DISCLAIMER: This article is intended for informational purposes only. None of the information contained in this article should be taken as legal advice. Neither ASG REAL ESTATE INC Nor Allan S. glass are attorneys. Readers are advised to seek legal counsel regarding any information provided herein as they relate to specific personal situations a reader may face. Further the information herein pertains to California only. Deficiency laws will differ in each state.
California has historically taken a strong public policy stance against deficiency judgments. The policy objective of the states anti-deficiency legislation is to place the risk of valuation upon the lender who is typically in best position to understand true market value and to discourage sellers and lenders from taking advantage of less knowledgeable buyers by overvaluing the underlying collateral in a standard real estate transaction.
The last part of this explanation dates back to the wild west days of California when most areas were still rural and the original housing boom was in full swing. In many ways similar to what happened in areas of Nevada earlier this decade, real estate syndicators would buy large tracts of undeveloped land in the middle of nowhere, subdivide the land into parcels and then sell those parcels to homeowners with the promise of future roadways, commerce, jobs and riches.
In many unfortunate circumstances these unknowing buyers found themselves not only with a worthless piece of land in the middle of nowhere, but also facing a financial judgement against them by a lender who allowed the prices to be artificially inflated, or by unscrupulous speculators who both sold and financed the purchases themselves at unfairly high prices.
definition of deficiency judgment
So what exactly is a deficiency judgment? According to Webster’s New-World Law Dictionary, it is defined as the following:
“N. A judgment for the balance of a debt already partly paid, typically through a forced sale of personal or real property.”
Relating to real estate, deficiency judgments occur as a result of a short sale or foreclosure sale and the rules governing when a lender may seek such judgments are set by state law. Each state has its own statutes and limitations and most rules have many exceptions adding furhter confusion to the process.
California Foreclosure Process
California is a lien theory state meaning you own your property after the close of escrow and lenders secure their loan with a promissory note (promise to pay) secured by a deed of trust. It is the deed of trust which allows them to take action should you choose or find yourself unable to pay as agreed. For a more in depth description of the California Foreclosure Process you may read my previous post.
To summarize, California lenders may choose to pursue the more lengthy court action referred to as a judicial foreclosure, or the expedited non-judicial foreclosure process to recovery their loss. An overwhelming majority (think 98% or more) of lenders in California choose to pursue the non-judicial method to foreclose for three primary reasons. First, it does not require additional court proceedings to complete, which leads to the second reason, the process is much faster than a judicial foreclosure.
The third primary reason lenders pursue non-judicial foreclosures is the “right of redemption” which is afforded to borrowers only after a judicial foreclosure; this rule effectively prevents the foreclosing lender from reselling the property as an REO anywhere from three (3) to twelve (12) months after the judicial foreclosure sale date. The right of redemption does not apply in a non-judicial foreclosure, thus lenders typically seek to resolve their problem loan quickly through the non-judicial process.
One Action Statute, A Security First Rule, and the Single Action State
California is considered a single action state with regards to a lender’s remedy in the recovery of any debt or the enforcement of any right secured by a mortgage upon real property. The rules governing this statute are found in California Civil Procedure Code Section 726(a). The purpose of the one-action rule is to protect a defaulting mortgagor (borrower) from being harassed by a lot of different actions filed against it by the mortgagee (lender).
The security first provision of 726(a) directs lenders to first proceed against the security for the debt prior to trying to enforce the underlying debt. In essence, if a lender takes real estate collateral as security for a loan in California, the lender must foreclose on the real estate security first. Further, a lender can only bring one œaction against the borrower, and must use it as the primary source of repayment when collecting the loan. If a lender chooses to seek a deficiency judgment against a borrower prior to seeking repayment through foreclosure they risk the possibility of losing their claim to the collateral. (See Security Pacific Nat’l Bank v. Wozab, 51 Cal. 3d 991, 997 (1990).)
Deficiency Judgment Protection in Foreclosure – Codes 580(b), 580(d)
Two sections of the California Civil Code Procedures outline the deficiency judgment protections afforded borrowers after a foreclosure sale. These codes do not protect borrowers in a short sale transaction, however most lenders facing these limitations after a non-judicial sale will negotiate a full release of liability on these loans if the short sale is financially beneficial when compared to a foreclosure. In most basic terms protecting 1-4 unit residential properties, owner occupied, where the purchase money loan was foreclosed on using a non-judicial foreclosure method, the following codify California’s rules:
California Civil Procedure Code 580 (b) – Covering the “character” of the loan, this section protects purchase money loans explicitly limited to loans on properties of 4 unit dwellings or less used as a principal residence. This section utilizes the term “vendor” which has been interpreted by the courts to also cover seller carrybacks and/or existing loans assumed by a new buyer in any type of property purchased (Costanzo v. Ganguly, 12 CA. App. 4 1085 (1993)). This statute explicitly precludes a deficiency judgment when sellers carry back financing at the time of purchase. This section, however, does not protect non-owner occupied or commercial properties.
California Code Civil Procedure 580 (d) – Covering the “process” of the foreclosure action. This statute is considered to create a “parity of remedies” for lenders allowing them to choose between the judicial vs. non judicial procedure. Initially enacted to protect borrowers from the practice of under bidding at a non-judicial sale which would then worsen the deficency, the statute now expressly prohibits a deficiency judgment after a non-judicial sale. Althougth 580d does not bar a sold out junior lien from seeking a deficiency judgment (see Walter E. Heller Inc. v. Bloxham, 176 Cal.App.3d 266 (1985)), it does protect borrowers on junior loans in cases where the senior foreclosing loan is the same lender (see Simon v. Superior court below).
