Equitable Mortgages and the Eight Factor Test
Founded on the principle that equity looks to substance over form, courts will find an equitable mortgage to exist when a deed or contract, while lacking the characteristics of a typical mortgage, is used to pledge an interest in real property as security for a debt with the intention of acting as a mortgage. On September 9, 2014 in Zaman v. Felton, the New Jersey Supreme Court decided that when determining whether a particular transaction gives rise to an equitable mortgage, a trial court must utilize the eight factor test set forth by the Bankruptcy Court for the District of New Jersey in O’Brien v. Cleveland. The eight factors set out in O’Brien for evaluating whether an equitable mortgage exists are:
- Statements by the homeowner or representations by the purchaser indicating an intention that the homeowner continue ownership;
- A substantial disparity between the value received by the homeowner and the actual value of the property;
- Existence of an option to repurchase;
- The homeowner’s continued possession of the property;
- The homeowner’s continuing duty to bear ownership responsibilities, such as paying real estate taxes or performing property maintenance;
- Disparity in bargaining power and sophistication, including the homeowner’s lack of representation by counsel;
- Evidence showing an irregular purchase process, including the fact that the property was not listed for sale or that the parties did not conduct an appraisal or investigate title; and
- Financial distress of the homeowner, including the imminence of foreclosure and prior unsuccessful attempts to obtain loans.
Zaman v. Felton: the Facts, the Court’s Analysis and Practical Pointers
In 2007, defendant Barbara Felton faced foreclosure proceedings on her unfinished house and fifteen acres of land in Plumstead Township. Unable to pay off the construction mortgage on the property, Felton entered into a written contract for the sale of her land with plaintiff Tahir Zaman for $200,000. With the threat of foreclosure looming, the parties closed one week later, with Zaman paying off the mortgage, outstanding tax obligations and other related expenses at closing. Simultaneously, the parties entered into a buy-back option agreement whereby Felton could repurchase the property within three months at a higher price. The parties also entered into a lease agreement whereby Felton could remain on the property as a tenant. Felton remained on the property for over a year after closing without paying rent or seeking to exercise her buy-back option before Zaman filed a complaint for possession of the property and damages.
At trial, Felton argued, among other things, that the agreement between the parties created an equitable mortgage. The trial court determined that there was no equitable mortgage because Felton had intended to sell her property, there was evidence that Felton understood that the sale was her only alternative to foreclosure, and the lease and buy-back agreements were separate agreements that were not a component of the original sale. The Appellate Division affirmed the trial court’s decision.
The Supreme Court, finding that the O’Brien framework “useful and consistent with New Jersey equitable mortgage jurisprudence,” remanded so that the trial court could make findings on each of the eight factors set forth in O’Brien. In making its determination, the Supreme Court ruled that the jury’s determination that Felton knowingly sold her property did not, in and of itself, determine that there was no equitable mortgage, but that the jury’s finding could be relevant to one or more of the O’Brien factors on remand. The Supreme Court also indicated that the imminent foreclosure proceedings, Felton’s inability to obtain a new mortgage or meet her obligations under her existing loan, and Felton’s failure to exercise her right of repurchase, might all be relevant in the trial court’s application of the O’Brien factors.
With the Supreme Court fully embracing the O’Brien factors, New Jersey practitioners seeking to prove or disprove the existence of an equitable mortgage should not rely on only one factor, but should instead attempt to provide factual evidence supporting arguments for or against each of the O’Brien factors. In addition, attorneys representing a client on the acquisition of distressed real estate, particularly in connection with the purchase of residential property, should carefully consider the O’Brien factors before advising a client on the structure of the transaction in order to avoid the seller successfully arguing the existence of an equitable mortgage after the fact.