This article the second part in a three-part series reviewing the history of the lender-borrower relationship. The first part, Pre-Wellenkamp history, can be found in our archives. This article focuses on the legal high ground held by owners against lenders and the sudden reversal of owners’ rights under federal mortgage law since the early 1980s. The third and final part in this series will conclude in May 2005.
Editor’s note — We would be remiss if we did not acknowledge that the counsel for the plaintiff in the court case examined in this article, Wellenkamp v. Bank of America (1978) 21 C3d 943, was not other than our legal editor, Fred Crane.
A sale without lender interference
Until mid-1974, lenders consistently threatened to call loans due should the owner sell the secured property.
Concern did not exist for either the type of sale, or the type of carryback financing arranged between the seller and buyer. If not paid in full or given a modification of the interest rate and monthly payments, the loan was called due.
If the called loan was not paid in full or modified, a Notice of Default (NOD) was recorded. The trustee would then complete the foreclosure, unless the debt was renegotiated or paid in full.
Most major lenders with competent legal advice were already aware the courts were not going to allow them to continue using the due-on clause to extort greater profits. The trend was to return the due-on clause to its prior status as a protective provision in a protective device (trust deed).
Then came Tucker requiring good faith use of a due-on clause. [Tucker v. Lassen Savings and Loan Association (1974) 12 C3d 629]
After Tucker in late 1974, the lenders, virtually en masse, stopped recording NODs on transfers of ownership interests.
However, they did continue to seek interest increases and assumption fees.
The lenders took advantage of owners and their brokers who were unaware of resale rights, or unwilling to undergo the expense and inconvenience of enforcing them.
The lenders continued to play their hand until borrowers learned to call their bluff. The education of the broker and buying public was very slow, the result of individual experiences rather than organization.
Agents’ conduct with lenders of record
Between 1974 and 1978, and prior to Wellenkamp, agents in a loan takeover transaction frequently did not understand their clients’ rights. These uninformed agents would call the lender of record to seek advice before writing up the purchase agreement.
Agents asked the lender three questions with regard to the buyer’s assumption of the loan:
- Can the buyer assume your loan?
- If you let the buyer assume, what interest rate will you charge?
- What points and fees will you charge for the assumption?
In essence, the exercise was a complete waste of an agent’s time. Also, the lender’s response was against the client’s best interests. The lender now knew the seller and the buyer were ignorant of the buyer’s right to take over the loan in a subject-to transaction.
This environment of agent and buyer ignorance suited the objectives of the lenders perfectly. Lenders could still use the due-on clause against unknowing consumers.
The lenders received considerable institutional assistance from brokerage trade groups and federal agencies who supported the lenders as necessary for the financing of resale transactions.
But, as each business cycle brought about tighter money conditions with higher rates, the buyers, sellers and agents became better informed. This enabled them to cut through to a closing and avoid lender interference.
On closing, the lender was advised of the subject-to transfer, which deliberately did not provide for a modification and an increased portfolio yield for the lender.
The lender would press the buyer for a “formal” assumption. But when seller, buyer and agent presented a concerted front against the lender-requested assumption, saying it was a subject-to transfer, one by one, the lenders started to back off.
As the agents became more informed, the lenders were forced to back down.
Thus, by the time Wellenkamp was decided in 1978, almost all lenders, including federal savings and loan associations (S&Ls) and private parties, had toned down their due-on interference.
Wellenkamp prohibits inhibition of transfers
In 1978, the California Supreme Court removed its gloves. No more warnings for the lenders. It was all over for the automatic use of the due-on clause as a tool to adjust portfolio yields.
In California, as in most other states, mortgage law prohibits any contract terms which restrain the owner’s right to sell, lease or encumber the property, called a restraint on alienation. [Calif. Civil Code §711]
The law in California existed even before the codes were enacted in 1872!
The California Supreme Court decision in Wellenkamp simply stated what knowledgeable real estate lawyers already knew – Civil Code §711 made it illegal for lenders to use a due-on clause when their security interests were not placed in danger of impairment. [Wellenkamp v. Bank of America (1978) 21 C3d 943]
Simply put, Wellenkamp prohibited any lender interference with a sale, except to protect the lender’s security interest. Increasing portfolio yield under exercise of the due-on clause was prohibited.
If the prospect of sale was in any way inhibited by the lender, even by the veiled or threatened use of the due-on clause, the lender had illegally interfered with the owner’s right to sell the secured property.
The lenders could not even insist on an assumption to impose personal liability on the buyer.
Now, the lenders who had made mistakes projecting their profits were prevented from shifting the cost of those errors onto borrowers.
Wellenkamp eliminated the automatic use of the due-on clause.
The California Supreme Court described the provision as the “due-on” clause, not the due-on-sale clause.
The ruling was not limited to just the sale aspect of ownership. Any interest secured by real property was included. Later in 1982, leasehold assignments were included, barring (until 1990) the landlord’s unreasonable termination of the lease on its assignment.
The lenders were told to use the due-on clause for protective purposes only. Lenders were not to use the due-on clause to escalate their profits at the expense of the consumer.
No longer could the lender use the due-on clause for the economic suppression of the very ownership interest which supported their loans and assured their repayment.
