An interesting dispute in the United States Bankruptcy Court for the Northern District of Indiana resulted in a March 27, 2007 opinion by Judge Harry C. Dees, Jr. about a borrower’s attempt to transfer ordinance citations, fines and other property-related liabilities to a lender. The issue was whether a mortgagor’s/borrower’s unilateral execution and recordation of a quit-claim deed effectively transferred the real estate to the mortgagee/lender. Although the case involved residential property, the rules and holding are equally applicable to commercial real estate and business borrowers. The lesson of Phillips v. City of South Bend, 2007 Bankr. LEXIS 1503 (N.D. Ind. 2007) is: a borrower simply can’t unload its real estate-based problems onto a secured lender without some kind of agreement or consent. (PhillipsOpinion.pdf).
The facts. The City of South Bend pursued a residential property owner for nuisance violations related to property, which was in disrepair and had documented unsanitary conditions in the yard. Potential fines and penalties were around $5,000. Citifinancial held a mortgage on the property. The borrower/mortgagor, in an apparent effort to avoid municipal liability, executed and recorded a quit-claim deed purporting to abandon the property and transfer title to Citifinancial. Citifinancial, however, never “acknowledged transfer of the property” or took “responsibility for maintaining the property.” Id. at 3. Citifinancial “did not accept the transfer” (although it is not entirely clear how Citifinancial manifested that non-acceptance). The borrower did not enter into any kind of written agreement with Citifinancial, and Citifinancial “took no action at all” with regard to the property. Id. at 14. There was no written consent by Citifinancial or any activity demonstrating consent, such as the physical possession of the property. Evidently, Citifinancial simply ignored the quit-claim deed.
Indiana mortgages, generally. Indiana follows the “lien theory” of mortgages. This means that a mortgage creates a lien on property but not title to it. Mortgagees do not have an ownership interest in the real estate. Id. at 15. Title to property cannot be transferred to the mortgagee unless there is a foreclosure and sale (or a deed-in-lieu of foreclosure). Indiana defines “foreclosure” as a legal proceeding that terminates a mortgagor’s interest in property. Id. “The right to possession, use and enjoyment of the mortgaged property, as well as title, remains in the mortgagor, unless otherwise specifically provided, and the mortgage is a mere security for the debt. Id. So, secured lenders holding Indiana mortgages merely have liens as security for their loans.
Transfer is a two-way street. In Phillips, the borrower executed and recorded a quit-claim deed in order to surrender the property, but no foreclosure took place. The Court held that the borrower could not compel the mortgage holder to accept the surrendered, quit-claimed property and that the borrower continued to be the owner of the property, with all the rights and obligations. The City properly enforced its property maintenance codes against the borrower, not the lender, as owner of the property. Id. at 15. The unilateral execution of a quit-claim deed in an effort to surrender the property to mortgage holder, while clever, ultimately accomplished nothing from the standpoint of avoiding liability.
Impact on commercial cases. Phillips impacts the handling of commercial foreclosure cases as well. A corporate borrower in possession of commercial real estate collateral could decide, in an effort to avoid certain liabilities related to the ownership of the land (such as public nuisance fines, utility charges or maybe even real estate taxes), to dump these problems back on a commercial lender simply by quit-claiming the property and surrendering possession. A secured lender may, for a variety of reasons, not want the property, particularly by quit-claim deed, until the property is run through a foreclosure. In that case, according to Phillips, the secured lender should take every possible action to show that it has not acknowledged or accepted transfer of the property or otherwise consented to ownership. Don’t sign any paperwork indicating you are the owner. Avoid physical presence on the premises. Make sure there are no communications with the mortgagor/borrower other than with statements that unequivocally demonstrate you do not want title to the property at that time (unless through a deed-in-lieu of foreclosure with a supporting agreement). That way, if and when you want to liquidate the collateral or become the owner of the property, you can do it on your own terms and avoid the potential liability found in Phillips.