Judicial Foreclosure: Things That Can Go Sideways During The Redemption Period
Judicial foreclosure is uncommon in California. In most cases, lenders will pursue nonjudicial foreclosure (aka “trustee’s sales”), which are simple, quick, and efficient. But when a lender is dead-set on recovering a deficiency judgment (assuming one is available), judicial foreclosure is the only permissible route.
In a judicial foreclosure, recovering a deficiency judgment is possible, but the borrower retains important rights, including fair value protection (in the form of an evidentiary hearing following the foreclosure sale) and the ability to redeem the property — i.e., to regain ownership by the end of the redemption period by paying the amounts required by a statutory formula.
The redemption period in most cases (where a deficiency remains following the sale) is one year. (Code Civ. Proc. §729.030.) There are several things that can go “sideways” during that year, creating problems for both lenders and borrowers. Here are a few.
Possession of the property
During the redemption period, the borrower retains the right of possession. “The law grants to the mortgagor the right to redeem the property and to remain in possession pending the expiration of the period of redemption.” (Shintaffer v. Bank of Italy Nat. Trust & Sav. Assn. (1932) 216 Cal. 243, 247, emphasis added.)
This means that the purchaser at the foreclosure sale, whether it’s the lender who made a credit bid or a third party purchaser, generally must wait a full year before taking possession.
The purchaser is entitled to charge fair rental value against a borrower remaining in possession. (Code Civ. Proc. §729.090(a).) But this obligation is difficult to enforce in real-time — courts may be reluctant to impose “unlawful detainer” remedies on a borrower remaining in possession during the redemption period. In reality, the borrower often gets a “free ride” of possession for the year.
Notwithstanding the borrower’s legal right to remain in possession during the redemption period, some purchasers take immediate possession over the borrower’s objection. While the borrower might have a forcible detainer remedy available, the wheels of justice often move too slowly to make the remedy meaningful.
In one case I was involved in at the appellate level, the lender/purchaser took possession over the borrowers’ objection, and remained in possession for nearly the entire one-year redemption period. The borrowers found it impossible to secure financing for the redemption payment because no new lenders were willing to make a loan to someone not in possession. It was not until possession was restored (with court intervention) just weeks before expiration of the redemption period that the borrowers were able to obtain financing for the redemption payment.
Maintenance and repairs vs. Improvements
During the redemption period, the purchaser (at the judicial foreclosure sale) can enter the property to undertake necessary maintenance and repairs. (Code Civ. Proc. §729.090(c).) All of the costs of such maintenance and repairs are added to the redemption price, essentially shifting them to the borrower if the borrower redeems. (Code Civ. Proc. §729.060(b)(2).)
Sometimes purchasers stretch this right, and make elective improvements to the property during the redemption period.
Such improvements have generally been frowned upon by the courts, and have no statutory basis. But that hasn’t stopped some purchasers from attempting to “improve the borrower out of the property” by making elective improvements and then seeking to add the often exorbitant costs of those improvements to the redemption price.
A savvy borrower can successfully challenge these tactics, but that doesn’t always happen. But any purchaser tempted to make improvements should remember that those improvements may essentially be “donated” if the borrower redeems and the court correctly disallows the costs of the improvements to be added to the redemption price.
What about “administrative and operating” expenses?
The purchaser at the judicial foreclosure sale is unquestionably entitled to collect rents or profits generated by the property during the redemption period. (Code Civ. Proc. §729.090(a).) But can a borrower in possession water down this right, by first deducting its “administrative and operating expenses” relating to the property before giving the purchaser only what’s left — i.e., net rents?
Case law seems to make pretty clear that the purchaser is entitled to the gross rents — i.e., any rents due and payable from tenants, without any deductions. “[T]he statute regards the purchaser as the owner in equity of the land, subject only to the right of redemption, and gives him the rents and profits, or the value of the use and occupation, – in short, the entire beneficial interest, except the actual possession.” (Walker v. McCusker (1887) 71 Cal. 594, 596, emphases added [referring to predecessor statute, §707].) The purchaser can even have a post-foreclosure receiver appointed for the singular purpose of collecting rents directly from the tenants during the redemption period. (Code Civ. Proc. §564(b)(4).)
But in a baffling recent decision by the California Court of Appeal (Fifth District in Fresno) — Wells Fargo Bank, N.A. v. 6354 Figarden General Partnership — the court held that the reference to “rents” in section 729.060(c), the companion statute to 729.090(a), means only “net rents.”
The Figarden opinion
In Figarden, the court addressed a scenario in which the lender/purchaser took possession during the redemption period over the borrowers’ objection, collected gross rents from tenants, and made administrative and operating (among other) expenses. The borrowers redeemed, and claimed they were entitled to a redemption price credit under section 729.060(c) in the amount of the gross rents collected by the purchaser.
The borrowers conceded that the purchaser’s legitimate expenses for necessary repairs, maintenance, and other items could be added to the redemption price pursuant to the statutory formula set forth in section 729.060(b), but argued that the redemption price could not include the purchaser’s “administrative and operating” expenses. The court of appeal agreed that administrative and operating expenses did not qualify as “maintenance or repairs” under section 729.060(b). Nonetheless, the court held that the redemption price credit under section 729.060(c) would be limited to “net rents” — i.e., whatever remained of the gross rents collected by the purchaser after the purchaser subtracted its administrative and operating expenses.
The Figarden decision is troubling on many levels. In the context of the facts in that case (purchaser in unlawful possession), it effectively allowed the purchaser to add an item to the redemption price — administrative and operating expenses — that is nowhere to be found in the statutory redemption price formula. It also opens the door to serious mischief by purchasers, who now have extra incentive to take unlawful possession of the property during the redemption period and incur exorbitant administrative and operating expenses (often charged by themselves or an affiliated “management” entity), thus increasing the effective redemption price and perhaps putting redemption out of reach. Further, the Figarden holding would force the borrower to pay administrative and operating expenses “out of pocket” as part of the redemption price, rather than paying them from the gross rents, as is customary for any enterprise that makes use of real property.
On the flipside, the Figarden decision creates the identical problems for purchasers/lenders. A purchaser who “plays by the rules” and allows the borrower to remain in possession during the redemption period might now be entitled only to the “net rents” arising from the property — i.e., whatever is left of the rents after the borrower in possession deducts its administrative and operating expenses. This result of Figarden seems flatly inconsistent with prior case law.
Interestingly, both the borrowers and the lender/purchaser in Figarden argued in briefing that the redemption price credit under section 729.060(c) must refer to gross rents. But the Court of Appeal forged its own path. When the borrowers petitioned for rehearing, one of the Justices voted in favor of granting rehearing, but the other two declined. As such, the Figarden decision is now precedent.
It will be interesting to see how future decisions address Figarden and the problems addressed above.
Lessons
Compared to a simple trustee’s sale, judicial foreclosure is a complex process with many boobytraps. Even after the sale is completed and the fair value hearing is adjudicated, many problems can arise during the redemption period. This post highlights just a few of them.