donald j. weidner1 sample balloon mortgage (supplement p. 34) “this mortgage deed” “mortgagor...
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Donald J. Weidner1
Sample Balloon Mortgage(Supplement p. 34)
• “This Mortgage Deed”
• “Mortgagor hereby grants, bargains, sells, conveys and confirms unto Mortgagee, in fee simple”
• Legal description of the land conveyed
• Mortgagor covenants that it “is indefeasibly seized of the Premises in fee simple and has full power and right to convey . . . And does hereby fully warrant title and will defend the same”
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Sample Balloon Mortgage(Cont’d)
• “CONDITIONED, HOWEVER, that . . . If Mortgagor shall fully perform all the covenants, conditions and terms of this Mortgage, then these presents shall be void, otherwise to remain in full force and effect.”
• The mortgagor also covenants– To pay the principal and interest “according to
the terms of the Note and this Mortgage.”– To pay all taxes and assessments.– To keep the buildings and improvements
insured
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Sample Balloon Mortgage(Cont’d)
• The mortgagor also covenants to give the mortgagee
– the right to spend money to cure defaults by the mortgagor [ex., to pay real estate taxes if the mortgagor does not] and add the amount to the mortgage
– the right, on default, to declare the “whole of the indebtedness . . . due and payable” and proceed to foreclosure [the “acceleration” clause]
Sample Balloon Mortgage(Cont’d)
The mortgagor also covenants that
–“all rents, profits, incomes . . . are hereby assigned and pledged as further security for payment of the indebtedness hereby secured with the right on the part of the Mortgagee at any time after default hereunder . . . to demand and receive the same and apply the same on the indebtedness hereby secured.”
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Sample Balloon Mortgage(Cont’d)
• The Mortgagor also covenants
– “Receiver. In the event suit is instituted to foreclose this Mortgage or enforce the payment of the Note . . . Mortgagee shall be entitled to the appointment of a receiver to take charge of the Premises, to collect the rents, issues and profits . . . and to . . . care for the premises, and such appointment shall be . . . as a matter of right to the Mortgagee.”
Sample Balloon Mortgage(Cont’d)
The mortgagor also covenants
•“Subordination. This mortgage” shall be “subject and subordinate to the lien of any and all institutional mortgages that may now or hereafter affect the premises,” provide they are in connection with the property and not more than $500,000.
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Deed of Trust
• From Klem v. Washington Mutual, 2013 Wash. LEXIS 151 (Feb. 28, 2013):– A deed of trust . . . Is a statutorily blessed
“three-party transaction in which land is conveyed by a borrower, the ‘grantor,” to a ‘trustee,’ who holds title in trust for a lender, the ‘beneficiary,’ as security for credit or a loan the lender has given the borrower.”
– If the trustee acts only at the direction of the beneficiary, then the trustee is a mere agent of the beneficiary and a deed of trust no longer embodies a three party transaction.
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C. Phillip Johnson Full Gospel Ministries, Inc. v. Investors Financial Services, LLC
(Text p. 339)• Church purchased land and building on credit.
• Gave Lender three documents:
1. A Note
2. A Deed of Trust with
a) an acceleration clause and
b) a Power of Sale
3. A Deed in Lieu of Foreclosure (DLFC) with language of
a) absolute conveyance, with
b) permission to record it, and
c) declaring a present default
d) reciting consideration of cancellation of existing indebtedness
e) Yet DLFC was accompanied by a “disclosure statement” that the DLFC would be put in escrow until default.
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Full Gospel Ministries (cont’d)• 7 months later, borrower defaulted on the note.• Lender, without pursuing foreclosure, recorded
the DLFC with the land titles.• Borrower argued that there was no consideration
given when the DLFC was executed. Lender disagreed, saying the DLFC was part of the package. And, under seal.
• On appeal: the DLFC, executed at loan origination, is a mortgage. Therefore, no need to address consideration.
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Full Gospel Ministries (cont’d)
• Court defines issue: “Is a deed in lieu of foreclosure, executed as a precondition to originating a loan, before any default in the loan, valid under Maryland law, to support conveyance of marketable title upon default, but without foreclosure, in light of the borrower’s equity of redemption.”
• Held: no, “it clogs the equity of redemption.”
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Full Gospel Ministries (cont’d)• A loan “workout” after default is a different
matter:– “After a mortgagor defaults on a note, she may
legitimately contract with the noteholder to execute a conveyance, in exchange for adequate consideration, so long as there is no overreaching.”
– “After a mortgagor defaults, she may negotiate a ‘short sale’ to avoid a deficiency judgment, i.e., further indebtedness persisting even after the proceeds from a . . . sale have been distributed.”
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Full Gospel Ministries (cont’d)
• The statute in Full Gospel Ministries says substance trumps form:– “Every deed which by any other writing
appears to have been intended only as security for payment of an indebtedness or performance of an obligation, though expressed as an absolute grant, is considered a mortgage.”
• Similar to the Florida Statute we shall see shortly.
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Mortgage Substitute Hypo # 1
Deed Absolute with Collateral
Documents
HYPO # 1
Alleged Borrower Alleged LenderSale
2 year option to repurchase
BorrowerPermits 2 years to pass without exercising option
What Kind of Evidence Might Borrower Want to Introduce to Establish that the Sale Coupled with an Option to
Purchase Was Intended and Should Be Treated As a Mortgage?
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Factors to Consider whether there is an “Equitable Mortgage”
(See Text p. 348)
[1] “Side agreements providing for reconveyance will readily be connected to the deed to support a finding that the deed and agreement formed a single security transaction.” A written agreement is not essential.
