Land Contracts: Clogging and Bankruptcy IssuesPrint this Page
by John C. Murray
© 2002. All rights reserved.
A conveyance once a mortgage is always a mortgage. This phrase, which became one of the "maxims of equity," can be traced to a seventeenth century English case in which the mortgage limited redemption to the mortgagor or his male heirs. This restriction was held to be a clog on the equity of redemption, and therefore unenforceable. As a result, an assignee of the mortgagor was permitted to redeem the mortgaged property.1 The clogging doctrine invalidates two types of mortgage provisions. First, no provision may prevent the mortgagor from redeeming and retaining ownership of the mortgaged property by paying the indebtedness in full prior to entry of a valid foreclosure decree. Second, no provision may grant the mortgagee a "collateral advantage."2 The clogging issue can rear its ugly head in land-contract forfeiture proceedings (in those states, such as Michigan, where forfeiture is permitted), in connection with the application of post-judgment payments due from the vendee. Another issue facing both land contract vendors and vendees is whether a land contract may be rejected as an executory contract by a bankrupt vendor or vendee. Consideration -- and resolution -- of this issue is important because if rejection is permitted, the rights of the non-rejecting party will differ depending on whether the bankruptcy action was filed by (or against) the vendor or the vendee.
The Wilson v. Taylor Decision
In an unreported Michigan decision, Wilson v. Taylor,3 the Michigan Appellate Court held that the land-contract forfeiture judgment issued by the lower court against the borrowers impermissibly clogged their right of redemption, because it contained language stating that payments made by the borrowers after entry of the judgment would be applied first to maintain current payments and then to the outstanding judgment. Under Michigan law, when, as occurred in this case, the judgment of possession is based on the forfeiture of a contract to purchase and the purchaser has paid less than fifty percent of the purchase price the borrower is entitled to a 90-day redemption period before a writ of restitution may be issued. The vendor forfeits the contract by sending the purchaser a notice of forfeiture, declaring the contract forfeited unless the purchaser cures the breach within either 15 days or the time provided in the contract, whichever is longer. If the vendor prevails in a summary proceeding action, the court will enter a judgment of possession. If the purchaser fails to satisfy that judgment, the court will enter a writ of restitution.4
The lender argued that the borrower had voluntarily agreed to the language in the judgment and understood its meaning. However, the court found that, as a factual matter, the borrowers had not been represented by legal counsel, did not understand that they had a legally protected right of redemption, and therefore had not voluntarily or knowingly waived their redemption right. The lender then appealed the appellate court's ruling to the Michigan Supreme Court.
The Michigan Supreme Court stated that it was not properly presented with the question of a clogging of the equity of redemption, because the appellate court already had ruled in favor of the defendant-vendees on the clogging issue and the plaintiff-vendor had failed to raise the issue on appeal and had furnished the court with only a one-sentence argument with no citation to authority.5
Land Contract Forfeitures and Foreclosures: Michigan Law
Under Michigan law, land contract vendors may avail themselves of either forfeiture remedies under the summary proceedings statute or foreclosure remedies under the State's mortgage foreclosure statutes. However, at least one Michigan court has ruled that, in connection with a foreclosure action on a land contract, there was no proper acceleration of the contract where the purchaser had brought current any arrearage before acceleration, notwithstanding a history of late payments.6
Michigan enacted legislation in 1998 with respect to mortgages of interests of installment land contact vendors or purchasers ("land contract mortgages").7 The "Land Contract Mortgage Act" ("Act") provides that mortgages of such contract interests are in most respects to be treated like mortgages of fee title interests ("real estate mortgages"), including requirements for creation, bases for determining priority, procedures upon satisfaction, and foreclosure proceedings. Filing in the land records perfects such mortgages without need for UCC filing, and the underlying contracts are valid without recording or acknowledgment. Mortgagees of such contract interests have the same rights to notice and cure as their mortgagors and must be named as parties in proceedings affecting the mortgaged interests. Under the Act a land contract mortgage is not a real estate mortgage -- which is created only when "the vendor and the vendee join in or subject their respective interests to a single mortgage."8
The Act clarifies the circumstances under which contract purchasers must continue to make payments to vendors or instead to the vendors' mortgagees (or foreclosure sale bidders), and clarifies the obligations of vendors or vendors' successors to complete a conveyance by deed upon satisfaction of contract purchasers' payment duties. This statute was enacted to address the fact that vendor and vendee interests in land contracts in Michigan were often considered illiquid and unfinanceable, because of the uncertainty as to whether a document purportedly creating a security interest in a land contract interest was security upon a real property interest or a personal property interest. It also was unclear whether the enforcement remedies of the holder of such a security interest would be governed by the Michigan mortgage foreclosure statutes or by the Uniform Commercial Code. Gary Taback, who was one of the prime movers behind (and helped to draft) this very worthwhile legislation, has written an excellent article on the Act and the issues that it addresses.9
Bankruptcy: An Executory Contract?
