Legal Opinion: CIM-0124

Index Number: 3.135

Subject: Refinancing - Sec. 223(f)

MEMORANDUM FOR: Louis N. Smigel, Acting Assistant General Counsel, 2AC

THROUGH: Richard A. Hauser, General Counsel, C

FROM: John J. Daly, Associate General Counsel for Insured Housing, CI

SUBJECT: FHA-insured Refinancing under Section 223(f) of New York 202
Projects:

Maria Isabel, CABS, and Aquinas Housing

This memorandum responds to a December 6, 2001 memorandum ("Opinion)"
from former Assistant General Counsel Sara Manzano to John Daly,
Associate General Counsel for Insured Housing. That memorandum concluded
that the proposed refinancing of the above-referenced Section 202
properties under Section 207[^1] pursuant to Section 223(f)[^2] of the
National Housing Act is legally barred by Section 207. In addition, we
received a copy of the Deed and Land Disposition Agreement for the CABS
Senior Housing Development Fund ("CABS Covenant") which was attached to
your note to our office dated January 31, 2001.[^3] For the reasons
expressed below, we have no legal objection to the proposed
transactions.

The Opinion states that the New York City Land Disposition Agreements
("Covenants") preclude the refinancing of the Section 202 properties
with FHA-insured mortgages pursuant to the Section 223(f) program under
the laws of the State of New York. The basis expressed for this position
is that these Covenant restrictions conflict with HUD's statutory
requirement that a mortgage insured pursuant to Section 223(f) be a
first lien as commonly given in the jurisdiction where the property is
located. In addition, the Opinion appears to be grounded in the
proposition that restrictive covenants that survive foreclosure would
"prime" the first lien status of a mortgage that is security for a loan
to be insured by FHA.

## "First Lien"

Section 207 of the National Housing Act ("Section 207"), in defining
acceptable mortgages, provides:

(a) As used in this section --

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(1) The term \"mortgage\" means a first mortgage on real estate in fee
    simple, ... and the term "first mortgage" means "such classes of
    first liens as are commonly given to secure advances (including but
    limited to advances during construction) on, or the unpaid purchase
    price of, real estate under the laws of the State in which the real
    estate is located....[^4]

Our research has not revealed any cases in New York that define a "first
lien." It is clear, however, that under both Section 207 and New York
law, a mortgage is a security interest in real estate. In the 1892 case
cited in the Opinion, a mortgage is defined under New York law as "any
conveyance of any interest in real property intended by the parties to
be security for the payment of a debt or the performance of some other
obligation. [Burnett v. Wright]{.underline}, 135 N.Y. 543 (1892). The
word \"lien,\" however, is used in the Opinion to connote almost any
manner of claim or interest in real estate, including the Covenants.
This interpretation can lead to legally unsupportable conclusions
regarding the relationship of \"liens\" to other encumbrances,
especially about which one should have recordation priority. This
crucial distinction between liens and encumbrances is clarified in the
cases discussed below, several of which are cited in the Opinion.

In [Marine Midland Bank v. Marcal Enterprises, Inc]{.underline}., 91
Misc.2d 810, 398 N.Y.S.2d 782 (1977), a case of first impression in New
York, the plaintiff sued to foreclose a mortgage and included as a
defendant the United States of America which had leased a portion of the
subject property. The plaintiff further claimed that existence of the
lease would make the property virtually unmarketable at a foreclosure
sale. The court held that, although a lease is an estate or interest in
real property, it is not a lien. Relying on the following definition of
lien, the court stated that clearly \"a lien is a security interest in
real property.\"

> In its broadest sense and common acceptation a lien is understood and
> used to denote a legal claim or charge on the property, either real or
> personal, *as security for the payment of some debt or obligation*.

