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Emerging Issues in Private and Judicial Foreclosures/Actions on Guarenties and Workouts
By Edythe L. Bronston

Judicial foreclosure is an alternative enforcement remedy available to the beneficiary of a deed of trust or mortgage in enforcing its lien against real property.  It is a legal action brought for the purpose of obtaining a judgment directing sale of the property and application of the proceeds of that sale to the amount due plus the cost of the action and sale.  Unless otherwise forbidden, a deficiency recovery may be obtained against the borrower if the sale proceeds are insufficient to cover the indebtedness.  After entry of the judgment, and upon application by the judgment creditor, a writ of sale is issued by the clerk of the court.  The property is then sold by a levying officer or an appointed receiver, subject to the judgment debtor's right of redemption. The entire procedure, from filing of the action through sale of the property is conducted under court supervision.

1.       Advantages And Disadvantages Compared To Non-Judicial Foreclosure

Generally, a mortgagee elects to foreclose judicially, rather than by way of a non-judicial trustee's sale, in order to obtain a deficiency judgment.  A preliminary consideration is, therefore, the availability of assets of the borrower's and/or any guarantors.  The advantage of a deficiency judgment is balanced by the existence of post-sale redemption rights and the trustor's ability to retain possession of the property during the redemption period.  These factors generally cause bidding at such sales to be somewhat depressed.  In addition, deficiency judgments can probably be discharged in bankruptcy.

Where there are disagreements between the foreclosing creditor and the debtor or there are competing priorities between the foreclosing creditor and other creditors, those disputes are often better addressed through a judicial foreclosure proceeding, rather than a non-judicial sale which will not be determinative as to those issues.  (A beneficiary may now waive its right to a deficiency judgment, and avoid post-sale redemption, and thus obtain the benefits of a judicial resolution of its disagreements with the trustor without losing the benefit of a final sale.)

In order to foreclose nonjudicially, the security instrument must include a power of sale clause.  This is because of a power of sale creates an independent right to dispose of the security upon default given to the creditor by the trustor.  McDonald v. Smoke Creek Livestock Co., 209 Cal. 231 (1930).  Without such language the only foreclosure remedy available is by way of judicial foreclosure.  Courts interpret granting language liberally.  So long as the security agreement does not make a non-judicial sale under the power of sale a creditor's exclusive remedy, such a clause merely adds a cumulative remedy to the existing remedy of judicial foreclosure.  CCP §725a.  

2.       Availability Of Deficiency Judgment

Deficiency judgments are impermissible in the case of (a) purchase-money secured debts, where money is lent by the seller to the purchaser for purchase of the real property security; and (b) debts representing money lent by a third party for the purchase of real property security comprised of a dwelling of four or less units occupied entirely or in part by the purchaser. CCP §580b.

3.       Parallel Foreclosure Remedies

A plaintiff does not elect a remedy by filing a complaint for judicial foreclosure and, in fact, it is very common for lienholders to proceed both judicially and non-judicially, by concurrently filing an action for judicial foreclosure and recording a notice of default, and proceeding with both.  It is not until a trustee's sale is conducted or a judgment of foreclosure is obtained that an irrevocable election of remedy has been made.  Vlahovich v. Cruz, 213 Ca1.App.3d 317 (1989).  Entry of a default does not constitute an election of remedies so long as no final judgment is obtained.  In re Madigan, 122 B.R. 103 (9th Cir. 1991).  (Note, however, that Madigan is a Ninth Circuit Bankruptcy Appellate Panel decision, interpreting California law, and is therefore not precedential.)

4.       CCP §580b

Unlike the one-action rule and the fair value provisions of the Code of Civil Procedure, Section 580b has nothing to do with the process of foreclosure, but rather denies a deficiency judgment depending on the nature of the secured transaction when it has originally occurred; i.e., whether the loan was originally obtained to purchase the real property collateral. The character of the original obligation is retained during subsequent transactions.  Brown v. Jensen, 41 Cal.2d 193, 197 (1953).

