CHAPTER II
This chapter will seek to conduct an absolute inquiry into what makes up security interest laws in the United States. In order to lay the foundation for comparisons in subsequent chapters, the three main elements of the study of the Saudi system will be reviewed here in the context of U.S laws with an emphasis on California state law.
The features of the California legal system will include the assessment of foreclosure rules and patterns in California. This will include a detailed fact-based evaluation of CCP580 (b), CCP580 (d) and CCP726 (a). The different components will enable the study to become more focused and more centralized in order to provide a solid basis for review.
INTRODUCTION
The state of California was chosen for this assessment as it offers measures that protect borrowers that are not offered in all of the United States. In California, a multipart statutory structure restricts the process by which lenders can proceed against debt secured by real property. Rule 580d and rule 726a of the California Code of Civil Procedure prohibit creditors from seeking a deficiency judgement after foreclosing in a non-judicial proceeding. Rule 580b prohibits the seeking of a deficiency judgement following judicial foreclosures in certain circumstances.
During the Great Depression of the 1930’s in the United States, the sale of foreclosed property was occurring at prices lower than the market value of the property. The creditor would then seek to obtain a judgment against the borrower for a very large deficiency. For this reason, anti-deficiency statutes were enacted. Anti-deficiency statutes were intended to provide a cushion for real estate markets in times of recession and protect homeowners from repressive debt. The statutes, which are now only in a limited number of states, mitigate the effect of strict foreclosure. The anti-deficiency statutes may limit the remedies to one action or foreclosure, or cap deficiency judgements to a fair market value or limit judgement to purchase money interest or forbid deficiency judgements in non-judicial foreclosures. If a lender performs a non-judicial foreclosure on the borrower’s property, all other assets of the borrowers are exempt from a claim by the lender. If the borrower has a purchase money loan that was used to buy the property and the borrower lives in it, all other assets of the borrowers is exempt from a claim by the lender. Assets are at risk, however, if the lender institutes a judicial foreclosure if the loan was a line of credit or remodel loan and not a purchase money loan. These exemptions cannot be avoided due to the one action provision. In most circumstances, a foreclosure will lead to a deficiency balance due the creditor after the sale of property. The majority of states in the United States of America allow a creditor to proceed against the borrower for collection of the balance of a deficiency. There are a number of states that do not authorize recovery of a foreclosure deficiency balance, this includes California In California, rules 580b, 726a and 580d address these anti-deficiency issues.
FORECLOSURE PROCEDURE
During a foreclosure procedure, a creditor has a choice of whether to file a judiciary foreclosure or a non-judiciary foreclosure. Judicial foreclosure is an action in equity that is brought to foreclosure upon the property of a defaulting borrower. The judicial foreclosure begins when the creditor files a complaint in court against the borrower. The judicial foreclosure encompasses involves a long series of steps that occur in court. This method of foreclosure is complicated, costly and time consuming. On the other hand, the non judicial foreclosure is less costly and occur more quickly.
The non-judicial foreclosure is authorized due to a provision of power of sale on a deed of trust. The power of sale clause allows the trustee to sell the property in order to satisfy the borrowers obligation after default. The non-judicial foreclosure is much simpler than the judicial foreclosure, and thus is the foreclosure method chosen most often by California creditors who experience defaulted loans.
The non-judicial foreclosure seeks to balance the interested of all parties involved. The creditor receives a quick and inexpensive method for recovery of the defaulted loan. The borrower obtains protection from loss of other property. The non-judicial foreclosure is initiated when the creditor makes a demand to the trustee for the foreclosure to be initiated. The trustee initiates the process by filing a notice of default with the court. The notice of default gives notice to all interested parties and must identify borrower name, property description, type of breach, amount of the default, and states the creditor’s intent to elect a foreclosure sale. A three-month period of time must pass before a notice of sale can be filed specifying the date, time and location of the foreclosure sale. The most significant distinction between the judicial and non-judicial sale is that a deficiency judgement is not an option if the lender pursues a non-judicial foreclosure.
RULE 580B ANTI-DEFICIENCY STATUTE
No deficiency judgment shall lie in any event after a sale of real
property or an estate for years therein for failure of the purchaser
the purchase price of that real property or estate for years therein,
or under a deed of trust or mortgage on a dwelling for not more than
four families given to a lender to secure repayment of a loan which
was in fact used to pay all or part of the purchase price of that
dwelling occupied, entirely or in part, by the purchaser.
Enacted in 1933, rule 580b limits the procurement of a deficiency judgment on a purchase-money mortgage after the sale of real property when the real property is secured by a one to four family home. This rule, along with 726a and 580d, is designed to limit remedies for creditors seeking recovery of debt against borrowers with secured real property in California. There have been many amendments to the statute over the years, which has brought the rule to its current stand. The most recent amendment occurred in 2012 when the rule was extended to include refinanced loans.
In Roseleaf Corp. v. Chierighino, the California Supreme Court rendered a principal decision clarifying the legislative purpose and intent behind section 580b. In Roseleaf, Chierighino purchased a hotel from Roseleaf Corporation with a first deed and chattel mortgage from an different party. Chierighino gave three notes to Roseleaf Corporation that secured three properties it owned that were tied to a second deed of trust. Chierighino foreclosed on all three properties in the first deed of trust which absorbed all the value of the second deed of trust. Roseleaf brought suit against Chierighino for the balance outstanding. In defense, Chierighino alleged the second deed of trust could not be used by the creditor to obtain a deficiency judgment. In reaching its decision, the court addressed the purpose of 580b and concluded that the purchase-money mortgage anti-deficiency rule was drafted to aid as a stabilizing feature in land sales by transferring the risk of insufficient security to the mortgagee. The shift in the risk to the mortgagee averts an overvaluation of the property by the creditor and avoids the worsening of a downturn in the economy that would result if defaulting purchasers were hampered with enormous personal liability.