[Id.]{.underline} at 783 (citing [Ansonia Nat\'l Bank v. United
States]{.underline}, 147 F.Supp. 864, 865 (D.C. Conn. 1956) (emphasis
added). The court held that the United States leasehold was an ownership
interest and not a security interest. Therefore, plaintiff\'s action did
not provide a basis for suing the United States under a statute[^5]
permitting the United States to be named as a party in any civil action
or suit in state court to foreclose a mortgage or other lien upon real
or personal property on which the United States has, or claims, a
mortgage or other lien. [Id.]{.underline}

Notably, the [Ansonia]{.underline} case, upon which the court in
[Marine]{.underline} relied, further defines a lien as \"*the right
which a creditor has of detaining in his possession the goods of his
debtor until the debt is paid*.\" [Id.]{.underline} at 865. (emphasis
added). In that case, an owner of land agreed not to erect any building
on a twelve foot strip of his land which adjoined land being acquired by
the United States for post office purposes. In an action against the
United States under the same statutory authority, the court held:

> In the instant case, there is no debtor-creditor relationship between
> the plaintiff and the United States. Moreover, even if the United
> Sates has some rights in relationship to plaintiff\'s use of land, the
> United States has no interest in that land out of which it could be
> satisfied if those rights were abused. Whether this agreement
> constituted an easement by grant or merely a covenant is immaterial.
> The fact that the United States has neither a lien or mortgage
> interest in the land is sufficient to deprive this court of
> jurisdiction over the action.
>
> [Ansonia Nat\'l Bank v. United States]{.underline}, at 865. It is
> clear from this case that what distinguishes recorded encumbrances,
> such as the Covenants, from recorded FHA-insured mortgage liens is the
> distinct differences in the remedies available for non-performance. A
> mortgage lien is based upon a financial obligation and the ultimate
> remedy for violation of the mortgage is foreclosure. The remedies for
> a violation of a covenant, on the other hand, are directed at assuring
> compliance with an agreement, such as to maintain the property for
> elderly housing. Under the general provisions of § 501 of the CABS
> Covenant,[^6] the non-breaching party may seek specific performance
> and money damages for violation of the Covenant. Pursuant to the more
> specific provisions set forth in § 503,[^7] the non-breaching party
> may bring suit to cure the breach of the covenant. The remedy of
> foreclosure, however, would not be available because there is no
> security interest in land out of which these rights could be
> satisfied, if abused.

[Nature of Restrictive Covenants Versus Mortgage Liens]{.underline}

Even when a restrictive covenant such as the Covenant survives
foreclosure, lien priority would depend upon the nature of the
restrictive covenant and whether it is a lien or encumbrance. An
encumbrance is any right to, or interest in, land which may subsist in
another to the diminution of its value, but consistent with the passing
of the fee. [Creative Living, Inc. v. Steinhauser]{.underline}, 78
Misc.2d 29, 355 N.Y.S.2d 897 (1974). Encumbrances may include a broad
spectrum of rights or interests in real estate that constitute a burden
on the property which can impair its free use or transfer. Encumbrances,
therefore, include mortgages, judgments, liens, leases, deed
restrictions, covenants, easements, and other limitations on the
ownership of real estate. [Id.]{.underline} Although liens are included
with the meaning of encumbrances, not all encumbrances are liens. A
restrictive covenant may, or may not, be a lien. Whether a restrictive
covenant constitutes a lien (i.e. creates a security interest) would
depend on the specific terms of the covenant and the remedies for
violation of such covenant.

## Inchoate Lien

The Opinion states that restrictive covenants may give rise to an
inchoate lien. In support of this position, the Opinion cites to
[Neponsit v. Property Emigrant Industrial Savings Bank]{.underline},

278 N.Y. 248, [reargument denied]{.underline}, 278 N.Y. 704 (1938).
[Nesponsit]{.underline} involved an action brought by a property
owners\' association to foreclose a lien arising from a breach of a deed
covenant requiring landowners to pay a fixed sum of maintenance fees.
Plaintiffs sought to foreclose upon an alleged lien arising from the
covenant contained in a deed of conveyance of land. Significantly, the
covenant explicitly stated that any unpaid charges would \"become a lien
on the land and shall continue to be such lien until fully paid.\"
[Id.]{.underline} at 251. In addition, the covenant expressly vested in
the property association the right to bring \"all actions against the
owner of the premises...for the collection of such charge and to enforce
the aforesaid lien,\" including foreclosure. [Id.]{.underline} at 254.
Liens of this nature which are recorded prior to the insured lender's
first lien would affect first lien status adversely because the deed
covenant in [Neponsit]{.underline} expressly created the lien, and the
remedy of foreclosure was available. Based on our review of the CABS
Covenant, it does not expressly create a lien, and it is our
understanding that all of the Covenants are similarly drafted.

