Presentation to Local Bankers on Issues in California Real Property Foreclosures Patrick Fields Of Counsel, Los Angeles Office Christopher J. Petersen Senior Associate, Los Angeles Office Squire Sanders (US) LLP June 6, 2012 37 Offices in 18 Countries
Introduction - The Very Basics There are two methods of what is usually known as real property foreclosure in California: foreclosure by trustee’s sale and judicial foreclosure. Trustee’s sale uses the power of sale provided in the real estate security instrument, whether it be a deed of trust or a mortgage, for a sale of the property by a private (non-governmental) trustee, with the proceeds applied to the secured obligations. Judicial foreclosures involve a lawsuit, with a government supervised sale of the property, followed usually by a hearing to establish the remaining debt of the borrower. The procedures for foreclosure (both kinds) are set forth in the California Civil Code – for the most part, the parties cannot depart from the legal steps set forth in the law. 2
Part One – Trustee’s Sales 3
Sequence of Events for a Trustee’s Sale Sequence of events for a trustee’s sale: (1) Default, (2) trustee records a notice of default, (3) after three months record a notice of sale, (4) after 31 days conduct the trustee’s sale (the law requires 20 days to elapse but federal tax liens recorded more than 30 days before a sale are not extinguished unless the IRS is given notice at least 25 days before the sale – the IRS still has a 120 day redemption right for any lien that would otherwise be extinguished). The purchaser at the trustee’s sale takes title in the condition as it was on the date the deed of trust was recorded, basically – therefore junior encumbrances on the property are wiped out and the purchaser takes the property free and clear of them and of the interest of the trustor. If the lender is the winning bidder at the trustee’s sale, and it usually is, it can then sell the property in the ordinary course and does not have to share the proceeds of that sale with the borrower/trustor. 4
Advantages of the Trustee’s Sale • Cost – minimal or no legal fees, trustee fees generally not large, often the largest cost is the trustee sale guarantee. • Speed – about four months, with the schedule usually under the lender’s control. • Net recovery from the property itself is usually maximized, due in large part to the absence of a right of redemption (discussed later). • Less likely that borrower will engage an attorney. • Easier to make sequential sales, if the debt is secured by multiple properties. 5
Disadvantages of a Trustee’s Sale • No deficiency against the trustor / borrower. • The trustee’s sale process itself does not protect against waste of the property or obtain the benefits of the rents of the property; to access these benefits/rights a suit is necessary. 6
Borrower’s Defensive Strategies Against Trustee’s Sale • File a bankruptcy petition, which stops the trustee’s sale process. • File a suit, seeking an injunction and possibly counterclaims for damages. • Suit after the trustee’s sale challenging the adequacy of the lender’s foreclosure process (one of the reasons for a trustee’s sale guarantee). • On the brighter side, use the three month period as an opportunity to exercise the right to reinstate the loan, notwithstanding an acceleration of the debt (unless the debt was entirely due in any event). The reinstatement period extends to five business days prior to sale; after that the borrower must repay the loan in full to stave off the sale. 7
Default Issues • Not all uncured breaches can be a strong basis for accelerating the debt and recording a notice of default. • Failure to provide financial statements, other non-material breaches while payments are being made and the collateral property is not impaired. Failure to reimburse for expenses? • Debt service coverage? Loan to value covenant? • Obviously, failure to make payments of principal and interest are adequate bases for default. • Also, failure to pay taxes, insurance are sufficient grounds for default and foreclosure. • Poorly documented workout transactions can give a borrower the expectation of a forbearance staving off a default. 8
Trustee’s Role • A valuable source of guidance and experience, but not a substitute for legal counsel. • Example, for certain owner-occupied residential property, additional procedures are necessary, as a pre-condition to the recordation of a notice of default. The foreclosure trustee will not guide the lender through those procedures. • Trustee relies on the lender’s assurances regarding the existence of a default. 9
Credit Bidding • Lender may “credit bid” rather than posting a cash bid like other bidders. • Lender is not required to bid the full amount of the debt or the fair market value of the property (some states, Arizona, require otherwise). • Lender may not negotiate with a third party to coordinate bidding; if so, the trustor may have a claim for damages. • A full credit bid could limit the lender’s remedies against guarantors and against the trustor for “bad faith waste” of the property (an exception from the antideficiency rule). • A full credit bid including accrued but unpaid interest would result in taxable income for the lender, because the lender is deemed to have received the amount it bid. 10
Deed In Lieu of Foreclosure • Lender or an affiliate receives title to the property from the debtor, prior to any foreclosure. • Lender or its affiliate takes the property subject to junior liens; sometimes the deed of trust is not reconveyed, but in such a case the consideration for the transfer could especially be challenged. • Advantages include faster resolution of the debtor’s rights and faster access to the property for the lender, but can be risky for the lender. Trustor may not have any continuing connection with the property, or else the deed in lieu could be viewed as a disguised mortgage. 11
Part Two – Judicial Foreclosures 12
Nature of Judicial Foreclosure • Lawsuit brought by a secured creditor to have a court do the following: Determine that the loan is in default; Order that the security be sold to satisfy the loan balance; Declare that the debtor is liable for any deficiency arising from an insufficient sale price at foreclosure; and Enter a deficiency judgment 13
Advantages of Judicial Foreclosure • Deficiency Judgment A judgment against the trustor for the difference between the unpaid balance of the secured debt (plus expenses) and the amount realized at the sale of the property or the fair value of the security, whichever is greater. • Prejudgment Remedies Appointment of a Receiver to collect rents and manage property • Orderly Resolution of Disputes Dispute between creditor and the trustor about the existence or nature of default; or Dispute between creditors over lien priority. • Additional Pressure on Debtor 14
Judicial Foreclosure and Deficiency Judgments • Two-Separate Phases of Same Lawsuit Phase I: Court adjudicates the debt, the default and the defenses of the debtor. If the creditor prevails, the Court orders the property sold and declares the debtor liable for any deficiency. Phase II: Court hearing regarding the fair value of the property to establish the amount of the deficiency. 15
Disadvantages of Judicial Foreclosure • Debtor’s Right to Redemption and Possession Purchaser does not acquire absolute nonredeemable title at the foreclosure sale Debtor or successor in interest has the right to redeem title to the property for 12 months – Debtor must pay the foreclosing creditor the purchase price paid at the foreclosure sale (not the total amount of the foreclosed obligation) Debtor has the right to possession of the property until the 12 month redemption period expires – Creditor is entitled to receive the rents, profits and the reasonable value for the use of the property during the redemption period • Time and Cost Subject to delays and costs associated with civil litigation • One Action Rule Security First: Secured creditor must proceed against its security before attempting to recover the underlying debt – Secured creditor cannot proceed against an unpledged asset of the debtor before first exhausting the pledged security 16
Judicial Foreclosure: Procedure • Obtain a Litigation Guarantee issued by a title insurance company to insure that the proper notices are given • File lawsuit for judicial foreclosure Creditor must name the following parties as defendants: – Current owner (even if the obligation was incurred by the former owner) – All former owners potentially liable for the obligation – All junior lienholders – Trustee (as a nominal defendant) Record a Lis Pendens – “Action Pending” clouds title Adjudication of Claims and Defenses – Parties proceed with civil litigation (discovery, motion practice, etc.) Entry of Foreclosure Judgment 17
Recommended Actions • Dual Actions Record Notice of Default and Initiate Non-Judicial Foreclosure File Judicial Foreclosure Lawsuit One issue with “dual tracking” is whether the costs of the alternative that is eventually not used may be properly recovered or claimed by the lender. 18
Questions / Discussion 19
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