Other relevant facts are:[2]declarations of the grantee; [3] the relations subsisting between the parties at the
time the deed was executed; [4] the retention by the grantor . . . of possession . . . and [5] the exercise of dominion and control over it in
making improvements and repairs, [6] paying taxes, [7] the value of the property compared with the
consideration actually paid.
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Equitable Mortgage(Text pp. 349)
• The “putative deed will probably have been recorded.”
• A bona fide purchaser from the grantee will generally be allowed to rely on the record.– Therefore, an unscrupulous grantee-lender may sell or
encumber the title as soon possible, leaving the grantor-borrower with limited rights.
– However, a subsequent grantee with notice is bound by the equitable mortgage characterization.
– See, ex., Fla. Stat. 697.01(2).• Deeds absolute are also often used by grantors
trying to hide assets from other creditors.
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Mortgage Substitute Hypo # 2
1) If Lender #2 records a mortgage, will it be the first mortgage?
2) Would Lender #1 be able to get an injunction to prevent borrower from making an outright conveyance?
• Tahoe: “Specific performance of the covenant against encumbrances might create an invalid restraint against alienation.”
3) Would it be easier for Lender #1 to enjoin Borrower from giving a mortgage to Lender #2?
• Tahoe: “Under these circumstances, enforcement as an equitable mortgage, which permits the property to be conveyed subject to the lien, is the only alternative to invalidation of the instrument.”
HYPO #2
Lender #2
Definite Borrower Definite Lender #1Loan
Note
Negative pledge [“Agreement not to transfer or encumber property”]
Records
BorrowerApplies for loan
Insists on 1M
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Enforceability of Due-on-Sale & Due-on-Encumbrance Clauses (Text p. 433)
• Prior to 1982, due-on-sale clauses were frequently invalidated by the courts as unreasonable restraints on alienation.
• Several state legislatures imposed restrictions on the enforceability of due-on-sale clauses--commonly prohibiting enforcing them in residential mortgages unless the mortgagee could establish that a transfer would impair mortgage security.
• The majority judicial approach held due-on-sale clauses were enforceable (presumption of enforceability) unless the borrower could show the lender engaged in unconscionable conduct.
• The minority judicial approach generally held due-on-sale clauses enforceable only if (presumption against enforceability) the mortgagee established reasonableness by showing that the transfer would result in security impairment or an increased risk of default.
• Due-on-encumbrance clauses were rarely litigated and the few reported cases permitted enforcement of the clause only when shown reasonably necessary to protect the lender’s security.
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Enforceability of Due-on-Sale & Due-on-Encumbrance Clauses (Cont’d)
• The enforcement of due-on-sale clauses by lenders enabled them to force repayment of lower-than-market interest rate loans during periods of rising interest rates upon the sale of the property by the mortgagor.
• Judicial and state legislative restrictions on the enforceability of due-on-sale clauses imposed severe economic burdens on depository institutions during a period of high inflation.
• In response, to protect the lenders, Congress passed the Garn-St. Germain Depository Institutions Act of 1982. 12 U.S.C. § 1701j-3.
• Garn-St. Germain preempts state laws that restrict due-on-sale clauses, and makes these clauses generally enforceable. 12 U.S.C. § 1701j-3(b)(1).
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Due-on-Sale & Due-on-Encumbrance Clauses (Cont’d)
• Garn-St. Germain covers any “person or government agency making a real property loan.” 12 U.S.C. § 1701j-3(a)(2).
• Due-on-sale clauses are defined broadly as any “contract provision which authorizes a lender, at its option, to declare due and payable sums secured by the lender's security instrument if all or any part of the property, or an interest therein, securing the real property loan is sold or transferred without the lender's prior written consent.” 12 U.S.C. § 1701j-3(a)(1) (emphasis added).
– Thus, the Act defines due on sale clauses to include due-on-encumbrance clauses.
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Enforceability of Due-on-Sale & Due-on-Encumbrance Clauses (Cont’d)
• Garn-St.-Germain, as a general rule, says that due on sale clauses and due on encumbrance clauses are enforceable.
• However, in a certain limited number of situations involving residences, due-on-sale and due-on-encumbrance clauses are not enforceable.
• The biggest exception is, that in the case of a single family residence, a due on encumbrance clause is unenforceable.– For example, an acceleration clause triggered by a
subsequent home equity loan is unenforceable.• There are other instances in which due-on-sale
clauses in residential loans are unenforceable. See12 U.S.C. § 1701j-3(d)(2-9) (Text p. 473).
Prepayment Privileges and Penalties(Text p. 435)
• Absent a specific provision in a note governing prepayment, the borrower is generally not entitled to prepay whenever the borrower likes– The rationale is that the lender has bargained for a
specific debt service schedule
• However, a minority of jurisdictions disagree.– In some, statute provides for a right to prepay unless the
note provides to the contrary– Some caselaw presumes a right to prepay– Federal law preempts state law in limited residential
situations• And prevents a due-on-sale clause from triggering a penalty
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Florida Statute: Substance Not Form Determines Whether Mortgage Exists
• Fla. Stat. sec. 697.01(1) (Similar to the Balloon Mortgage provision at Supp. 36):
• “All conveyances, obligations conditioned or defeasible, bills of sale or other instruments of writing conveying or selling property, either real or personal, for the purpose or with the intention of securing the repayment of money, whether such instrument be from the debtor to the creditor or from the debtor to some third person in trust for the creditor, shall be deemed and held mortgages, and shall be subject to the same rules of foreclosure and to the same regulations, restraints and forms as are prescribed in relation to mortgages.”
