Deficiency Judgments in California

The good news for California borrowers is all purchase-money loans on a one- to four-unit residential dwelling are exempt from deficiency judgments.

Hard-money loans in California -- loans taken out after the home was purchased through a refinance or second mortgage -- can be subject to a deficiency judgment under the following conditions:

• The lender forecloses under judicial proceedings (California Code Civil. Proc. - 726).
• Most lenders foreclose through a trustee's sale; however, which does not give the lender the right to pursue a deficiency judgment, with one exception (see second hard-money second mortgages below).
• A three-month time limit applies to actions for deficiency judgments under a judicial foreclosure.
• If the second mortgage is hard money and the lender has lost security for that loan through a foreclosure or short sale -- making the security for the promissory note worth nothing -- the beneficiary of that second mortgage can pursue a deficiency judgment (Roseleaf Corp. v. Chierighino, 59 Cal. 2d 35 (1963).

Private Sale or Judicial Proceeding? The foreclosure process can take place in one of two ways. Either the lender will invoke its powers of a private trustee's sale, which are given under the deed of trust, or it will bring a lawsuit for a judicial foreclosure, pleading that it has a deed of trust against the property, that you have defaulted on the loan secured by the deed of trust, and that the Court should therefore order the deed of trust foreclosed and decree that the property be sold to pay off the entire loan debt.

In either event, the lender will send you and all other lienholders written notices of your default on the loan and its intention to conduct a foreclosure unless you cure your arrears and pay all late fees. If the lender fails to do so in the manner prescribed by the foreclosure statutes, it will not be entitled to a foreclosure at all.

A private sale is far faster than a judicial foreclosure: It will happen approximately four to seven months after the lender first gives notice of the default (depending on the loan in question and the diligence of the foreclosure trustee). In contrast, a judicial foreclosure takes as long as any other lawsuit on the regular civil calendar - that is, approximately one year or longer -- and a civil litigation entails attorney's fees, procedural complications, and the risk of cross-claims from a desperate or aggrieved borrower who suddenly has every incentive to assert them. A private sale is therefore much better for the lender because it is typically quicker and less expensive to conduct, unless the property lacks sufficient value to pay off the borrower's entire debt. In this one instance, the judicial foreclosure is better because it allows the lender to obtain a personal judgment against the borrower for the outstanding amount owed on the loan after the foreclosure sale. This outstanding amount is called the deficiency, and the judgment against the borrower is called a deficiency judgment. However, a lender cannot obtain a deficiency judgment if the underlying debt arises from "purchase-money loan," which is either a "seller carry-back loan" (see above) or a third-party purchase-money loan for a owner-occupied residential property that has no more than four units (see above).

The matter can be summarized as follows. A lender cannot get a deficiency judgment if it forecloses by private sale, nor can it do so if the underlying loan was a purchase-money loan. Therefore, a lender will choose to sell the property at a private sale if (1) the sales proceeds will pay the entire loan or (2) the loan was a purchase-money loan.

It is often the case that the lender will forgo a judicial foreclosure and use a private sale even if (1) the sale will likely or certainly fail to yield funds sufficient to pay the full debt; and (2) the lender is entitled to a deficiency judgment for the remainder against the borrower. Often the lender will simply prefer the convenience and expediency of a private sale, but this will depend in part on whether it would be profitable for it to pursue the borrower for the likely deficiency, and this depends on the likely amount of the deficiency and the borrower's ability to pay it.

There is an additional advantage to conducting a foreclosure by private sale. The purchaser of property at a private sale will become its owner, save where the defaulted borrower is able to attack the sale on grounds of procedural irregularity or gross lack of fair consideration for the sale. (Moreover, a foreclosing lender cannot claim more from the sales proceeds than what it is strictly entitled to take under the foreclosure statutes. ) Generally speaking, the purchaser of a property at a private sale take the property and owns it free and clear of any lien subordinate to the deed of trust under which the foreclosure has been conducted.