California Rule 580b makes purchase money deeds of trust non-recourse by forbidding any deficiency judgment following foreclosure. The statute created the rule that a real property buyer in California that pays with a promissory note that is secured by a deed of trust will not be personally liable on the note, and the lender must only look to the security in the real property for enforcement of the loan obligation in foreclosure and may not seek a deficiency judgement.
With the 580b anti-deficiency rule, mortgage lenders will be less likely to overvalue the property because the higher the risk the lender takes on a larger loan amount, the less likely they are to get that full amount if a default were to occur. Rule 508b has the ability to shield borrowers during difficult economic times because it prevents the aggravation of a decline in property values during a depression and it relieves defaulting borrowers from having to face a substantial personal liability. The court reiterated the ability of 580b to function as a stabilizing device in land sales as the risk shifts to the creditor.
As can be seen from the case law establishing the applicability of rule 580b, California has one of the strictest anti-deficiency laws in the United States. Under the California rule, a creditor cannot seek a deficiency judgment after foreclosing on a purchase-money loan acquired for the purpose of purchasing the real property. The purchase money loan may be a first, second, or third mortgage, or even a home equity line of credit. If the borrower received the loan and mortgage to secure all or part of the real property purchase price, no deficiency is allowed after foreclosure.In amendments to the rule 580b, any refinances of the purchase money loan are also exempt from deficiency. The only exception to the anti-deficiency rule are loans that were not purchase money loans.
Following Coker, rule 580b was amended to only include purchase money mortgages for one to four family homes. This was the type of real property dealt with in the case of Coker. The court also specifically equated non-recourse loans as purchase money loans.
Continuing with its liberal construction of rule 580b, the court in Prunty v. Bank of America, held that construction loans used to build a dwelling is covered under the rule even though it was not technically a purchase money loan as the loan was used for construction. The court reasoned this decision on the concept that rule 580b was enacted to prevent overvaluation of real property. Lenders will not overvalue property with rule 580b because it would be a gamble to take on a higher loan amount and the creditor would be less likely to get the full amount of the loan if the borrower defaults.
In sum, the three types of loans that the California courts have found to be applicable to the anti-deficiency statute include Purchase money loans, Non-recourse loans and Construction loans. Purchase money loans are loans which they borrower used the money borrowed, in whole or in part, to buy the real property. According to the case law, the real property must be a one to four family home which the borrower occupies. Non-recourse loans are also purchase money loans that set up specifically to avoid deficiency judgments. These loans provide that if the borrower owes money on the loan after default, seizure and forclosure sale, the creditor may not seek a deficiency judgement. A construction loan is a loan used by borrowers to finance the construction of a residence on real property that the borrower owns.
The constitutionality of anti-deficiency judgment statutes has been questioned by scholars. Many claim that a lender’s right to deficiency judgment should always remain enforceable, and several courts have ruled accordingly. Reading the legislative intent of anti-deficiency statutes in a broad manner leaves the courts in era in which anti-deficiency statutes were passed. Scholar pronounce that times have changed and the usefulness of anti-deficiency statutes no longer exist. In today’s economic world, borrowers are much more aware of the process and terms of property loans. Affordability of attorneys is more common and borrowers entering into real estate contracts can adequately obtain legal advice. The internet provides a valuable source of information. For these reasons, scholars claim anti-deficiency statutes are no longer needed and are “unwarranted government intervention in financial markets”.
Another critique that scholars dispense upon anti-deficiency statutes are that the rules have long term effects on the economy and the real estate market. Lenders will search for creative ways to guarantee that the full amount of the loan can be redeemed in the event of a deficiency. This may include the use of a guaranty. A guaranty is a promise given to a lender by a guarantor to ensure full payment of the loan if the debtor defaults. Rule 580b could be circumvented with a guaranty as the guarantor would not be liable. California courts have forced this upon lenders with its expansive interpretation of rule 580b. Waivers of the rule are practically unavailable and policy and precedent have determined this. Interestingly, many of the real property loans in California will be insured by the federal government or supplied with a guarantor, and, therefore, not subject to state law or the purposes expressed. In turn, state law will have little influence on the public, which will result in the loss of the economic effect of the purpose entirely.
Another method lender has used to circumvent the anti-deficiency rule is to convert the loan to a subordinated loan under a construction loan. This can be accomplished by the lender through attaching the real property loan to an anticipated or upcoming construction project. This practice has been upheld by the courts in California. Out of state lenders are also not subject to California’s anti-deficiency rule as the general rule is that the law that governs the debt is the law where the loan was obtained.
