Lender Beware: Unrecorded Vendee Liens Threaten Loan Priority
In today's fast-paced world, where computers can produce loan commitment letters and mortgage documents within hours, and where fax machines eject the borrower's comments and requested changes to those documents almost immediately, the low tech due diligence process is still important to protecting a bank's lien position when it makes a mortgage loan. It is essential to review the loan application and other documentation carefully. The time pressures developing in the real estate financing arena may cause oversights that impair the lender's lien position. Unrecorded interests in real estate, which are discoverable by due diligence, may obtain priority over a first lien mortgage. To understand how easily an interest in real estate can become a lien that primes what is intended to be a first mortgage, consider the following common scenario:
A real estate developer applies for a loan from a financial institution to develop land for a residential subdivision. As part of the application, the developer provides the financial institution with contracts whereby the developer has "pre-sold" houses in the subdivision and the potential purchasers have each placed a deposit with the developer. The loan officer is impressed with the developer's business plan and the real estate contracts are an added bonus, showing the developer's initiative and that there is interest in the subdivision. The existence of the contracts indicates that a loan may be a good risk. The financial institution obtains a title search and finds that the developer owns the property free and clear of any liens. The loan officer also causes an appraisal of the property to be conducted and, looking at the bottom line, finds that the value of the property supports the loan needed by the developer. The financial institution agrees to lend money on the project in return for a blanket first mortgage on the entire subdivision. The loan committee gives the transaction the green light and it soon closes. A title insurance company issues a lender's policy to the financial institution, insuring the mortgage as a first lien mortgage on the real estate. The loan officer and financial institution are later shocked to learn that a contract purchaser has sued to foreclose a "vendee's lien" and that the lender's blanket "first" mortgage is subordinate to the vendee's lien. How did this happen? As in all lien priority disputes, the issue is what the lender knew or should have known at the time it made the loan.
With the possibility that a vendee lien may prime the mortgage, financial institutions must take steps to protect themselves. In order to do so, it is essential to understand the concept of a vendee's lien and the diligence with which a potential loan transaction must be analyzed. A vendee's lien is a common law device created as an equitable remedy to protect purchasers of real property in the event the seller defaults or does not perform according to the real estate contract. Courts have constructed the remedy on the theory that when parties enter into a contract for the sale of real estate, the pre-contract interests of each party are equitably converted by virtue of the trust relationship, or duty of good faith and fair dealing, between the parties. The purchaser, or vendee, becomes the equitable owner of the land, and the seller, or vendor, is considered a trustee of his real estate for the benefit of the purchaser. When the purchaser pays a portion of the purchase price, the seller becomes a trustee of the money and the purchaser acquires a lien as if the seller had executed a mortgage to the purchaser. In other words, the vendee's lien is a judicially created doctrine to remedy the perceived unfairness to contract purchasers of real estate who are injured by the misconduct of the seller. Courts use the vendee's lien as a remedy primarily where the land appears to be the sole asset or source of recompense to the purchaser. The lender, however, must fend for itself in order not to be injured by the creation of a vendee's lien.
Recognizing The Warning Signs
While the factual scenarios where courts have recognized vendee's liens are as varied as are real estate transactions, the common thread running through all court decisions in which courts have recognized superior vendee's liens is awareness of another's interest in the property, whether by knowledge, notice, or possession. Recognizing the interests of a vendee is the key to protecting lien priority.
Knowledge of another's interest in real estate may be actual or constructive, written or oral. Actual knowledge means information that is in the possession of the lender. The most common form of actual knowledge occurs where a builder/developer has attached purchase contracts to a construction mortgage application. Indeed, for some situations, some lenders may require a purchase contract as a prerequisite to providing construction financing. Obviously, the lender should read the purchase contract in the process of considering the construction loan application. The lender's reading of the contract reveals the terms of the agreement, including any down payments or other advances by the purchaser. However, the lender's actual knowledge of the purchase contract and down payment, prior to making the loan, makes it difficult for the lender to argue that it did not know that anyone else had acquired an interest in the mortgaged property. The knowledge precludes the lender, in the face of a priority suit by the purchaser, from asserting the traditional bona fide purchaser defense that it made the loan and took back the mortgage in good faith and without notice of any adverse claims.
Constructive knowledge is information that is in the possession of an agent of the lender. For example, the appraiser sent to the property in the above scenario gained information about the value of the real property that is deemed to be within the knowledge of the lender. The appraiser may have discovered other facts which may affect the lending decision. If the appraiser discovered that a structure had already been partially constructed on the land, and, in speaking with the purchaser, discovered that the purchaser had made additional monetary advances to the developer/borrower to facilitate timely construction of the house, or for "extras", the appraiser's knowledge would be imputed to the lender. The lender would have constructive knowledge of the additional advances. Thus, because the lender had knowledge of the advances prior to making the loan, it is probable that the purchaser's additional advances will be added the vendee's lien and gain priority over the lender's mortgage.
The numerous court decisions concerning vendee's liens provide other examples where the lender's knowledge of the purchaser's interest in the property lead to the creation of a vendee's lien. In one case, the lender, while inspecting the property, spoke directly to the purchaser and was informed of the down payment on the house. In another, the lender discovered that the purchaser was involved in litigation with the seller/borrower. In numerous cases, the lender was deemed to be on constructive notice of the purchaser's interest by the filing of a notice of lis pendens by the purchaser, regardless of whether the lender actually discovered the notice. In addition, the purchaser often records the real estate contract thereby providing constructive knowledge of all of the contract's terms.