Florida Statute: Substance Not Form Determines Whether Mortgage Exists (cont’d)
• Is a negative pledge within Fla. Stat. 697.01(1)?– Is it a conveyance?– Is it a writing selling property?
• Reflecting the general rule, Fla. Stat. 697.01(2) provides:
“Provided, however, that no such conveyance shall be deemed or held to be a mortgage, as against a bona fide purchaser or mortgagee, for value without notice, holding under the grantee.”
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Installment Land Contracts as Mortgage Substitutes
H & L Land Co. v. Warner, 258 So.2d 293 (Fla. 2d DCA 1972):• “An installment land sale contract, or so-called contract for
deed, evidences a sale of the land and an obligation of the seller to convey and of the purchaser to pay the purchase price in installments . . . and is essentially a security instrument taking the place of a purchase money mortgage.– “The doctrine of equitable conversion is established in
Florida. * * * if a land sale contract is specifically enforceable, and is free of equitable imperfections, the vendee becomes the equitable owner of the land and the vendor holds legal title as security for the vendee’s performance.”
• “[A]n installment land sale contract is in essence a mortgage, and pursuant to Fla.Stat. s 697.01, F.S.A., the safeguards for the debtor and the remedies for the creditor are the same as those between a mortgagor and mortgagee.”
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Three Basic Theories of Mortgages
1. Title. Mortgage passes title at outset.2. Lien. Mortgage is nothing but a lien.3. Intermediate. Mortgage is a lien at the
outset, but passes title upon default.• In general, the theories have low predictive
value.• However, the theories have some predictive
value on issues concerning the lender’s right to rents after default and prior to consummation of foreclosure proceedings.
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Commercial Mortgage Variations• Call provision: permits lender to call in the note for
complete repayment at specified intervals before the loan has been fully amortized.
• Participation: gives lender a share in property’s income and/or appreciation in value.
• Convertible mortgage: analogous to a convertible bond—provides that the lender’s interest as a creditor can be converted into an equity interest. – Ex., “a fixed rate loan that entitles the lender at a
specified point to convert the unamortized portion of the loan (say, 70% of the property’s initial value) into an equity interest (again 70%) in the property. Frequently, a convertible mortgage will give the lender the right to buy out the mortgagor’s remaining equity interest (here 30%) at a predetermined price or at a price calculated on the basis of a predetermined formula.”
• Personal liability: most loans on income-producing property are nonrecourse.
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USURY VARIABLES
• Variations Among State Usury Laws– Range in rates– Range in penalties– Range in what is deemed to constitute
interest– Range in exemptions
• Because of the above variations, do not assume that the usury case law of one state is persuasive in other states.
Congressional Curbs on Usury Limits
• In 1979 and 1980, Congress preempted state constitutions and laws imposing usury limits on first lien residential mortgage loans used to acquire property– But authorizing states a limited opportunity to
impose such limits• Text (p. 380) states that at least 15 states have
reimposed such limits on first mortgage loans.• Other mortgage loans are subject to greater usury
limitation by the states.
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NV One, LLC v. Potomac Realty Capital, LLC
(Text p. 570)
• Plaintiff LLC sought a loan to rehabilitate and renovate a former post office– Plaintiff LLC signed a $1.8 million note– In addition, two individual plaintiffs “personally
guaranteed the loan.”
• Interest was accruing on the full face amount of the loan– More than half of the face amount was stated
to have been put in escrow– But no money was put in escrow or set aside
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NV One, LLC v. Potomac Realty Capital, LLC (cont’d)
• In short, when interest charged was computed on the basis of the limited amount of money actually disbursed, rather than on the basis of the full face amount of the note, the interest charged clearly exceeded the state’s statutory usury limit. – This loan fell outside the limited exception in the
statute for certain commercial loans that are 1. in excess of a certain amount; and 2. not secured by a principal residence; and 3. which are certified by a CPA as being capable of being repaid
• The loan was otherwise qualified but there had been no prior certification by a CPA
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NV One, LLC v. Potomac Realty Capital, LLC (cont’d)
• Issue: Did the usury savings clause in the loan documents validate an otherwise usurious contract?– “It is the intent of Maker [of the note] and Payee
[of the note] to conform strictly to the usury . . . laws . . . and . . . in no contingency or event whatsoever . . . shall the amount paid or agreed to be paid . . . exceed the amount permissible”
– Any excess amounts actually paid are to be treated as overpayments and refunded.
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NV One, LLC v. Potomac Realty Capital, LLC (cont’d)
• “If lenders could circumvent the maximum interest rate by including a boilerplate usury savings clause, lenders could charge excessive rates without recourse.”– Lenders would be incentivized to charge excessive
interest rates because the worst that could happen to them was the receipt of the maximum permissible interest
• The burden of compliance should be on the lender– who is a repeat player in a better position to assure
compliance– Even if both parties are sophisticated business entities
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FOUR ELEMENTS THAT MUST BE MET BEFORE A LOAN CAN BE CONSIDERED USURIOUS (Text p. 580):
1) An agreement to lend money
2) Interest in excess of that allowed by statute
3) An absolute, not contingent, obligation to repay the principal
4) An intent to violate the usury laws
NOTE: Intent, #4, is usually presumed if the other 3 elements are shown.
NOTE: An absolute obligation to repay, #3, is difficult to avoid without defeating the lender’s business objectives.
NOTE: There has been considerable federal preemption of usury limits in residential mortgages (since Pres. Carter).
