RECENT COURT RULING HIGHLIGHTS THE IMPORTANCE OF CERTAINTY IN MORTGAGE DOCUMENTS AND FORECLOSURE PROCEEDINGS

by Jeffrey R. Dobson, Jr.

Citizens State Bank v Nakash

On February 9, 2010, the Michigan Court of Appeals decided a case that reinforces how critically important it is to have appropriate future advance language in a mortgage when future advances are anticipated. In this case, improperly drafted documents and/or a miscalculated foreclosure bid resulted in a significant loss to the senior mortgagee and a significant gain for a junior mortgagee.

The Facts

Defendant Nakash loaned intervening plaintiffs the Melistas $250,000 and secured his loan by taking a mortgage on a property owned by the Melistas. The "Nakash Mortgage" was recorded, but the accompanying promissory note was not. However, the Nakash Mortgage referenced the related unrecorded promissory note, which did contain language indicating that future advances were possible and would be secured by the Nakash Mortgage.

Nakash subsequently loaned the Melistas $80,000 in a series of loans that were evidenced by promissory notes from the Melistas. These notes were not recorded. Nakash also claimed that he loaned the Melistas an additional $124,000, but he could not produce any documents proving these loans.

After the Nakash Mortgage was recorded, Citizens loaned the Melistas $500,000, which was secured by a junior mortgage on the same property that the Nakash mortgage was held on. The "Citizens Mortgage" was also recorded.

Nakash instituted foreclosure proceedings on the Nakash Mortgage after the Melistas defaulted on their loans. Nakash was the only bidder at the sheriff's sale and bid about $475,000. This amount was apparently based upon the original $250,000 loan and the later loans and it included costs and interest.

Citizens filed suit claiming that it was improper for Nakash's bid to include amounts from the loans that were not secured by the Nakash Mortgage because the document did not expressly create a future advance mortgage. Citizens argued that Nakash's bid created a surplus to which Citizens, as the junior mortgagee, was entitled.

The Court's Ruling

The Court of Appeals affirmed the trial court's decision that the Nakash Mortgage's incorporation by reference of an unrecorded promissory note with a future advance clause did not create a future advance mortgage. The Court of Appeals relied on MCL 565.901(b), which requires the instrument creating the future advance mortgage to be recorded.

This case aptly demonstrates that strict adherence to statutory mortgage requirements is required for good practice. Specifically, in light of this holding, one must be very sure to include appropriate future advance language in the instrument that is actually recorded. The related ancillary lesson here is that a party that seeks to collect on an instrument using foreclosure must be very careful that it calculates its bid properly, and that calculation must include a precise review of the subject document with a view toward strict adherence to legal requirements.

PROPERTY OWNERS AND LENDERS LOSE PROTECTION OF CREDITORS' RIGHTS ENDORSEMENT

by Katheryne L. Zelenock

Title companies across the country have discontinued offering the ALTA 21 endorsement, also known as the "creditor's rights endorsement," which provided lenders and owners with title insurance protection for losses or damages arising out of the voidability of an estate or interest in property (including a mortgage) due to a fraudulent transfer or preference under federal bankruptcy, state insolvency, or similar creditors' rights law. While not available in certain states (most notably New York, New Mexico, Texas and Florida), the creditors' rights endorsement was particularly favored by larger national lenders that were introduced to new borrower relationships through correspondents or brokers, and by parties purchasing properties.

The endorsement, promulgated by the American Land Title Association ("ALTA"), was withdrawn as an industry "standard" endorsement effective March 8, 2010. Even before that withdrawal, however, most title companies had in recent months severely tightened the underwriting criteria for issuing the endorsement, making it increasingly difficult to obtain.

The endorsement was intended to close a risk gap that is typically part of the title insurance policy for commercial transactions closed using the ALTA policy (the most frequently-used form in Michigan and most states across the country). Both the owner's and lender's title policy forms exclude coverage for situations where the transaction being insured is a fraudulent or preferential transfer under the federal bankruptcy, state insolvency, or similar creditors' rights laws (past chain of title events were covered).