In contrast, the purchaser of a property at a judicial foreclosure might be required to sell back the property to the defaulting borrower under the redemption statutes, which entitle the defaulting borrower to redeem his property by paying the foreclosure purchase price to the purchaser at foreclosure (along with redemption fees and related surcharges). For this reason, a property in judicial foreclosure is typically sold at a special discount, which compensates the purchaser for the risk of being forced to sell the property at a specified price to the defaulting borrower under the redemption statutes.

There are thus "pros" and "cons" to each kind of sale. The private sale is far quicker, and gives certain title to the new purchaser, therefore allowing the sales price to be higher, but the lender cannot recover the deficiency for any outstanding balance.

The judicial sale entitles the lender to a deficiency judgment, unless the loan was a purchase-money transaction. At the same time, it entitles the defaulting borrower to redeem his property if he can pay the necessary charges and cure his arrears.

Lastly, a judicial foreclosure is the proper approach when there are several encumbrancers, and dispute has arisen between them as to the priority of their rival liens. In a judicial foreclosure, the court will rule on the order of priority of the competing liens, thereby resolving the dispute.

Our Example Revisited. To return to our lovely example, in which you find yourself driving north to forget your wife's abandonment and the simultaneous loss of your job under humiliating circumstances, we can now easily apply the above rules. Wells Fargo, having made a purchase-money loan to you, has no interest in convening a judicial foreclosure: It cannot recover any deficiency because the loan was a purchase-money transaction (you used the loan to buy the home). Moreover, the value of your home is so high that Wells Fargo will have its entire loan paid off from the sales proceeds. Moreover, there is no controversy between competing lenders, and therefore no need for any sort of judicial determination of priorities. Wells Fargo will therefore foreclose upon your home by use of a private sale, which will take place 120 days after you first receive a formal notice of your default from Wells Fargo, unless you cure your default in the meantime, or, failing this, convince Wells Fargo to accept your title deed in lieu of foreclosure.

But suppose you encumbered the property not only with the Wells Fargo loan, but also with a second loan from Second Place Loans, Inc., which made a loan to you of $100,000 and secured it by a deed of trust, which was second in priority, after Wells Fargo's deed of trust. In this case, Wells Fargo is said to hold the first deed of trust, and Second Place Loans, Inc. is said to hold the second deed of trust.

If you default on the Wells Fargo debt, and Wells Fargo forecloses, the foreclosure will have the effect of extinguishing Second Place's deed of trust: The foreclosure of a senior lien always has the effect of extinguishing all junior liens. In this event, Second Place will no longer be your secured creditor, but will find that it is merely an unsecured creditor for its entire loan in the exact same manner as, say, Visa is your unsecured creditor for credit-card charges that you have made but not yet paid. Second Place will therefore not allow Wells Fargo to foreclose; it will "cure" your arrears to Wells Fargo rather than suffer the loss of its security, and will make these payments part of your obligation to Second Place; if you fail to meet this obligation, Second Place will foreclose its second deed of trust, and most likely it will use a private sale to conduct its foreclosure, since this is the quickest way to have the property sold and your debt paid.

But suppose the value of the property falls significantly after you take the loan from Second Place. In this instance, Second Place might decide that it is better to conduct a judicial foreclosure, so that after the property is sold it can obtain a judgment against you for the outstanding amount still owed after the sale. Unlike Wells Fargo, Second Place did not make a purchase-money loan to you, and therefore it is entitled to a deficiency judgment if there is a shortfall after the foreclosure sale.