CCP §580b covers only "standard" purchase-money transactions and certain variations which come within the policy of the statute.  Roseleaf Corp. v. Chierighino, 59 Cal.2d 35 (1963); Spangler v. Memel, 7 Cal.3d 603 (1972).  The section is applied automatically to prohibit a deficiency judgment against a purchaser (1) in a standard two-party transaction in which the vendor takes back a deed of trust from the buyer for all or part of the price; (2) where such a deed of trust is a second deed of trust, so long as the senior deed of trust secures a conventional first priority loan on the property; and (3) where a loan from a third party is given to enable the buyer to purchase a one- to four-unit dwelling which the buyer will personally occupy in whole or in part.  Prunty v. Bank of America, 37 C.A.3d 430 (1974).  The language of section 580b has been liberally construed to extend anti-deficiency protection beyond the standard transaction where the circumstances of the case indicate the policies of the statute will be served.  Spangler v. Memel, supra, at 610.  Courts have interpreted the “vendor” requirement broadly if to do so will further the purposes of Section 580b.  The critical factors in determining vendor status are the degree of the lienholders’ participation in the sale and whether the financing provided by the lienholders was necessary to the consummation of the sale.  Costanzo v. Ganguly, 12 Cal.App. 4th, 1085, 1090 - 1091 (1993).

When a purchase money obligation is assigned, the assignee is also subject to the limita­tions of Section 580b.  Clayton Development Co. v. Falvey, 206 C.A.3d 438, 444 (1988).

The California Supreme Court has asserted two purposes for this section:  (a) to prevent overvaluation of the land by placing the risk of inadequate security on the purchase money mortgagee; and (b) to stabilize property values.  In transactions which differ from the standard, California courts analyze whether the purposes of the statute will be met by granting a deficiency judgment.

5.       Application Of CCP §580b

The courts have found it difficult to apply these policies to specific standards.  In Brown v. Jensen, the California Supreme Court stated that Section 580b was intended to ensure that a beneficiary can look only to its security for recovery of a purchase money debt, since the seller taking back a deed of trust is aware of the value of that security and therefore assumes the risk of its subsequent inadequacy.  The Roseleaf court, however, rejected this position, declaring instead that by placing the risk of inadequate security on the seller:

"A vendor is thus discouraged from overvaluing the security.  Precarious land promotion schemes are discouraged, for the security value of the land gives purchasers a clue as to its true market value and that if inadequacy of the security results, not from overvaluing, but from a decline in property values during a general or local depression, Section 580b prevents the aggravation of the downturn that would result if defaulting purchasers were burdened with large personal liability.  Section 580b thus serves as a stabilizing  factor in land sales."

In fact, the opposite result is often produced, in that a buyer will likely offer more, not less, for real property if that purchaser knows it carries immunity from personal liability after any default.

The stabilization aspect of Section 580b is intended to apply where, through no fault of the parties, the market has declined with the result that the value of the security is no longer adequate to cover the debt.  As addressed by the Roseleaf court, the policy is aimed at slowing down an overall economic depression, as a trustor who loses the property is more likely to default on other obligations if also faced with a deficiency judgment.  This will have a spiraling effect on the unpaid creditors, thus "aggravating a downturn in the economy".  (In 1963, the statute was amended to partially exempt third-party lenders of commercial property, of dwellings of more than four units, or dwellings of four or less units which the buyer will not personally occupy).

In Shepherd v. Robinson, 128 Cal.App. 3d 615, 623 (1981), vendor status was found in a transaction where the original purchase money loan was refinanced to facilitate a sale of the property and the holder of the first in this refinancing then took back a second trust deed.  The  court reasoned that although the lienholder was not the legal owner of the property, he was nevertheless a “vendor” for purposes of Section 580b, because his participation and financing was necessary to the sale.

In the recent case of Conley v. Matthes, 56 Cal.App. 4th 1453, 66 Cal.Rptr. 2d 518 (1977), the court found that Section 580b applied as a matter of law to bar a deficiency action brought by a seller of two real properties who loaned money and took back a second deed of trust on one property but recorded it against another property which had already closed escrow, holding that the two purchases were essentially one transaction. 

