Validity of Collateral Agreements in Mortgage: Understanding Equity Redemption, Study notes of Law

Download Validity of Collateral Agreements in Mortgage: Understanding Equity Redemption and more Study notes Law in PDF only on Docsity! THE EQUITY OF REDEMPTION: THE VALIDITY OF COLLATERAL AGREEMENTS WITHIN MORTGAGE TRANSACTIONS Bonnie McClain Independent Resear Prof. Skillern April 22, 1983 V»vl> M, The doctrine of the equity of redemption was developed in England as a Common Law protection against unjust enrich- ment. The equity of redemption guarantees to the mortgagor that, prior to foreclosure, upon satisfaction of all obligations under the mortgage, he may redeem his property in toto. In other words, when the mortgagor satisfies the mortgage obligation, he will be in the same position as he was prior to executing the mortgage.1 This doctrine was originally developed by the Courts of Equity, which held that it was inequitable for a good faith mortgagor to be forced to relinquish his land when the mortgagee could be made whole by acceptance of a 2 complete monetary payment. The equity of redemption is often confused with the statutory right of redemption. These two doctrines, however, do not grant a mortgagor identical protection. The equity of redemption protects a mortgagor's right to redeem his property prior to foreclosure upon full payment of the debt. The right of redemption protects the mortgagor after the foreclosure sale has occurred by allowing him to repurchase the land at a reasonable, and entered into between the parties while on equal terms without any improper pressure, unfair dealing, 12 or undue influence. English courts have examined the affect of the equity of redemption on two main collateral agreements: options to purchase and grants of bonuses. A. Options to Purchase In the early English case of Kreglinger v. New Patagonia 13 Meat and Cold Storage Company, J the court upheld the use of a collateral agreement in a mortgage document. In this case, Kreglinger, a firm of wool brokers, agreed to loan New Patagonia Meat and Cold Storage Company (New Patagonia) $ 10,000 at six percent interest. In addition to the monetary loan provisions, the mortgage included a collateral agreement. It provided that for five years the mortgagor would sell sheep skins only to the mortgagee as long as the mortgagee was willing Ik to buy at the best price offered. If the mortgagor sold the skins to other persons, it was to pay a commission to the mortgagee. The loan was not due for five years, but the agreement permitted the mortgagor to repay at any time upon giving one month's notice. After giving the proper notice, the mortgagor paid the loan amount in three years. The mortgagee believed that it still had the right to exercise the option to purchase for the full five years as was specified in the mortgage agreement. 5- The House of Lords, in Kreglinger, held that the equity of redemption did not affect the validity of the option to purchase agreement. The House of Lords concluded that the option to purchase was not part of the mortgage transaction, but rather a collateral contract entered into as a condition of the company obtaining a loan. ^ The court stated that in this case the lenders had restricted sales without "fettering" the equity of redemption. The House of Lords found that before the option to purchase agreement would be invalid, the option 1 6 must have been part of the terms of the mortgage. The court held that the option agreement was seperate from the mortgage, even though it was in the same document, and was, therefore, intended to last the full five years notwithstanding repayment of the loan. B. Bonuses English courts also have examined the validity of a grant of a bonus within a mortgage agreement. Early English cases had held any collateral agreement invalid if the agreement was contained in the mortgage document. However, by the late nineteenth century, the equity courts began making exceptions to this rule if the collateral agreement granted the mortgagee a bonus that was reasonable and was made by parties at arms length.1'7 1 R In Mainland v. Up,john the Court of Chancery made bonus agreements am exception to the general rule of invalidating any collateral agreement. The court stated that the general bViO-J 6- rule was, "that any device by which a mortgagor is made to pay on redemption more than the principal, interest, and costs, will not be upheld." 19 The court held that, where a loan had been given by a mortgagee to a mortgagor upon collateral of a speculative character, the mortgage agreement could specify that the mortgagee was to receive a bonus or commission which would be deducted from the loan amount at the time the loan was made. The court explained further that the allowance of a bonus would be valid only if the parties were on equal footing, knew what they were doing, and made the agreement voluntarily, fairly, and without undue influence.^ The English cases have engrafted these exceptions onto the general rule, so that now collateral agreements and other agreements unrelated to the debt security may be made contem- poraneously with a mortgage, so long as the equity of redemption is not "fettered." In addition, the courts have made an exception to the general rule for bonuses even if they fetter the equity 21 of redemption. A narrow exception also has been created for any agreement which the court may determine to be a condition of the loan, rather than part of the mortgage transaction, 22 even though it is contained in the same document. II. The Equity of Redemption in the United States A. Texas Law Texas case law has rarely discussed the equity of redemption as that doctrine applies to collateral agreements, Howeve 0313.-2 The courts have realized that a problem could, arise when a borrower is able and willing to repay the loan when it is due, but may be prevented from redeeming his property if the mortgagee has already exercised the option to purchase the property or at least has retained the option after repayment. The Superior Court of New Jersey in Humble Oil Refining 30 Company v. Doerr held that an option to purchase for a fixed price, contained in the mortgage, constituted a clog 31 on the equity of redemption. J In Humble, Doerr was attempting to expand his service station. He was successful in obtaining a bank commitment for a $ 20,000 construction loan which would be secured by a mortgage on the premises. A Humble Oil representitive, who serviced the present station, told Doerr that Humble could help him get better loan terms- a $ 35>000 loan at a lower interest rate and for a longer term. These terms were to be obtained by leasing the station to Humble at a rental charge equal to the amount to be charged each month on the new mortgage. Doerr was then to assign the Humble rental payments to the bank as additional security. Humble would then lease the premises back to Doerr at the same rental cost so that he could continue operating the station. The sublease gave Humble the option to purchase the premises "at any time" for $150,000. Before the end of the lease term Humble told Doerr that it chose to exercise its option. Doerr refused to perform the option, so Humble brought suit for specific performance and, in the alternative, for damages. 