Exercising Options To Buy, Rights Of Intervening Interests, Notice, Bona Fide Purchaser, Duty Of Inquiry, & Other Stuff

A recent California case (decided December 15, 2006) which, while not directly dealing with foreclosure rescue situations (ie. sales, leasebacks, and options to buy), contains a legal discussion that may be of some interest to property owners of all states (and their attorneys) who have entered into a typical foreclosure rescue arrangement (a transaction where the property owner, either knowingly or unknowingly, "sells" or otherwise signs over title to the home to a "rescue operator", who then simultaneously leases back the premises to the homeowner, coupled with an option to buy back the premises) where the financially strapped property owner retains actual possession of the property).

Further, the specific situation I am contemplating is one where, after taking title to the property, the foreclosure rescue operator "strips the equity" from the property either by getting a mortgage on the property, or by selling the property to a third party (who may finance the purchase with a mortgage), with the original homeowner retaining actual possession of the property throughout the subsequent transactions.

Wachovia Bank v. Lifetime Industries, Inc.(Cal. website)

or

Wachovia Bank v. Lifetime Industries, Inc. (at findlaw.com)

E037560

Cal. App. Ct. 4th Dist., Div. 2

145 Cal. App. 4th 1039

2006

This case involved a rather complicated corporate sale leaseback real estate transaction between a bank and a large national retailer that included options to purchase the subject property as part of the overall transaction.

The specific facts of the case are a bit too involved to be recited here, and I don't believe it is necessary to do so since the focus of this post is to bring attention to a part of the discussion in the case that could have some affect on how financially strapped homeowners can approach getting the title to their property back from a rescue operator (or a subsequent purchaser and/or encumbrancer) where the rescue operator has "equity stripped" the property.

The text I 'm focusing on deals with the effect of an option to purchase on subsequent purchasers and encumbrancers who have notice of the option, and the applicability of the "relation back" doctrine.

The specific text in the case that I want to emphasize follows (anything in bold is my own emhasis; all other emphasis is contained in the original):

• "Although an option gives the optionee contractual rights to purchase the property, it "is merely an offer to sell and vests no estate in the property to be sold." (Leslie v. Federal Finance Co., Inc. (1939) 14 Cal.2d 73, 80 [92 P.2d 906]; see also Warner Bros. Pictures v. Brodel, supra, 31 Cal.2d at p. 772 ["[a]n option contract relating to the sale of land ... conveys no interest in [the] land," italics added]; San Jose Parking, Inc. v. Superior Court (2003) 110 Cal.App.4th 1321, 1326 [2 Cal. Rptr. 3d 505] [same]; 1 Miller & Starr, supra, § 2:7, pp. 19, 24 [an option "is not a transfer of the title or any estate in the property"].)"

• "However, when the option is exercised, the right to purchase the property relates back to the time the option was made. (Claremont Terrace, supra, 146 Cal. App. 3d at pp. 406-407; Anthony v. Enzler (1976) 61 Cal. App. 3d 872, 876 [132 Cal. Rptr. 553]; Seeburg v. El Royale Corp., supra, 54 Cal. App. 2d at p. 4.)"

• "Thus, subsequent purchasers of the property with notice of an option to purchase take subject to the right of the optionee to complete the purchase. (Claremont Terrace, supra, at p. 406.)"

• "The effect of these rules with respect to competing claims to title to property is summarized by Miller and Starr: "When a purchaser or encumbrancer acquires an interest in the property after the option is given but before it is exercised, and he or she has notice of the option, when the option is exercised the title received by the optionee relates back to the date the option was given and extinguishes the interest of the intervening party." (5 Miller & Starr, supra, § 11:108, pp. 283, 285, italics added.)"

• "Implicit in this relation-back rule is the fact that the optionee has actually received title to the property pursuant to the exercise of the option. Until title is transferred, the optionee, after exercising the option, holds only a right to complete the purchase, enforceable by specific performance; intervening interests, while subject to this right, are not yet extinguished."

