Relief for innocent property owners, but maybe not so much for innocent mortgagees.

The Constitutional Court recently handed down a landmark decision regarding the interpretation of section 118(3) of the Local Government: Municipal Systems Act 32 of 2000 (Act).

The matter came before the Court as a confirmation application for a declaration of invalidity against section 118(3) on the basis that it arbitrarily deprived home owners of their right to property. In sum, the section creates a "charge upon the property" for any municipal debts owing on the property, which also grants the municipality preference as a creditor over any mortgage bond registered against the property.

This section has, for some time, been interpreted by municipalities as creating a real right in favour of a municipality, which it could enforce against not only property owners who incur copious amounts of municipal debts but against any subsequent owners who may have purchased the property from such previous owner. Further still, the municipality believed that the section afforded it a preference over any mortgage bonds registered against the property, even for loans advanced to innocent new owners by their respective innocent mortgagees.

The High Court in Pretoria declared section 118(3) invalid in so far as the "charge upon the property" survives transfer of ownership into the name of a new owner who did not incur the municipal debts prior to transfer. The Constitutional Court thus had to determine whether the charge created by section 118(3) survived transfer of the property.

After engaging in an eloquent and succinct interpretive exercise, the Court declined to confirm the declaration of invalidity as section 118(3) was capable of an interpretation that was in line with the Bill of Rights. The Court found that the security created by section 118(3) did not survive transfer of the property to a new owner. Thankfully for new owners, this interpretation led to the declaration that "upon transfer of a property, a new owner is not liable for debts arising before transfer from the charge upon the property…"

Amidst the chorus of approbation for this much welcomed order, it is still worth asking: where does this leave mortgagees of the property in light of the fact that section 118(3) is still constitutionally valid?

This question is relevant particularly in respect of Banking Association South Africa's (BASA) involvement in the matter. Although BASA was only an amicus curiae (friend of the court) and thus not entitled to relief for its members, it supported the contention that the section was unconstitutional. BASA also took the argument slightly further by arguing that the section was not only unconstitutional because it condoned arbitrary deprivation of the new owners' property rights, but also of the real security rights that the new owners conferred on mortgagees who provide loans on the security of the property after transfer.
It is perhaps prudent to take a few steps back to understand what cause for concern mortgagees had or should have with regard to section 118(3):

Section 118 came into existence when the Act was enacted in March 2001. With this, came the introduction of the preferent right that a municipality enjoys in respect of a "charge upon the property", including over any mortgagee in respect thereof. Subsection (3) of the Act makes express provision for the attribution of preferent creditor status to a municipality with regards to municipal debts.

The introduction of this status meant the following:

1. Should such a claim by the municipality be a charge upon the property, it would seemingly survive transfer of ownership and be a preferent claim over any new mortgagee;
2. A mortgagee's security is in actual fact not so secure as the value of the security and even its entire existence is potentially in jeopardy;
3. Flowing from the above, general economic stability and certainty fell into jeopardy; and
4. It is likely that this could have a direct impact on potential mortgagees or banks decisions to approve or disapprove mortgage applications

Some of these implications also find credence in case law. In City of Johannesburg v Kaplan the position of mortgagees was crisply explained as follows: only after satisfaction of such [municipal] debts will the remainder, if any, be available for payment of the debt secured by a mortgage bond over the property". Here the learned judge held that this was indeed the meaning and effect of section 118(3). In City of Tshwane Metropolitan Municipality v Mathabathe it was again held that an interpretation of section 118(3) that entailed that the municipality loses its status as a preferent creditor or right to exercise the charge upon the property after transfer, was "plainly wrong". Therefore, the preferent right conferred upon municipalities unequivocally remained.