The creditors' rights endorsement provided coverage for fraudulent transfers or preferences through the date of the title insurance policy (i.e., typically through closing or recording of the insured deed or mortgage), therefore including the transaction being insured --- and also covered payment of costs, expenses and attorneys' fee incurred to defend the insured against those claims---unless the insured party knew that the transfer was fraudulent, or if the party was not a purchaser in good faith. This coverage permitted purchasers and lenders to limit their investigation of the financial condition of other parties in the transaction.

Shifting Potentially Significant Risks

With plummeting or uncertain property values, and property owners under increasing financial stress, assessing whether a party is technically insolvent or in trouble with its creditors is increasingly difficult. This determination is particularly challenging when evaluating individuals, trusts, or other entities with many assets and a variety of debt obligations.

The creditor's rights endorsement provided purchasers and lenders with a convenient means of insuring some of these uncertainties, though many title insurers felt that the financial underwriting necessary to provide the coverage in an informed fashion was outside of the fair scope of title insurance. The creditors' rights problem occurs only infrequently (though much more common in a down market), but its effects are powerful: the transaction can be avoided, leaving a purchaser without the intended property, or a lender without sufficient security. Anecdotally, the title insurance industry reports that some of its largest title insurance claim payouts relate to creditors' rights coverage.

Fraudulent Conveyances

Section 548 of the Bankruptcy Code permits a bankruptcy trustee in either a voluntary or involuntary bankruptcy to invalidate pre-petition transfers made by a debtor where it can be demonstrated that there was an actual intention to hinder, delay or defraud other creditors. The Code also permits the trustee to avoid transfer where the debtor has received less than a reasonably equivalent value for the property transferred and: (i) the debtor was rendered or became insolvent as a result of the transaction; or (ii) was engaged in or about to engage in a business transaction for which had unreasonably small capital in relation to its remaining property; or (iii) intended or believed that it would incur debts beyond its ability to pay.

Section 544 provides that the trustee on behalf of unsecured creditors may avoid any transfer, in a liquidation proceeding, of an interest or obligation incurred by the debtor that is voidable under applicable state fraudulent conveyance statutes.

Preferences

Section 547 of the Bankruptcy Code provides that a trustee may avoid a transfer made: (i) to or for the benefit of creditors; (ii) for or on account of an antecedent debt owed by the debtor before the transfer was made; (iii) while the debtor was insolvent; (iv) the timing of the transfer is generally within 90 days before the date of filing of the petition, or between 90 days and 1 year before the date of filing if the creditor is an insider of the debtor; and (v) the transfer enables the creditor to receive more favorable treatment than the creditor would have received absent the transfer.

The Value Defense

A defense to a fraudulent transfer claim is that the transferee gave value in good faith for the transfer. Under §548(c)(1) of the Bankruptcy Code, the good faith defense applies to both actual and constructive fraud claims, and allows a transferee (whether a purchaser or lender) to obtain a lien or retain any interest transferred or enforce any obligation incurred to the extent of the value given. State fraudulent conveyance codes typically provide similar good faith defenses. These defenses protect a party that has given "reasonably equivalent value" or "fair consideration" for their interest, without knowledge that other creditors were being hindered or delayed.

For many purchasers and lenders, the good faith defenses provide a means of defending a transaction that, unbeknownst to the purchaser or lender, had indications of a fraudulent conveyance. For example, a routine refinance transaction, where loan proceeds provided by a third-party lender are being used to pay off a prior loan from another third-party lender, without excessive proceeds to the Borrower, is relatively low-risk with respect to creditors' rights issues. Similarly, a good-faith non-affiliated purchaser of real estate is generally protected.

Difficulties can arise, however, when some parties are being "bought out" of a transaction or radically modifying their ownership of an entity (perhaps not constituting an exchange of reasonably equivalent value), or in cases where courts may consider whether a purchaser or lender "should have known" about other existing creditors who might have expected an interest in transferred collateral. Issues may also arise in transactions where collateral is being offered by a party other than the primary obligor to a loan---where a party offers a mortgage to secure the obligation of a sister or parent entity, for example, or in cases of cross-collateralization of obligations among affiliated parties.