Usury Avoidance
• Text at 580:– “The more common efforts at usury avoidance include
a sale and repurchase characterization; discounts from the face value of the note; prepayment penalties; brokerage or placement fees; late fees; inspection fees; standby or commitment fees if the lender is funding a permanent loan; requirements that the borrower deposit part of the loan proceeds in an interest-free account with the lender; sale-leaseback arrangements; and equity “kickers” such as a percentage of the borrower’s gross or net income earned from the security.”
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Interest Contingency Rule
• Assume a loan is risky. A rational investor will expect a greater return on risky investments.– How might a loan be structured if the lender wants more
a greater return than the “interest” that would be allowed under an applicable usury limit?
• The casebook suggests one possible solution: provide the lender a share of the profit on the sale of an asset, even if that share of profits ultimately pushes the lender’s total return above the usury level.
• This type of solution is possible because of the interest contingency rule, which is a fundamental principle in the usury case law.
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Interest Contingency Rule (Cont’d)• One statement of the interest contingency rule:
– “[A] promise to give the lender a greater profit than the highest permissible rate of interest upon occurrence of a condition, is not usurious if the return promised on failure of the condition is materially less than the amount or debt with the highest permissible rate of interest.”
• Note: a lender whose “greater profit” is in the form of a share in profits as opposed to a share of gross receipts may risk partnership classification– Profit sharing is a strong indication of partnership (but
RUPA protects shared appreciation mortgagees)
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Interest Contingency Rule (Cont’d)• A second statement of the interest
contingency rule suggests that nonrecourse loans might be treated more favorably: – “in a loan the lender does not share in the
profits of the enterprise, nor does he run any risk of the loss of his capital other than that of the insolvency of the borrower, attendant upon all loans.”
– From Golden State Lanes v. Fox, involving a sale-leaseback
• A nonrecourse lender risks loss of capital even if the borrower is solvent
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Corporate Borrower Exemption• The most common statutory exemption from usury
laws is for loans made to corporate borrowers.• Text (p. 580): “The central question . . . concerns
the extent to which, to qualify [for the corporate borrower exemption], a corporation must have a life and business purpose independent of usury avoidance.” – “New York and several other states take the view
that any corporation, even one formed exclusively for the purpose of avoiding usury limitations, qualifies for the corporate exemption.”
– Courts are split.
• “Governing law” clauses are common in loan agreements.
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Time Price Doctrine (to avoid usury)• Is a Seller’s agreement to provide purchase
money financing to his Buyer an “agreement to lend money” within the meaning of the usury law?– Stated differently, is a seller-provided purchase
money mortgage a loan subject to the usury law?
• The “time-price” doctrine says that a seller has a right to charge more for a sale on credit than for a cash sale.
• What if the seller sells on credit at the cash price but explicitly charges “interest” at a rate in excess of the maximum rate?– See Mandelino v. Fribourg (Text p. 581)
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Heller Financial Inc. v. Lee(Text p. 581)
• Florida Limited Partnership with a Sole Corporate General Partner took out a senior loan and a junior loan to purchase an Orlando hotel. This case concerns the smaller loan, which was the junior loan.
• The $9,900,000 junior loan was made both to the Limited Partnership and to its sole corporate General Partner. The loan was secured by the equity interest in the limited partnership and by the equity interest in its General Partner.
• After the closing of the loans and hotel acquisition, an unrelated corporation managed the hotel.
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Heller Financial Inc. v. Lee (cont’d)
• At issue was Section 11(b) in the Note, which made the borrowers’ obligation to repay nonrecourse, subject to a carve-out:– “Subject to the provisions set forth below, no Maker
shall be personally liable to pay the Loan . . . and Holder agrees to look solely to the Assignments and any other collateral . . . pledged . . . to secure the loan. Notwithstanding the foregoing, each Maker (excluding Robert Ahnert), . . . shall be personally liable for . . . (b) repayment of the Loan and all other obligations of the maker under the loan Documents in the event of [any breach of certain covenants].”
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Heller Financial Inc. v. Lee (cont’d)• The referenced covenants said that each borrower
agreed not to permit the filing of any encumbrances on the Hotel other than those provided for in the senior loan documents.
• Approximately $821,212 in encumbrances were filed (4 tax liens and 2 mechanics liens).
• Issue: Do the Makers of the note become personally liable on the full $9,900,000 loan because they permitted less than a tenth of that amount ($821,212) in encumbrances to be filed?– Or are they only liable for the smaller amount?
• Held: the makers are liable for the full loan: “Section 11(b) is not a liquidated damages provision because it provides only for actual damages.”– Which the court said was payment of the
unamortized loan balance.
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Junction Bit & Tool Co. v. Village Apts., Inc.(Supp. p. 42)
• In an earlier case, the Supreme Court of Florida had said that an election to sue on a note at law acted as a bar to any subsequent suit for foreclosure of a mortgage executed as security for the note.
• Here, the Court reversed its earlier decision:• If the earlier judgment on the note leaves the
creditor unsatisfied– that unsatisfied judgment on the note was no
remedy and– hence, does not bar the remedy of foreclosure
on the mortgage.
A First Look at the Transfer of Notes (text p. 446)
• “Although both the note and mortgage are transferred, the note is viewed as the controlling document.”
• Article 3 of the Uniform Commercial Code applies.
• A note transferee who qualifies as a holder in due course takes free of important defenses of the maker of the note.– Think of a HDC as an especially well protected BFP
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A First Look at the Transfer of Notes (cont’d)
• To qualify as a holder in due course, the transferee must acquire a negotiable instrument in good faith and without notice of defenses against it.