Remember, if the lender uses a private sale, it can only recover the proceeds from the sale of the property, but cannot otherwise recover a penny more of the debt that the borrower might still owe even after the foreclosure sale. But in a judicial foreclosure, the lender is entitled to a deficiency judgment against the borrower for any outstanding amount still owed after the sale of the property. Therefore, a lender might wish to use a judicial foreclosure, despite the long delay that it entails, if there will likely be a significant debt owed on the loan even after the foreclosure, since at a private sale the lender waives this outstanding amount (or "deficiency"), but at a judicial foreclosure the lender gets the foreclosure proceeds, plus a personal judgment against the borrower for any deficiency, so long as the loan was not a purchase-money loan.

Let us again consider that accursed home that you unwisely purchased in the Silicon Valley when you still loved your ex-wife and loyally reported to your ex-boss every day. You will recall that you paid $680,000 for it by making a down-payment of $136,000 and using a Wells Fargo loan of $544,000. Suppose that the foreclosure happens five years later - after you have paid down the loan to, say, $525,000 (typically, you pay mostly interest during the early years of loan repayment, then begin to retire principal more and more quickly as your repayment continues). Suppose that the fair-market value of the home has since risen to, say, $800,000.

You have also taken the second loan for $100,000 from Second Place. You therefore hold $175,000 of equity in the Property - that is, the $800,000 value of the property, less the Wells Fargo encumbrance of $525,000, less the Second Place encumbrance of $100,000.

If you default on the Wells Fargo note but not on the Second Place note, Second Place will cure the Wells Fargo arrears and charge you for it (otherwise, Wells Fargo will foreclose, thereby extinguishing Second Place's second deed of trust). If you fail to pay Second Place for its "service" of curing the Wells Fargo arrears, it will foreclose on the second deed. It will do so by private sale, since the property has enough value to support its lien: A purchaser will pay at least $100,000 to buy the property with the Wells Fargo encumbrance of $525,000. Indeed, a sensible purchaser will be willing to pay up to $200,000 - $250,000 to buy the $800,000 property with the $525,000 encumbrance. In this instance, $100,000 and fees price goes to Second Place, and the remainder, which is called the surplus, is disbursed to junior lienholders in order of priority, with the remainder to you (in our example, there are no such junior lienholders, and therefore the entire surplus would be remitted to you).

But if real estate prices have tumbled since Second Place made its loan, it might elect to conduct a judicial foreclosure, even though it will take a long time to be done, and even though the sales price will be a little lower to account for the defaulting borrower's right of statutory redemption: After the judicial foreclosure, Second Place will receive a judgment against you personally for the outstanding balance.

Say that real estate prices have fallen dramatically: The country has been dragged into a catastrophic depression, and your home is no longer worth $800,000, but rather is worth only $200,000. In this instance, Second Place will conduct the judicial foreclosure, since no one will pay $100,000 (plus the surcharge for curing the Wells Fargo debt) to acquire a $200,000 property that is encumbered by a $525,000 purchase-money loan. After the judicial foreclosure, Second Place will have a deficiency judgment against you for the outstanding amount owed on your obligation.

If you never took a second loan, but merely owe $525,000 to Wells Fargo at the time of foreclosure, Wells Fargo will perform the foreclosure by a private sale, even if the value of the property has fallen far below the amount of the debt, since there can be no deficiency judgment on a purchase-money loan. The rationale for this should by now be clear: If there is a general collapse of the economy, a simple homeowner who borrowed only to purchase his home should not be forever undone by a deficiency judgment for the balance of his loan; his loss should be limited only to the loss of his home, unless he has taken additional loans against it after acquiring title.

