Holder of wraparound mortgage must abide by terms or lose it

Real Estate Weekly, Dec 7, 1994 by Edward L. Schiff

The legal principal - which holds that a holder of a wraparound mortgage must meet its obligations to the underlying mortgagee or it loses the wraparound mortgage - has been made clear in the case of 51 Fifth Avenue v. Coronet Properties, (New York Law Journal, June 10, 1992). That principal has been re-affirmed in the case of Landsman et. al. v S&I Associates, et. al. (603 N.Y.S.2d 371).

The plaintiffs were shareholders in a cooperative housing corporation which acquired title to 520 West 50th Street, New York City in June, 1988. The title to the property was transferred to the cooperative pursuant to an offering plan which was filed by S&I Associates as sponsor. The property was conveyed subject to an underlying mortgage held by East New York Savings Bank for $1.5 million. In addition, a wraparound mortgage was made in favor of Midtown Associates, also in the sum of $1.5 million, but reserving a higher interest rate payment than the underlying mortgage. Midtown Associates (whose principals were the same as the principals of the sponsor) were thus to receive an interest rate of 13.5 percent per annum, while it was required to pay the East New York Savings Bank a much lesser interest rate. The difference in the interest rates represented the profit to the holder of the wraparound mortgage.

Midtown Associates failed to make the required mortgage payments to East New York Savings Bank as required by its wraparound mortgage, thereby precipitating a default of the underlying mortgage.

The plaintiff shareholders commenced a law suit against the sponsor, S&I Associates, and the holder of the wraparound mortgage, Midtown Associates, as well as individual defendants, who were the officers and directors of the cooperative, but who were aligned with the sponsor. The sponsor controlled the board of directors of the cooperative.

Plaintiffs claimed that the wraparound mortgage was no longer valid because: a) there was no consideration given by Midtown Associates for the wraparound mortgage and b) Midtown Associates failed to comply with its obligations to pay East New York Savings Bank the interest and amortization payments as required by the wraparound mortgage.

Plaintiffs also sued the individual defendants as officers and directors of the cooperative for breach of their fiduciary duty to the cooperative by refusing to declare the wraparound mortgage invalid.

The plaintiffs claimed, in their first cause of action, that since the Bank's underlying mortgage as well as the wraparound mortgage were both in the same principal amount $1.5 million, the only purpose of the wraparound mortgage was to reserve a higher interest rate as profit to the sponsor. The wraparound mortgage was thus rendered invalid because no consideration was given for the mortgage.

Justice Beverly C. Cohen, who heard this case in Supreme Court, New York County, dismissed this cause of action by stating that it is perfectly appropriate for a sponsor to provide a profit based on the differential between the interest rate reserved by the wraparound mortgage and the rate in the underlying mortgage. The wraparound mortgage constituted part of the consideration along with the cash payment paid at the closing. Justice Cohen further stated that simply because there was no additional mortgage tax on the wraparound mortgage (since there was no additional monies borrowed beyond the underlying $1.5 million held by East New York Savings Bank), it is not a sufficient reason to invalidate the wraparound mortgage for lack of consideration. A mortgage that has no taxable consideration may none-the-less be a valid mortgage if other considerations exist. The wraparound mortgage was part of the total purchase price, which is adequate consideration.

The second cause of action of plaintiffs sought to have the wraparound mortgage invalidated because the sponsor-controlled board of directors of the cooperative failed to make payments on the East New York Savings Bank mortgage, as required by the wraparound mortgage; and that such default is a basis for invalidating the wraparound mortgage.

Justice Cohen agreed with the plaintiff shareholders and ruled that the wraparound mortgage provides that if the holder of the wraparound mortgage fails to pay the underlying mortgagee, the holder of the wraparound mortgage shall forfeit the entire wraparound mortgage of $1.5 million. Further, the Attorney General's regulations governing cooperative conversions contain a provision that the wraparound mortgagee will lose his equity in the wraparound mortgage if he defaults on his obligations to make payment on the underlying mortgage.

Thus, it was clear that the wraparound mortgage must be invalidated because the holder defaulted in its obligations to pay the underlying mortgagee.

The plaintiffs further claimed that the individual defendants who were members of the board of directors of the cooperative breached their fiduciary duty to the cooperative by their failure to disavow the wraparound mortgage.