My interest in the recitation of the law contained in this text is how, if it all, it applies in the context of a foreclosure rescue transaction where the operator "equity strips" the property as described above.

What Happens If The Homeowner In Possession Makes All His/Her Lease Payments To The Real Estate Operator And Ultimately Exercises The Buy Back Option?

Based on the law recited in the above text and assuming the holders of the intervening interests are "on notice" of the homeowner's rights and equities in the property, it appears that a homeowner in a foreclosure rescue arrangement who exercises the buy back option could both get back title to the property, and possibly get it back free of the intervening interests that arose subsequent to the sale leaseback arrangement with the rescue operator and up to to the exercise of the buy back option. Stated another way, it appears that the homeowner's interest may prevail and the intervening interests will be extinguished if the holders of those interests do not qualify for "bona fide purchaser for value and with notice" status.

What Happens If The Homeowner In Possession, Rather Than Exercise The Buy Back Option, Successfully Asserts A Claim Of Being The True Owner Of The Property By Invoking The Equitable Mortgage Doctrine?

While the recitation of the law in the above text did not arise in the context of a property owner asserting ownership of the property by invoking the equitable mortgage doctrine, I wonder why the same result shouldn't occur; that is, as long as the subsequent purchasers and encumbrancers are "on notice" of the equitable mortgage (ie. as long as they do not qualify as "bona fide purchasers), I do not know why the result would be any different. My belief is that, if a judicial declaration is obtained declaring that the homeowner is the true owner of the property under the equitable mortgage doctrine, based on the text in case above, that declaration should also "relate back" to the date of the original sale leaseback, which would pre-date the interests of any subsequent purchasers and encumbrancers.

In either case (assuming these assertions are correct), whether the homeowner prevails would depend on whether or not the subsequent purchasers and encumbrancers qualify as bona fide purchasers for value, and without notice.

Does Actual Possession Of The Property By The Homeowner Throughout The Entire Arrangement Impart "Notice To The World" (ie. Subsequent Purchasers and Encumbrancers) Of Any And All Legal Interests That The Homeowner May Have In The Property?

To try to answer this question, I've extracted the following text from the California Supreme Court decision in Scheerer v. Cuddy, 85 Cal. 270, 24 P. 713; (Cal. 1890) with regard to actual possession constituting notice to subsequent purchasers (all bold text is my own emphasis):

• "The actual possession of the premises by the appellant was sufficient to put the respondent upon inquiry as to the nature and extent of its claim. ( Pell v. McElroy, 36 Cal. 268; O'Rourke v. O'Connor, 39 Cal. 446; Moss v. Atkinson, 44 Cal. 9, 17; Hunter v. Watson, 12 Cal. 363; 73 Am. Dec. 543; Lestrade v. Barth, 19 Cal. 660, 675; Dutton v. Warschauer, 21 Cal. 610; 82 Am. Dec. 765.)"

• "The effect of such possession, and the diligence required of the vendee to ascertain the extent of the claim of the party in possession, is thus clearly stated in Pell v. McElroy, 36 Cal. 268.

• The fact of open, notorious, and exclusive possession and occupation of lands by a stranger to a vendor's title, as of record at the time of a purchase from and conveyance by such a vendor out of possession, is sufficient to put such purchaser upon inquiry as to the legal and equitable rights of the party so in possession, and such vendee is presumed to have purchased and taken a conveyance from the vendor with full notice of all the legal and equitable rights in the premises of such party in possession and in subordination to these rights, and this presumption is only to be overcome or rebutted by clear and explicit proof on the part of such purchaser, or those claiming under him, of diligent, unavailing effort by the vendee to discover or obtain actual notice of any legal or equitable rights in behalf of the party in possession."

• "And when the location of the land is such as to render personal application to and inquiry of the occupant practicable, a purchaser failing to make such application and inquiry is no more entitled to be regarded a purchaser in good faith than if he had so inquired and ascertained the real facts of the case."

