BENOV v. COAST FUNDING CORPORATION (1992)

Coast Funding Corporation and Coast Financial Corporation (hereafter Coast) appeal from a judgment in favor of Michael L. and Bonnie S. Benov (hereafter the Benovs), ordering Coast to forgive the Benovs' obligation on a promissory note and to reconvey the deed of trust securing payment on the note.   The Benovs purchased a condominium in Foster City in November 1986 with financing provided by a tax exempt bond issue of the Foster City Community Development Agency (hereafter the Agency).   The effect of the judgment is to give them ownership of their condominium, free and clear of all encumbrances, with payment of only a negligible portion of the agreed purchase price.   The trial court reasoned that this anomalous result was demanded by a “mortgage forgiveness” clause, inserted in the note to assure the tax exempt status of the bond issue.

In 1985, the Agency sold an issue of tax exempt revenue bonds with an aggregate principal amount of $20,600,000 and a yield of 10.1781 percent subject to a Trust Indenture with Security Pacific National Bank (hereafter the Trustee).   The Agency intended to use the bond proceeds to extend loans to first-time home buyers, of low and moderate income, at rates below those available on the commercial market.   It contracted with Coast to perform an essentially administrative role in the proposed financing.

Coast is a small family-owned mortgage banking company, managed largely by the president, Walt Hoefler, his wife and two children.   After successfully participating in four other municipally financed home mortgage programs, it paid the Agency a nonrefundable $120,000 fee for the privilege of “originating” and servicing loans funded by the bond issue.   This meant that Coast would process and close the loans, advancing the borrowers money from its own line of bank credit, and then sell them to the bond trustee.   Under its agreement with the Agency, Coast would retain responsibility for servicing the loans throughout their term.   Coast hoped to make money by charging fees both for closing and servicing the loans.

The bond issue proved to be ill-timed.   Commercial interest rates on fixed-rate loans fell unexpectedly below the rate that the Agency could offer, and adjustable rate mortgages offering more attractive terms became widely available.   The Agency was able to make only four loans, amounting to only 2 1/212 percent of the bond proceeds.   The last of these loans was to the Benovs who used the proceeds to purchase their condominium.   On October 27, 1986, the Benovs gave Coast a promissory note for $145,300, secured by a deed of trust, calling for monthly payments of $1,323.69 over a 30–year term.   Coast subsequently sold the note to the Trustee.

Both the note and the deed of trust contained a “Mortgage Forgiveness Rider” which provided:  “Upon the redemption of the last outstanding bond of the issue of bonds designated as the Foster City Community Development Agency single Family Mortgage Revenue Bonds, 1985 Issue (the “Bonds”) pursuant to the Indenture relating to the Bonds, dated as of March 1, 1985, by and between the Foster City Community Development Agency and Security Pacific National Bank, and upon payment to the Foster City Community Development Agency of any amount to be paid to it pursuant to said Indenture, the Borrowers obligation to make payments under this Note shall cease and shall be forgiven by the Agency and the Trustee.”

The trust indenture between the Agency and the Trustee required investment of the bond proceeds within three years.   With this deadline approaching, the Trustee decided to unwind the transaction.   In March 1988, the trust sold back to Coast the three loans then outstanding for $243,143.91, representing their principal value of $363,153.91 less $120,000—in effect refunding to Coast its participation fee.   As the Benovs had paid off only $865 of principal, the principal value of their loan was $144,434.91.   The trust then redeemed the entire bond issue and paid off all amounts owing by the Agency, using the unexpended portion of the bond proceeds, income earned from investment of these proceeds, and a portion of the proceeds from the sale of the three loans to Coast.   The Agency retained $200,000, representing the excess of the earnings in the bond fund over the amount needed for bond redemption.   On the advice of bond counsel, it placed this sum in a “housing set aside fund” to be used in the future to aid low or moderate income home buyers in Foster City.

After purchasing the three loans back from the trust, Coast sought to obtain refinancing for the borrowers on terms that would make the loans acceptable to the secondary mortgage market.   It successfully refinanced two loans but encountered an obstacle in negotiating with the Benovs.   Acting on the advice of Mr. Benov's brother, a vice-president of Shearson Lehman Brothers, the Benovs claimed that under the mortgage forgiveness rider, the “loan should be forfeited” and the entire balance owing on the promissory note should be “forgiven.”   The Benovs subsequently retained counsel who advised them that they could stop payments on the note.   They made their last payment on December 1, 1988, and filed the present suit against Coast on January 23, 1989.

The second amended complaint alleges a cause of action for breach of contract and three equitable causes of action seeking the remedies of specific performance, a decree removing a cloud on title, and declaratory relief.   The Benovs later dismissed the breach of contract claim so that the case proceeded to trial before the court on the three equitable causes of action.   By the time their suit came to trial, the Benovs had moved out of the condominium and were renting it out as a source of income.

