Revisiting California’s Anti-deficiency Legislation
California’s real estate market has been heading south for a while now, and the journey may not be over. A real estate developer I spoke with recently told me he had about $200 million of land sales in escrow and expected none of the sales to close. In his opinion, raw land could not be sold today under any circumstances.
Property owners trying to arrange a “short sale” have called wondering about their lender’s remedies. I will discuss “short sales” briefly below, but first I think it is instructive to understand the remedies available to a lender. As a matter of fact, there is a lot more to discuss when it comes to lenders’ remedies than there is when it comes to short sales.
California has long had a variety of statutes which limit lenders’ remedies in the event of a default. A number of these, known as the anti-deficiency rules, were enacted after the collapse in real estate values during the Great Depression of the 1930’s. Each of these rules operates a bit differently, but each serves to limit a lender to foreclosing on its collateral and precludes a lender from seeking a monetary judgement against the borrower personally, which the lender could satisfy out of other assets of the borrower. This is considered good news, however that is certainly relative. The bad news is, you may lose your property, which may be your home. The good news is, that is all you will lose.
You are in this happy situation if any one of the following situations described below applies to you. For purposes of this discussion, I will assume the rather typical situation of a loan secured by a borrower’s residence, though a number of the anti-deficiency rules apply equally to commercial contexts.
A. No Deficiency after a Trustee’s Sale
California’s Code of Civil Procedure Section 580d absolutely precludes any deficiency judgement when the lender has elected to foreclose under the power of sale contained in its deed of trust. Well this is great. It is not limited to residences, first liens, noncommercial property, purchase money mortgages, or anything (except that it does not apply to publicly issued debt permitted by the Commissioner of Corporations or made by a public utility under the Public Utilities Act.)
First, a bit of background. In a typical real estate loan, the borrower signs a promissory note, which evidences the debt, and a deed of trust with its power of sale, which is a security device creating a lien on the real property to secure the note. The lender holds the promissory note until it is paid off, at which time the lender must return it to the borrower and release the deed of trust.
Without Section 580d, a lender would have the prerogative of suing, in a regular civil suit, to enforce its promissory note as well as the lien created by the deed of trust. The lender suing on the promissory note could get a judgement for the full unpaid balance of the note, along with all the other amounts provided for in the note, such as continuing interest, perhaps default interest, late charges and all of the fees and costs that the note provided, including the costs of suit. This would be a personal judgement against the borrower. Any proceeds from a foreclosure sale would be applied to that judgement and reduce it, but any remaining unpaid balance would be the personable obligation of the borrower, satisfiable out of other assets of the borrower, if any. This difference between the amount due on the promissory note and the amount the collateral fetches at sale is called a deficiency, and the judgement in that amount is called a deficiency judgement. (Not exactly. See the discussion of the fair value limitation in section C below)
In fact, under common law, a lender could do both: sue on its note and obtain a deficiency judgement and foreclose under its power of sale. It could only collect its debt once; any proceeds recovered from the collateral would be applied to reduce the debt. However, the lender would have the best of all worlds: a quick and easy resort to the collateral and the deficiency judgement as well.
California Code of Civil Procedure Section 580d flatly precludes this. If the lender resorts to its collateral privately and expeditiously, without going to court, as its power of sale provides, it can do no more. And this is the case whether the loan is a commercial loan, a second, third or fourth lien on the property or any other “note secured by a deed of trust or mortgage upon real property.”
Why is this so great for borrowers? Because the lender almost always prefers to foreclose under the power of sale in its deed of trust. Doing so is (relatively) quick and certain, and in a falling real estate market time is money. I do not know what percentage of defaulting loans result in a sale under the power of sale provisions in a deed of trust, but my experience has been that it is virtually 100%. Trustees who specialize in these matters have told me that they have never seen a judicial foreclosure which is the alternative to a trustee’s sale. As for myself, I have only seen them in circumstances where the situation is very unusual, such as borrower fraud that resulted in substantial borrower assets other than the collateral which may have been seriously overvalued as part of the borrower fraud. (See “An Old War Story” for an example) However, the normal lender analysis must weigh the benefits of quick resort to the collateral versus the rather lengthy and peril-filled process of a civil lawsuit with the only upside being a judgement that may be difficult or impossible to collect on. Lenders seem to virtually automatically prefer the former, with the result that borrowers are almost always let off the hook.
However, this is a lender election, technically, and the homeowner/borrower cannot compel it. This must be born in mind when discussing short sales, which I promise will take place below.
Sold Out Juniors. Foreclosure sales extinguish all estates “behind” or recorded later in time than the foreclosing lien. Thus, the lien of second and subsequent financing will be extinguished when the first lien forecloses. California’s Supreme Court has held that the junior lienholder’s rights should not depend on the senior’s election of remedies and consequently permit the sold-out junior to bring an action directly on the note despite the fact that the senior foreclosure was via power of sale in a deed of trust. This benefits the junior lien holder at the expense of the borrower, who may lose the property via trustee sale and remain subject to personal liability on the second.