• "Whether the respondent knew of the appellant's possession, or not, is immaterial."

• "It was his duty to know who was in possession of the property before making the purchase, and his purchase without ascertaining the fact must be regarded as the strongest evidence of bad faith on his part."

• "The burden of making the proper inquiry was cast upon him by the mere fact of actual possession on the part of the appellant."

• "If it were allowed that by failing to acquaint himself with the fact of possession on the part of another than the vendor the vendee could avoid the effect of the rule above stated, he could purposely avoid any inquiry on the subject, and thereby evade the rule and its consequences entirely."

The foregoing text is from a case that is over 115 years old. For those who prefer a case of more recent vintage, the following text is extracted from the California appellate court case, In re Marriage of Cloney, 91 Cal. App. 4th 429, 110 Cal. Rptr. 2d 615; (Cal. App. Ct., 1st Dist., Div. 3, 2001) (bold text is my emphasis):

• By statute, notice may be actual or constructive. Actual notice is defined as "express information of a fact,” while “constructive notice” is that “which is imputed by law.” (Civ. Code, § 18.) “A person generally has ‘notice’ of a particular fact if that person has knowledge of circumstances which, upon reasonable inquiry, would lead to that particular fact.” (First Fidelity Thrift & Loan Assn. v. Alliance Bank (1998) 60 Cal.App.4th 1433, 1443; Civ. Code, § 19; 5 Miller & Starr, Cal. Real Estate (3rd ed. 2000) Recording and Priorities, §§ 11:49-11:51, 11:58-11:59.)4 It is “black-letter law” that a bona fide purchaser for value who acquires his or her interest in real property without knowledge or notice of another’s prior rights or interest in the property takes the property free of such unknown interests. On the other hand, as respondent necessarily acknowledges, it is an equally well-established principle of law that any purchaser of real property acquires the property subject to prior interests of which he or she has actual or constructive notice. (Stout v. Gill (1930) 110 Cal.App. 445, 449; Hochstein v. Romero (1990) 219 Cal.App.3d 447, 451-452; 5 Miller & Starr, Cal. Real Estate, supra, Recording and Priorities, §§ 11:49-11:51.)

• 4 Civil Code section 19 provides as follows: “Every person who has actual notice of circumstances sufficient to put a prudent man upon inquiry as to a particular fact, has constructive notice of the fact itself in all cases in which, by prosecuting such inquiry, he might have learned such fact.”

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• "A party to a real estate conveyance is not entitled to ignore any information pertinent to title that comes to him or her, even from outside the recorded chain of title, to the extent such information puts him or her on reasonable inquiry notice of information that may bring into question the state of title." ( Triple A Management Co. v. Frisone, supra, 69 Cal. App. 4th at p. 531; First Fidelity Thrift & Loan Assn. v. Alliance Bank, supra, 60 Cal. App. 4th at pp. 1443-1445.)"

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Less than eight months after Scheerer v. Cuddy, above, was decided, the California Supreme Court decided Hyde v. Mangan, 88 Cal. 319, 26 P. 180; (1891). This case dealt with the equitable mortgage doctrine defense being successfully claimed by a person in possession of property who was being sued in an ejectment action, and also dealt with the issues of actual possession constituting notice, as well as the "duty of inquiry" that said possession creates on the part of subsequent purchasers and encumbrancers.

This case was the subject of a recent post so, rather than duplicate it, I will simply refer you to Equitable Mortgage Defense In Homeowner - Tenant Eviction - Pt. 3 Addendum for more information.

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Based on the text in these cases, it appears that the subsequent purchasers and encumbrancers may have a "duty to inquire" of the party in possession as to any and all rights and equities that possessor has, and that their failure to do so would result in their being imputed with the knowledge of the sale leaseback and the possible ownership rights that the possessor may have by invoking the equitable mortgage doctrine.

