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California Supreme Court Clarifies Anti-Deficiency Protection for Purchase Money Loans

The California Supreme Court has published its much anticipated decision clarifying the scope of anti-deficiency protection under Code of Civil Procedure section 580b for purchase money loans in Coker v. JPMorgan Chase Bank.  (A purchase money loan occurs when a borrower obtains a loan to purchase real property and uses that property as collateral.)

Here are the details of the Supreme Court’s opinion:

Facts

In 2004, Carol Coker purchased a condominium in San Diego County with a $452,000 loan that was later assigned to JPMorgan Chase Bank (“Chase”).  During the recession, Coker fell behind on her payments, and in 2010 she received a notice of default.

Coker and Chase agreed to a short sale to a third party for $400,000.  Under the terms of the short sale agreement, Coker was to net nothing from the sale, and Coker agreed to remain responsible for all deficiency balances remaining on the loan after the short sale “per the terms of the original loan documents.”  In short, Coker purported to waive the anti-deficiency protections for purchase money loans set forth in Code of Civil Procedure section 580b.

The short sale closed in July 2010.  In January 2011, Coker received a collection letter from an agent of Chase demanding the $116,686.89 balance remaining on her loan.

Coker filed a lawsuit seeking declaratory relief, asserting that section 580b prohibited Chase from collecting the deficiency.

All of the underlying events happened before the Legislature amended section 580b to clarify its broad scope, and before the Legislature enacted section 580e, which expressly prohibits deficiency liability following short sales.

Lower Court Holdings

The trial court sided with Chase, dismissing Coker’s complaint without leave to amend.

But the Court of Appeal reversed, holding that Chase’s ability to recover a deficiency after the short sale was barred by section 580b, and that Coker’s purported waiver of section 580b was unenforceable.

The California Supreme Court granted review.

The Supreme Court’s Opinion

The Supreme Court sided with Coker, affirming the decision of the Court of Appeal.  The Court’s holding addressed several issues, as noted below:

Section 580b limits a lender’s recovery on a standard purchase money loan to the value of the security — regardless of how the security is exhausted (i.e., by foreclosure sale, short sale, or otherwise)

The Supreme Court began by noting that section 580b broadly applies to purchase money loans, and provides the borrower with anti-deficiency protection that serves as “a stabilizing factor in land sales for two reasons. …  First, lenders are less likely to overvalue the homes they finance when they cannot hold homeowners personally liable for any deficiency.  … Second, when an economic downturn causes widespread depression of property values, section 580b prevents the aggravation of the downturn that would result if defaulting purchasers were burdened with large personal liability.”

Chase argued that section 580b does not apply after a short sale.  But the Supreme Court disagreed, holding that section 580b limits a lender’s recovery on a standard purchase money loan “to the value of the security, no matter how the security has been exhausted[.]”  (Emphasis added.)  In short, if the loan is a standard purchase money loan, the lender’s recovery is limited to the security, regardless of whether the security is exhausted by way of foreclosure sale, short sale, or “even if no sale has occurred under the deed of trust securing the unpaid loan.”

There are narrow exceptions for “non-standard” purchase money loans

The Supreme Court observed that there are situations where the protections of section 580b may not apply because the loan is not a “standard” purchase money loan.

This might occur, for example, when a deed of trust is given on land other than the land purchased, or when the borrower and lender agree that the loan will be subordinated to a future construction loan (i.e., where commercial development will substantially alter the security value of the land).

Even in these “non-standard” purchase money loan scenarios, the Court held, courts must still examine whether applying section 580b’s anti-deficiency protection would comport with the Legislature’s intent.

Coker’s loan was a standard purchase money loan; the short sale did not change the loan’s nature

Turning to the facts of the case, the Supreme Court held that the loan between Coker and Chase was a standard purchase money loan, noting that Coker “did nothing more than buy a home to live in using purchase money financing.  She did not buy the property as investment or commercial property, did not develop it, and did not refinance it or obtain construction financing to materially increase its value.  There is nothing distinctive to remove her purchase money mortgage from the mass mainstream of home purchase transactions.”

As such, the Court held that section 580b “applies automatically here.”

The Court rejected Chase’s argument that the short sale agreement destroyed the purchase money nature of the loan.  The short sale agreement “never put Chase at risk of losing the value of its security” — it did not call for the substitution of other security, it allowed Chase to retain the deed of trust until the short sale closed, and it did not leave the note unsecured upon a mere expectation of payment.  Instead, the “short sale, like a foreclosure sale, allowed Chase to realize and exhaust its security.”

The lender’s policy arguments rejected

The Supreme Court also rejected Chase’s policy arguments.

Chase argued that applying section 580b’s anti-deficiency protections to short sales would not deter overvaluation of property and would not stabilize the economy in times of distress.  Instead, Chase argued, applying section 580b to short sales would fuel “borrower speculation and overvaluation” (because buyers know they can escape personal liability for any deficiency) and incentivize borrowers to “strategically default in numbers that saturate the market.”

The Court viewed Chase’s arguments as a general attack against anti-deficiency laws, and observed that such attacks have been implicitly rejected in a long line of cases.

Section 580b, the Court held, is “a macroeconomic stabilization measure” ensuring that purchasers as a class are harmed less than they might otherwise be during times of economic distress so that the economy benefits.  That statutory purpose, the Court held, “is equally served by applying section 580b whether defaulting borrowers have lost their homes by foreclosure or a short sale.”

Section 580b cannot be waived

The Court held that Coker’s purported waiver of section 580b in the short sale agreement was invalid and unenforceable as a matter of public policy.  A “law established for a public reason cannot be contravened by a private agreement. … A key purpose of section 580b is to stabilize the state’s economy, to the benefit of all.  The public benefit section 580b provides is one of its primary purposes.”

Section 726 can be waived post loan origination

Finally, as a side note, the Court held that Coker’s waiver of Code of Civil Procedure section 726 (the “One Action Rule”) was valid.  Section 726 requires that a secured creditor can bring only one lawsuit to enforce its security interest and collect its debt, and also requires the creditor to rely on the security before enforcing the debt (the “security first” aspect of section 726).  Here, by agreeing to the short sale, Coker waived her right to later assert section 726.  “As a result, Coker cannot complain that Chase failed to bring a foreclosure action rather than a breach of contract action.”

That waiver, however, was inconsequential.  Coker, the Court held, “never complained that Chase brought the wrong kind of lawsuit against her; she has instead maintained that Chase could not bring any kind of recovery action because the short sale triggered the protections of section 580b.”

In short, the Court held that “[w]hen a borrower waives her rights under section 726 by agreeing to a short sale, section 580b remains a barrier to any deficiency judgment after the lender collects the full value of its security from the sale.”

Lesson

Under the Coker decision, section 580b is an important “macroeconomic stabilization measure,” which bars deficiency liability for standard purchase money loans — regardless of whether the security is exhausted by foreclosure sale, short sale, or some other means.

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