EFFECTIVENESS OF 580B
Rule 580b proved to be successful during the Great Depression, however, in more modern times it was not effective. The anti-deficiency rule did not provide protection for the real estate market in California in 2008 when there was a financial crisis and recession and ultimate real estate market crash. The offering of a considerable amount of risky alternative mortgage products created the situation and the protection of the anti-deficiency law was for the borrowers and not the creditors. During the 2008 real estate crisis, buyers who took high loan to value loans went into negative equity. When the negative equity became excessive, many of these borrowers made the decision to exercise the “put” option in their mortgage loan and walk away from the loan. The home was returned to the lender at par value. This happened more excessively in California than any other state and the anti-deficiency statute protected the buyer and not the market itself. Thus, the anti-deficiency rule accelerated the real estate crisis in California rather than offer any protection.
The primary purpose of anti-deficiency statutes is to prevent overvaluation of property. This is done by placing the risk of inadequate security on the lender. By putting the risk on the lender, risky lending practices are discouraged as are precarious land schemes. The spirit of the anti-deficiency rule is to protect borrowers against the aggravation of an economic downturn.
SIMILAR ANTI DEFICIENCY LAWS IN THE UNITED STATES
Alaska, Arizona, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah and Washington also have anti-deficiency judgement statutes comparable to California’s law. These states similarly adopted the anti-deficiency statutes during the Great Depression as a buyer relief.
When a borrower defaults on a loan secured by real property, a California creditor has several options to seek recovery on the debt. The first and most significant options are to seek a foreclosure either judicially or non-judicially. In a non-judicial foreclosure, court involvement is not necessary. The creditor files a notice of default with the county recorder’s officer and gives notice to all interested parties. After a statutory waiting period, the property is foreclosed by the trustee by the selling of the real property at a public auction. This remedy is the most common in foreclosures throughout the United States. The popularity of this avenue for a remedy exists because it is significantly less costly and it prevents the borrower from seeking judicial forms of rescue such as redemption or repurchase of property, instead, the sale of the foreclosed property is final. A non-judicial foreclosure is also more expedient. However, the seeking of a non-judicial foreclosure has drawbacks to the creditor. The anti-deficiency rules in California forbid the lender from seeking a deficiency judgement if the sale does not satisfy the debt. This applies even if the borrower’s loan was a purchase money mortgage. When a non-judicial foreclosure occurs, the title on the real property is free and clear of any mortgager in the past who may wish to buy back the real property after the completion of the foreclosure.
580B WRAP-UP
When a foreclosure of real property in California is judicial, the parties proceed through the court of law over the matter. In this circumstance, the lender may pursue a deficiency judgment against the borrower. However, under rule 580b if the loan is a purchase money loan, deficiency judgment is not permitted. A purchase money loan exists if the buyer used the proceeds from the loan to purchase residential property in which he or she occupies either in whole or in part. A non-purchase money loan would include loans for remodeling or lines of credit. Rule 580b pertains to two types of property loans in California: purchase money loans and seller carryback loans. According to this rule, a deficiency judgment is not permitted if the property is occupied by the owner and it is a residence of four or less persons. As for seller carryback loans, deficiency judgements are not permitted. The advantage of a judicial foreclosure is that the lender may in some circumstance seek deficiency from the borrower. This remedy is also costly and takes a longer period of time than a non-judicial foreclosure. Additionally, judicial foreclosures allow for a statutory redemption right. While rule 580b refers to a money judgment for the balance due upon a loan secured by a deed of trust or mortgage and a judicial foreclosure, rule 580d refers to a judgment proclaimed for deficiency on a note secured by a deed of trust or mortgage upon real property in a non-judicial foreclosure.
RULE 580 (D): ANTI DEFICIENCY IN NON JUDICIAL FORECLOSURES
No judgment shall be rendered for any deficiency upon a note
secured by a deed of trust or mortgage upon real property or an
estate for years therein hereafter executed in any case in which the
real property or estate for years therein has been sold by the
mortgagee or trustee under power of sale contained in the mortgage
or deed of trust
California’s primary anti-deficiency statute is Rule 580d which was enacted in 1940. This rule prohibits creditors from obtaining a deficiency judgment after a non-judicial sale on foreclosed property. This statute was created to protect the debtor. A deficiency judgment can only be sought by a creditor in a judicial foreclosure action. Rule 580d as it applies to land sale contracts, forbids deficiency judgments and prohibits creditors from suing for the remaining balance without exhausting the security first. It prohibits a deficiency judgment in a non-judicial foreclosure. The rationale for the statute is that since in non-judicial foreclosures there is no right to redemption for the debtor, creditors should be barred from obtaining a subsequent deficiency judgement This rule substitutes the debtor’s right of redemption ensuring the sale of the real property will satisfy a realistic share of the debt.
Most foreclosures are non-judicial which means the foreclosure takes places outside of court. When the foreclosure occurs in this manner, rule 508d mandates that the foreclosure is the only remedy that a lender may seek against the home owner. The lender may not seek recovery for any balance difference owed on the property.
However, in National Enterprises, Inc. v. Woods, the court addressed rule 580d and determined that the one action rule does not prevent a junior lienholder from suing on a debt after a senior lienholder judicially foreclosed on the security.
Rule 580d expressly provides deficiency protection following a trustee’s sale only to a borrower who executed a promissory note secured by a deed of trust. Promissory notes are thus the protected document. The court has interpreted the term “note” narrowly and has ruled this consistently. In Wileys of Marin Company v. Pierce, a deed of trust was foreclosed upon that secured a lease and the court determined rule 580d was not applicable for this reason. Also in Passanisi v. Merit McBride Realtors, Inc., the debtor sought to claim that an action for attorney’s fees was unenforceable under rule 580d. However, the court found the judgment enforceable because the rule applies to notes and not actions for attorney’s fees.