10. The Humble court found that the lease was really a guarantee of payment and that the option contained in the lease was an equitable mortgage securing that guarantee. Based on its finding that the agreement constituted a mort- gage, the court held that Humble was not entitled to either specific performance or damages. The court held that the option was unenforceable because it was a "clog" on the equity of redemption. The court stated, "it is well settled that an option to buy property for a fixed sum cannot be taken contemporaneously by the mortgagee." Humble was consistant with the early English "option to purchase case" Kreglinger, even though their holding differed. In Kreglinger, the mortgagee had to match the "best price offered" before being granted the option, whereas in Humble, the option remained at a fixed price. Therefore, Kreglinger's option closely resembled a right of first refusal, in which the mortgagor could still redeem his land; he simply had agreed to sell his product to a certain party at the "going rate." These facts differ from those in Humble, where the mortgagor had to sell the actual mortgaged property at a fixed rate. In Humble, the mortgagor was taking the chance that he might lose the real property prior to repayment, thus "fettering" his right to redeem. The Humble court was careful to limit its holding to mortgages. The Humble decision also was brought closer to agreeing with the Kreglinger holding when the court indicated that a different rule might apply where f\f»IOC; t« VAVVJ (1) the optionee has a right of first refusal; (2) the optionee is a joint venturer with the owner-lessor; or (3) the parties enter into a three party lease.-' C. Florida The Florida Supreme Court also has considered options to purchase and the relationship of the options to the doctrine of the equity of redemption. It granted specific performance of an option to purchase in MacArthur v. North Palm Beach Utilities. •JJ In that case, MacArthur sold a tract of land to North Palm Beach Utilities (North Palm Beach) taking back a purchase money mortgage. MacArthur also agreed to loan North Palm Beach $800,000 for the construction of a water supply and sewage disposal facility. The $800,000 was evidenced by notes and secured by a first mortgage upon the property where the water system was to be located. The mortgage agreement contained an option, which gave MacArthur the right to purchase the water system any time after the due date of the first note and any time prior to the full payment of any summ due under the mortgage agreement. The Florida court noted that, absent a loan, a seller may sell his property to a third party and reserve an option 37 to repurchase. The court decided that MacArthur should not be penalized simply because he held a mortgage. The court decided that the option agreement was valid under these circumstances. According to the commentator, "The court's after the claim is due, and before his right of redemption is foreclosed." I n Coursey, the mortgagor gave the mortgagee a mineral interest in a portion of the mortgaged property as additional consideration for the lender's agreement to extend the time of payment of an existing mortgage. The interest in the property also was granted the mortgagee so that he would accept a renewal note secured by a new mortgage. The court found that all of the instruments concerned in the agreement formed kg part of a single transaction. 7 The borrower prepaid the debt in full, but the mortgagee refused to reconvey the mineral interest. The Oklahoma Supreme Court held that under the equitable theory of mortgages, "a mortgagor is entitled by force of law, to have the mortgaged premises relieved from the lien and his entire estate restored to that extent which he would have had if the mortgage transaction had never taken place." Thus, the court held that the agreement was a clog on the equity of redemption and was therefore void. Although the Coursey holding was based on Oklahoma statutes, other jurisdictions might decide along the same lines as the Coursey court, due to the fact that relevent statutes simply codify the Common Law doctrines which form the equity of redemption. III. Conclusion t> * Jl 15. The courts have been inconsistent in deciding what constitutes a clog on the equity of redemption. Thus, a mortgagee should attempt to use an alternative collateral device rather than placing a collateral agreement in the mortgage document. As stated by one writer: It may well be that modern day courts will be willing to disregard the old case law that was developed to curb abuses which are no longer relevent and recognize that an option to purchase £~ar other collateral agreement_7 is simply another method for a lender to secure a fair and reasonable return for loaning money given the inflationary economic realities of the eighties. J However, if the courts choose to continue to enforce the equity of redemption, there are a few drafting methods which have been suggested that may persuade a court to uphold a transaction which contains a collateral agreement. These drafting suggestions may tend to show the court that the agreement was not intended to be part of the mortgage and therefore not in violation of the equity of redemption. If possible, the option agreement or other collateral agreement should be placed in a document which is seperate from the mortgage agreement or deed of trust. No reference to the collateral agreement should be made in the mortgage or deed of trust. If the documents are kept seperate, the court may find that there was no intent to include such 00® 3 collateral agreement in the mortgage or deed, of trust, there- fore not offending the equity of redemption. It may be helpful to evidence in the seperate agreement that the mortgagor was a sophisticated and experienced business person or at least that he had been represented by an attorney during the transaction. If the court can determine that the parties were at arms length, it may find that there was no unfair advantage taken by the mortgagee. An offer of seperate consideration for the collateral agreement may also be helpful in persuading the court that the equity of redemption has not been violated. If the mort- gagee gives the mortgagor added consideration for the collateral agreement other than the mortgagee's willingness to make a loan, the court may consider this an indication that the collateral agreement was seperate from the mortgage agreement. Case law has indicated that collateral agreements will be carefully scrutinized, but are generally allowed if they do not clog the equity of redemption. Avoidance of a clogging problem may be difficult if certain collateral agreements are contained in the mortgage. Therefore it is necessary for a mortgagee or his counsel to be very careful in the drafting of mortgage documents.