The most common form of constructive knowledge, recording of interests pursuant to state recording statutes, do not always reveal obvious liens. Most jurisdictions' recording statutes provide for the recording of any interest in land, no matter what the type of interest. Therefore, real estate contracts which disclose a deposit may be recorded and give notice to potential lenders of prospective purchasers. In fact, recording may be the only way to give notice of one type of interest: an installment contract. Unlike a purchase with a mortgage, where title passes to the purchaser immediately, subject to divestment through foreclosure if the mortgage is not paid, where a purchaser seeks to buy property by way of an installment contract, title to the property does not pass until the last installment is paid. The seller retains legal title to the property and is not obligated to deed the property to the purchaser until all installments of the purchase price are paid. Without recording the installment contract, the purchaser leaves the seller in the position where he can transfer legal title to the property to a subsequent purchaser. Often, however, the installment contract specifically prohibits the purchaser from recording the contract because the seller wants to use the property as collateral for a new loan or to be able to refinance the property, resulting in a hidden interest in land not discoverable by a search of public records, but one that subjects the lender to the loss of lien priority.
Closely related to constructive knowledge is notice. Notice is usually a subtle reference or clue to the interest of another that may require the lender to make inquiry to determine the actual facts. Notice may take the form of a phone call from someone claiming an interest in the property, storage of items on the property, newspaper articles that come to the lender's attention, or any number of other ways. Any item that causes the lender to question the purchaser's sole and undivided interest in the property may be considered notice that requires inquiry to determine the true facts.
Possession is also a factor in creating vendee liens. Courts often impute knowledge of the condition of the property to the parties to a real estate transaction. If a person other that the borrower is occupying the property, the lender should make inquiry to determine the nature of the occupant's interest. Possession may take many forms. The property may be fenced or posted. Someone may be living in a temporary structure on the property. A partially completed permanent structure on the property may be occupied. In all of these cases, the lender takes a mortgage at peril to its priority.
No Help From Purchasers
Of course, vendee's liens would be unnecessary if purchasers took the proper steps to protect themselves. Initially, in an ordinary real estate transaction, purchasers should escrow any deposit with a third party, ideally a title company, closing agent or attorney who has a trust account . If for some reason, the transaction fails to close, it is much easier to recover deposit money from a trust account than from a seller whose only assets may be illiquid. In addition, many states provide for the recording of real estate contracts, much the same as deeds and mortgages. In this way, the purchaser can make known to potential lenders and other prospective purchasers, in a form that lenders will find, that he or she has a prior interest in the real estate. Nonetheless, purchasers are often unsophisticated in real estate transactions, taking part in relatively few such transactions in the course of their lifetime. Therefore, they take few precautions. Purchasers tend to pay down payments directly to the seller, to make monetary advances to the builder and subcontractor for extras, and fail to record purchase contracts. Thus, because vendees cannot or will not take steps to notify the lender, the lender must protect itself.
Title Reports Miss Vendee Liens
Lenders often do not get information about purchasers' interests from the expected sources. Ordinarily, a financial institution will require a title search and title insurance when making a loan and taking a mortgage on real property as security. In doing so, the loan officer may feel that he or she has taken the proper steps to protect the lender's interests. However, vendee's liens are created by the interaction of the real estate contract and the seller's default and must be recognized and enforced by the courts. Thus, vendee's interests are generally not recorded and are unlikely to appear in any title search. Nonetheless, the facts creating the vendee's lien are often disclosed to the lender, who does not recognize the potential for the lien. Moreover, the standard exclusions in a title policy include an exception for matters known to the insured but not appearing in the public records. Vendee's liens often fit this exclusion and it is possible that the title policy will not cover the lien. Therefore, lenders should not ignore the possibility of a vendee's lien and expect title insurance to protect them.
Given the sometimes tedious nature of discovering all interests in the property, lenders may be tempted to ignore certain warning signs, or may be too busy to examine all leads. In some cases, the loan officer may not want to look too closely for fear of revealing information which will kill the deal. Nonetheless, the lender cannot ignore warning signs and claim later that it lacked knowledge concerning the purchaser's interest. It should make a diligent attempt to discover any adverse interest in the property. There are a variety of methods to discover and or prevent vendee liens. First, make a thorough inspection of the loan application and any attached documents. Real estate contracts attached to the application are a clear warning signal of a purchaser's interest in the property. Second, have an experienced appraiser or real estate agent physically visit the sight to look for signs that anything is amiss. A proper inspection will reveal occupants and other evidence of a purchaser's interest. Third, review the title report carefully for any recorded document which presents a claim on the property. The title search will reveal any notice of lis pendens or recorded purchase agreement. If the lender discovers no adverse interests after a diligent search, a court will be less likely to allow a vendee lien, reasoning that the lender took reasonable steps to protect its interests.
If a potential vendee lien is discovered by due diligence, the lender does not necessarily lose the lending opportunity. There are a variety of methods the prevent the lien from priming the mortgage. The most familiar method is to require the vendee to subordinate its interest to the lender's as a condition of making the loan. Another is to require the developer to place all deposits with a third party escrow agent. Where a third party holds the deposit in a trust account, the cash will be readily available should the developer breach the purchase agreement. Additionally, many jurisdictions now allow, and many lenders now require, a notice of settlement to be filed in the recorder's office providing a period of time where liens do not attach. The notice of settlement may confer partial protection by providing a window wherein the loan may close with no hidden interests attaching to the property. Finally, the lender must ensure that any mortgage taken as security is promptly recorded in order to place potential purchasers on record notice of the mortgage. Recording the mortgage will turn the tables on any prospective purchaser, giving notice of the lender's interest in the property and placing the burden on the purchaser to protect his own interests.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.