• The UCC (1990) states that good faith (among merchants) “means honesty in fact and the observance of reasonable commercial standards of fair dealing.”– 2001 revision comment says honesty in fact is
subjective and reasonable commercial standards is objective.
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Notes Under the Uniform Commercial Code: A Quick Overview
(Supplement pp. 50-52)
• Caveat about the Smith & Lubell statement at text p. 566: “Since the note is evidence of a debt and is a negotiable instrument, only one copy of it should be signed by the borrower.”– Under the Uniform Commercial Code, not all
notes qualify as negotiable instruments– The “holder” must take a negotiable instrument
to be a “holder in due course.”
Rights of Holder in Due Course
• Rights of a holder in due course (UCC 3-305)– In general, a holder in due course takes free
of “personal defenses” but takes subject to “real defenses” (see next slide)
– Breach of warranty is a personal defense from which the HDC takes free
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UCC § 3-305 DEFENSES AND CLAIMS IN RECOUPMENTA holder in due course is not subject to “personal
defenses” (such as breach of warranty).A holder in due course is subject only to the following
“real” defenses: ”(1) a defense of the obligor based on
(i) infancy of the obligor to the extent it is a defense to a simple contract,
(ii) duress, lack of legal capacity, or illegality of the transaction which, under other law, nullifies the obligation of the obligor,
(iii) fraud that induced the obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn of its character or its essential terms, or
(iv) discharge of the obligor in insolvency proceedings;”
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Official Comment to Revised UCC 3-305
• The Official Comment to the revised UCC 305 states that the holder in due course doctrine:– “applies only to cases in which more than two
parties are involved. Its essence is that the holder in due course does not have to suffer the consequences of a defense of the obligor on the instrument that arose from an occurrence with a third party.”
• The big issue is usually who qualifies as a holder in due course.– See UCC 3-302, 3-104, 3-106.
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UCC § 3-302 Who is a Holder in Due Course ”(a) [With very limited qualification], ‘holder in due course’ means
the holder of an instrument if: (1) the instrument when issued or negotiated to the holder does not bear such apparent evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into question its authenticity; and (2) the holder took the instrument
(i) for value, (ii) in good faith, (iii) without notice that the instrument is overdue or has
been dishonored . . . , (iv) without notice that the instrument contains an
unauthorized signature or has been altered, (v) without notice of any claim to the instrument . . . , and (vi) without notice that any party has a defense or claim
in recoupment . . . .”
- § 3-104 (b) provides: “Instrument means a negotiable instrument.”
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Notice
• Consider that a HDC is one who takes without “notice” that the instrument is overdue or of a defense against it.
• “Notice” does not require actual knowledge because it is defined in terms of “reason to know.”– A person has notice of a fact if the
person, “from all the facts and circumstances known to the person at the time in question, has reason to know that it exists.” UCC 1-202(a).
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UCC § 3-104 When Instrument is Negotiable
”(a) [With minor exceptions], ‘negotiable instrument’ means an unconditional promise or order to pay a fixed amount* of money, with or without interest or other charges . . . if it:
(1) is payable to bearer or to order . . . ;
(2) is payable on demand or at a definite time; and
(3) does not state any other undertaking . . . to do any act in addition to the payment of money, but the promise or order may contain (i) an undertaking or power to give, maintain, or protect collateral to secure payment . . . .
* The old language requiring a “sum certain” was removed. New Section 3-112(b) was added.
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New UCC Section 3-112(b) and “Fixed Amount”
• UCC Section 3-112(b) now provides:– “(b) [i] Interest may be stated in an instrument
as a fixed or variable amount of money or it may be expressed as a fixed or variable rate or rates. [ii] The amount or rate of interest may be stated or described in the instrument in any manner and may require reference to information not contained in the instrument.”
• This language was added in 1990 to dispel any doubts about the negotiability of variable interest rate notes.
• Furthermore, the entire amount due need not be calculable from what is written in the note itself.
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UCC § 3-106 When Promise or Order Unconditional
“(a) [With minor exception], for the purposes of Section 3-104(a), a promise or order is unconditional unless it states (i) an express condition to payment, (ii) that the promise or order is subject to or governed by another record, or (iii) that rights or obligations with respect to the promise or order are stated in another record. A reference to another record does not of itself make the promise or order conditional.
(b) A promise or order is not made conditional (i) by a reference to another record for a statement of rights with respect to collateral, prepayment, or acceleration, or (ii) because payment is limited to resort to a particular fund or source.”
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More on Whether a Note Fails the “Unconditional Obligation” Requirement to be a Negotiable
Instrument
What result in a 1975 Florida case: the note stated it was “secured by a mortgage on real estate . . . The terms of said mortgage are by this reference made a part hereof.”- See Holly Hill Acres, LTD. V. Charter Bank of Gainsville, 314 So. 2d 209 (Fl. App. 1975) (text p. 448).
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UCC § 3-203 Transfer of Instrument; Rights Acquired by Transfer
(a) An instrument is transferred when it is delivered by a person other than its issuer for the purpose of giving to the person receiving delivery the right to enforce the instrument.
--Transfer of the right to enforce it(b) Transfer of an instrument . . . vests in the transferee any right of the transferor to enforce the instrument, including any right as a holder in due course, but the transferee cannot acquire rights of a holder in due course by a transfer, directly or indirectly, from a holder in due course if the transferee engaged in fraud or illegality affecting the instrument.
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UCC § 3-203 Official Comment2. . . . Under subsection (b) a holder in due
course that transfers an instrument transfers those rights as a holder in due course to the purchaser. The policy is to assure the holder in due course a free market for the instrument.
