Thursday, March 1, 2007

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.

Cal. App. Ct. 4th Dist., Div. 2
145 Cal. App. 4th 1039

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.”


  • "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.)"


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.


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:

  • (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.


Tuesday, February 27, 2007

Equitable Mortgage Defense In Homeowner - Tenant Eviction - Part 3 Addendum

This is an addendum to the post dealing with the equitable mortgage defense in California. Click here to see the prior post, Equitable Mortgage Defense In Homeowner - Tenant Eviction - Part 3. Subsequent to that post, I came across a pretty old California Supreme Court case which, if it is still good, both provides additional support for the viability of the equitable mortgage defense in an eviction/ejectment action, and further, may constitute the law of the state regarding this defense in homeowner-tenant evictions in California.

This case was an action for ejectment. The defendant, Mangan, was the equitable owner of property which was purchased on a deferred sale contract, where the legal title owner, a railroad, was to keep legal title to the property until Mangan fully paid off the contract (within five years of the sale contract). Upon entering the contract, Mangan "entered into the possession of said property, and ever since said time have been in the open, notorious, and exclusive possession and occupancy thereof, having valuable improvements thereon, and claiming to own the same."

About 4 years later, Mangan borrowed money secured by the equitable interest in the property. As part of the loan agreement, Mangan assigned the equitable interest in the property as collateral for the loan to the lender.

Within the next 4 1/2 years, the ownership interest in the property assigned by defendant Mangan to the lender as collateral was assigned and reassigned until the interest ended up in the hands of the plaintiff, Hyde (the railroad had yet to receive full payment on the original sale to defendant Mangan). A week after receiving the assignment, plaintiff Hyde made full payment to the railroad company for the land, surrendered the contract, received a deed to the land from the railroad company, and subsequently began an ejectment action to remove defendant Mangan from the property.

The lower court, in ruling for the defendant Mangan in the ejectment action, found that:
  • the assignment of the contract of sale to the original lender was a mortgage of defendants' Mangan interest in the land,
  • the possession of defendants Mangan was sufficient to put plaintiff on inquiry as to their rights, and
  • having failed to make such inquiry, Plaintiff was in no better position than if he had done so, and had been fully informed as to the defendants' claims and equities.
On appeal to the California Supreme Court, plaintiff Hyde (now the appellant) "[r]elies upon two main propositions in this case, either of which, if maintained, he claims would entitle him to recover:

1. That he is the owner and holder of the legal title to the premises, and in an action of ejectment, the legal title must control;

2. If the assignment of the contract were to be held to be a mortgage, the debt for which it was given being barred, defendants are entitled to no consideration without offering to redeem."

With regard to these two propositions, the California high court responded as follows (bold text is my emphasis):

  • "The first proposition, that "in an action of ejectment the legal title must control," is not the law of this state. The case of Willis v. Wozencraft, 22 Cal. 615, decides: "A mere equitable title to land, if it is of such a character as entitles the holder to possession in equity, is a sufficient defense under our system of practice to an action for the possession, brought even by the holder of the legal title. ( Central Pacific R. R. Co. v. Mudd, 59 Cal. 585; Whittier v. Stege, 61 Cal. 238; Hicks v. Lovell, 64 Cal. 17; 49 Am. Rep. 679.)"

  • "As to the second proposition contended for by appellant, there is a line of authorities which supports such contention. (Hughes v. Davis, 40 Cal. 120; Bruck v. Tucker, 42 Cal. 352; Pico v. Gallardo, 52 Cal. 206.) This proposition of law as laid down in the cases just cited is based upon another principle of law, established for the first time in this state in Hughes v. Davis, 40 Cal. 120, and which has since been discarded by section 2925 of the Civil Code. This principle as announced by the court was, "that an absolute deed which is shown by parol evidence to have been intended as a mortgage conveys the legal title to the property." And our attention has not been directed to any authority since this principle ceased to be the law of this state which has held to the doctrine laid down in those cases; but upon the contrary, the later decisions of this court hold that under the general issue the defendant may be allowed to show that the deed by which the plaintiff claims title is a mortgage, and therefore gives him no title."

With regard to the issue of possession of the land by the defendant Mangan (now the respondent), the high court observed (bold text is my emphasis):

  • "The plaintiff came into court in this action with full notice of all the rights and equities existing between the railroad company and the defendants, and between Brownstone and his assignees and the defendants; for the defendants were in the open, notorious, and exclusive possession of this land at all these times, and plaintiff made no inquiry to ascertain the rights or claims of defendants, and he is in no better position, and no more entitled to be regarded as a purchaser in good faith than if he had so inquired and ascertained the real facts of the case. ( Pell v. McElroy, 36 Cal. 268; Bank of Mendocino v. Baker, 82 Cal. 114; Scheerer v. Cuddy, 85 Cal. 273.) Neither could the plaintiff be recognized as a bona fide purchaser from his assignor, Erlanger, upon the additional ground that in the sale of equitable interests the principle of bona fide purchasers has no standing. (Taylor v. Weston, 77 Cal. 534.)"

With regard to plaintiff Hyde's payment of the balance of the contract to the railroad company in exchange for the deed, the court stated:

  • "If we regard the plaintiff as the assignee of the railroad company, he then purchased the legal title subject to the equitable title of the defendants under the contract, and his legal rights in maintaining this action are identical with those of his assignor; and under the facts as disclosed by the record in this case, the railroad company could not prevail in this action."


On the basis of this decision, it appears that a tenant who is being evicted (at least in California) has the right to challenge the title of the purported landlord seeking ejectment under the equitable mortgage doctrine and, if it can be established that the purported landlord's interest in the property is nothing more than a mortgage, the purported landlord should not prevail.


While the issue I wanted to touch on here was the availability of the equitable mortgage defense in an eviction/ejectment action where the tenant is claiming to be the equitable owner of the property, a second issue was also touched on. That issue involves the principle that, when one is in open, notorious, and exclusive possession of property, a subsequent purchaser of the property is placed on full notice of all the rights and equities existing between the possessor and the "seller" of the property. Accordingly, a subsequent purchaser is not entitled to the rights of a bona fide purchaser when such purchaser fails to inquire as to the rights and equities the possessor may have, but rather, purchases subject to those rights and equities.

The issues of actual and constructive notice, possession as notice, the duty to inquire, and bona fide purchaser are issues I try to address further in Exercising Options To Buy, Rights Of Intervening Interests, Notice, Bona Fide Purchaser, Duty Of Inquiry, & Other Stuff.

For the next post in the series, see Equitable Mortgage Defense In Homeowner - Tenant Eviction - Part 4.

Go here for other posts on the equitable mortgage doctrine in California. California equitable mortgage valedictorian emdefense