For every lender, the primary objective is to recover all outstanding amounts owing to them by the borrower. To secure the full repayment of the debt, the lender will typically charge a mortgage over a property of the borrower, and in circumstances where the borrower defaults on their debt, a power of sale may be enforced by the lender. But what if the lender would prefer to keep the property instead of enforcing the power of sale? Can the lender insert a term into the mortgage that compels the borrower to transfer the mortgaged property to the lender upon default?
In 16th century England, such clauses were standard practice and routinely upheld. However, contemporary Australian case law is clear – you cannot do it. Why? Because it ‘clogs’ the equitable right of redemption.
Let’s consider the following scenario – a lender (as mortgagee) advances $1 million to a borrower (as mortgagor), and to secure its repayment, the lender takes a mortgage over the mortgagor’s land, which is currently valued at $2 million. The wider property market considers the mortgaged land to be undesirable, but the lender sees potential in the land and thinks it could soon be valued at $3 million. The lender has therefore decided to insert an ‘option to transfer’ clause in the deed of mortgage with words to following effect:
upon an event of default, the mortgagor must transfer the mortgaged property to the mortgagee as full satisfaction of the mortgage debt.
That is, upon an event of default, the lender will receive full possession of the mortgaged property. If the lender’s predictions are correct, they would receive a $3 million property, which if they could realise at that price, may result in them earning a $2 million profit on their original $1 million loan.
Unfortunately, in 2018, such a transaction structure would be unenforceable, even if the mortgagor agreed to it.
Why is it unenforceable?
It clogs the equitable right of redemption
Typically, a mortgagor is entitled to redeem their property once the debt secured by the mortgage has been discharged, or the surplus remaining after a power of sale has been exercised by the mortgagee. This is referred to as the mortgagor’s ‘equitable right of redemption’.
However, if an option to purchase (or transfer) is included as part of the mortgage transaction (as is the case in the above example), then the option will be void for extinguishing – or ‘clogging’ – the mortgagor’s equity of redemption. This position is consistent with the doctrine that ‘once a mortgage, always a mortgage’.
Another reason why an option to purchase (or transfer) won’t work is because it would likely be a penalty. It would be construed as a penalty if the amount to be paid by the mortgagor on default exceeds what can be regarded as a genuine pre-estimate of the damage likely to be caused by the breach.
In this scenario, the $2 million gain by the mortgagee – which represents a disproportionate gain compared to the loaned amount – is likely to significantly exceed any damage suffered by the mortgagee because of the default.
If the transaction falls under the Australian Consumer Law, given the uneven bargaining powers between the parties and potential unfair tactics, the option may also be struck out on the grounds of unconscionability or be otherwise declared void as an unfair contractual term. The option will be an unfair contractual term if:
- the option causes a significant imbalance in the parties’ rights;
- it is not reasonably necessary to protect the legitimate interests of the mortgagee; and
- it would cause significant financial detriment to the mortgagor.
Whereas a mortgagee under a power of sale is only entitled to the amount of proceeds sufficient to satisfy the debt owed by the mortgagor, an option to purchase (or transfer) would unfairly give the mortgagee possession of the entire house – even if it’s worth more than the debt owed.
Can the mortgagee just sell the land back to itself through a power of sale?
No, unless an exception applies.
The courts have held that a mortgagee exercising a power of sale cannot sell to themselves as it is deemed a ‘logical impossibility’. Nor can a mortgagee sell to an officer, solicitor or agent acting for the mortgagee.
There is an exception to this though. If the purchaser of the security is a person or entity that is only merely associated with the mortgagee, then the sale may be valid. However, the sale must be a truly independent bargain. It cannot be a sale where the purchaser is effectively under the mortgagee’s control.
For instance, in the case of Sewell v The Agricultural Bank of Western Australia (1930) 44 CLR 104, the High Court upheld a sale by a bank to its own employee – a district inspector – in circumstances where the bank was found to have first exhausted all reasonable efforts to sell land through public advertising over 18 months. The sale was valid because the employee was not involved in the process of sale and the bank had taken steps to ensure that the best price for the land was obtained.
How to make the transaction enforceable
An option to purchase (or transfer) the land may be valid if it is a separate and independent transaction to the lending arrangement secured by the mortgage.
However, the mere separation of the transaction or document may not be sufficient to deny the existence of a clog on the equity of redemption. It is the transaction itself which must be independent, and a Court will look to the chronology of the transactions and the substance of the whole transaction to determine whether the purchase is independent of the mortgage.
Whilst English courts historically upheld clauses that purported to transfer the mortgaged land back to the lender in an event of default, under contemporary Australian law, such clauses are unenforceable, even if it has been agreed to by both parties.
The law leans towards protecting vulnerable mortgagors and therefore, once a mortgage, always a mortgage.