Real estate secured loans inspire all sorts of litigation.
I see it from both sides of the coin, since I represent developers and investors (who are frequently borrowers on secured loans) and private money lenders (who often lack the institutional resources and wisdom of larger commercial lenders).
Understanding the lender/borrower dynamic after a loan falls into default can have a huge impact on the bottom line.
MISTAKE #5: Misunderstanding Secured Loan and Guaranty Rights/Liability
California law is generally perceived as more “borrower-friendly” than other states. The main sources of borrower protection are the anti-deficiency statutes and the one action rule.
Borrower Protections: Anti-Deficiency and One Action Rule
The anti-deficiency statutes (e.g., Code of Civil Procedure sections 580a through 580e and 726(b)) and the one action rule (Code of Civil Procedure section 726) arose out of the Great Depression. The policies underlying these statutes aimed to limit a lender’s recovery to the security in most cases, to restrict the availability of a deficiency judgment to narrowly defined circumstances, and to ensure that the borrower receives credit for the fair value of security property before being subjected to deficiency liability.
These borrower protections are so substantial that even where a deficiency is possible, many lenders choose to foreclose by trustee’s sale (which offers speed and finality) and waive their right to a deficiency. Generally, to obtain a deficiency judgment, a lender must go through the judicial foreclosure process, which entails sometimes lengthy litigation and results in an auction sale subject to the borrower’s right of redemption.
One Action Rule: “Security First” Cases
California’s one action rule is one of the most powerful (albeit underutilized) defenses available to borrowers on real estate secured loans. The one action rule is also the source of many lender headaches.
The most developed line of cases featuring the one action rule involves the “security first” doctrine — i.e., before a lender can obtain a deficiency judgment against a borrower (or even seize any of the borrower’s non-collateral assets), the lender must first exhaust all security in one action for judicial foreclosure.
One classic violation of this rule occurs when a lender — before foreclosing on the security property — takes a “banker’s offset” by applying the borrower’s non-collateral assets (such as from a savings account also held with the lender) to the secured loan balance. Another classic violation occurs when a lender seizes the borrower’s non-collateral assets via attachment or some other pre-judgment remedy before the foreclosure sale. The sanction for violating the one action rule can be substantial, and most often involves the loss of all security (leaving the lender unsecured).
The California Supreme Court has also suggested that in particularly egregious cases — such as where the lender persists in conduct violating the one action rule despite receiving a warning — a “dual sanction” might be imposed, leaving the lender with no security AND no enforceable debt.
Borrowers can raise the one action defense either as a shield (by objecting to the lender’s seizure of non-collateral assets, which usually results in the lender quickly returning those assets), or as a sword (by allowing the lender to seize non-collateral assets and then later asserting that the lender’s conduct results in the loss of security).
One Action Rule: Co-Obligor Cases
Another line of one action rule cases involves co-obligors on secured loans, such as where multiple members of an LLC sign the note as co-borrowers.
These cases generally hold that even if the security property is provided by only one borrower, ALL borrowers are entitled to rely on the security. Thus, a lender cannot make “side deals” with one borrower to dispose of the security (via short sale or other private sale, which purports to preserve the right to a deficiency) without the consent of the co-borrowers.
A lender who fails to follow these prerequisites will likely be held to lose its right to pursue a deficiency judgment against any borrower who did not consent to the private sale of security.
Receivers are commonly utilized during the foreclosure process to “preserve, maintain, and protect” the security property. Most California deeds of trust allow for this, and normally the process is free of controversy.
But, sometimes lenders attempt to stretch the conventional role of the receiver to include tasks that arguably go beyond a receiver’s traditional role, and which might conflict with the deed of trust. Examples include:
- instructing or authorizing the receiver to develop the security property, and charge development costs to the borrower’s tab
- having the receiver attempt to sell the security property, purportedly “free and clear” of all liens
- adding exorbitant “administrative” or “management” fees as part of the receiver-related costs to be added to the secured debt
Sometimes lenders can slip these items through unchallenged, but prudent lenders should take care to avoid stretching the traditional receiver role too far. Wise borrowers should pay attention to the receiver’s monthly reports and challenge improper charges immediately instead of waiting until the receiver’s final accounting and discharge.
The widely believed fiction is that guarantors are just “backstops” to be held accountable only if the borrower doesn’t pay. The reality is that under California law, guarantors are clearly on the liability front lines.
Borrowers enjoy many statutory protections, including the anti-deficiency statutes and the one action rule, that cannot be waived at the inception of the loan.
Guarantors, on the other hand, also have many statutory protections (e.g., to force the lender to go after the borrower first, to force the lender to go after the borrower’s security first, to force the lender to join co-guarantors), but almost all can be freely waived. Sophisticated lenders almost always use forms requiring the guarantor to waive these protections, and those waivers are normally enforceable.
This leaves very little wiggle room for the average guarantor.
One defense that sometimes works is the “sham guaranty” defense, which commonly features a borrower and guarantor that are functionally the same person or entity. (By asserting this defense, however, a guarantor may get itself into “alter ego” trouble.) The “sham guaranty” defense is most effective where there is evidence that the lender was directly involved in creating the “sham” guarantor structure in an effort to avoid anti-deficiency protections.
Another defense for guarantors, which is usually available only against unsophisticated lenders, is the “secured guaranty” defense. In short, if a lender (whether by mistake or inattention) accepts a guaranty that is, itself, secured by real property, then the lender must comply with the one action rule and pursue the security first before going after the guarantor directly. This most often occurs where the deed of trust includes expansive language defining the “secured obligation” to include guaranties relating to the loan.
Whether you are a borrower, guarantor, or lender, take the time to understand your rights. When a loan goes into default, there are many traps for the unwary.
Next post in series (coming soon) … MISTAKE #6: Failing to Protect Trade Secrets
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