[Recordation and Priority]{.underline}

Several cases are cited in the Opinion in support of the position that
any restrictive covenants that are recorded prior to HUD's first
mortgage survive foreclosure and thus "prime" the first lien status of
the FHA insured mortgage. The word "prime" is used vaguely in the
Opinion to mean "recorded prior to and therefore take priority."[^8] In
other words, the Opinion stands for the proposition that *any*
encumbrance recorded prior to the insured lender's first lien would
adversely affect its first lien status. This position, however, has no
support in any of the case law cited in the Opinion. For example, the
Opinion cites to [Maidment et al. v Newbridge Properties,
Inc]{.underline}., et al., 53 N.Y.S.2d 581 (1945), where "it was held
that the mortgage lien was not subject to restrictive covenants set
forth in deeds of conveyance made by the mortgagor *after* recording of
the mortgage." (emphasis in original). Indeed, this is the general
common law rule of \"first in time first in right." [Metropolitan Life
Insurance Co. v. United States]{.underline}, 9 A.D.2d 356, 194 N.Y.S.2d
168 (1959). The [Maidment]{.underline} case, however, does not stand for
the proposition that restrictive covenants recorded *prior to* the
FHA-insured mortgage necessarily would have an adverse effect on first
lien status[^9] nor does it hold that all restrictive covenants are
liens. In fact, based on the definitions of lien set forth in both the
[Marine]{.underline}[^10] and [Ansonia]{.underline}[^11] cases,
restrictive covenants that do not constitute liens, even though recorded
before the insured mortgage, would not prime the mortgage's first lien
status under New York law.

[Rejection of Title]{.underline}

The Opinion cites a line of cases in support of the position that
restrictive covenants, such as the proposed Covenants, justify the
rejection of title. [Isaacs v. Schmuck]{.underline}, 245 N.Y. 77 (1927);
[O\'Hara v. Bronx Consumers Ice Co]{.underline}., 254 N.Y. 210, 172 N.E.
472 (1930). These cases involved actions by prospective purchasers to
recover down payments from the sellers. In both the [Isaacs]{.underline}
and the [O\'Hara]{.underline} cases, the courts held that when
prospective purchasers bargain for property without restrictions (or
subject to specifically enumerated restrictions), any restrictions that
exist outside of those contemplated or bargained for in the proposed
contract justify the rejection of title and the return of the
purchaser\'s down payment. A prospective purchaser of any HUD-insured or
HUD-owned property surely would have knowledge of any duly recorded
restrictive covenants that would limit the use of the property. Unlike
the purchasers in the cases cited, buyers of HUD properties would make
an informed decision and *may* reject title. A purchaser\'s rejection of
title, however, is not mandatory. Acceptance or rejection is dependent
upon the needs of the purchaser and the nature of the bargain. This
concept of rejection of title by a purchaser, however, has no bearing on
the issue of the first lien status of the FHA insured mortgage and is
not relevant to the issue of the quality of the lien held by the insured
lender.

[Title Policy/Marketability]{.underline}

In a transaction involving FHA mortgage insurance, there must be
compliance with the statutory "first lien" requirement. The status of
the first lien on an FHA insured mortgage is established through a title
insurance policy. See 24 CFR 200.61; HUD Handbook 4430.1, Paragraph
(1-10) (The title policy must show the insured mortgage as the first
lien.). We understand that a title company in New York has indicated
that it will insure the first lien status of the FHA-insured mortgage in
the proposed transactions. We are not certain whether the Covenants will
appear as informational items or exceptions to the title policy. In any
event, the Covenants then would raise the issue of marketability.
Handbook 4430.1 provides at the outset of the above-cited paragraph that
the Director of Housing Development is responsible for making a
determination about whether any title exceptions adversely affect
project value or marketability. In addition, the HUD Form 7 Closing
Instructions indicate under item 5(a)(3) that exceptions falling within
a \"doubtful\" zone may be waived by the local Director and \"where
there is such a waiver, the closing attorney will rely thereon.\" This
procedure remains in effect so the Housing program office is charged
with making an administrative policy determination about whether a
particular exception on the title policy adversely affects the value or
marketability of a project, including any covenants that run with the
land.