Concerns regarding interests of mortgagee's became more prominent and recognised following these judgments and the effect of the current interpretation of section 118(3) on mortgagee's became a popular topic of discussion. Authors such Lourens du Plessis considered the question in some depth. He noted that despite the alleged clear meaning of section 118(3) and / or its economic benefit for municipalities, it was questionable whether it would pass constitutional muster. Du Plessis thus noted, correctly, that courts had, thus far failed to consider the question of its constitutionality, whether purposefully or otherwise. He then spoke directly to the effect of section 118(3) on mortgagees:

"Section 118(3) deprives the mortgagee of that preferent right vis-à-vis a municipality in a manner that frustrates the object of the bond as a mechanism in securitatem debiti. In some instances the proceeds of the sale of a property may be sufficient to cover both the municipal and mortgage debts, but that does not detract from the fact that prior to the sale the mortgagee had been deprived of a real right to preferent payment of a debt from the proceeds of the sale of the property, that is, from his/her real security to the property. Section 118(3) therefore also (and even to a greater extent than section 118(1)) effects a deprivation of property as envisaged in section 25(1) of the Constitution."

Despite questions of the constitutionality and fairness of the section vis-à-vis mortgagees, such as banks, being a legitimate concern, the courts stuck to their guns. In City of Tshwane Metropolitan Municipality v Mitchell even where the property which was the subject of the dispute was sold in execution, the Court followed the abovementioned line of judgments in concluding that "nothing would prevent the appellant from perfecting its security over the property, should it wish to do so…". Interestingly however, this case also birthed the first opposing view to the seemingly-widely-accepted trend, in the dissenting judgment of Zondi JA. In a minority judgment Zondi JA held that it indeed is a general common law rule that a charge upon a property survives transfer, however that there are exceptions. Zondi JA noted that a case such as the one presented by section 118(3) should be regarded as falling within such said exceptions. Furthermore, Zondi JA held that if the objective of the legislature was survival of the charge upon property following transfer, it would have been specifically expressed in the legislation.

While this minority brought a new and fresh perspective, the position in law with regards to section 118(3) remained the constitutionally un-challenged view that the charge upon the property was one which survived transfer and as such the municipality remained a preferent creditor, over and above any and all mortgagees. The mortgagee's security remained in jeopardy. Until now… (well at least for mortgagees over properties in the hands of new owners).
The beauty of the Constitutional Court's judgment is that, although section 118(3) remains valid and the declaration is in respect of new owner's liability for historical debts only, the reasoning in respect of new owners' related mortgagees is clear: if the charge (the whole charge) against the property were to survive transfer, it would result in the arbitrary deprivation of property, paragraphs 60 to 61 of the judgment make it plain that this arbitrary deprivation would operate not only in respect of the new owners but any bond-holder as well. Consequently, the Court unequivocally concluded that an interpretation which would allow such a state of affairs would be constitutionally unsound. Accordingly, the charge upon the property falls away in its entirety upon transfer to the new owner. Meaning, banks holding mortgages over new properties that have historical debts can relax for now…. but not too much.

Here is why not too much. Section 118(3) speak only of "an amount due", without any reference to time periods. Accordingly, mortgagees' exposure to the risks presented by the preferent status of municipalities over any mortgage is not limited to only historical debts. Therefore, should a new property owner head in the direction of the previous owner and default with its municipal debts, the preferent right conferred upon the municipality in respect of the property still remains. While this conundrum was not the question before the Constitutional Court in Jordaan the fact of the matter is section 118(3) remains constitutionally valid. This means that while innocent mortgagees of innocent new property owners can relax, innocent mortgagees of not so innocent defaulting home owners still face a threat to the real security rights that they enjoy in respect of properties they have financed. This is because, if a home owner defaults and allows its municipal debt to grow, that debt can still have an impact on a mortgagee's real security rights should a municipality wish to avail itself of the preferent right created by section 118(3).

In this way, the object of the bond mechanism as a complete and conclusive form of security for debt remains frustrated by the section. Although some interests of mortgagees were touched on at various points in the Jordaan judgment, because the impact of section 118(3) on their rights was not an issue squarely before the Constitutional Court, whether or not this section can or will pass constitutional muster vis a vis mortgagees remains a question for another day.