Another significant issue is whether, if a bankruptcy proceeding is filed by (or against) the land contract vendor or vendee after execution of the land contract, the land contract will be construed under § 365 of the Bankruptcy Code ("Code") as an executory contract that can be assumed, assigned or rejected by the trustee in bankruptcy or debtor in possession ("DIP"). With respect to those situations where the vendor is the debtor in bankruptcy, §§ 365(i) and (j) treat installment land contracts as executory contracts that can be assumed, assigned or rejected by the trustee or DIP. Obviously, the vendee is not harmed if the trustee or DIP assumes or assigns the land contract. If, however, the trustee or DIP elects to reject the land contract, under which the vendee is in possession, the vendee is protected and may elect either to treat the contract as terminated or remain in possession.10 If the vendee elects to treat the contract as terminated, it is granted a lien on the property to the extent of the purchase price paid. If the vendee elects to remain in possession, it must continue to make the scheduled payments and does not have any other right to damages, other than to offset against the payments due any damages caused by the nonperformance of any obligation of the debtor after rejection. Section 365(i)(2)(B) provides that the trustee or debtor in possession is required to deliver title, but has no other obligations to perform under the contract. With respect to the situation where the land contract vendee is not in possession of the property, the vendee may be limited, in the event of rejection of the installment land contract by the vendee, to a lien for money or other consideration actually paid. The legislative history to § 365 states:
A party with a contract to purchase land from the debtor has a lien on the property to secure the purchase price paid, if the contract is rejected and the purchaser is not yet in possession.11
If the vendee is the debtor in bankruptcy, the cases are divided as to whether the vendee (or trustee) must assume or reject the contract as an executory contract or whether he or she can treat the land contract as equivalent to a mortgage with the vendor's claim being either fully or partially secured, depending on the value of the security. Some courts hold that installment sale land contracts are not executory because they are actually in the nature of a sale with a continuing security device, with no significant obligations remaining to be performed other than delivery of the deed upon payment in full of the contract purchase price.12 However, other courts have found that installment land sales contracts are executory because each of the parties has unperformed obligations. For example, in Terrell v. Albaugh (In re Terrell),13 the Sixth Circuit Court of Appeals found that the debtor-purchaser's interest in a land contract was an executory contract because there were material obligations left to be performed by both parties to the contract. The court stated that:
Under Michigan law, the failure of either party to perform his remaining obligations would give rise to a material breach allowing the other party to avoid continued performance. The failure of a vendee to continue paying installments gives the vendor a number of remedies for breach, including forfeiture and foreclosure... . Likewise, if a vendor fails to transfer title when promised or impairs his or her ability to deliver title in the future, he or she has committed a material breach entitling the vendee to sue for specific performance or to cease performance and sue for rescission.14
One commentator advises a case-by-case analysis to determine if a land contract constitutes an executory contract:
Because of the similarity of such contracts to secured mortgage loans, courts have often treated them as secured debts rather than executory contracts. The classification of a particular contract depends on the terms of the transaction. If the seller has not significant duty to the buyer other than to convey title upon completion of payments, the contract should be found to be a secured debt and not an executory contract. Treatment of the contract as a secured debt rather than an executory contract has a number of ramifications, including the inapplicability of section 365.15
The Act amended Michigan's land-contract statute, subsequent to the In re Terrell decision, supra, to provide (perhaps in response to the implied recommendation of Judge Kennedy in her opinion in In re Terrell) that "[u]ntil the vendor named in the contract has ceased in law to be bound by the provisions of the contract, the obligation to convey the land remains a continuing executory obligation of the vendor."16 It is questionable whether, given the Sixth Circuit's decision in In re Terrell, the insertion of this language in the Act was necessary, as bankruptcy courts in the United States remain sharply divided on this issue.
