Tuesday, November 25, 2014

FYI: Cal App Holds Creditor Waived Right to Deficiency by Violating "Security First" Rule

The California Court of Appeal, Fifth District, recently held that a creditor waived its right to a deficiency judgment, because it violated the security first principle in Cal. Code Civ. P. § 726(a) by releasing its interest in a part of its collateral without the consent of all debtors and before foreclosing on the remaining parcel.


A copy of the opinion is available at:  http://www.courts.ca.gov/opinions/documents/F067812.PDF


A bank (“Bank”) filed a judicial foreclosure action to collect a loan secured by two parcels of real estate.  The loan was made to a husband and wife and, after the husband died, the loan went into default.  Bank and wife agreed to a short sale of one of the parcels that was her separate property.  Afterward, Bank foreclosed on the remaining parcel and obtained a deficiency judgment against the representatives of the husband’s estate (“Appellants”) only, as a deficiency judgment was not allowed against the wife because of her bankruptcy.


As you may recall, California generally does not allow deficiency judgments after most residential foreclosures.  See Cal. Code Civ. P. § 580b.  Creditors seeking deficiency judgments must first exhaust all real property security to qualify for a deficiency judgment, and such exhaustion of the real property collateral must be through a single judicial foreclosure lawsuit.  See Cal. Code Civ. P. § 726.  These requirements in section 726 are referred to as the “one form of action” rule.


The consequence of not following the “one form of action” rule is a waiver of the creditor’s rights to a deficiency judgment.  Additionally, if any of the real property collateral is exhausted through any other means, such as a private sale without the consent of the debtors, a deficiency judgment is barred.  See, e.g., Pacific Valley Bank v. Schwenke (1987) 189 Cal.App.3d 134, 145.


Additionally, California protects debtors liable for deficiency judgments from low bids at the judicial foreclosure auction, by limiting the amount of the deficiency judgment to the difference between the fair value of the property and the amount of the indebtedness.  See Cal. Code Civ. P. § 726(b).  A second protection is the right to redeem the property based on the foreclosure sale price, not the amount of the secured debt.  See Cal Code Civ. P. § 726(e). 


On appeal, Appellants argued that the trial court erred by holding them liable for a deficiency judgment because Bank waived its right to a deficiency when it violated the “security first” rule.  By agreeing to a short sale of the second parcel without their consent, the Appellants argued that Bank deprived them of the protections they would have had if the second parcel had been included in the judicial foreclosure action.  The Appellate Court agreed.


Relying on Schwenke, the Appellate Court held that the security first principle in section 726(a) barred any liability for deficiency because Bank, without consent of the Appellants, released part of the security for the note when it allowed the wife to sell the second parcel in a private sale. 


In so ruling, the Appellate Court rejected Bank’s argument that Schwenke was bad law or that the Court should recognize an exception to the consent requirement.  Relying on numerous Court of Appeal decisions that cited Schwenke and referred to its consent requirement, the Appellate Court concluded that Schwenke “is consistent with the statutory language and the concepts underlying the security first principle.”


The Appellate Court also rejected Bank’s attempt to distinguish Schwenke, by arguing that Schwenke is unreliable in the absence of cases involving loans with multiple debtors secured by more than one parcel of real property.  The lack of further appellate decisions since Schwenke, according to the Appellate Court, showed that “bankers and their lawyers have had little trouble applying the rule of law that consent of all debtors must be obtained by the creditor before releasing any parcels securing the loan.”


In short, the Appellate Court concluded that a creditor and one of the debtors should not be able to modify the contractual obligations of the co-debtors without the co-debtor’s consent to that modification. 


Bank presented an alternate argument that did not involve the co-debtor’s consent, contending that “security” for purposes of the “security first” principle is determined at the time of the filing of the action, not when the loan was executed.  Bank supported its argument by citing Bank of America v. Graves (1996) 51 Cal.App.4th 607, which held that where the value of the security has been lost through no fault of the creditor, the creditor may bring a personal action on the debt on the theory that if the security become valueless at the time the action is commenced, the debt is no longer secured. 


The argument was rejected by the Appellate Court for two reasons.  First, the security for the loan, which included two parcels, had not been lost or became valueless at the time Bank commenced its foreclosure.  A judicial foreclosure action on the remaining parcel rather than a personal action on the debt was appropriate.  Second, the parcel sold in the short sale was not exhausted or lost through no fault of Bank.  Instead, Bank released its deed of trust pursuant to its agreement with the wife, without the consent of the Appellants.  For these reasons, the Appellate Court held that the principles in Grave regarding valueless or lost security did not apply.


Accordingly, the Appellate Court reversed the trial court’s order granting the motion for summary adjudication and the related decree for judicial foreclosure and writ of sale, and remanded the matter to the superior court with instructions to enter an order denying the motion for summary adjudication.





Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
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Email: RWutscher@mwbllp.com


Admitted to practice law in Illinois



              McGinnis Wutscher Beiramee LLP





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