6.       Jurisdiction, Venue, Parties

Only California courts have jurisdiction to foreclose liens secured by California real property.  Lilly-Brackett Co. v. Sonnemann, 157 Cal. 192( 1910).  The proper venue for a foreclosure action is the county in which the property is located.  CCP §392(1).  The present owner of the real property must be named as a defendant, as must all owners of fractional interests and, if a deficiency judgment is being sought against those parties, the original borrower and any intermediate owners who assumed the debt.  Tenants whose leases are subordinate to the deed of trust of the foreclosing creditor should be named as defendants if the plaintiff wishes to terminate their leases.  Since a foreclosure action has no effect on senior liens, such senior lenders need not be joined as defendants.  Naming a senior lienholder as a party defendant may be appropriate, however, where there is disagreement about the priority of the liens or to resolve conflicting claims to rents and profits.  The senior lienholder may then cross complain to foreclose its lien.  The resulting judgment may provide that a sale be conducted to satisfy both liens in such a case.  Junior lienholders should of course be named as defendants in order to cut off their lien rights and terminate their right of reinstatement and redemption.  Where a junior lienholder is omitted, the real property will remain subject to that junior lien and the junior may elect to foreclose on its own lien in order to obtain a deficiency judgment, since the junior lien was not eliminated and the lienholder does not have status of a "sold out" junior lienholder.  It is good practice to name all persons known to have interest in the property, even if those interests are unrecorded.  In order to ascertain the identity of these parties, it will be necessary to obtain a Litigation Guaranty.           

Complaints for judicial foreclosure often contain an additional cause of action for specific performance of a provision in the loan documents regarding the right to collect rents, issues and profits (usually by way of a receiver).

7.       Defenses To Judicial Foreclosure Action

A trustor/mortgagor may assert any defenses against an action to foreclose which are available in an action on the note, provided that the foreclosing creditor is not a holder in due course.  Com. C. §§3104, 3302, 3305.  Such defenses may also be asserted by junior creditors.

A defendant also has a defense to an application for deficiency judgment if the underlying loan was purchase-money or where the application is improperly asserted against a particular defendant.  In addition, a guarantor may assert defenses based on exoneration of the guarantee, where the underlying obligation has been altered.

8.       Statute of Limitations

Judicial foreclosure of liens imposed by both a deed of trust and mortgage is subject to the statue of limitations applicable to the principal obligation (Civil Code §2911) and is therefore subject to the four-year limitation period of CCP §337, which applies generally to limit actions on written contracts; i.e., four years from the maturity date of the obligation.


9.       Trial

No jury trial is available in a judicial foreclosure action.  Downing v. LeDu, 82 Cal. 471 (1890).  In addition to the original loan documents, the beneficiary must present evidence of the borrower's default and the present unpaid balance, as well as proof of any lender advances authorized by the loan documents.  If the plaintiff sustains its burden of proof, the court will enter a judgment of foreclosure and an order of sale, directing the levying officer in the county where the judgment is to be enforced to sell the real property.  CCP §712.010.  The court may appoint a receiver to enforce a judgment for possession or sale of property.  CCP §712.060.  The judgment will direct that the sale proceeds be applied first to court costs and to expenses of the levy and: sale and then to the amount due to the plaintiff, including attorneys' fees if called for in the loan documents.  The judgment will also include the amount of the indebtedness and determine personal liability, if any.  The actual sale will be in the manner provided for execution of judgments in CCP §716.020, if there is no deficiency, or CCP  §§729.010-729.090, if the judgment includes a deficiency.

10.       Fair Value Limitations On Deficiency Judgments (CCP §§726(b) and 580a)

If a deficiency judgment is available and the proceeds of sale are insufficient to satisfy the full indebtedness, the plaintiff must make application for same within three months after the sale and produce evidence of the value on the sale date, at a fair value hearing.  At the hearing, the Court will take evidence of the fair value of the property and will address no other issues.  The Court may appoint a probate referee to appraise the property, either on its own motion, or on application of any party made no later than 10 days prior to the hearing.  The amount of the deficiency judgment is limited to the difference between the total indebtedness, including interest and costs of levy and sale, and the fair value of the property on the date of the sale. CCP §726(b).

A California Court of Appeal has held that the fair value limitation provisions of CCP §§580a and 726 do not apply to a sale free and clear of liens under the Bankruptcy Code, since such a sale is neither a judicial nor nonjudicial foreclosure sale under California law.  In addition, the fair value limitation provisions to such a sale are not compelled by California's principles of equity.  Coppola v. Superior Court (Singer), 211 C.A.3d 848, 857 (1989).

