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• Mortgages
Another device closely related to land transfer and records, and in which equity has played a major role, is the mortgage, as well as security interests more generally. Mortgages on real estate are familiar examples of security interests. A security interest is a conditional property right in an asset that secures the payment of a debt. The mortgage is evidenced by a document separate from the promissory note or the debt contract. The security interest gives its holder the right to seize the asset in the event of nonpayment of the debt, as well as the right to be paid ahead of other junior creditors, which is very relevant in bankruptcy. The filing of a bankruptcy stays proceedings to seize an asset but maintains the security interest holder’s seniority. Whether inside or outside bankruptcy, priority means that secured creditors are to be paid before general creditors, who are to be paid before equity holders (shareholders in a corporation, the landowner in the case of a real estate mortgage). Various secured creditors are paid in the order of their priority, which is usually first-in-time according to when their interest was perfected. Mostly perfection is effected by recording or filing, but some security interests can receive their priority through possession or other special rules. (Note that all these devices for perfection, whether it be recording, filing, or taking possession, have a notice effect.) A house worth $200,000 might be subject to a first mortgage of $100,000 and a second mortgage of $50,000. The homeowner then has equity of $50,000. (As we will see, this term derives from the “equity of redemption,” which is the right of the owner to save the property by paying off the debt.) Suppose the value of the house declines to $130,000, and the owner defaults. The holder of the first mortgage is paid in full ($100,000), the holder of the second mortgage gets $30,000, and there is no equity. If the loan is a recourse loan, the second mortgage holder might be able to get a deficiency judgment against the borrower for $20,000. If the loan is nonrecourse, the borrower is not personally liable.
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Why would a lender and borrower agree on a security interest? The borrower can get a lower interest rate if the debt is secured, because the lender runs less risk of not getting its money back. Of course the interest rate on other debt incurred by the borrower should adjust upward, because the borrower will have fewer assets available to satisfy other debts. Sophisticated lenders dealing with borrowers will ask to inspect the borrower’s books and put covenants against pledging borrower assets into their loan agreements. But in the case of tort creditors and other small creditors, no upward adjustment in rates may happen. Some have theorized that secured debt is thus problematic, because it harms tort creditors and other nonadjusting creditors, but there is scant empirical evidence that this is a major problem.9 (To some extent, the problem is handled by mandatory insurance requirements in certain industries, such as taxi cabs.) Others argue that secured debt allows for specialization in monitoring the activities of the borrower, who as an equity holder prefers risk more than is optimal overall. (As residual claimants, equity holders get all the upside after fixed claims are paid but suffer no losses beyond their investment.) Where security interests fit into the overall picture of financing both descriptively and normatively is still an active area of inquiry.
We saw in Chapter 4 how security interests in personal property are governed by the UCC and leave a large scope to self-help by the holder of the security interest in the event of nonpayment. Mortgagees (the holders of real estate security interests) are not allowed to use self-help against defaulting mortgagors (borrowers giving mortgages). Instead they must go through an elaborate process of foreclosing on the mortgage. Traditionally, in a strict foreclosure the lender-mortgagee would go into equity court to set a time limit on the mortgagor’s exercise of the equity of redemption, thereafter “foreclosing” that possibility forever and leaving the
9.Yair Listokin, Is Secured Debt Used to Redistribute Value from Tort Claimants in Bankruptcy? An Empirical Analysis, 57 Duke L.J. 1037 (2008).
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property with the mortgagee. In almost all states the strict foreclosure has been replaced with judicial foreclosure, in which the mortgagee files an action seeking a foreclosure sale. These days the procedures for judicial foreclosures and foreclosure sales are governed by statute. At any time during the process, the debtor has the right to pay the debt and keep the property. States vary also in whether the lender-mortgagee can seek a deficiency judgment where the proceeds from the foreclosure sale are insufficient to cover an outstanding recourse debt. The foreclosure sale is not necessarily the end of the story. In roughly half the states, the borrowermortgagor has a time period (up to two years) to exercise a statutory right of redemption by paying the price paid by the purchaser at the foreclosure sale. Over time, there has been some oscillation in terms of how much extra leniency to provide for defaulting borrow- er-mortgagors. Some see a tendency for legislatures to favor bright line rules, which are then muddied up by courts, whereas others have argued that the system is relatively stable except in periods of widespread financial distress during which both courts and legislatures try to rescue borrowers who are in trouble.