While the presentation here of these quotes from the foregoing California court cases doesn't in any way purport to be a thoroughly researched presentation of the issue of possession imparting notice to subsequent purchasers and encumbrancers of all the legal rights that the possessor may have, I think that it is undeniable that it is an issue that merits a very close look if you are a homeowner (or an attorney representing a homeowner) who has been a victim of a "home equity stripping" by a foreclosure rescue operator in the manner described earlier in this post.

For one thing, one can pick up any textbook on "Real Estate Law 101" and probably find at least a paragraph or two about possession of property constituting notice (I know that an old textbook that I have laying around, Real Estate Law - 8th Edition, by Robert Kravotil and Raymond J. Werner, copyright 1983, at Ch. 7.05(a), has three paragraphs on the issue; it does caution, however, that there are a few states in which possession does not impart constructive notice). The point here is that the idea that actual possession of property may constitute notice to prospective buyers and encumbrancers (or at least create a "duty of inquiry" upon the prospective holders of such subsequent interests) is not a novel proposition.

For a second thing, I have written a post relating to "notice" and the "duty to inquire" under Illinois law and, based on what I found, it sure seems like possession in Illinois does create, at a minimum, a "duty of inquiry" and possibly, constitute notice, in that state as well. See Equitable Mortgage Doctrine In Illinois - Pt. 2.

(Regarding New York law on this issue, see an opinion article entitled Possession as Constructive Notice of Rights of Tenants: Arcane, Possibly Archaic, which makes reference to what reportedly is the leading New York case, Phelan v. Brady (119 N.Y. 587, Ct. of Appeals 1880), which supports the proposition that a tenant in possession establishes actual notice or at least creates a duty of inquiry upon the person acquiring an interest in the subject property which, if not pursued, establishes constructive notice of tenant's rights to the extent of what might have been ascertained.

I believe that the importance of this issue can be demonstrated by two California incidents that have been the subject of media reports and on which I have wriiten posts. See Northern California Woman's Unwitting Sale Of Home Leads To Lawsuit, involving a single victim of an "equity stripping" foreclosure rescue transaction.

See also Two Plead Guilty In Combined Foreclosure Rescue/"Straw Buyer" Mortgage Fraud Scam, which involved an alleged mass fraud / "equity stripping" operation that affected over 100 Southern California homeowners. A five person group has been implicated. Two have already pleaded guilty and the remainining three are currently awaiting trial. Details of this alleged scam, as described by Federal prosecutors, are set forth in the plea bargain agreement of one of the defendants. See Cynthia Valenzuela Plea Bargain Agreement, Stipulated Statement of Facts, at pages 15 through 21.

These two reported incidents seem to be the type of "equity stripping" situations where a homeowner can attempt to claim (1) that the subsequent purchasers and encumbrancers are not "bona fide purchasers" and, accordingly, (2) that their interests are inferior to that of the homeowner.

Whether you are located in California or in another state, the issues described herein (and the applicable state case law) merit a close look by an experienced real estate attorney in the state where the property is located to determine whether or not a plausible claim can be made by a homeowner against the subsequent purchasers and encumbrancers in an "equity stripping" foreclosure rescue arrangement.

In this regard, issues dealing with exercising options to buy, the equitable mortgage doctrine, the relation back doctrine, the rights of subsequent purchasers and encumbrancers, bona fide purchaser for value and without notice, actual and constructive notice, and the duty of inquiry all merit consideration.

Post script

For free online access to any of the California cases cited herein, you can try one of two sources:

• Findlaw.com (California) - Reportedly contains California cases going back to 1934, or
• California Courts: Opinions of the Supreme Court and the Courts of Appeal (powered by Lexis) - For those unfamiliar with this website, once at this page, click "Searchable Opinions 1850 - Present" in the left hand column, then click "Continue", after reading and agreeing to the Terms of Service click the box to acknowledge same, then click "View Opinions", at which point you can enter the case citation in the appropriate search box and pull up the case.

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