The legislative intent of rule 580d establishes that there is an equitable trade-off of protections and limitations that affect the borrower and the creditor in a non-judicial foreclosure. The rule protects the borrower from notice requirements and a right to postpone the sale so that he or she may redeem the property from the lien prior to the sale. Non-judicial foreclosure proceedings must be conducted in a fair and open manner. The property must be sold to the highest bidder, which allows the borrower, or anyone to contribute in setting the price on the property. The borrower is relieved from personal liability under rule 580d. In the event of a non-judicial foreclosure, the borrower only loses the secured real property and the creditor must bear the burden of any loss in value of the property that is in addition to the sale price.
In Union Bank v. Gradsky, the court set forth the boundaries of rule 580d, granted a guarantor protection under rule 580d, and thus gave the rule the same applicability as rule 580a which arguably rendered rule 580a unnecessary. In Gradsky, the bank elected to non-judicially foreclose on real property and later seek the unpaid balance from the guarantor, the court held that in doing so, the bank was prevented from pursuing against the guarantor under rule 580d.
When a creditor opts to foreclose on a real property loan non-judicially, the creditor may not pursue a deficiency due to the creation of an estoppel. The court in Gradsky held that a lender is prevented from collecting a deficiency from a guarantor after a non-judicial foreclosure because the election of the non-judicial foreclosure acts to eliminiate the guarantor’s subrogation rights against the prime obligor. As a result of this holding, lenders place waivers in guaranty contracts that explicitly waive the defense.
Rule 580d is may be waived by the debtor after default. In Cathay Bank v. Lee, the court denoted the requirements for a valid waiver of rule 580d’s protections. The waiver must be intentional and explicit and it must inform the buyer of the legal consequences of the waiver.
A significant holding regarding junior creditors and rule 580d provides that when two separate loans are secured with separate deeds of trust by the same real property, rule 580d that forbids a judgment for any remaining balance unpaid after the creditor's non-judicial foreclosure under a power of sale in a deed of trust on real property does not preclude a junior creditor from attaining a personal money judgment for the full amount due on the junior debt when the senior lienholder accomplishes a non-judicial foreclosure that extinguishes the junior lienholder's security interest. However, a junior lienholder is barred from a deficiency judgement of it forecloses its own lien by a sale.
EFFECTIVENESS OF 580D
Although rule 580d typically lays dormant during times of inflation and increasing values in property, when the economy becomes stagnant and property values decline, the rule provides protection to borrowers. The rule equalizes judicial and non-judicial foreclosures by focusing on the tradeoff between the borrower obtaining his statutory redemption rights and the creditor obtaining a deficiency judgment. Thus, if a lender wishes to seek a deficiency judgement, it must institute a judicial foreclosure which makes the sale subject to statutory redemption rights. If the creditor wants to expedite the sale without a redeemable title, rule 580d forbids a deficiency judgement.
Anti-deficiency rules failed to prevent the 2008 real estate market crisis and rule 580d provided no protection to the market in California. The type of foreclosure, judicial or non-judicial had seen the same effect during the real estate cash. Again, this was due to the offering of a considerable amount of risky alternative mortgage products during the time while borrowers were protected by anti-deficiency laws. Creditors and the real estate market itself were impacted the greatest. The buyers who took high loan to value loans went into negative equity. When the negative equity became excessive, many of these borrowers made the decision to exercise the “put” option in their mortgage loan and walk away from the loan. The home was returned to the lender at par value. Thus, as previously stated, the anti-deficiency rule accelerated the real estate crisis in California rather than offer any protection.
LIQUIDITY MONEY AND 580D
Residential real estate markets may go through periods that are hot and periods that are cold. A hot market occurs when prices are rising. Liquidity is decent because average selling times are short, and the amount of transactions is higher than normal. Cold markets have the opposite features—prices are falling, liquidity is small, and volume is down. The value of houses also decline and sellers are slow to drop their prices. This in turn causes marketing times to raise and the sale volumes to lower. These are all characteristics of a cold real estate market. The hot market has just the opposite characteristics. Real estate prices rise during hot markets. However, prices do not appear to rise fast enough because houses are quickly snapped up after they are brought to market.
Investment property is chosen based on yield and liquidity. While yields generate revenue and cash flow throughout ownership, liquidity governs how successful the investor will be. Liquidity determines if assets will be sold fast or slow and if the price will be higher or lower than the market value. Property that sells easily and bought at market value is liquid. Conversely, assets that are more difficult to sell and execute for a discounted price are regarded as illiquid. Real estate is the most illiquid assets as it necessitates more capital to buy than other types of securities or precious metals. Selling of the property takes more time as a buyer must be found and the transaction process must be completed in full. Property assets are also restricted to location and affected by changes to the local market. Many buyers also ask for discounts in exchange for a faster transaction.
Liquidity increases for various reasons. A high demand from a wide audience of potential buyers increases liquidity. A high product has an increased liquidity. And, the ease at which it is to estimate the value of an asset increases liquidity. Real estate, however, has a low liquidity compared to other assets. This is likely due to the inability of the east at which it is to estimate the value of the real property.