Particularly for lenders who are underwriting the financial condition of the parties (and therefore may have knowledge of the competing creditors), and for developers or property owners engaging in transactions among affiliated entities, these issues may present a problem. Given current market conditions, and the absence of the benefit of title insurance for these issues, it pays to be alert to the potential issues.

HARBOR SHORES PROJECT SECURES SIGNIFICANT VICTORIES
DUAL COURT DECISIONS ALLOW CRITICAL WEST MICHIGAN COMMUNITY REDEVELOPMENT PROJECT TO CONTINUE

by Tammy L. Helminski

Both the Michigan Court of Appeals and the U.S. Federal District Court, Western District of Michigan, recently provided the Harbor Shores project in Benton Harbor, Michigan significant legal victories. Benton Harbor is a community plagued by social and economic challenges, as evidenced by the civil unrest that occurred in 2003 and, most recently, the proposed financial takeover by the state. Harbor Shores is a community redevelopment project whose ambitious goal is to spur the growth of a new economic base for the area to help address these challenges. The project is implemented by a non-profit developer and involves the coordination of three municipalities to create a golf/tourism destination where all profits are put to use in community benefits programs.

Critical to the project were approvals by the City of Benton Harbor, the National Park Service ("NPS") and the Army Corps of Engineers (the "Corps"). These approvals were challenged by two groups of plaintiffs. At the state level, the plaintiffs challenged the City of Benton Harbor's approval to allow Harbor Shores to lease a portion of a public beach front park for use as part of a Jack Nicklaus signature golf course. The Michigan Court of Appeals found that the City's agreement to lease the property was a permissible use under documents that legally restricted the use of the Park land to "park purposes" or for "public purposes[s] relative to . . . park use."

In federal court, the plaintiffs challenged, under the Administrative Procedures Act ("APA"), the review of the environmental impacts of the project conducted by the NPS and the Corps under the National Environmental Policy Act ("NEPA"). The U.S. District Court for the Western District of Michigan, found the administrative record supported the agencies' findings of no significant impacts.

The Project

Benton Harbor is a city located in the southwest corner of Michigan near Lake Michigan. Like many other urban areas, it is faced with challenges, such as high rates of poverty and unemployment. Following civil unrest in 2003, Governor Granholm instituted a task force to investigate how to improve the quality of life in the city. A key conclusion from the task force was that the unique natural features of the area were underutilized and the task force recommended the City create a tourism destination development, such as a golf course.

Cornerstone Alliance, Alliance for World Class Communities and the Whirlpool Foundation, all local non-profit organizations, responded to this recommendation by coming together and creating Harbor Shores Community Redevelopment, Inc. ("Harbor Shores"), a non-profit corporation. Harbor Shores was established, according to its articles of incorporation, "for the purpose of fostering redevelopment and revitalization of blighted real property and remediation of environmental contamination; encouraging the creation of employment and educational opportunities, economic growth, and housing; sponsoring and funding programs that will benefit the disadvantaged in Berrien County, Michigan; and pursuing other eleemosynary purposes."

Harbor Shores took on the mission of implementing the task force's recommendation of creating a tourism-based development. The ambitious community redevelopment project it created involves a 530-acre commercial and residential development spanning three communities – the city of Benton Harbor, Benton Charter Township, and the city of St. Joseph. The project is anchored by a public Jack Nicklaus signature golf course, with profits from the project being used for community benefits programs. Three holes of the golf course are to be located on approximately 22 acres of land leased from the City in Jean Klock Park, the City's only beachfront park.

The Challenges

As is often the case in large developments, the project met with opposition. In this case, the opposition focused on the use of Jean Klock Park. Two groups of plaintiffs challenged the project. The first group filed a lawsuit at the state level, and questioned whether a lease to a private entity was an allowed use under the original deed dedicating the park and under a 2003 consent judgment that applied to the property due to an earlier lawsuit. The second group of plaintiffs filed an action in federal court, primarily on claims under the Administrative Procedures Act ("APA") that certain federal government approvals for the project did not properly follow the National Environmental Policy Act ("NEPA").