Until 1982, the risks were to remain with those who created the problem – the lenders.
The Wellenkamp era
After Wellenkamp, more and more brokers began advising their clients to use existing financing to close transactions.
Those brokers who previously had cooperated with the lender interference now advocated “subject-to” financing.
In fact, the tide of judicial favor in California was so strongly behind the borrower that as late as February 1982, the Wellenkamp ruling was applied to private lenders as well. [Dawn Investment Co., Inc. v. Superior Court of Los Angeles (1982) 30 C3d 695]
Unfortunately, many lenders placed a high value on their ability to coerce extra profits, so much so that they simply refused to accept the court’s decisions.
The federal S&Ls, in particular, continued to interfere successfully with sales, arguing that they were not subject to state law.
State lenders also continued to fight – but shifted the battle from the legal to the political arena.
Then, in June 1982, the United States Supreme Court gave all federal S&Ls the right to automatic enforcement of their due-on-sale clauses, regardless of security impairment or the assuming borrower’s creditworthiness. [Fidelity Federal Savings & Loan Assoc. v. de la Cuesta (1982) 458 US 141]
This resulted in serious inconsistencies between state and federal due-on practices.
The Garn Act
Intended to settle this due-on furor, the Garn-St. Germain Federal Depository Institutions Act of 1982 (Garn) extended to all lenders and carryback sellers the rights which de la Cuesta gave only to federally chartered S&Ls.
Signed into law on October 15, 1982, Garn brought about a blanket preemption of state law restrictions on “due-on” practices.
Together, de la Cuesta and Garn created a new body of federal mortgage law.
Garn deemed “due-on” clauses to be automatically enforceable by all real estate and mobilehome lenders, institutional or private. Garn gave lenders the right to enforce the due-on clause that existed as a provision in most trust deeds.
Thus, since 1982, buyers, sellers, brokers and lenders alike have scrambled to protect their own interests and win at the real estate game.
In economic terms, the right to automatic enforcement shifted an enormous amount of wealth from real estate owners to their lenders, resulting in modifications at high interest rates that stifled sales. However, Garn did make one limited concession.
A “window period” was established for all loans not originated by federally chartered S&Ls.
This window period allowed owners who bought property after Wellenkamp believing the loan to be assumable, to realize their expectations of reselling the property subject to the old loan.
In California, this “window period” affected acquisitions from Aug. 25, 1978 (the date of the Wellenkamp decision) to Oct. 15, 1982 (the date Garn became law).
Loans originated or assumed during the window period were exempt from automatic “due-on” enforcement on sales for three years after the window period closed.
Obviously, the window period expired when Garn became the law, but an exemption from automatic due-on enforcement still applied to many window period loans until Oct. 15, 1985.
This exemption period became known as the “grace period.”
After Oct. 15, 1985, any loan with a due-on clause, made or held by any institutional or private lender, could be accelerated on the sale of the secured property without regard to security impairment, risk of default or origination date.
The same rule applies to those loans with due-on-encumbrance clauses.
FHLBB steps in
In itself, Garn provides only general guidelines for “due-on” enforcement.
The Garn Act gave the Federal Home Loan Bank Board (FHLBB), now known as the Office of Thrift Supervision, authority to issue rules, regulations and opinions interpreting Garn, and also delegated this authority to other regulatory agencies. [12 United States Code §1701j-3(e)]
In early 1983, the FHLBB issued a set of regulations spelling out in detail what constitutes a sale or transfer, what types of transfers will trigger the “due-on-sale” clause, and what limitations are placed on the enforcement of the due-on clause.
Among transfers which trigger due-on enforcement are those resulting from:
- grant deed;
- quitclaim deed;
- land sale contract;
- lease with option-to-buy;
- purchase under a lease/option;
- lease of more than three years;
- creation or refinancing of a junior lien (owner-occupied, single-family residences excluded);
- foreclosure of a second trust deed; and
- transfer into a trust (owner-occupied, single-family residences excluded).
In drawing up these regulations, the FHLBB took care to define specifically what events constitute a “sale or transfer” under Garn.
The FHLBB defines a “transfer” as the conveyance of any right, title or interest in the secured real estate – whether equitable or legal, voluntary or involuntary, such as in a judgment creditor’s or tax lien sale.
With exceptions, any transfer (sale, encumbrance or lease) will trigger the lender’s acceleration rights. In fact, a completed sale or transfer is not always necessary!
Depending on the contractual terms of the due-on clause in the trust deed, the lender’s acceleration right could be triggered by an agreement to sell or transfer the secured property.
Options to buy, purchase agreements, and sales escrows would trigger the due-on clause if the trust deed so states. Most do not.
Significantly, the regulations left some issues undetermined. Loopholes still exist in the due-on catch-all.
Neither the regulations nor Garn itself says anything about purchase agreements, escrow instructions or limited partnership interests.
To be sure, there are plans to use these loopholes as paths to avoid due-on enforcement under Garn.
Three-year escrows with interim occupancy, “agreements-to-agree” and limited partnerships are only a few of the vehicles the ingenious real estate industry will see replacing the “subject-to” transfer when interest rates again begin to rise.