580D WRAP-UP
Rule 580d is complemented by rule 726a, the one action rule. Suppose a bank lends a borrower $5,000.00 to purchase and develop a strip mall in an exclusive neighborhood in the community. The note on the loan is secured by a deed of trust on the strip mall. For a variety of reasons, the borrower subsequently goes into default. The borrower has another account at the bank with $250,000. The bank must determine which avenue to proceed in recovering the defaulted debt from the borrower. The bank can bring a judicial foreclosure and recover the entire debt, it can institute a non-judicial foreclosure or it can set-off the borrowers other account and then institute either a judicial or non-judicial foreclosure.
In a judicial foreclosure, the bank could recover the value of the shopping center when sold and also a deficiency judgement if the debt exceeds the amount of the proceeds of the foreclosure sale. There may be some issues that arise in the judicial foreclosure for the bank. The borrower may be losing his other assets and the judicial foreclosure is time consuming so time is of the essence. A judicial foreclosure be result in no recovery of the deficiency judgement by the bank for this reason.
The bank may choose to foreclose non-judicially. Non-judicial foreclosures are much quicker and the borrower may not lose all his other assets before foreclosure. However, a deficiency judgement is forbidden in non-judicial foreclosures according to rule 580d and the bank would only recover the proceeds of the sale of the strip mall. Lastly, the bank could set-off the borrower’s account that is in the bank with $250,000.
However, the anti-deficiency rule and the one action rule limit this course of action. If the bank sets off the money in the account, the borrower can demand the return of the money. The bank may return the money and proceed against the security first, or it may refuse to return the money and thus lose the security on the strip mall and the right to pursue any balance further due on the debt. If the borrower does not ask for the return of the money from the account, the bank keeps the account money but loses its security in the real property.
This situation portrays the workings of rule 580d and 726a. A borrower in California who signs a promissory note only promises to pay any deficiency if the sale does not satisfy the note. The borrower is not making an unconditional promise by signing a note for real property due to the consequences of the anti-deficiency rule and the one action rule.
RULE 726A ONE ACTION RULE
There can be but one form of action for the recovery of any
debt or the enforcement of any right secured by mortgage
upon real property
The one action rule set forth in rule 726a of the California Code of Civil Procedure expresses the judicial economy justification of election of remedies laws by forbidding multiple judicial actions by the lender of a mortgage and requires the lender to deplete its collateral before chasing the creditor’s other assets. An action is considered a court proceeding where one party seeks enforcement of right against another. Yet, in California, an action as applied in rule 726a also includes extrajudicial remedies. California creditors holding mortgages for borrowers were permitted to bring more than one action against a defaulting borrower prior to the implementation of rule 726a. Actions were brought to foreclose on the property, and actions were also brought on the note itself.
The one action rule was first adopted by California in 1860 to abolish the distinction between law and equity proceedings in property law proceedings out of concern for multiplicity of lawsuits against borrowers. The rule intended to relieve the stress of borrowers who feared two actions, in both law and equity courts, in mortgage debt situations. The rule relieved creditors of having to file multiple actions against defaulting borrowers. Rule 726a requires creditors to seek recovery in one judicial action which would include the foreclosure and a personal judgement for any deficiency.
In Felton v. West, the court made the one action rule effective to mortgage foreclosure actions and allowed the creditor to foreclose and obtain judgment for deficiency in the same court action. Common law remedies were no longer available for creditors in California, which set itself apart from other jurisdictions in regard to this matter. The one action rule was enacted as a means to relieve debtors from the possibility of being sued multiple times on a foreclosed property. The one action rule mandates that any creditor who makes use of the power of the sale in deed of trust on the real property of a borrower may not sue the borrower for any deficiency.
Rule 726a is not only considered a one action rule but also can be termed as a security first rule or an anti-multiplicity rule. This means that a creditor is only authorized to bring one judicial action against the foreclosed borrower, and this must be completed prior to obtaining a judgment of deficiency against the debtor. A lender of a real property loan is restricted from taking more than one action to enforce a debt. The action may include foreclosing non judicially, foreclosing judicially, or suing the purchaser personally on the promissory note for debt balance. Ultimately, this rule limits a creditor to one foreclosure proceeding or court action against a borrower who falls behind in mortgage payments.
This rule seems to allow the creditor to sue the borrower personally on the promissory note and not sue at all on the foreclosure. However, California courts have interpreted the one action rule to entail that a lender must pursue the real estate before suing the borrower personally.
In Walker V. Community Bank, the one action rule translates as a “security first rule.” The goal of the rule is to stop a secured creditor from suing the borrower that defaulted on the debt itself prior to foreclosing on the security interest. This means that a mortgage creditor must foreclose the security, which is the home, rather than suing the borrower directly on the underlying promissory note. As a result of these rules, the options for creditors are restricted when a borrower defaults on a mortgage.
The security first rule is actually a corollary to the one action rule or it is the foundation behind the one action rule. Rule 726a forbids an independent action of the borrower’s note so that the only way for a beneficiary to recover is through a deficiency judgement after the foreclosure sale where the funds did not amount to the whole of the loan. The security first principle, thus converts the borrowers promise to pay too conditional rather than absolute. The borrower only promises to pay a deficiency if the foreclosure sale does not satisfy the note.
In Bank of America v. Daily, the court defined the sanction against the creditor for violating the rule as a loss of its rights in the security. The sanction also included releasing the debtor from any liability on the debt. The court noted that a pre-foreclosure setoff would reduce the likelihood that a bank would ever seek a money judgement as it would deprive the debtors of funds awaiting a determination by the judicial court of any deficiency. The banks incentive to seek the highest price for the collateral at a foreclosure sale would also be reduced and the entire burden would be on the debtor prior to the foreclosure. Thus, to allow the bank’s setoff action to go unsanctioned would effectively encourage upcoming breaches of the one action rule and thus deplete the protections intended for the debtor.