Michigan Courts Agree that the Lease of a Portion of Jean Klock Park for a Public Golf Course Use is a Permissible Public Use

Jean Klock Park is an approximately 74 acre city park located along Lake Michigan. It was gifted to the City of Benton Harbor in 1917 by the Klock family. The granting deed stated that the "land and premises shall forever be used by said City of Benton Harbor for bathing beach, park purposes, or other public purpose; and at all times shall be open for the use and benefit of the public, subject to such rules and regulations as the said City of Benton Harbor may make and adopt."

In the early 2000's, the City sought to convert a portion of the northern end of the Park, along what is known as "Grand Boulevard," for sale to a private developer. A lawsuit challenging that proposal was resolved by a consent judgment whereby the Plaintiffs agreed to the development provided that the remainder of the Park be used as a park. Specifically, the consent judgment states that the Park shall not be used "for any purpose other than a bathing beach, park purposes, or other public purpose related to bathing beach or park use; provided, however, that there shall be no recreational vehicle park campsites; provided, further, that the City shall for all time be authorized and empowered to operate its water treatment facility, located at the south end of the park, including but not limited to capital improvements and expansion."

Thus, the Deed and Consent Judgment read together allow the City to use the Park for "park purposes" or for "public purposes[s] relative to . . . park use."

Harbor Shores' use of the 22 acres of the Park for the public golf course is memorialized through two agreements with the City – a lease agreement and a maintenance agreement. These agreements place many conditions upon Harbor Shores' use of the property, including obligating it to pay the City rent, perform certain maintenance of the leased portions as well as other portions of the Park, and implement preferential programs for residents. Additionally, these agreements subject Harbor Shores' operations to certain oversight by the City.

Plaintiffs argued that these agreements for Harbor Shores to use the leased land for the three holes of a public golf course did not serve a "public purpose" and that it was not a "park use" as required by the Deed and the Consent Judgment.

On review of motions, the Berrien County Circuit Court disagreed with Plaintiffs and held that the public golf course use, as memorialized in lease and maintenance agreements between defendants City of Benton Harbor and Harbor Shores, serves a public purpose and is a park use. This decision was affirmed by the Michigan Court of Appeals. Drake, et al v City of Benton Harbor, et al, per curiam, unpublished, No. 287502, (Mich App, January 21, 2010).

Upon its review, the Michigan Court of Appeals also disagreed with Plaintiffs' argument that because the City leased the land the land was no longer being used by the City. Looking at the plain language of the deed, the court found the deed's restriction "is a restriction on the use of the property – not a restriction on Benton Harbor's right to convey or otherwise assign its right to use the property." Furthermore, the court found that the City was indeed using the property by employing it to earn rent from leasing it to Harbor Shores for use as a public golf course: "Benton Harbor's lease of the real property for monetary gain is thus a use of the property."

Likewise, the court disagreed with plaintiffs' argument that the deed required the property to remain under public ownership and that the Harbor Shores lease removed the Park from such ownership. The plaintiffs relied on City of Huntington Woods v City of Detroit, 279 Mich App 603; 761 NW2d 127 (Mich App 2008) in which the court found the restriction in the deed from the Rackham family to the city required that the property be used "exclusively as a public golf course for the use of the public" precluded the sale of the property to a private developer. The court distinguished the deed in Huntington Woods from the Jean Klock Park deed in that: "the placement of the word 'public' before golf course in Huntington Woods could be construed as an indication of ownership concerning the golf course. In this case, the placement of the word 'public' before the word 'purpose' in the deed place [sic] restrictions only on the use of the property."

Moreover, the transaction at issue in Huntington Woods was a sale of the property, whereas the conveyance to Harbor Shores is a lease. The fact that the Harbor Shores lease could be renewed up to 105 years did not matter due to the extensive oversight and control the City has over the property: "Benton Harbor having retained significant control over the property, the lease is not in effect a conveyance."

Finally, the court rejected Plaintiffs' invitation to review extrinsic evidence to ascertain whether the lease to Harbor Shores to operate a public golf course constitutes a "public purpose," "public park use" or "park purpose" under the restrictive covenant and subsequent consent judgment. The court found no ambiguity in the use of these terms. Under the terms' plain, ordinary meanings and as supported by case law, the use of the portions of Jean Klock Park by Harbor Shores as a public golf course "falls within the meaning of both a public park serving a public purpose."