There is one exception to this rule stated in the concluding clause of subsection (b). A person who is party to fraud or illegality affecting the instrument is not permitted to wash the instrument clean by passing it into the hands of a holder in due course and then repurchasing it.
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UCC § 3-203 Official Comment (Cont’d)4. The operation of Section 3-203 is illustrated by the
following cases. In each case Payee, by fraud, induced Maker to issue a note to Payee. The fraud is a defense to the obligation of Maker to pay the note under Section 3-305(a)(2).
Case #1. Payee negotiated the note to X who took as a holder in due course. After the instrument became overdue X negotiated the note to Y who had notice of the fraud. Y succeeds to X's rights as a holder in due course and takes free of Maker's defense of fraud.
In other words, an originator of a subprime note and mortgage may have engaged in consumer fraud. The originator can transfer the note to someone who takes as a HDC. That HDC can sell its right to HDC status even to someone who buys with notice of the originator’s fraud.
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UCC § 3-203 Official Comment (Cont’d)
There is an exception in the case of a fraudulent originator who subsequently reacquires the note:
Case #2. Payee (who induced the maker by fraud) negotiated the note to X who took as a holder in due course. Payee then repurchased the note from X. Payee does not succeed to X's rights as a holder in due course and is subject to Maker's defense of fraud.
Giorgi v. Pioneer Title Insurance Co.(Text p. 437)
• Two couples (“Makers”) executed a Note and D/T. Note was payable to payeees H, W. – Payees recorded D/T.
• Note was delivered to Pioneer, Trustee under the D/T, to hold note in escrow for collection. – The D/T (as usual) directed the Trustee to collect
on the note, disburse the proceeds to the payee named in the note and reconvey the property to the maker.
• Payee H died, his interest passed to Payee W• Payee W assigned all her interest in the note and
D/T to Giorgi before the note became due.Donald J. Weidner60
Giorgi v. Pioneer Title Insurance Co. (cont’d)
• Payee W did not physically transfer the note or the D/T to her assignee, Giorgi, telling Giorgi that she had lost both.
• Georgi recorded the Assignment to him of the Note and D/T with the mortgages (and Ds/T)
• Nevada statute said that recordation of an assignment of a beneficial interest under a D/T is constructive notice to all persons.
• Giorgi gave Makers of the note notice that he was the assignee
• However, neither Giorgi nor the Makers gave the Trustee actual notice of the assignment.
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Giorgi v. Pioneer Title Insurance Co. (cont’d)
• Makers continued to make Note payments to the Trustee– Even though Giorgi had told Makers he
was the assignee of the note
• Trustee continued to follow the trust instructions and: 1. disbursed the money to original payee W
(who accepted the money even though she had assigned the note to Giorgi) and
2. reconveyed the property to Makers after the note payments were completed.
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Giorgi v. Pioneer Title Insurance Co. (cont’d)
• Giorgi sued both original Payee-Assignor W [a clear wrongdoer] and the Trustee [who never had actual notice of the assignment (but not the Makers, who made all the payments required of them)]– The suit against original Payee-Assignor W
was successful.– But the suit against the Trustee was NOT
successful.
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Giorgi v. Pioneer Title Insurance Co. (cont’d)• Giorgi Argued: the Nevada statute says a
recorded assignment of a D/T is constructive notice to the world, and the Trustee is part of the world. Court Rejected this argument.
• More generally, point #1: When there is a negotiable instrument secured by a D/T (or mortgage), the law of negotiable instruments prevails over mortgage law.
• Assignee Giorgi never got physical possession of the note—never became its “holder” – The Maker is supposed to pay the Holder
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Giorgi v. Pioneer Title Insurance Co. (cont’d)
• “[T]he maker of a negotiable note secured by a mortgage or deed of trust cannot discharge his liability by payment to one not the holder or one not authorized by the holder to receive payment.”
• Stated differently: “And a debtor is not justified as against an assignee of the security in making payments to a mortgagee or a beneficiary named in a deed of trust who does not have possession of the instrument.”– Many F/C proceedings have been halted when
the debtor challenged the party seeking foreclosure to produce the note.
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Giorgi v. Pioneer Title Insurance Co. (cont’d)• Point #2. Granted, it is hard to rationalize the
law of notes with the law of mortgages. The law of mortgages should not be applied to interfere with “the mobility of the debt” and the mortgage is “a mere incident of the debt.”– NOTE: strong policy favoring a market in debt
• Point #3. Trustees (or title companies) should not be required to keep searching the title before disbursing the payments they receive on the notes they hold for collection– Trustees can continue to disburse the payments to
the trust beneficiaryDonald J. Weidner66
Doyle v. Resolution Trust Corp.(Text p. 439)
• Doyle sued Trinity S & L for breach of contract and for fraud in connection with an adjustable rate note he signed.– RTC in 1990 became the receiver that got Trinity’s
interest (par for the course in the “S & L crisis”)
• Doyle later added assignee FNMA, who purchased the note and mortgage, as a defendant.
• The “gist” of Doyle’s complaint was that Trinity, without his consent, increased the interest rate on his note from 11% to 15% and forged his initials on the change.
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Doyle v. Resolution Trust Corp. (cont’d)
• Doyle sought actual and punitive damages and cancellation of the note and mortgage.
• At trial, Doyle recovered both [1] actual and punitive damages against wrongdoer Trinity S & L and [2] cancellation of the note and mortgage held by FNMA.
• The cancellation of the note and mortgage held by FNMA is the sole issue on appeal.