Code 580d does set limitations on deficiency judgments when the lender chooses the judicial process. In these cases deficiency judgments are limited to the lesser of:
a) the amount by which the debt exceeds the fair market value of the property at the time of foreclosure sale
b) the amount by which the debt exceeds the sale price of the property at foreclosure sale
It’s important to note that each of these rules apply on their own, regardless of the other rules. Meaning you only need to meet the requirements of one of these civil codes to be protected against a deficiency judgement on any particular loan.
Pending Additional Protection
During the recent housing crisis many professionals and politicians addressing foreclosures felt it unfair that a borrower who refinanced a purchase money loan unwittingly put himself at risk of a deficiency judgment after a foreclosure sale. In particular, those who simply refinanced to lower a monthly payment without taking additional cash out of their homes. As a result California Senate Bill 1178 was introduced and passed by the California legislature in 2010.
Intended to extend homeowner protection against deficiency judgements to refinanced purchase money loans in instances where the homeowner did not “cash out” the bill was ultimately vetoed by then Governor Arnold Schwarzenegger last year.
Short Sale Protection Code 580(e)
Seen by some to be a compromise on the failed SB 1178, legislators introduced California Senate Bill 931 in 2010 to extend deficiency judgment protection to homeowners in a short sale transaction. The bill was passed by the legislature, signed into law, and became California Civil Prodecure Code 580(e).
Prior January 1, 2001 deficiency judgment protection was only afforded to certain borrowers after a non-judicial foreclosure sale occurred. However, the passage of SB 931 created this new statute extending further protection in the case of short sale on one to four unit residential properties regardless of residency. This statute only applies to senior liens and therefore does not protect borrowers from deficiency judgments on junior liens after a short sale.
Exceptions to the Rules
In spite of the statutes listed above, there are circumstances where a borrower can lose his/her deficiency protection, and other exceptions to the rules. They include:
1) Fraud – Deficiency protection is not extended to a homeowner in cases where a borrower fraudulently induced the lender into making the loan in the first place. California Civil Procedures Code 726 (f) (g) & (h). In these instances lenders may also seek punitive damages.
2) Bad Faith Waste – You may have heard about the case of San Diego Police officer Robert Acosta bulldozing his home last June after losing it to foreclosure. This is an extreme example of “bad faith waste” which can also describe willful neglect on the part of the homeowner (Cornelison v. Konbluth 15 Cal .ed 590 (1975)). These acts include reckless, intentional, and/or malicious injury to the property by the homeowner.
3) Non standard Transactions – These transactions include those where non traditional means of financing were used to consummate the transaction. Examples would be loans which originated with a seller as non purchase money and were later assumed by a subsequent purchaser, construction loans on property not intended as a principal residence, or subordinated seller carry back loans on vacant land.
Simon v. Superior Court (Bank of America), 4 Cal. App. 4th 63 (1992)
Although a borrower is not protected from a deficiency judgment after foreclosure on a junior lien which is sold out and rendered economically worthless, that exception does not apply if the lender itself has taken some action to make the security worthless. The California courts clarified this position in Simon v. Superior Court stating that a creditor who loses it’s security through a culpable act does not come within the exception to the security first rule.
In plain speak, if the same lender holds both the senior and junior loan, the lender cannot pursue a deficiency judgment on the borrower for the junior loan after foreclosing on the senior loan. This is also true if the junior loan obligation was originated by a different entity, but was later assumed by the senior lender.
For example, let’s assume a borrower had a first trust deed held by Chase Bank and a second trust deed originally held by Washington Mutual Bank. Now that Chase has assumed the liabilities of Washington Mutual (WAMU) they have effectively become the same lender. If Chase were to foreclose on this first trust deed, they would not be able to pursue a deficiency judgment against the borrower on the second trust deed. The same holds true for Countrywide / Bank America, etc. etc.
Although this only applies in the case of a foreclosure sale and does not apply in a short sale, it is very important to understand the implications of this case when negotiating a short sale transaction. If a short sale is in the financial best interests of a lender, a skilled negotiator can use this case to reason with a lender and help them understand why a claim to deficiency should be waived. If it is not, the seller can hold out for a more costly and lengthy foreclosure sale that ultimately prohibits the lender from seeking the deficiency.
Release of Lien v. Full Satisfaction or Release of Liability
Not every short sale approval letter is created equal. Further, receiving a settlement letter from the bank does not mean that they have agreed to release the borrower from all future liability in connection with the loan. In order to complete a short sale a lender must agree to release the lien against the property securing the loan. Thus every approval letter will stipulate a “release of lien” to accommodate the short sale.
However, unless your approval letter specifically includes language referring to a “full satisfaction” or “release of liability” the borrower may find themselves subject to a deficiency judgment after closing a short sale. Therefore a full release or satisfaction should be sought on approval letters from a junior lender (senior liens are protected under code 580e) whenever possible.
California is very protective of borrowers when is comes to deficiency judgments. With the introduction of Ca. Civ. Proc. Code 580(e) in January of 2011, some of these protections have also been extended to borrowers in a short sale transaction. Most protection is afforded to purchase money loans on principal residences, however several cases have extended the reach of deficiency protection to consumers. Although most sold out junior lenders retain the right to pursue a deficiency judgment, this right does not apply to all junior liens in California (Simon v. Superior Court).
Finally, a short sale approval letter does not always release a borrower from future liability and should be reviewed carefully for specific language addressing a full release of liability.