In Security Pacific National Bank v. Wozab, the court followed the rule of Daily but imposed a nearly one-million-dollar sanction which was reversed in 1990. The bank took the setoff without foreclosing on the deed of trust and the lower court determined that the setoff was the bank’s one action permitted under rule 726a which resulted in the nearly one-million-dollar sanction. The California Supreme Court determined conversely with the lower court and stated that the setoff was not an action but rather an extrajudicial act. The court set the sanction to loss of security interest only. This sanction allows for a creditor to pursue the underlying debt but as an unsecured creditor.
The court in Wozab was highly split and left questions regarding when and whether the one action rule applies to setoffs. Scholars recommend that the recommended course of action should lie between the court’s opinion and the dissents response. If a lender makes an inappropriate setoff, but then almost immediately reverses it on its own or at the request by a debtor, a sanction should not be transmitted since the parties return to the status quo. However, if the lender does not reverse the setoff, a sanction is appropriate and the lien should be done away with just as in Wozab. Also, if the lender does not reverse the setoff even after a formal demand, the remaining debt should be eliminated as a sanction. A setoff, as an extrajudicial action, would deny a debtor of the affirmative defense under the one action rule, and thus, a sanction including the elimination of the remaining debt would be appropriate.
726A AS A SHIELD AND A SWORD
As set forth in case law, the one action rule has been interpreted as a shield for the borrower as it may be used as an affirmative defense, and it has been interpreted as a sword for the creditor as it allows for sanctions upon creditors who violate the rule. The borrower must raise the one action rule as an affirmative defense in a creditor seeking a personal judgment on a security interest loan for real property. This is a shield that the rule provides. If creditors violate the rule by bringing a personal action prior to foreclosing, they may receive a sanction. This sanction is not set forth in the rule itself but rather provided in case law interpretation of the legislative intent behind the rule itself.
The most significant justification for the rule to act as an affirmative defense is to prevent multiplicity by the creditors in suing the borrower. There are also several other rationales for the rule as well. The rule compels competitive bidding to test the value of all the security. It forces creditors to look to all security as the primary source before looking to the debtor. And, it accepts the party’s agreement when the loan was created that the security is the primary fund for satisfying the debt.
The rationale behind the use of the rule as a sword is to prevent a creditor from suing a debtor on the debt itself prior to foreclosing on the real property security interest in which the debt secures. Although the rule itself does not explicitly set out the sanction consequence, courts have sought guidance in the legislative intent of the rule itself. The sanctions that may be suffered by creditors who violate the rule exist to prevent multiplicity. The sanction is intended to protect the debtor’s assets from additional and extensive litigation costs when the debtor is already facing a financial crisis. The sanction also stops the creditor from getting a judgement lien on everything owned by the debtor including the mortgage or deed of trust, prevents the creditor from not seeking competitive bidding for the property, and thus forces a fair market value on the property.
The sanction within the one action rule has been criticized by scholars as being too harsh. As for the whole of rule 726a, scholars have noted that the rule requires the creditor to seek a judgment against the collateral before seeking a judgment against the deficiency balance. Additionally, deficiency judgments are not authorized in non-judicial foreclosures, only in judicial foreclosures. A judgment for deficiency is also only authorized in non-purchase money loans. Borrowers of commercial property loans and investment properties as well as loans on apartment buildings may also face a deficiency judgment.
The controlling factor under the rule is whether the mortgage was obtained to secure all or part of the purchase price of a dwelling. A deficiency balance resulting from a second mortgage acquired to obtain a home equity line of credit is not be excluded by the California law if it is not a feature of the purchase price of the home. However, a deficiency balance ascending from a second mortgage approved that was utilized to secure the purchase price, such as an 80/20 loan, would be forbidden by the California law
Some scholars claim that the rationalization for the initiating of rule 726a has become unclear since its inception. Originally intended to eliminate the distinction between law and equity proceeding and relieve multiple actions against borrowers, These scholars reiterate that the rule was intended to protect borrowers but has been interpreted as being a protection for creditors. This has resulted, scholars claim, from the inaccurate interpretation of the 1894 case Felton v. West. In this case, the court made it clear that a creditor must exhaust his security before seeking a personal judgment against the debtor. Making the rule mandatory eliminates creditors choice in seeking a remedy against a debtor, and it creates a law significantly different than many other states.
There are two important issues under this rule. First, a creditor cannot obtain a personal money judgment against the borrower prior to foreclosing on the security interest of the debt. Second, a creditor who does not adhere to this rule may receive a sanction for violation of the rule. A creditor may not relinquish a security interest in real property by obtaining a personal money judgment prior to foreclosing on all security for the debtor. The creditor is forbidden to sidestep the rule as the liability of the mortgagor is dependent on the fact that a sale of the mortgaged property shall unsuccessfully satisfy the debt and costs. Basically, a creditor must bring an action on and exhaust the mortgaged security before recovering from the debtor personally.
Additionally, if a creditor does not follow the procedures laid out in the rule, sanctions will be imposed upon it. Sanctions could result for the creditor by bringing an action directly on the note. Also, sanctions could be handed out if the creditor forecloses on less than all of the security in a judicial foreclosure action.