Foreclosures: California's One Action Rule
With interest rates on adjustable mortgages on the way up, the pundits suggest we are headed for another round of foreclosure activity the likes of which we have not seen since the S&L crisis in the 1980s. That makes now a good time to review the laws relating to foreclosure and deficiency judgments-and recent changes that have occurred in that area.
The Legislature enacted the One Form of Action rule-often simply called the One Action Rule-to eliminate multiple actions when a creditor elects to sue after a debtor's real property has gone into default. It specifically provides: "There can be but one form of action for the recovery of any debt, or the enforcement of any right secured by mortgage upon real property." (Cal. Code of Civ. Proc. - 726(a).)
In jurisdictions without such a rule, property owners can be forced to simultaneously defend against both a personal action on the debt and a foreclosure action on the security, making it difficult, if not impossible, for the debtor to avoid a deficiency judgment. Not only is this unfair to property owners who reasonably relied on the value of the security for protection from personal liability, but it further strains limited judicial resources.
California's deficiency-judgment statutes were intended to work in tandem with the One Action Rule to avoid such problems. Because the One Action Rule has the effect of inducing most creditors to foreclose on their security interests before seeking a personal judgment, these statutes protect debtors from a deficiency judgment if the property subject to foreclosure is a dwelling intended to be occupied by four or fewer families-one of which includes the purchaser-and if the loan secured by the deed of trust or mortgage was used to pay all or part of the purchase price of the property being foreclosed. (Cal. Code of Civ. Proc. Code - 580b.)
The purposes behind the One Action Rule and the deficiency-judgment statutes are to prevent multiple actions, compel exhaustion of all security before a deficiency judgment is entered, and ensure that debtors are credited with the fair market value of the secured property before they are subjected to personal liability. (See In re: Prestige Ltd. Partnership-Concord v. East Bay Car Wash Partners, 234 F.3d 1108, 1115 (9th Cir. 2000).)

Deficiency-Judgment Protection
In the years leading up to the S&L crisis, many lenders had substantially relaxed their appraisal standards. Profits were high and the focus was on making loans, not on ensuring that the underlying security was adequate. When properties began to go into default at unprecedented rates, it became obvious that thousands of appraisals were inflated, and countless borrowers were unnecessarily exposed to debt far in excess of the value of their secured real property. In short order, this vicious cycle flooded the pool of Real Estate Owned (REO) properties in lender inventories and ultimately brought down a major industry.
A primary purpose of the antideficiency statutes is to place the risk of such overvaluation and inadequate security on the lenders who stand to profit directly from the loans they make. Taken together, sections 726, 580a, 580b, and 580d of the California Code of Civil Procedure constitute a comprehensive statutory scheme that specifically protects defaulting borrowers from being taken advantage of by overly aggressive lenders who may care more about making loans than protecting borrowers. (See Clayton Dev. Co. v. Falvey, 206 Cal. App. 3d 438, 445 (1988).)
Under this scheme, if the proceeds from the sale of the real property are insufficient to cover the debt, the lender's right to a deficiency judgment may be limited or barred under one or more of these statutes. (See Prestige, 234 F.3d at 1115.) Thus, the One Action Rule works in concert with California's deficiency-judgment statutes to give a borrower leverage against a creditor who wants the freedom to choose between either enforcing a security interest via a foreclosure proceeding, or circumventing the antideficiency statutes and suing on the underlying note-whichever better suits its needs. (See Clayton Dev. Co., 206 Cal. App. 3d at 445.)

Exceptions to the Rules
The antideficiency provisions, which primarily aim to protect against overvaluation by lenders, apply automatically only to standard purchase-money transactions. (See Roseleaf Corp. v. Chierighino, 59 Cal. 2d 35, 41 (1963) and Sprangler v. Memel, 7 Cal. 3d 603, 610, and 612 (1972).) Thus, for example, section 580b does not apply when the purchaser intends to proceed with a different use of the property, such as commercial development, because the purchaser controls the success of the venture and should bear the risk of failure.
Section 580b also does not apply when the borrower has refinanced the real property, often to take out additional equity or obtain financing at better terms. (See Union Bank v. Wendland, 54 Cal. App. 3d 393, 400 (1976).) Conversely, when the borrower has never refinanced and the real property is still encumbered by the original purchase-money trust deed, the borrower retains the protection of the antideficiency-judgment statutes. (See Foothill Village Homeowners Ass'n v. Bishop, 68 Cal. App. 4th 1364, 1367 n.1 (1999).)