Federal Court Confirms Federal Agencies Properly Followed NEPA When Reviewing the Project

The plaintiffs in the federal court action alleged eleven causes of action, the most substantive of which were based on alleged violations of the APA for failure to properly consider environmental impacts of the project under NEPA. NEPA is implicated whenever there is a major federal agency action, which here were two federal agency decisions – a "conversion" approval by the NPS under the Land and Water Conservation Fund ("LWCF") grant program and a permit issued by the Corps for the filling of 3.31 acres of wetlands.

The NPS involvement with the Park began in 1975 when it awarded the City a $50,000 LWCF grant to fund improvements to Jean Klock Park. As a condition of this grant, the City agreed that the land would continue in the same use and, per the LWCF regulations and associated grants manual, any "conversion" of the land for a different use would require "mitigation." Here, the 22 acres of the Park leased to the City for the golf course were treated as being converted for which there would be mitigation.

Both the NPS and the Corps prepared and/or reviewed environmental assessments ("EA") discussing the environmental impacts of the proposals and alternatives to the proposals. Based on the EAs, the agencies determined that the project would not have a significant impact on the human environment and issued findings of no significant impact ("FONSI"), thus rendering unnecessary the need for full environmental impact statements ("EIS").

Plaintiffs challenged these decisions by claiming that the NPS improperly limited its scope of review to the 22 acres subject to the lease and the properties being proposed for mitigation. Plaintiffs argued that NPS should have considered the impacts of the whole 500 acre development and not doing so was an improper segmentation of NPS's NEPA analysis.

Upon review of motions for summary judgment and motions to dismiss brought by defendants, the court found the NPS properly limited its review to only those 22 acres affected by the LWCF program and rejected plaintiffs' NEPA scoping challenge. There was no basis for the NPS to federalize the entire development and consider other parts of the project where there was no NPS jurisdiction. The court also found that the NPS, by only looking at a portion of the overall development, did not improperly segment its NEPA analysis. The court considered the combined review of the NPS and the Corps and determined that all the relevant effects were considered and that this was not a segmentation case where a limited review by one agency left some aspects unconsidered.

A second NEPA-based challenge to the agencies' decisions brought by the plaintiffs was that the government failed to take a hard look at certain environmental impacts, such as alleged dune destruction, use of fill material, tree removal, species impact and environmental contamination of mitigation parcels. In evaluating each, the court looked to and relied on the administrative record. For each, the court found that the agencies had considered these issues and that the plaintiffs had failed to articulate what other impacts could have been considered but were not. Thus, the court held that the agencies did not act arbitrarily and capriciously and that the agencies had taken a hard look at the impacts identified by the plaintiffs.

A third NEPA-based challenge brought by the plaintiffs was that the NPS failed to consider reasonable alternatives. After looking at the administrative record, the court concluded the Plaintiffs' objections to the NPS alternatives analysis were without merit. The court found that the Plaintiffs had not identified any viable alternative that could have been considered but was not. The court recognized that economic goals of the project could be considered in determining whether certain alternatives were viable and that an EA only required brief discussions of alternatives, not the more robust treatment afforded in an EIS.

The court, in its 52-page opinion, also found in favor of the defendants on the remainder of the eleven counts Weiss, et al v Kempthorne, et al, unpublished, 1:08-CV-1031, (WD Mich, January 15, 2010).

The Course is Set to Open in Summer of 2010

Plaintiffs in the state court action have filed a notice of appeal to the Michigan Supreme Court. Plaintiffs in the federal court case have also filed for appeal to the Sixth Circuit. In the meantime, construction work continues on the Harbor Shores project, with the full golf course scheduled to be open in Summer 2010. Dickinson Wright represented Harbor Shores throughout the procurement of these critical approvals and the legal challenges thereto, serving as lead counsel in the state court action and local counsel for the Washington D.C.-based firm Bracewell & Giuliani in the federal court case. Dickinson Wright continues to represent Harbor Shores as the development and operations progress. For more information about the development, the resort and the golf course, see:

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.