The Pain $ of Not Knowing - Contract For Deeds

[Dion DePaoli]

I thought it would interesting to share some recent experience we have had with some of these instruments. To that extent, an illustration of the pain that can come with working with an instrument that is not the same as a mortgage and what can happen if you (or your counsel for that matter) fail to do proper research on and properly execute.

Let me begin by saying, there are some here that are more experienced than I in terms of working with contract for deeds. (Yes, Bill, you) However, I consider myself and my firm pretty competent in our knowledge and skill around RE cash flowing instruments. As such, we are pretty good with due diligence and we do know what we don't know and how to know what we didn't. We are by and large a whole loan mortgage firm and not so much a buyer of these instruments per se. In the recent year or so, there has been a lot of activity with these instruments trading in the secondary market. It has become not unusual to see one or two or so in a pool of loans open for purchase. As such, over the months, we have come to own some, albeit, not many at all.

Allow me to pause there and lodge a complaint to the secondary market and include brokers and sellers alike. I have seen brokers and sellers use the general term "Notes" to describe a pool of assets. I have seen them as a homogeneous pool of Contract For Deeds (which for the reader also includes Land Contract, Bond For Title and Installment Contract For Deed...those are all the same thing) I have also seen a mixed bag of goods, where the pool contains both mortgages and CFD's. This practice of using the term "Notes" to generically describe whole loan mortgages and CFD's is problematic as it does not properly describe what the asset actually is. Is there a Promissory Note in a "CFD"? Yes, there is, there is also a Promissory Note in a whole loan mortgage too. Great, aren't they all "Notes" then? No they are not. The security instrument attached to the note is a different animal altogether. Perhaps, someone somewhere knew that and purposely slipped CFD's into the mix starting the trend under the guise of hoping nobody would notice. If you are an aspiring or practiced whole loan mortgage buyer, do not be deceived, you likely do not want any of these CFD's. To not point to the distinction amongst assets is, I would argue, is an annoyance and deceptive practice to some extent. If you're foreshadowing, I don't have anything positive to say about these instruments.

I digress, to the story at hand. So we are working through our due diligence for the acquisition of a pool of assets. As what has become the aforementioned slight norm, we come across the first CFD file. It is an interesting looking little guy. It's dressed like a mortgage. It walks like a mortgage. It quacks like a dog. Wait, what? The file, has the collateral paperwork of a standard distressed mortgage. But it also has a CFD contract. As the dig gets deeper, there is also a DIL. Somewhere out there, somebody had a light turn on, they see a connection. So the borrower did a DIL and the Mortgagee did a CFD back to the borrower. How nice of everyone to play along. Bill, just said "Equity of Redemption" at least 3 times. (I know your reading this, the NSA told me so) However, for the other readers, we will come back to that in a couple moments.

So the file is set aside for specific due diligence on the asset. Then the next one pops up. Then the next and the next and so on. Pretty soon, we have set aside around 30% of the pool. (an issue in and of itself) There are variations to each of them. Some have the old borrower as the 'Vendee' (tenant, if you will) and some have a new Vendee, a new tenant that was not the borrower. The pool we are working on has a national footprint, so these instruments span many different states. The paperwork for all of these was a created standardized template. The paperwork is created and executed under the guidance of an attorney which is not a national firm. So, in an essence, they tried to create a uniform instrument and use it everywhere. The presence of an attorney, I suppose, would give some confidence of the legitimacy of the instrument. The idea of a templated CFD is a red flag. The laws around CFD for each state is different so they couldn't possibly be all the same. So begins the due diligence on the assets themselves.

Ultimately, we end up with around 10 different states. The CFD's are dropping faster than interest rates at a Federal Reserve meeting. By dropping, I mean loaded with defects. The defects range from lack of proper disclosure to the Vendee, to failure, to record to exclusions that are forbidden by state law and a BP popular non-compliance to SAFE Act. Now, if you are in the distressed paper space, defective paper is not all that scary. Most things can be fixed. Operative word, "most". In addition, the barrier to fix is usually costly.

Well, just how risky you want to know. The easily quantified concepts were staggering in and of themselves. For instance, CFD is not a simple lease/rental agreement which you make and stick in file. Many states require recording. Lack of recording will deem the instrument unenforceable in the event of defaulted payment. OK, so then let's just record the instrument so it can be enforced then. Great! Record requirement was within 180 days of the execution of the agreement. The penalty for not recording within said time. A mere $100 per day. The average age of the instruments was over two years.

