #1] and therefore pursuant to Paragraph 17 of [the Lease], the Net Ground Rental Lease is subordinate to the loan and mortgage in favor of [Lender #2]....

115 Donald J. Weidner 115 Balch v. Leader Federal (contd) Court said the Certificate is ambiguous and must be interpreted against the drafter, Lender #2. If the Certificate does not mortgage the fee, what does it do? –By signing the Certificate, the Balches effectively either (1) agreed that the amount of the [Lender #2] loan was equal to or less than the cost of the improvements placed upon the hotel lots [within the meaning of the lease provision limiting the Lessors subordination] or (2) waived the applicable provisions of the ground lease regarding that limitation.

116 Donald J. Weidner 116 Balch v. Leader Federal (contd) According to the court, what should Lender #2 have done? –Get New Fee Owner to mortgage the Fee, or –Get New Fee Owner to authorize the Tenant to act [as its agent to] mortgage the fee, or –Draft Estoppel Certificates that clearly mortgage the fee.

117 Donald J. Weidner 117 Balch v. Leader Federal (contd) The first Fee Owner mortgaged the fee, with the mortgage covering only the original construction loan and its takeout and any renewal, extension or refinancing thereof. –With the Lender # 2 loan proceeds, Crestwood paid off the original loan, and Lender #1 released its mortgage. –Is the Lender # 2 loan a renewal, extension or refinancing of the original loan?

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