The Dual Role
For a borrower in default, the One Action Rule offers two important benefits. It may be used upfront as an affirmative defense, or it may be invoked later as a sanction.
If the borrower successfully asserts the One Action Rule as an affirmative defense, the lender will be forced to foreclose its security interest before pursuing a money judgment against the debtor for any deficiency-if that is even possible given the protections available to the borrower under the antideficiency statutes. (See Security Pacific Nat'l Bank v. Wozab, 51 Cal. 3d 991, 997 (1990).)
A borrower who wishes to rely on the antideficiency-judgment statutes to avoid personal liability must raise the One Action Rule as an affirmative defense in the answer or, at the latest, by the start of trial-that is, when the lender would still have a chance to comply with the rule-or he or she is "simply too late." (See Scalese v. Wong, 84 Cal. App. 4th 863, 868 (2000) and Spector v. National Pictures Corp., 201 Cal. App. 2d 217, 225-26 (1962).)
However, a borrower who fails to assert the One Action Rule as an affirmative defense may still invoke it as a sanction against the lender, because by not foreclosing on its security interest in the action brought to enforce the debt, the lender has made an election of remedies and waived any right to subsequently foreclose on the security or sell the security under a power of sale. (See Security Pacific Nat'l Bank v. Wozab, 51 Cal. 3d 991 at 997 (1990) and Prestige Ltd. Partnership-Concord v. East Bay Car Wash Partners, 234 F.3d 1108 at 1114 (2000).)
Beginning in 1990, the law changed in two important ways. First, the California Supreme Court held that a creditor cannot be subject to the double sanction of losing both the security interest and the underlying debt. Second, a court of appeal held that a creditor could not enforce an agreement with the debtor to waive application of the One Action Rule as a sanction. These decisions have significant ramifications for borrowers and lenders alike.

No Double Sanctions
The landmark case of Security Pacific Nat'l Bank v. Wozab places limits on using the One Action Rule as a sanction. In Wozab the California Supreme Court held that it would be inequitable to subject a lender to the double sanction of losing both the security and the underlying debt. Indeed, the court held that allowing the Wozabs to evade their debt almost in its entirety would be both a gross injustice to the bank and a corresponding windfall to the Wozabs, allowing them the benefit of their bargain without incurring the burden. (51 Cal. 3d at 1005-06.)
Later decisions by the Ninth Circuit Court of Appeals continue to apply the precedent set in Wozab.
In DiSalvo v. DiSalvo, the Bankruptcy Appellate Panel of the Ninth Circuit reversed, in part, a decision that double-sanctioned a creditor's efforts to collect first on the debt, in violation of section 726, by extinguishing both the security interest in the real property and, indeed, the $100,000 debt itself. (221 B.R. 769, 775 (9th Cir. 1998), overruled in part as to other issues by In re DiSalvo v. DiSalvo, 219 F.3d 1035 (9th Cir. 2000).) Although, as the bankruptcy court observed, the creditor's actions in attempting to collect the $100,000 debt netted only $83, the creditor controlled the security-first aspect of the One Action Rule and could have invoked it at any time to bar the collection efforts.
Because a bankruptcy court can provide sufficient protection for a debtor whose business is threatened by the actions of a creditor without requiring that the creditor forfeit both the security and the debt, the appellate court held that the bankruptcy court's sanction of extinguishing the debt was an abuse of discretion "so severe as to be punitive and would result in a windfall to debtor." (219 F.3d at 1037.)
In Prestige Ltd. Partnership-Concord v. East Bay Car Wash Partners, decided later the same year, the Ninth Circuit was asked to address the issue again in a case in which the debtor sought to bar a creditor's unsecured claim against his bankruptcy estate. (234 F.3d at 1111 (2000).)
Prestige, the debtor, purchased a car wash business from East Bay, the creditor, giving East Bay a promissory note secured by a deed of trust that included the personal guarantee of one of Prestige's partners, Jerry Brassfield. After Prestige defaulted on the note, East Bay filed an action on the guaranty rather than foreclosing on its security interest in the car wash. Although Brassfield asserted the One Action Rule as an affirmative defense, East Bay obtained a writ of attachment against $75,000 in Brassfield's personal bank accounts.
Shortly thereafter, Prestige filed a petition for bankruptcy. The bankruptcy court held that Brassfield was a primary obligor on the note, " 'such that the purported guaranty added no additional liability,' and that East Bay had taken its action under - 726(a), resulting in waiver of its security interest in the real property." (234 F.3d at 1112.) As a result, the superior court dissolved the writs, and East Bay released its attachment.
Unable to collect against the guaranty and having lost its security interest in the car wash, East Bay filed proof of its now unsecured claim in the bankruptcy action. The bankruptcy court decided in the creditor's favor, holding that East Bay "lost its security only, not its debt, and was not subject to the provisions of - 580b." The Ninth Circuit affirmed, citing Wozab and DiSalvo. In reaching its decision, the appellate court noted that Prestige had taken advantage of its right to invoke the sanction aspect of section 726 in the bankruptcy court, resulting in East Bay's loss of its security interest.
Moreover, just as in Wozab-where the court observed that the debtors had accepted the bank's reconveyance of the deed and thus acquiesced in, indeed demanded, the bank's decision not to foreclose-Prestige was the one who sought to have East Bay's security interest waived. Thus, under the holdings of both Wozab and DiSalvo, it would be inequitable to impose a double sanction that would deny East Bay both its security interest in the car wash and the underlying debt. (234 F.3d at 1115.)
The law is clear: Violating the One Action Rule extinguishes the creditor's security interest, but not the debtor's underlying obligations. Thus, after Wozab and its progeny, debtors who are protected by the deficiency-judgment statutes should take care not to waive the One Action Rule lest they lose its protection, yet remain liable "in total" for their debts.