11.       Reinstatement.

There is a statutory right to cure a default and reinstate a loan at any time prior to entry of the decree of foreclosure.  This right to cure and reinstate is also held by the trustor's successor in interest or any person having a subordinate lien or encumbrance.  Civil Code §2924c.  (As to a non-judicial sale, a party may reinstate five business days before such a scheduled foreclosure sale.  CCP  §2924c(e).  Saturdays are considered business days.  Civil Code §7.  If the sale is later postponed or renoticed, the reinstatement period is automatically extended to five business days prior to the new date of sale.)  Reinstatement differs from redemption in that it restores the loan to its original installment basis by paying off only the defaulted installments plus costs and expenses; i.e., acceleration is reversed.  Conversely, under redemption, the entire loan must be paid off, along with costs and fees.  In the event of a judicial foreclosure, the fees include the cost of a litigation guarantee.  Civil Code §2924c(c).

12.       A Junior Lienholder's Right To Cure Is Largely Illusory.

Virtually all deeds of trust, even where junior liens are permitted under certain circumstances, are cross-defaulted with those junior liens.  If a borrower cures the default under the senior deed of trust, there will still be an existing default in that the junior debt will itself be in default as a result of the non-cure of the junior lender's protective advance to the senior creditor.  The senior lienholder would still, therefore, be able to declare a default under the junior lien and immediately recommence the foreclosure process.  Cure by the junior, therefore, will do little other than to effectuate an additional four-month delay.  Since cure of the junior lienholder's protective advance to the senior may not be the type of default under the senior lien which if cured would effect a reinstatement, the junior lienholder may ultimately have no other option than to pay the senior obligation in full.

There is no provision under the Civil Code for cure of non-monetary defaults.  If a lender has included a non-monetary default in its notice of default, reinstatement will not be brought about, according to the statute, even if the borrower cures both the monetary and non-monetary defaults.  Because of the harshness of this result, case law has developed which requires that non-monetary defaults be material and that the lender's security actually be impaired before a lender may pursue a foreclosure based solely on a non-monetary default.

13.       The Effect Of Bankruptcy On Reinstatement

Pursuant to Civil Code §2924g(d), a non-judicial foreclosure sale may be conducted no sooner than seven days after the earlier of (i) dismissal of the action or (ii) expiration or termination of the injunction, restraining order, or stay (which required postponement of the sale), whether by entry of an order by a court of competent jurisdiction, operation of law, or otherwise, unless the injunction, restraining order, or subsequent order expressly directs the conduct of the sale within that seven-day period.  Relief from stay of the bankruptcy proceeding filed subsequent to the recordation and publication of a notice of sale will, therefore, revive the reinstatement time period unless a bankruptcy court order expressly states otherwise.  Some bankruptcy courts, however, believe that a non-judicial foreclosure sale is invalid unless notice of sale has been republished, with actual notice to the debtor and junior lienholders.  In re Tome, 113 B.R. 626, Bkrtcy. C.D. Cal. (1990).  While it is unlikely that Section 2924g(d) applies to judicial foreclosure sales, it is probably wise to renotice a judicial foreclosure sale as well, if the property is part of a bankruptcy estate.  In the recent California case of Tully v. World Savings & Loan Assn., 56 Cal.App. 4th 654 (1997) (petition for review denied by California Supreme Court 10/1/97, 1997 Cal. Lexis 6235), however, expressly held that Tome was not compelling authority and therefore not binding on the Tully court.  In fact, the opinion states that In re Tome has been rejected and severely criticized by other federal bankruptcy courts, including the Eastern District of California in the case of In re Jauregui, 197 B.R. 673 (Bkrtcy. E.D. Cal. 1996).

The Ninth Circuit Bankruptcy Appellate Panel recently held that a Chapter 13 debtor has the right to cure a mortgage default after the judgment of foreclosure but prior to the sale of a debtor's principal residence, thus adopting the "estate theory" of cure under 11 U.S.C. §l322(b)(5).  The estate theory is based on the concept that the right of redemption is included in the concept of property of the bankrupt estate (11 U.S.C. §541) and that the appropriate point of cutting off the right to cure is the foreclosure sale, at which point a third party is introduced.  In re Hurt, 158 B.R. 154 (9th Cir. BAP 1993).  A strong dissent in Hurt asserted that in order to cure there must be a contractual relationship, which relationship is extinguished by a decree of foreclosure, and that rights cannot be resurrected which have been extinguished under state law.  Holdings on this issue vary throughout the circuits.