[Conclusion]{.underline}

Not all restrictive covenants are liens. In fact, restrictive covenants
that do not constitute liens, even though recorded before the insured
mortgage, do not prime the mortgage's first lien status. Even when a
restrictive covenant survives foreclosure, lien priority would depend
upon the nature of the restrictive covenant and whether it is a lien. In
addition, the concept of rejection of title by a purchaser has no
bearing on the issue of the first lien status of the FHA insured
mortgage and is not relevant to the issue of the quality of the lien
held by the insured lender. Whether the Covenants adversely affect the
value or marketability is a matter to be resolved by program
administrators. In short, the Covenants do not expressly create liens
(i.e. a security interest in land out of which these rights could be
satisfied, if abused), and as such, the remedy of foreclosure is not
available.

> For the reasons expressed above, we have no legal objection to the
> proposed transaction provided: (1) a title company in New York in fact
> insures that the FHA-insured mortgage is a first lien; (2) the opinion
> by counsel to the mortgagor does not disclose any defect in title that
> would raise questions about the first lien status; and (3) Field
> Counsel or FHA administrators are not made aware of any liens which
> otherwise would jeopardize the first lien status of the insured
> mortgage. The position expressed in this memorandum should be applied
> by HUD closing attorneys in this and other transactions with similar
> encumbrances.
>
> cc: Deborah VanAmerongen, 2AHMFAM
>
> cc:
>
> C Hauser 10110
>
> CA Weidenfeller 10110
>
> VanAmerongen 2AHMFAM
>
> CD Denison 8162
>
> CI Daly 9226
>
> CIM File/Chron 9228
>
> CIM Potts 9228
>
> CIM Hopkins 9228
>
> CIM McKenzie-John 9228
>
> **ACORN NO. 342951**
>
> **GIM:MCKENZIE-JOHN: 2/14/02 (H:gim/KMJManzano2-13)**
>
> **REVISED:JJDaly:jjd 02/21/2002 202-708-1274**
>
> **H:gim/KMJManzano2-13-Revised**
>
> **CIM CIM CIM**
>
> **Date Date Date**
>
> **McKenzie-John Hopkins Potts**
>
> **\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_
> \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_**
>
> **CI C**
>
> **Date Date**
>
> **Daly Weidenfeller**
>
> **\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_**

[^1]: 12 U.S.C. 1713(a)

[^2]: 12 U.S.C. 1715n(f)

[^3]: Based on our review of the Deed and Covenant, we agree with your
    statement that the Covenant limits the exercise of a right of
    reversion to the period of construction. Therefore, this restriction
    no longer would be operative because the period of construction
    ended years ago.

[^4]: 12 U.S.C. 1713(a)(1).

[^5]: 28 U.S.C. § 2410(a)).

[^6]: [See]{.underline} page 35, § 501 of the CABS Covenant which
    states, in relevant part, that:

    > in the event any party hereto shall fail to comply with or violate
    > any of the provisions of this Agreement, then and in that event
    > the other party hereto may institute such actions or proceedings
    > as it may deem advisable as well as proceedings to compel specific
    > performance and the payment of all damages, expenses and costs.

[^7]: [See also]{.underline} page 42, § 503, Paragraph B which provides,
    in pertinent part:

    > The City shall have the right in the event of any breach of the
    > covenant...and the United States shall have the right in the event
    > of any breach of the covenant...to exercise all the rights and
    > remedies, and to maintain any actions or suits at law or equity or
    > other proper proceedings to *enforce the curing of such breach of
    > agreement or covenant*, to which it or any other beneficiaries of
    > such agreement or covenants may be entitled. (emphasis added).

[^8]: The term "prime" has been defined as follows: "To take priority
    over." [Black's Law Dictionary]{.underline}, Seventh Edition, at
    1210.

[^9]: [See]{.underline} [Estate of Dresner v. State]{.underline}, 242
    A.D.2d 627, 662 N.Y.S.2d 780 (1997) (although chronological priority
    of liens is a factor to be considered in determining priorities, it
    is not dispositive).

[^10]: 398 N.Y.S.2d 782, 783.

[^11]: 147 F.Supp 864, 865.