No Waiver of Sanction
In O'Neil v. General Security Corp., the court held that a borrower's agreement with his lender to waive application of the One Action Rule as a sanction and allow the lender, who had already brought a personal action against the borrower, to proceed with a foreclosure action against the secured property is not enforceable. (4 Cal. App. 4th 587, 598 (1992).)
First, the court held that the sanction aspect of the One Action Rule operates for the benefit of both the primary borrower and third parties claiming an interest in the property, whether as successors-in-interest or as third-party lienholders. As such, the court concluded that the security and priority rights in the secured property held by a third party have independent status, are entitled to independent protections, and cannot be defeated by unilateral waivers by the borrower in favor of the lender. Indeed, the court questioned whether such a waiver agreement would even be enforceable against the borrower who made it.
Second, the court held that all of the lender's remedies, including foreclosure of the security, merge into and are extinguished by the judgment, limiting the lender's subsequent remedies to those remedies available to it as a judgment creditor.
Third, the court held that if a borrower's waiver agreement were enforceable, many of the policies and protections of the statutory scheme would be undermined.
Although the O'Neil decision might trap an unwary lender who pursues a personal judgment first in reliance on the borrower's agreement to waive the sanction aspect of the One Action Rule, this is not its greatest danger. A bigger problem could arise if a lender secures a single promissory note with deeds of trust on properties located in multiple jurisdictions, one of which is California. If the note goes into default, the lender might want to commence foreclosure actions against its security interests in all jurisdictions simultaneously. However, under California's One Action Rule, filing a foreclosure action in another jurisdiction before foreclosing the lender's security in this state could result in the lender losing its security interest in the California property.
In addition, under the holding in O'Neil, an agreement with the borrower to waive the sanction aspect of the One Action Rule following a default would be of no help. Thus, before proceeding with such an arrangement, a prudent lender should carefully consider its exit strategy in the event that the loan goes into default.