B. No Deficiency for Purchase Money
California’s Code of Civil Procedure Section 580b provides that “purchase money” loans may not give rise to a deficiency judgement. However, this section is a little trickier. Purchase money is defined as either:
- Credit extended to the buyer by the seller to finance the purchase of the property which is secured by that property; or
- funds lent to the buyer by a third party if used to pay for a dwelling of four units or less occupied at least in part by the purchaser.
- Thus, this applies to all seller financing and to institutional financing for homes and small unit properties.
This is relatively good news. It means that if you have not refinanced, your loan is probably not recourse no matter what. It also means if you are a seller, and take back paper, you may only look to your collateral, the property you are selling, for repayment. This is a risk you should bear in mind. It is a risk that the law expressly wants to place on sellers. One of the purposes of the rule is to make sellers responsible for the value of the property being sold.
C. The One Action Rule
As mentioned above, under the common law, lenders have the prerogative of suing on their promissory note, foreclosing on the collateral via their security device, and perhaps bringing another action to obtain possession of the premises. California Code of Civil Procedure Section 726 (a) forces lenders to elect between a judicial proceeding and a trustee sale. The lender may pursue a money judgement against the debtor only if it elects judicial foreclosure and pursues all of its remedies against the debtor in California court where the lender must run the gauntlet of all of the perils and pitfalls encountered along the path of obtaining a judgement and enforcing it.
In addition, California Code of Civil Procedure Section 726(b) limits a deficiency to “the amount by which the indebtedness exceeds the fair value of the property.” Thus, a new issue, the property’s value, is added to the equation. The deficiency is not simply determined by the amount the property fetches at sale. After obtaining its judgment, the creditor must return to court within three months of the judicially supervised sale of the property and conduct a fair value hearing.
Oh yeah, and the debtor has a one year right to redeem the property, something a bidder at the judicial sale must take into account. Is it any wonder trustees sales look so good?
The foregoing rules are a folksy oversimplification. Crafty lenders’ lawyers have constantly sought ways to circumvent these rules. Crafty borrowers counsel have constantly sought ways to abuse them. Thus the law has evolved. The courts have been forced to invoke notions of “standard” transactions to determine whether a set of facts justified the protections of the law based on the policy of law. Complex lending transactions, including subordination agreements in multi-tiered lending arrangements have created problems for relatively straightforward code sections dealing with the relatively straightforward notions such as “purchase money.” And then there is the guy that lives in his boat installed on his lot in the desert. (The lender really didn’t plan on making a residential loan.) And of course, there are a handful of other statutes that bear on the matter, including federal truth in lending statutes. The good news is that borrowers have an array of protection. The bad news is that the protections can be unpredictable, and expensive to access in the sense that counsel familiar with these matters can be expensive.
And so you want to know about short sales. By “short sales” I am talking about a sale of a property which will bring less than the outstanding indebtedness on the property, so that the lender will fall short of being fully paid off. These require the lenders’ consent, since each lender is only required to release its lien when it is fully paid off.
These always make sense to a borrower in default, and such borrowers think they should make sense to a lender as well. After all, as noted above, a lender’s principal remedy will almost always prove to be a trustee sale. A defaulting homeowner thinks a sure “normal” sale gets the lender to a better position without incurring the trustee’s fees and without the market stigma of a trustee’s sale. The defaulting borrower always thinks the lender ought to accept this, and release the borrower from liability.
For some reason, lenders have never seemed to look at matters quite that way, though maybe this will change. Perhaps lenders simply prefer to thoroughly test the market, though this means a bit of a delay and the pain of some trustee fees, which they may not recoup. Perhaps lenders distrust their borrowers, fearing a collusive sale at less than market value to a straw purchaser or some other consideration flowing to the borrower outside of the sale transaction. Perhaps it is simply bureaucratic inability to make an entrepreneurial type of decision. For whatever reason, my experience has been that borrowers have had a difficult time obtaining their lender’s consent to a short sale. A recent Los Angeles Times article on the subject confirmed this. Multiple liens on the property complicate things a great deal. The priority between the lienholders assure that the most senior lenders will recoup a far higher percentage than the more junior lenders. Getting everyone to agree will be problematic at best.
Short sales may become even more difficult to arrange now that so many mortgage loans have become securitized. Rather than a lender being asked to make a decision about one of its loans, that loan is packaged with hundreds or thousands of other loans, and held by distant lenders, or syndicates of investors. The decision making is that much more attenuated. As a simple matter of administrative convenience, I would expect a short sale to become increasingly difficult to arrange.