Federal Court Says Foreclosure Rescue Sale Leaseback Is A Usurious Loan, North Carolina Equitable Mortgage Doctrine Invoked

In a 1985 case, the U.S. Court of Appeals for the 4th Circuit affirmed a lower court jury verdict finding that North Carolina's usury statute (N.C. Gen. Stat. § 24-2; for interest, generally, links to provisions of N.C. Gen. Stat. § 24, or for the text of the entire chapter, see N.C. Gen. Stat. § 24) was violated in a foreclosure rescue deal that involved a sale leaseback transaction with a homeowner facing foreclosure who was given a right to repurchase her home. The lower court determined that the arrangement, in substance, was a mortgage under North Carolina's equitable mortgage doctrine.

On a cautionary note, however, to those making claims under the Federal Truth In Lending Act ("TILA"), the Federal appeals court reversed a lower court finding that the TILA applied to the transaction in question. Notwithstanding the fact that it was undisputed that the foreclosure operator had entered into twelve similar sale leaseback transactions with other financially strapped homeowners in the year in question, the appeals court ruled that the foreclosure rescue operator did not fall within the definition of a "creditor", as specifically defined by the TILA, and accordingly, the TILA was inapplicable. In essence, the court said that the evidence presented as to the other twelve sale leaseback transactions did not show that enough of those transactions could be found to be equitable mortgages. Therefore, the evidence was lacking to show that the foreclosure rescue operator engaged in the requiste number of equitable mortgage transactions that would cause the operator to fall within the definition of "creditor" as defined by the TILA.

In this case, the homeowner presented affidavits from only four of the other 12 homeowners claiming that they thought their transactions were mortgage arrangements (one of whom recanted the assertion at trial); the operator, on the other hand, presented affidavits from eight of the 12 other homeowners in which they asserted that they knew the transactions were sale leasebacks. Several of these homeowners later testified at trial on behalf of the operators. In this regard, the court stated:

• We do not think a jury is free to recharacterize another transaction not the subject of the suit as a loan with a security interest, rather than a sale with an option to repurchase, when the transaction is evidenced by a general warranty deed absolute on its face and both parties to the transaction give unrefuted testimony that the transaction was a sale with an option to repurchase. To allow a jury to recharacterize such a transaction as a loan with a security interest would be contrary to the North Carolina Supreme Court's command that the true nature of a transaction depends upon the intention of the parties.

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With respect to the equitable mortgage doctrine, the court set forth the applicable North Carolina law as follows (text broken up for ease of reading, bold text is my emphasis):

A) Under North Carolina law, the test for determining whether a conveyance with an option to repurchase represents a true sale or merely a loan with a security interest focuses on the intent of the parties and not the form of the transaction. O'Briant v. Lee, 214 N.C. 723, 200 S.E. 865 (1939); McKinley v. Hinnant, 242 N.C. 245, 87 S.E.2d 568 (1955). In ascertaining the real intention of the parties, however, the simple declaration of the plaintiff, who was grantor in the deed, will not suffice to show that the parties intended to create a mortgage. The North Carolina Supreme Court has stated:

• The intention [to create a mortgage] must be established, not by simple declaration of the parties, but by proof of the facts and circumstances dehors the deed, inconsistent with the idea of an absolute purchase; otherwise, solemnity of deeds would always be exposed to the slippery memory of witnesses.

O'Briant v. Lee, 214 N.C. at 731, 200 S.E. at 870 (quoting Watkins v. Williams, 123 N.C. 170, 31 S.E. 388 (1898)). Thus, although a plaintiff may repeatedly testify that the transaction was intended to be a loan and that the land was conveyed for the sole purpose of securing the payment of that loan, the plaintiff must present more than his own simple declaration. Instead, the plaintiff must present proof of facts and circumstances dehors the deed inconsistent with the idea of an absolute purchase.

B) The North Carolina Supreme Court has identified six factors as pertinent in determining whether a transaction is a sale or a loan:

1. whether there was a debtor-creditor relationship created at the time of the transaction, Hardy v. Neville, 261 N.C. 454, 457, 135 S.E.2d 48, 51 (1964);
2. whether the "grantor" remains in possession or whether the grantee takes immediate possession of the property, id. at 457, 135 S.E.2d at 51;
3. whether the "grantor" was under distress and hard-pressed for money at the time of the transaction, O'Briant v. Lee, supra; Hardy v. Neville, 261 N.C. at 457, 135 S.E.2d at 51;
4. whether the transaction originated out of an application for a loan, O'Briant v. Lee, 214 N.C. at 733, 200 S.E. at 871;
5. whether the purported sale price is less than the net worth of the property, id. at 733, 200 S.E. at 871; and
6. whether the "grantor" was obligated to exercise the "option to repurchase." Hodges v. Hodges, 37 N.C. App. 459, 246 S.E.2d 812 (1978).

The North Carolina Supreme Court has counseled that doubts about whether the transaction is a sale or a mortgage are to be construed in favor of a mortgage in order to prevent the possibility of oppression created by an outright sale. O'Briant v. Lee, 214 N.C. at 732, 200 S.E. at 869; McKinley v. Hinnant, 242 N.C. at 252, 87 S.E.2d at 573.

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In affirming the jury verdict with respect to the violation of the state usury statute, the only issue of law addressed was whether, in light of the reversal of the Federal claims under the TILA, the pendent state usury claim should be dismissed for lack of federal jurisdiction. In this regard, the court stated:

A) In United Mine Workers v. Gibbs, 383 U.S. 715, 16 L. Ed. 2d 218, 86 S. Ct. 1130 (1966), the Supreme Court held that if a federal claim against a party is dismissed before trial, the pendent state law claims should be dismissed as well.

B) The Ninth Circuit has held, however, that once a trial is held a court of appeals should order dismissal of a pendent claim on remand only "when the federal cause of action was so insubstantial and devoid of merit that there was no federal jurisdiction to hear it." Traver v. Meshriy, 627 F.2d 934, 939 (9th Cir. 1980) (citing Hagans v. Lavine, 415 U.S. 528, 94 S. Ct. 1372, 39 L. Ed. 2d 577 (1973)). It also stated that if the federal claim was not frivolous, then the issue of whether the district court should have heard the pendent state claim is a matter committed to the sound discretion of the district court. Traver, 627 F.2d at 939.

C) We conclude that Redic's Truth in Lending claim was not frivolous and that the district court did not abuse its discretion in hearing Redic's pendent North Carolina claim for usury. Therefore, we affirm that portion of the district court's decision awarding her $1,944 in damages against Schwartz for charging her usurious interest.

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Redic v. Gary H. Watts Realty Co., 762 F.2d 1181 (4th Cir. 1985) North Carolina equitable mortgage kappa