• The note alteration was clearly material.• Court initially concluded that this particular note was
not a negotiable instrument (and that therefore FNMA could not qualify as a HDC).
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Doyle v. Resolution Trust Corp. (cont’d)• An Oklahoma intermediate appellate court had
said that the note was not a negotiable instrument: It was not for a “sum certain” because an external index, rather than the instrument itself, had to be consulted to determine the precise amount payable.
• The Oklahoma S. Ct. reversed (and its reversal reflects current law of the U.C.C.).
• Therefore, because the note was negotiable, a subsequent holder could be a HDC if it took the note for value, in good faith with no notice of its defect (the unauthorized alteration).
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Doyle v. Resolution Trust Corp. (cont’d)Did FNMA have notice of the defect?
•Under the U.C.C., one has notice of a fact when one has;
• a) actual knowledge of it;
• b) received a notification of it; or
• c) reason to know it exists.
•Absent a finding FNMA had notice of an unauthorized alteration, FNMA “could enforce the note, as originally executed, free from any claims or defenses Doyle might have against Trinity.”
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Doyle v. Resolution Trust Corp. (cont’d)• FNMA had actual knowledge that the
interest rate was altered.
• However, it had no knowledge that the alteration was unauthorized.
• FNMA frequently purchased notes with altered interest rates, provided the maker’s initials appeared alongside the alteration.
• FNMA was not required to dig further unless other factors called the alteration to FNMA’s attention (Trinity “had a fine reputation”)
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Doyle v. Resolution Trust Corp. (cont’d)
• Doyle also reflects the strong policy in favor of the marketability of debt instruments.
• Court focused on U.C.C. 3-304(1):
“The purchaser has notice of a claim or defense if
(a) the instrument is so incomplete, bears such visible evidence of forgery or alteration, or is otherwise so irregular as to call into question its validity, terms or ownership or to create an ambiguity as to the party to pay.”
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Doyle v. Resolution Trust Corp. (cont’d)Court upheld the trial court, stating:
---Whereas there is a subjective test to determine whether a holder takes in “good faith”
[but law of U.C.C. now says that good faith has both a subjective aspect (“honesty in fact”) and an objective aspect (”reasonable commercial standards of fair dealing in the trade”)]
---There is an objective test to determine whether a holder has “notice of defenses”—the question is what a reasonable person in the holder’s position would know
--and that is a question of fact properly determined below
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Doyle v. Resolution Trust Corp. (cont’d)
• The lower court also said – The originating lender was not FNMA’s agent (and
therefore FNMA was not bound as a principal for an agent’s bad acts); and
– There was no other “close connectedness” between assignee FNMA and the assignor/originating lender that, for example, would have put FNMA on notice of any bad practices of the originating lender .
• See the apparent split in the cases (text p. 447) about whether the holder’s notice of the transferor’s shoddy business practices constitutes reason to know with respect to the transferred note.
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Note on Mortgage Electronic Recording System(Text p. 445)
• The federal government helped private sector mortgage lenders and others to create “Mortgage Electronic Registration System, Inc.”
• Lenders, banks, insurance companies and title companies become members of MERS and pay an annual fee.
• They appoint MERS as their agent to act on all mortgages that they register on the new electronic system.
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MERS (cont’d)• A MERS mortgage is recorded with the county land
records with the MERS Corporation named “as the lender’s nominee or mortgagee of record” on the mortgage.
• The MERS member owning the beneficial interest may assign the ownership rights or the servicing rights to another MERS member.
• The assignments are not part of the public record.• Rather, they are tracked electronically on MERS’s
private records. – How can borrowers identify a lender with whom to
negotiate?– How can the operation of markets be studied?
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MERS (cont’d)• Mortgagors are notified of transfers of servicing rights• But not notified of transfers of beneficial ownership.• Text discusses the facilitation of “an efficient secondary
market in mortgages”– bemoaning pesky judicial decisions questioning MERS– while noting “legitimate concern if unrecorded mortgage
assignments in secondary market transactions are not placed on the public record.”
• Note: Even apart from MERS, the assignee of a mortgage note is not required to notify the maker of the assignment.
• New rule requires notice within 30 days of note assignment (not just of change in servicer) (Text 449).
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Associates Home Equity Services, Inc. v. Troup(Text p. 390)
• Classic type of civil rights case. This in N.J. in 2001.• Elderly, minority, inner-city resident Troup signed
contract to purchase home improvements.• Home improvement company steered her to
defendant originating lender to finance their contract.
• In 1996, originating lender provide her a loan:– $46,500 amount– 11.6% interest (plus 4 points at closing)– 15 year term– $41,600 balloon (due at end of 15 years)
• Originating lender sold her note and mortgage to defendant Associates Home Equity, who paid a premium for it because of its high interest rate.
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Associates Home Equity (cont’d)
• Borrower defaulted on the note.• Notepurchaser Associates (assignee of note and
mortgage) filed an action to foreclose • Borrower asserted defenses against the
foreclosure and counterclaimed on the basis of various statutes, including:– CFA, the Consumer Fraud Act– TILA, the Truth in Lending Act– FHA, the Fair Housing Act– CRA, the Civil Rights Act Sec. 1982– LAD, the Law Against Discrimination (New Jersey)
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Associates Home Equity (cont’d)
• In short, the court allowed the case to move forward to the discovery stage.
• Borrower is permitted to raise overlapping defenses to establish “equitable recoupment” in the foreclosure proceeding even if its claims would be time-barred as an independent matter.
• Borrower asserted predatory lending, discriminatory lending and unconscionability.