A judicial foreclosure sale is administered by a court, but some states allow parties to include a provision for a private foreclosure sale in the mortgage. As with judicial foreclosure sales, there is a concern that the price the property fetches in such sales will be on the low side (often the lender-mortgagee is the only bidder), and in a private foreclosure sale courts must also scrutinize the procedure adopted by the mortgagee administering the sale.10 Often it makes sense for a defaulting borrower-mortgagor if possible to sell the property him or herself and use the proceeds to pay the lender.
The equity of redemption and the more recent statutory right of redemption act like call options held by the mortgagor, that is, the right but not the obligation to purchase the property for the outstanding debt (in the case of the equity of redemption) or the
10. See, e.g., Murphy v. Fin. Dev. Corp., 495 A.2d 1245 (N.H. 1985).
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foreclosure sale price (in the statutory right of redemption). Because the borrower-mortgagor retains this stick in the bundle of rights, one can expect the price a bidder would pay to be correspondingly depressed. Although this is clearly a benefit to a defaulting borrower ex post, whether this helps borrowers (or which ones at the expense of which others) ex ante depends on the adjustment in interest rates and any cross-subsidies involved. In a nonrecourse debt, the borrower-mortgagor has the opposite type of option. Because the borrower is not on the hook beyond the value of the security, the borrower in effect has a put option whose exercise price is the outstanding amount of the debt. Thus in our example above, if the property is worth only $125,000, the nonrecourse borrower has the right to force a sale (like the exercise of a put option) to the lender for the value of the loan, here $150,000.
Lenders have used other mortgage-like devices, sometimes to get around the procedural requirements of a foreclosure. A deed of trust is structured like a transfer of ownership of the land to the lender-mortgagee who holds the land in trust for the mortgagor until the debt is paid. As option theory would indicate, this is an equivalent structure to the regular mortgage lien in which the mortgagor is considered the owner. From a legal point of view, the equivalence has led courts to treat deeds of trust the same as mortgages, including providing for procedural safeguards and the right of survivorship (see the discussion of severance in Chapter 5). Another method, which was originally designed to give the lender maximum protection, is the installment sales contract, in which the lender retains ownership until all the payments (over time) are made. In the old days, the lender could retain the land even if the buyer defaulted after paying almost all the purchase price. Equity courts, not surprisingly, intervened to allow late payment or restitution of amounts paid when a forfeiture appeared unfairly excessive or unfair. (Courts often point to the maxim that “equity abhors a forfeiture.”) The same equitable tradition is at work here as with the penalty doctrine in contract law, according to which liquidated damages clauses providing for damages greatly in excess of actual
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damages will not be enforced unless they are a reasonable ex ante forecast of damages. Given the general policy of freedom of contract, a flat ban on penalties has long been treated as a puzzle in need of explanation. Although it is true that high liquidated damages in the general contractual context can be used to deter entry into an industry (reducing competition and increasing market power), it is doubtful that installment sales contracts may be used for such purposes. Perhaps, as with the related (and again equitable) unconscionability doctrine, courts use the antiforfeiture reasoning in cases in which some other type of hard-to-prove overreaching or opportunistic behavior has infected the deal. By their nature, these considerations are difficult to tease out of appellate opinions. These days, installment sales contracts and other similar devices are often treated as mortgages, with the full redemption rights that mortgagors enjoy.
The tendency to treat other mortgage-like devices as mortgage liens, with all that that entails, can be regarded as yet another instance of the numerus clausus at work. Rather than let parties create new and possibly idiosyncratic variants on security interests, the law mandates a standard package of rights, duties, and procedures for this special property interest. In a particularly dramatic recent example, the Federal Communications Commission (FCC) tried to achieve the effect of a security interest by cancelling a broadband personal communications service (PCS) license for failure to pay after a spectrum auction. The U.S. Supreme Court held that under the Bankruptcy Code, the FCC could not do this without actually taking a security interest, which it had failed to do.11
Finally, it is worth recalling that mortgages on land go a long way toward explaining the continued importance of land to property law. Although it is true that personal property and intellectual property are increasingly important, and land is less central to advanced economies than in the formative years of the estate system, land is
11. FCC v. NextWave Pers. Commc’ns Inc., 537 U.S. 293 (2003).