In a memorandum of decision, the trial court found for the Benovs, and on September 6, 1991, entered judgment ordering, among other things, that Coast “remove the cloud on [the Benovs'] title to the condominium located ․ in the city of Foster City ․ by forgiving [their] obligation to make payments upon the promissory note pertaining to the property, by cancelling and delivering up to [them] the promissory note, by reconveying to [them] the deed of trust encumbering [their] title to the property and purporting to secure repayment of the promissory note, and by taking any and all further actions that are or may become necessary to cancel and revoke the effect of either of these instruments.”   The court subsequently awarded the Benovs $57,720 in attorney fees.

The trial featured testimony by two municipal bond attorneys regarding the purpose of the mortgage forgiveness rider.   Although they disagreed about why the clause was included in both the loan documents and the trust indenture, their testimony was consistent in other respects.   Federal tax law imposes many conditions on municipal bond issues of this kind to secure tax exempt status.   Among other things, the issuing agency cannot expect to collect interest on the mortgages that exceeds by more than 1 1/818 percent the interest it expects to pay on the bonds.   A 1 1/818 percent spread between the yield of the mortgages and the bonds is regarded as sufficient to pay for the cost of finance;  a larger spread is viewed as profit, rendering the entire issue taxable.   As a device to ensure tax exempt status while preserving an adequate spread to cover costs, bond attorneys devised the mortgage forgiveness rider in the mid–1980's.   Where this clause was included in the trust indenture, the agency could set the spread between the yield on the mortgages and the bonds at slightly more than the permitted 1 1/818 percent.   At some future date, generally calculated to occur within the last five years of a thirty-year loan, the yield from the outstanding mortgages would then equal the amount needed to pay off all the bonds, while giving the agency a yield of 1 1/818 percent.   The clause requires that at this date the agency would forgive any outstanding balance on the mortgages.   The agency was not harmed by this forgiveness because it was only giving up an amount that it could not retain in any event under federal tax law.

 By all accounts, the mortgage forgiveness rider was generally inserted in the promissory note and deed of trust as well as the trust indenture.   The Benovs' expert witness, Perry Israel, thought that the clause should be included in the loan documents as an aid to its enforcement;  it served to ensure that the lenders would not fall “asleep at the switch” and fail to forgive the obligation.   Coast's expert witness, Clifford Gerber, appeared to agree with this opinion but stressed another purpose.   The clause was also needed as an admonition to the borrower because the mortgage forgiveness would result in income tax liability to the borrower at some unspecified time in the future.   Without the clause, the lender might be faced with aggrieved borrowers, complaining of unexpected tax liability or, alternatively, of having sold their property shortly before forgiveness of the balance owing on the mortgage.   Regina Bryant–Fields, the attorney who drafted the provision, testified that she included it in the promissory note and deed of trust solely to notify borrowers of a prospective event affecting their interest.¹

According to the Benovs' witness, Perry Israel, when the mortgage forgiveness rider first appeared, it ordinarily took the simple form of the clause in the present transaction, but municipal bond attorneys soon became concerned about unintended consequences when the bonds were redeemed early.   Refinements in the clause later began to appear, denying forgiveness, for example, when an attorney certified that it was not necessary to maintain the tax exempt status of the bond issue.   Here, it is undisputed that mortgage forgiveness of the Benovs' note would serve no tax purpose.   In such a case, Israel conceded, a clause requiring mandatory forgiveness is “very harsh.”

 We consider that the case at bar is governed by the familiar rule that “a contract ․ will if possible be construed to avoid a forfeiture.”   (1 Witkin, Summary of Cal.Law (9th ed. 1987) Contracts, § 770, p. 696;  Rest.2d Contracts, § 227, subd. (1);  cf. Civ.Code, § 1442.)  Ballard v. MacCallum (1940) 15 Cal.2d 439, 444, 101 P.2d 692, states the rule plainly:  “We have two possible constructions, one of which leads to a forfeiture and the other avoids it.   In such a case the policy and rule are settled, both in the interpretation of ordinary contracts and instruments transferring property, that the construction which avoids forfeiture must be made if it is at all possible.”

 Under Ebbert v. Mercantile Trust Co. (1931) 213 Cal. 496, 2 P.2d 776, it is clear that an interpretation of the mortgage forgiveness rider as cancelling the Benovs' obligations on the promissory note would come within the concept of a forfeiture.   The Ebbert plaintiff purchased a tract of land by paying a sum of cash and executing a promissory note, secured by a deed of trust, for the balance.   The note provided that its payment was conditional on the vendor's performance of a “care contract” to cultivate fig trees on the land.   This contract obliged the vendor to perform specified agricultural services and gave it the right to one-half of the proceeds of the crop.   After three years, the vendor became bankrupt and ceased providing the services;  the plaintiff continued to grow figs and received the entire proceeds of the crop for three years prior to suit.   The plaintiff then brought suit to cancel the promissory note and deed of trust.