Scholars do not vary on the consequence of sanctions, however, they do not agree on the proper scope of the sanction. The majority of scholars believe that sanctions should be limited to only the loss of the creditor’s rights in the security interest only. Others hail that the sanctions for violation of the one action rule should include loss of the portion of the debt that is not in the creditor’s one action, and also loss of the security interest.
A method used by California lenders to avoid the one action rule is to provide debts through the use of a guaranty or through the execution of two loans – one securing the personal property and the other securing the real property of the borrower.
The one action rule has a dramatic impact on the real estate market in California. In most states, if a loan is unsecured and the borrower defaults, the creditor may sue for the entire unpaid principal balance of the loan and also enforce a personal judgment on any asset belonging to the debtor. In California, this is not the case. If any portion of a loan is secured by California real property, under the one action rule the creditor must judicially foreclose on the real property and seek a personal judgement in the same action. The creditor is forbidden from suing the debtor personally on the debt until the security is exhausted. If the creditor chooses to sue on the note and disregards the security, protection of the one action rule can be waived by the debtor and the only remedy would be the personal action.
Rather than being a true one-action rule, where creditors can only pursue one action and in doing so waives any other rights, the California rule allows a creditor to attain a borrower’s other assets so long as the process of doing so in a court action is correct. This does not protect debtor’s assets. Additionally, mandating the order in which an action must be sought by a creditor may ultimately be costly to the creditor since the value of the borrower’s assets could decrease while the creditors is pursing the security action first. The creditor may even lose the other assets to other creditors who are also seeking judgements against the debtor in other actions. So, the rule places a burden on creditors but it does not benefit debtors.
The waiver of rule 726a by borrowers has been an issue regularly discussed by the courts as well as by scholars. In Bank of America, N.A. v. Roberts, the debtor agreed to be held liable the unpaid balance of the loan but subsequently claimed a rule 726a defense. The court held that the debtor sufficiently waived the 726a defense by agreeing to the short sale and to remain liable on the balance. Debtor’s facing foreclosure are obviously under financial duress and rule 726a was purposefully implemented to protect buyers during these times. This confusion as well as the inconsistency continues as there has never been any explanation as to why a creditor would actually want to file multiple actions to collect on a single debt. Multiple actions cost more money and multiple recoveries are not very likely. Thus, the question asked by scholars is why a straightforward prohibition against splitting a cause of action would not work as well or better than rule 726a, which has caused so much grappling over what defines an action when the anti-multiplicity standard is activated or waived. Nor has legal scholars explained why a straightforward election of remedies rule would not protect borrowers just as well as the security-first rule.
EXAMPLE OF 726A APPLICATION
The following scenario displays the way in which the one action rule is applied. A Bank has an account for the debtor, and the bank then loans money to the debtor/borrower and takes a security interest in the debtor/borrower’s real property. The borrower defaults on the loan. The bank then applies the proceeds of the account to the debt rather than foreclosing on the security. The question presented is whether it is possible for the debtor to raise the one action rule or not, and why?
The debtor may raise rule 726a as an affirmative defense in this situation and ask the court to force the creditor to exhaust all security in the debt prior to seeking judgment against other assets. Or alternatively, the debtor may forgo using the rule as an affirmative defense and instead ask the court to impose a sanction on the creditor for not foreclosing on the security first.
SIMILAR ONE ACTION RULES IN THE UNITED STATES
The one action rule only exists currently in five states, which are predominately western states. Idaho, Montana, Nevada, New York and Utah have one action laws. The rules in each of these states are very similar to rule 726a in California. The rule forces lenders to exhaust its collateral before accessing a debtor’s other assets through a personal judgment. The ability of the rule to protect creditors and address judicial economy allow for these states to continue with the application of a one action rule. In 2008, a large number of loan borrowers defaulted and mortgage foreclosures were unprecedented across the United States. California’s one action rule did not protect the market in its state during this real estate market collapse.
726a WRAP UP
When a lender pursues a personal judgment against a debtor without exhausting the borrower’s security first, or when the lender leaves out part of the security for a single debt from a judicial foreclosure, the debtor may present the one-action rule as an affirmative defense which compels the creditor to exhaust the security before going any further on the debt. The affirmative defense is predicated on the judicial understanding that the one-action rule forbids a creditor from unilaterally waiving a security interest in real property and seeking a personal judgment. The reasoning behind preventing a creditor from evading the one-action rule in this way is that the debtor's personal liability is dependent upon the exhaustion of all of the security. Without the ability to ask the court to compel the creditor to exhaust the security first, the one action rule would not have any substance. Also, without the ability to raise the defense of the one action rule, debtors of real property would be at the mercy of the lenders who would have the freedom to choose between obtaining a judgment on the note and a lien on all other debtor assets or alternatively, a foreclosure followed be a possible deficiency judgment. The affirmative defense available to the debtor allows the debtor to challenge the creditor’s classification of the debt as unsecured. Raising the affirmative defense is not a requirement for the debtor as he or she may forgo the defense and rely on the sanction provision in the one action rule instead.
THE 2008 HOUSING MARKET CRASH
As mentioned above, the anti-deficiency statutes were not as effective in the 2008 housing market crash as they had been in the Great Depression. There were many causes of the 2008 housing market crash in the United States including subprime lending, relaxed underwriting standards, a housing bubble, a drop in prices of homes, and the deregulation of the lending industry. One of the causes of the crash can be attributed to the banking industry. The economy began with a recession at the end of 2007 which was the result of a credit crisis that was instigated by the burst of the housing bubble. Subprime loans were being issues at a standard that was diminished. The underwriting standards were so relaxed that resulted in speculation and a rapid increase in defaults when home prices froze.