The Act has provided much-needed guidance and clarification with respect to the issue of whether a lender's mortgage or other security interest in a land contract constitutes an interest in real or personal property. The Act has also removed -- for better or worse -- the uncertainty (at least in Michigan) as to whether, where the land-contract vendee is the debtor in a bankruptcy proceeding, the land contract is an executory contract that can be assumed or rejected by the vendee-debtor. However, land contract vendors and lenders who take a security interest in the land-contract vendee's interest must still, as a result of the Michigan appellate court's (and the Michigan Supreme Court's) holding in Wilson v. Taylor, supra, be aware of the application of the clogging doctrine to the vendee's redemption rights -- especially in those situations where the vendee is unsophisticated and is not represented by counsel.
1 See Howard v. Harris, 1 Eng. Rep. 406 (Ch. 1683).
2 See, e.g., West v. Reed, 55 Ill. 242, 244 (1870) ("It is settled beyond controversy, that contracts between a mortgagor and mortgagee, for the purchase or extinguishment of the equity of redemption, are regarded with jealousy by courts of equity, and will be set aside if the mortgagee has, in any way, availed himself of his position to obtain an advantage over the mortgagor."); Humble Oil & Refining Co. v. Doerr, 303 A.2d 898, 906 (N.J. Super. Ct. Ch. Div. 1973) ("the [clogging] doctrine is universally applied, both in the United States and England"); Lincoln Mortgage Investors v. Cook, 659 P.2d 925, 927 (Okla. 1982) ("the [clogging] doctrine voids any provision in an original mortgage agreement limiting or modifying the right of redemption by payment of the full mortgage debt after default for any reason"); Russo v. Wolbers, 116 Mich. App. 327, 336, 323 N.E.2d 385, 389 (1982) ("Michigan adheres to the doctrine against clogging the equity of redemption."). See also RESTATEMENT (THIRD) OF PROPERTY: MORTGAGES, § 3.1 cmt. a (1996) ("Under [the clogging] rule, no agreement contained in the mortgage, or contemporaneous with it, could cut off a delinquent mortgagor's equity of redemption without resort to foreclosure by the mortgagee. Thus the equity courts refused to enforce attempts by a mortgagee, at the inception of the mortgage transaction, to have the mortgagor waive the right to insist on foreclosure in the event of a default."); 1 Grant S Nelson and Dale A. Whitman, REAL EST. AND FIN. L. § 3.1 (3d ed. 1993); John C. Murray, Clogging the Equity, 8 MICH. REAL PROP. REV. 132 (1981); John C. Murray, Clogging Revisited, 33 REAL PROP. PROB. & TR. J. 279, 300-302 (1998).
3 No. 164978, LC No. 93-064685-AV (Mich. Ct. App. Jan. 5, 1996), rev'd on other grounds, 577 N.W.2d 100 (Mich. 1998).
4 See MCLA §§ 600.5701, 600.5726, and 600.5744.
5 Wilson v. Taylor, note 3 supra, 577 N.W.2d at 105. See also Annot., Redemption Rights of Vendee Defaulting Under Executory Land Sale Contract After Foreclosure Sale or Foreclosure Decree Enforcing Vendor's Lien or Rights, 51 A.L.R.2d 672 (1957).