• Borrower asserted that notepurchaser either acted in concert with the originating lender or controlled its conduct.
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Associates Home Equity (cont’d)
• Predatory lending was defined in terms of loans that are not suitable for the borrowers:– “In essence, the loan does not fit the
borrower, either because [1] the borrower’s underlying needs for the loan are not being met or [2] the terms of the loan are so disadvantageous to that particular borrower that there is little likelihood that the borrower has the capacity to repay the loan.”
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Associates Home Equity (cont’d)• The borrower argued that the loan originator and
notepurchaser were engaged in “reverse redlining”:– Recall that “redlining” refers to withholding
financing from neighborhoods a lender disfavors• “Reverse redlining is the practice of extending
credit on unfair terms” to specific geographic areas due to the income, race or ethnicity of the residents.– The focus is on communities that lack access to
traditional lending institutions.• Reverse redlining has been held to violate the
FHA (Federal Housing Act), the CRA (Civil Rights Act) and the LAD (New Jersey law against discrimination).
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Associates Home Equity (cont’d)• Racial or ethnic factors may be implicated in
reverse redlining:– A plaintiff may establish a colorable claim
of reverse redlining by demonstrating that “defendants’ lending practices and loan terms were ‘unfair’ and ‘predatory,’ and that the defendants either intentionally targeted on the basis or race or that there is a disparate impact on the basis of race.”
• Discovery may reveal that notepurchaser’s guidelines are discriminatory.
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Associates Home Equity (cont’d)
• Court rejected notepurchaser’s argument that recoupment is inapplicable because the foreclosure proceeding is not one to collect a debt.
• A foreclosure action “is a quasi in rem procedure to determine not only the right to foreclose, but also the amount due on the mortgage.”– Borrower seeks to reduce the amount due
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Associates Home Equity (cont’d)• The Federal Trade Commission regulates
“consumer credit contracts,” which must disclose:– “ANY HOLDER OF THIS CONSUMER CREDIT
CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER . . . .”
• This holder rule “strips the ultimate holder of the paper of its traditional status as a holder-in-due-course and subjects it to any potential defenses which the purchaser might have against the seller.”
• A business may not so structure a consumer credit transaction to separate the consumer’s duty to pay from the seller’s duty to perform.
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Associates Home Equity (cont’d)
• There was an issue whether the originator’s loan was a purchase money loan.
• Under the FTC rule, a purchase money loan is a cash advance received be a consumer to purchase goods or services from a seller who:– 1. refers consumers to the creditor or– 2. is affiliated with the creditor by common
control, contract or business arrangement.• There was also an issue whether the
notepurchaser was affiliated with the originating lender or designated from the outset to be the notepurchaser.
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Note 1 to Associates Home Equity
• Nelson and Whitman, Real Estate Finance Law Sec. 5.30 (5th ed. 2007):– The FTC’s rule makes it an unfair trade
practice for a seller of goods or services to finance a sale without including language that makes the lender subject to the consumer’s claims and defenses.
– In the case of third-party financing, “the loan must have been made in connection with a sale of goods or services and a type of ‘close connectedness’ criterion must be satisfied”• “but it is much simpler and looser than the
UCC’s.”
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Note 1 to Associates Home Equity (cont’d)
• “The lender is brought within the rule’s ambit if the seller of the goods or services [1] refers consumers to the lender or [2] is affiliated with the creditor by [any] business arrangement.”
• The FTC rule does not apply to financings or sales of interests in real estate—it only applies to sales of goods and services.
• As of 2007, it only applied to purchases of $25,000 or less.
• If the seller does not include the FTC notice in a note, its purchaser may qualify as a HDC.– Although Associates suggests that an assignee may
be liable for a failure to include the required language.
Note 4 to Associates Home Equity• TILA, the Truth in Lending Act, subjects
creditors to liability for violating its disclosure standards.
• In certain loan transactions, debtors have a right of rescission.
• Debtors may rescind by midnight of the third business day after the transaction for any reason.
• The three-day “cooling off” period is extended if the creditor does not give the required disclosures.
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Inroads into rights of holders (cont’d) (p. 447)
• The Home Ownership and Equity Protection Act of 1994 amended TILA to address “high cost” home equity mortgage loans – Defenses that could be raised against the originator can be
raised against the assignee of these high cost mortgages– Act does not apply to “residential mortgage transaction,”
that is, a purchase money loan that enables a consumer to purchase a residence.
– Special disclosures must be given– Certain terms are prohibited (negative amortization, certain
balloons, etc.)– Certain conditions must be met to have a valid prepayment
penalty• This is also an area of concern for the new Consumer
Financial Protection Bureau.
West’s F.S.A. § 701.04. Cancellation of mortgages, liens, and judgments Effective: October 1, 2007
(1) Within 14 days after receipt of the written request of a mortgagor, the holder of a mortgage shall deliver to the mortgagor… an estoppel letter setting forth the unpaid balance of the loan secured by the mortgage, including principal, interest, and any other charges properly due under or secured by the mortgage . . . . Whenever the amount of money due on any mortgage, lien, or judgment shall be fully paid to the person or party entitled to the payment thereof, the mortgagee, creditor, or assignee… to whom such payment shall have been made, shall execute in writing an instrument acknowledging satisfaction of said mortgage, lien, or judgment and have the same . . . duly entered of record in the… proper county. Within 60 days of the date of receipt of the full payment of the mortgage, lien, or judgment, the person required to acknowledge satisfaction of the mortgage . . . shall send . . . the recorded satisfaction to the person who has made the full payment.