The Supreme Court denied this relief on equitable grounds:  “The note expressly provides a penalty for failure to perform the care contract.   That penalty is the forfeiture of the right to enforce the note and deed of trust.   A penalty need not take the form of a stipulated fixed sum;  any provision by which money or property would be forfeited without regard to the actual damage suffered would be an unenforceable penalty.  [Citations.]  By its terms, the provision would apply here regardless of the amount of the balance due on the note, and irrespective of the kind or extent of default in performance, or the amount of beneficial performance already received.”  (Ebbert v. Mercantile Trust Co., supra, 213 Cal. at p. 499, 2 P.2d 776.)

The remedy sought here is still more drastic.   The Ebbert plaintiff presumably suffered some harm when the vendor ceased performance of the “care contract.”   The Benovs were not harmed in any way by the redemption of the bonds;  they seek rather to secure a windfall at the creditor's expense.

In our opinion, the language of the mortgage forgiveness rider can be construed as applying only where the trust holds the note at the time it redeems the bonds and pays off the issuing agency's obligations.   First, the clause provides that the note “shall be forgiven by the Agency and the Trustee. ”  (Emphasis added.)   Neither the Agency nor the Trustee would have power to forgive the note after it had been validly conveyed to a third party.   Secondly, the clause refers to bond redemption “pursuant to the Indenture” and payment to bondholders “pursuant to said Indenture.”   This twice repeated phrase can read as contemplating forgiveness in a manner consistent with the Trust Indenture.   The Indenture calls for forgiveness only of mortgage loans “held by the Trustee” at the time of redemption:  “If the Agency shall pay ․ to the Holders of the Bonds ․ the principal and interest and Redemption Price ․ and the Agency shall pay ․ all amounts payable to the Trustee ․ all Mortgage Loans then held by the Trustee shall be deemed for all purposes to be then paid in full.”  (Emphasis added.)

This interpretation is, moreover, entirely reasonable.   It could serve no conceivable tax purpose to forgive the notes after they have passed out of the trustee's hands;  forgiveness could then only affect the interests of the transferee, not those of the trustee or the issuing agency.   Similarly, following conveyance of the mortgage loans, the clause is no longer needed as a notice to the holder of a possible taxable event;  the trustee will then have no occasion, or power, to forgive the note so as to create a tax liability.   Finally, it is in the interest of the trust and the issuing agency to have the option of unwinding the transaction by selling outstanding mortgage notes.   Such action will not adversely affect the borrower's interests in any way.   But, if the notes are subject to forfeiture after sale, they clearly will not be marketable.

 Choosing an interpretation of the mortgage forgiveness rider in the promissory note that avoids a forfeiture, we hold that, since the trust had transferred the Benovs' promissory note prior to redeeming the bonds and paying the obligations of the issuing agency, the Benovs remain fully obligated to make all payments required by the terms of the note.²  We do not reach Coast's further contention that the Benovs are barred from relief under the equitable doctrine of unclean hands.

The judgment is reversed.   Costs to appellants.

FOOTNOTES

1.   The Benovs invoke the rule that “where extrinsic evidence has been properly admitted as an aid to the interpretation of a contract and the evidence conflicts, a reasonable construction of the agreement by the trial court which is supported by substantial evidence will be upheld.”   (In re Marriage of Fonstein (1976) 17 Cal.3d 738, 746–747, 131 Cal.Rptr. 873, 552 P.2d 1169.)   But in our view, the rule has no application to the case at bar.   The record reveals no significant difference between the testimony of the Benovs' witness, Perry Israel, the Coast's witnesses, Clifford Gerber and Regina Bryant–Fields, except on the question of the purpose served by including the mortgage forgiveness clause in the loan documents.   This question does not concern an issue of fact about which the witnesses were competent to testify, i.e., financial practices in the municipal bond market, but rather turns on inferences to be drawn from the undisputed terms of the contract, a matter of law lying outside the sphere of expert testimony.  (9 Witkin, Cal.Procedure (3d ed. 1985) § 294, p. 305.)  “ ‘An appellate court is not bound by a construction of the contract based solely upon the terms of the written instrument without the aid of evidence [citations], where there is no conflict in the evidence [citations], or a determination has been made upon incompetent evidence [citation].’ ”  (Parsons v. Bristol Development Co. (1965) 62 Cal.2d 861, 865, 44 Cal.Rptr. 767, 402 P.2d 839.)

2.   As Coast argues, Restatement Second of Contracts section 230, subdivision (2), appears to offer an alternative analysis leading to the same conclusion.  (See O'Morrow v. Borad (1946) 27 Cal.2d 794, 801, 167 P.2d 483 [citing Rest., Contracts, § 307, the predecessor of § 230, subd. (2) ].)

NEWSOM, Associate Justice.

STRANKMAN, P.J., and DOSSEE, J., concur.