Steady growth in the housing market occurred in the mid too late 90’s. However, the stock market crash in 2000 led investors to move aware from stock and into housing. Money for housing loans was readily available at relatively cheap rates. Additionally, financial institutions created a variety of new loans including the interest adjustable loan, the interest only loan and the zero down loan. The housing market was in a buying frenzy as a result. Lending institutions securitized the loans rather quickly putting the risk on someone else. Derivatives grew exponentially and cash reserves shrank. Housing prices California grew nearly twenty percent a year. Nearly half of the California home loans were interest only or negative amortization.
In 2006, defaults began to occur on the subprime loans. By 2007, Freddie Mack was no longer buyer subprime loans, subprime lenders were filing bankruptcy and the stock market hit a record high. Then, in 2008, subprime loans became deplete and lenders across the country had loans in the housing market of over 1.5 trillion dollars. As lenders crashed and buyers continued to default, over three million foreclosures were filed in the United States.
The offering of a considerable amount of risky alternative mortgage products created the situation and the protection of the anti-deficiency law was for the borrowers and not the creditors. During the 2008 real estate crisis, buyers who took high loan to value loans went into negative equity. When the negative equity became excessive, many of these borrowers made the decision to exercise the “put” option in their mortgage loan and walk away from the loan. The home was returned to the lender at par value. This happened more excessively in California than any other state and the anti-deficiency statute protected the buyer and not the market itself. Thus, the anti-deficiency rule accelerated the real estate crisis in California rather than offer any protection.
OVERALL REVIEW OF POLICY IMPLICATIONS
A primary objective of anti-deficiency legislation is to ensure the sale of the foreclosed real property at a fair market value. Public auctions are not optimal environments for maximizing the price offered for real property however. This is because real property is not a fungible asset. Real property must be placed on the market typically for long periods of time in order to generate high bids. Additionally, foreclosed real property often are not inspected prior to sale which increases the risk for the potential purchaser. And, cash payment is expected at the time of the auction sale. For these reasons, the real property is sold at a foreclosure sale for a nominal bid. This nominal bid is likely to be less than the amount the defaulting borrower owed on the loan. The creditor will then wish to seek an anti-deficiency judgement. Due to the limitations placed on creditors to seek anti-deficiency judgements, lenders may pass on the cost and risk of loss to borrowers and thus leave the borrower without any substantial benefits. For example, high interest rates may be imposed.
A benefit generated by the anti-deficieny statutes is the economic efficiency as a result of the laws. A form of insurance against adverse effects of mortgage default and foreclosure exists for borrowers. Since most individuals are risk averse, this insurance reduces the risk and promotes economic efficiency by pooling together a large number of uncorrelated individual risks. The aggregate level of risk in society is also reduced by the law of large numbers: as the number of pooled risks increase, the probability of default due to an unexpected happenstance occurring becomes more readily predictable. Insurance also encourages economic efficiency by serving as an intermediate between people with high and low marginal utilities for capital. Most people display a declining marginal utility for money. Insured individuals pay their premiums out of low utility dollars. These low utility premiums in turn are paid out as high marginal utility dollars to individuals who have suffered circumstances allowing them to a recovery. Thus, the insurance given by the laws take full advantage of the marginal utility of capital among people and across time. Economic efficiency is promoted through the availability of anti-deficiency because the incentives to engage will attract risk averse individuals as the homebuyer’s risk is minimized. This can also lead to increased well-being among individuals and a higher level of housing consumption.
An unintended consequence of the anti-deficiency laws is the creation of a type of moral hazard on the part of the borrower. Once the equity in the real property vanishes due to falling prices or unpaid interest and penalties, the borrower no longer has an incentive to maintain the value of the real property that is secured by the loan nor protect the waste if he or she is insulated from personal liability. However, despite the thought of this type of moral hazard, this had not been the reaction of individuals who are underwater homeowners. Evidence shows that a very small percentage of homeowners strategically default due to negative equity.
Finally, lenders are skilled at evaluating risks in the real estate market. Borrowers typically have no education on the matter and do not appreciate the associated risks with purchasing a home. Thus, it should be lenders who capture most of the risk associated with foreclosure. Besides, the sophisticated banking industry may very well be considered the central driving force behind deficiencies and profits because their decisions and actions impact the likelihood of losses in the real estate market. Also, lenders can more easily absorb the losses associated with loan defaults and foreclosure. Shifting the burden to the lender would be not only practical but also logical.
CONCLUSION
Anti-deficiency laws should be established in Saudi Arabia much like that in California in order to prevent economic crisis in the real estate market. Removing the load of the risk off the borrower and placing it on the lender under the anti-deficiency laws will ensure that the housing market can continue to operate while ensuring that borrowers will continue to invest in the real estate market. Anti-deficiency statues place the larger proportion of the risk associated with mortgage loans upon the lender, as should be. Lenders produce the loan product and are better positioned to understand and monitor economic markets and have the capability to downturn risks when needed. Mortgage lenders are trained in evaluating and assessing risks. The lender thus has the ability to contemplate a fall in the economy. Additionally, lenders are more able to absorb losses that are associated with default and foreclosure on real property loans.
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