The next sort of quantifiable cost deals again which comes to light in the event of payment default is lack of disclosure. Disclosure of what you ask. Well, in some states, EVERYTHING, North Carolina comes to mind, they have a laundry list of things that need to be disclosed, literally was like a page and half (I actually laughed out loud seeing how much stuff was required) and it is to be included in the agreement itself. Illinois requires a disclosure certificate, in other words a disclosure that is notarized. The penalty for the failure to disclose is making the Vendee whole to the point prior to the execution of the instrument which would include a refund of all principal, interest and fees paid over the life of the agreement.

Other defects had legal implications. For instance, in many states, the Vendor (Seller) can not really create an As Is Where Is sale and put all of the due diligence on the buyer. To the extent that the property doesn't have to be new, but the Vendor is responsible for the condition of the property in full prior to sale otherwise, Vendee has been coerce and could be found that fraud has been committed. To an extent that if you had a dilapidated property and used a CFD you could have issues.

The popular star of BP forums, the SAFE Act was an issue. Sure an attorney created and executed these under their practice. Should be fine right? No, not really. First, the attorney firm as mentioned was/is not a national firm. Thereby being licensed by the bar in only, well, one state. So that firm can only practice law in that state. The SAFE Act provides some exemption from license to an attorney who is practicing law. You can only practice law in the state your licensed in. (this just in!) Additionally, the attorney is ONLY exempt if they are not considered "In the Business" of making loans. While that is an ambiguous statement on purpose, we can assume that making these instruments well into the double digits in one calendar year is not acting on the safe side of the SAFE Acts direction. Also, refer back to point one, if you make them in a state you are not a member of the bar, that seems to be evidence that...you are in the business.

The final risk grouping here that I will point out, just so happens to be my favorite 'humdinger' in the group. And perhaps one that could have tangent conversations in spirit to other industry practices, now that I have had some time to reflect. A Mortgagee can not take away the Borrower Equity of Redemption. The equity of redemption essentially is the right of the borrower to redeem the debt which is being foreclosed upon. This right is present in all foreclosures and expires either pre or post sheriff/trustee auction depending on the state. Essentially, the Mortgagee can not circumvent a foreclosure proceeding, that is not equitable (fair) to the borrower.

Enter, Deed in Lieu turned Contract for Deed. A DIL is not enforceable if it is executed under duress. The borrower must willingly and without coercion give title to the Mortgagee in lieu of the foreclosure action in exchange for satisfying the debt that is owed. The issue, well one of the many, with Contract for Deeds and alike, is that a failure of payment (just one) can be deemed or defined as a default opposed to a delinquency. The Vendee is not afforded a grace period under law (120 days) to cure the delinquency before a foreclosure action can be commenced. These are the CFD horror stories, Vendee is in contract for years, close to the maturity and misses one payment and it all was a waste, the Vendor (Seller) takes back the property and treats payments like rent.

It does not seem like a stretch of reality for a Vendee's defense to be they were coerced into the DIL in order to recieve back the CFD. On a side note for further discuss, might this apply to rental agreements too in some distant manner? (@Bill Gulley what do you think?)

The DIL and CFD in unison are robbing the borrower from the right of equity redemption and seem to be circumventing foreclosure. "Hey, Mr. Borrower, give you your deed since your so late and I will sell it back to you with this ______ (CFD/Option/Lease/Rent/Etc) and you can stay in your home and refinance me out when you have better credit....blah, blah, blah" That is a story, that unfortunately has occured too many times around the US in many cities and towns. Is it a legal house of cards waiting for the right legal venue to decide it is all illegal? Whoa...the implications would be HUGE!!!

Perhaps in states where the foreclosure process is not judicial, this defense may be a little more difficult sine eviction and foreclosure may take the same amount of time but only if some form of redemption is afforded to the borrower/tenant/vendee.

Needless to say, the Seller of these instruments was not as impressed with our diligence, discovery and epiphany. What seller would be? "Hey Mr Seller, your stuff is not worth the paper it is written on, sorry." There has been and maybe still is this trend of using these instruments in the world of REI. They are being used by many different folks for many different reasons. Generally speaking, they are instruments purposely designed to strip equity from the buyer/vendee/borrower whether intentional or not. The idea, that a single default does not afford any redemption right seems to scream loudly in support of that idea. It would seem that increased use is now starting to illustrate increased incompitence.

Contract for Deeds have often been refereed to as "Poor Man's Mortgage", many judges believe them to be archaic instruments. Archaic or arcane, it would seem the slur name is still relative only, this time the "poor man" is the Mortgagee not the Mortgagor.