At a nonjudicial foreclosure sale (also known as a trustee’s sale) a lender is entitled to make a “credit bid” — i.e., bidding all or portions of the amount owed on the debt — instead of a cash bid.
Lenders often times make a “full credit bid” (bidding the entire amount owed on the debt, including principal, interest, fees, and costs), because the lender may feel that the amount of the credit bid is immaterial since a deficiency judgment is barred anyway by Code of Civil Procedure section 580d. And, as a practical matter, it is easier to instruct the auctioneer to enter a one-time full credit bid than to make an opening underbid followed by incremental bid raises if necessary.
But making a full credit bid carries significant, often overlooked, risks.
Beware the full credit bid
A full credit bid may prevent the lender from pursuing post-sale remedies against the borrower or third parties.
One recent appellate decision from the later part of 2014 illustrates the point — Najah v. Scottsdale Insurance Co. (2014) 230 Cal.App.4th 125, published September 30, 2014, review denied by California Supreme Court on December 17, 2014.
In Najah, the court of appeal held that a lender’s full credit bid at a foreclosure sale precluded the lender from making an insurance claim against the borrowers’ insurer under a mortgagee coverage provision for known pre-foreclosure damage deliberately caused by the borrowers to the building on the property.
Before the foreclosure sale, the lender’s inspections of the property revealed “severe damage to the building and debris everywhere[;] … electrical wires hanging from the ceiling; broken mirrors, furniture and bathroom fixtures; damaged walls, ceilings and carpets; and interior doors removed and left lying on the floor” as well as missing items, including air conditioning and heating units, kitchen appliances, and commercial laundry equipment.
Six months after acquiring the property at the foreclosure sale the lender sued the insurer, seeking recovery for the damage to the property as outlined above.
The full credit bid rule
The court of appeal explained that under the “full credit bid rule,” a full credit bid at a foreclosure sale establishes the value of the property as being equal to the outstanding indebtedness, and after a lender obtains property through a full credit bid, it is precluded “from later claiming that the property was actually worth less than the bid.”
The court went on to describe the dual purposes of the full credit bid rule:
- First, the rule prevents double recovery by the lender. “[T]he lender’s only interest in the property is the repayment of the debt. The lender’s interest having been satisfied, any other payment would result in a double recovery.”
- Second, the rule “serves to protect the integrity of the foreclosure auction.” The purpose of the trustee’s sale is to resolve the question of value through competitive bidding, and a “lender who intends to later claim that the value of the property was impaired due to waste, fraud or insured damage, but nonetheless makes a full credit bid, interferes with that process by impeding bids from third parties willing to pay some amount between the value the lender places on the property and the amount of its full credit bid.”
The fraud exception
The court acknowledged an exception to the full credit bid rule for fraud claims against nonborrowers who fraudulently induced a lender to make a loan, where the lender demonstrates that its full credit bid was a proximate result of the defendant’s fraud.
But the court held that this exception did not apply under the facts present, since the lender was “fully aware of the state of the property” before the foreclosure sale.
Satisfaction of the debt eliminates mortgage insurance recovery
The court observed that under the “standard mortgage clause” at issue, the insurer agreed to pay for damage to buildings on the property regardless of whether the damage was caused by the borrower’s misconduct.
But, the court noted, the trade off for such broad coverage is that the amount payable under the policy “is limited to the amount necessary to satisfy the debt, even if it is less than would be required to repair the physical damage to the property[.]”
Because the debt was extinguished by the lender’s full credit bid at the foreclosure sale, the lender was barred from seeking insurance proceeds for pre-foreclosure damage to the property.
The Najah decision is just the most recent example of a recurring lesson for lenders: generally, the best approach for a lender is to acquire property at a foreclosure sale through a partial, not full, credit bid. If a portion of the debt remains intact, the lender preserves rights to obtain the benefits of a mortgage insurance policy and to pursue other claims relating to the property.