6 Kent v. Pipia, 185 Mich.App. 599, 603, 462 N.W.2d 800, 802 (1990).
7 MCLA § 565.356 et seq. (1998).
8 MCLA § 565.356, sec. 6(c) and (g) (1998).
9 See Gary A. Taback, The "Land Contract Mortgage" - It's Brand New, 25 MICH. REAL PROP. REV. 211 (1998).
10 11 U.S.C. § 365(i)(2).
11 124 Cong. Rec. 11.093 (Sept. 28, 1978); S.17.410 (Oct. 6, 1978).
12 See, e.g., In re Belmonte, 240 B.R. 843, 851 (Bankr. E.D. Pa. 1999) ("the Court is confident that the agreement is an installment land contract that should be treated as a security device and not an executory contract"); Kane v. Inhabitants of the Town of Harpswell, 248 B..R. 216, 2000 WL 622284 at *8 (1st Cir. BAP [Me.] 2000) (installment sale contract was not an executory contract where vendor had no significant remaining obligation to purchaser other than to convey title upon completion of payments, and sale of property was essentially sale of real estate pursuant to which debtors became equitable owners); In re Heward Bros., 210 B.R. 475, 477 (Bankr. D.Idaho 1997) (installment land sale contract was security device and not an executory contract under § 365); In re Streets & Beard Farm Partnership, 882 F.2d 233, 235 (7th Cir. 1989) (holding that a land sale contract is not in the nature of an executory contract, where the only remaining obligation on the part of the seller is to deliver legal title to the borrower); In re Walker, 277 B.R. 870, 871-72 (Bankr. S.D.Ind. 1998) (citing Streets and Beard, supra, with approval and holding that because the Indiana Supreme Court has held that a land contract sale should be treated as a secured transaction (Skenzdel v. Marshall, 261 Ind. 226, 301 N.E.2d 641 (Ind. 1973), and because "delivery of legal title is not the kind of legal obligation that renders a contract executory," the land contract was not in the nature of an executory contract); Horton v. Rehbein (In re Rehbein), 60 B.R. 436, 440 (9th Cir. BAP 1986 (contract for deed was not an executory contract where debtor had fully performed by placing deed in escrow).
13 892 F.2d 469 (6th Cir. 1989).
14 Id. at 472-73. The court specifically overruled the decision of the court in In re Britton, 43 B.R. 605 (Bankr. E.D. Mich. 1984), which held that land contracts are not executory, at least in those situations where the vendee has filed for bankruptcy, because of the similarity of land contracts to purchase money mortgages. The court distinguished land contracts from mortgages, stating that, "unlike most mortgages, 'performance remains due to some extent on both sides' and the failure of either party to fulfill his or her obligations would excuse the other from continued performance." Id. at 473. For other cases that have ruled that land contracts and other forms of purchase agreements are executory contracts, see In re Delex Management, 155 B.R. 161, 164 (Bankr. W.D.Mich. 1993) ("A land contract is an executory contract within the meaning of the Bankruptcy Code"); Speck v. First National Bank of Sioux Falls (In re Speck), 798 F.2d 279, 279 (8th Cir. 1986) (installment sale contract is executory because obligations remain on both sides); Sundial Asphalt Co., Inc. v. V.P.C. Investors Corp. (In re Sundial Asphalt Co., Inc.), 147 B.R. 72, 80 (E.D.N.Y. 1992) (contract for sale of land remains substantially unperformed and executory until specific performance is ordered); Butler v. Resident Care Innovation Corp., 241 B.R. 37, 46-47 (D.R.I. 1997) (same).
15 3 Collier on Bankruptcy par. 365.02[a] (15th ed. rev. 2000) (footnote omitted). See also Robert A. Hendricks and Joan Schleef, Land Contracts in Bankruptcy: Terrell Revisited, 18 MICH. REAL PROP. REV. 57 (1991).
16 M.C.L.A. § 565.361, sec. 11.1 (1998).