14.       Equity Of Redemption

If a decree of foreclosure determines that a deficiency judgment may be ordered against a defendant, the real property is sold subject to a statutory right of redemption.  CCP §§729.010 et seq..  The right to redeem is limited to the judgment debtor or his successor in interest.  CCP §729.020.  A successor in interest includes a post-foreclosure sale assignee of the debtor's right of redemption, a bankruptcy trustee, or a junior lienholder who acquired the debtor's interest in the property through a prior foreclosure.  15 Cal.L.Rev. Comm. Reports 2001; 82 A.J. 9356.  Note, however, that junior liens are wiped out by a foreclosure sale and do not reattach if the trustor exercises his right of redemption.  See, Bernhardt, California Mortgage & Deed of Trust Practice, CEB §377.

The period during which property may be redeemed from a foreclosure sale ends three months after the date of sale if the proceeds of sale are sufficient to satisfy the secured indebtedness plus interest and costs of the action and of sale, or one year after the date of sale if the proceeds are insufficient.  CCP §729.030.

This right of redemption from sale should not be confused with the right of a junior lienholder to redeem property from a lien.  Any person having an interest in property subject to a lien has a right to redeem it from the lien at any time after the claim is due and before that person's right of redemption is foreclosed.  By such redemption, the redeemer becomes subrogated to all the benefits of the lien, as against all owners of other interests in the property, except to the extent that the redeemer was bound to redeem for their benefit.  Civil Code §§ 2903, 2904.

15.       Notice Of Sale.

If the decree of foreclosure determines that a deficiency judgment may be ordered, the sale is governed by CCP §716.020, except that the notice of sale of the property must state that the property will be sold subject to the right of redemption and must state the amount of the secured indebtedness with interest and costs.  Notice of the sale may be given upon entry of judgment for sale of the property.  CCP §729.010.  If property is sold subject to the right of redemption, the levying officer must personally or by mail serve upon the judgment debtor notice of such right.  CCP §729.050.

16.       Bidding At Foreclosure Sale

Any party may bid at the foreclosure sale, including the debtor.  The sale extinguishes the lien under which it is sold and any junior liens.  CCP §701.630.  Such liens do not reattach to the property after redemption.  CCP §729.080(e).  This means that if a trustor/mortgagor is able to come up with sufficient cash, he or she may overbid the lender and wipe out junior liens.  A junior lienholder may also redeem from a senior lien prior to foreclosure and, upon doing so, will become subrogated to all the benefits of the senior lien.  Civil Code §2904.

It is usually advisable for the mortgagee to credit bid up to the amount of the property's fair value, since if the property sells for less than its fair value, the borrower has a right to redeem at the sale price, plus costs, though the creditor will be limited in its deficiency judgment to the difference between the fair value of the property and the debt.  In order to make such a determination, of course, a current appraisal must first be obtained.

17.       Effect Of Bankruptcy On Redemption

There is no dispositive case on this issue, but it appears that the automatic stay of 11 U.S.C.  §362 does not toll the redemption period, but that a debtor or trustee in bankruptcy has 60 days after filing of the bankruptcy petition to redeem a property, if expiration would otherwise have occurred (under state law) during the first 60 days.

18.       Status During Redemption Period

A debtor retains the right to possession of the property during the period of redemption.  CCP §729.090.  The purchaser at the foreclosure sale is, however, entitled to receive the rents and profits of the property or the value of the use and occupation of the property during this period, but rents collected must be applied as a credit on the amount needed to redeem.  CCP §729.090(b).  The purchaser is entitled to repair and maintain the premises during this period and may obtain an order from the Court restraining waste, with or without notice.  CCP §729.060(c).

It is unlikely that a purchaser at a judicial foreclosure sale can bring an unlawful detainer action against a trustor who defaults in payment of rents, as the trustor is entitled to possession during the redemption period.  Once the redemption period has passed, however, the purchaser can obtain a money judgment for the rental value of the property during the redemption period.  CCP §729.090(a).

During the redemption period, third party tenants remain tenants of the trustor/mortgagor, as the right to possession is undisturbed by the sale.  It is unclear as to whether under-market rents can be raised to a market level by a purchaser during the redemption period, but it is unlikely, as there is no statutory mechanism available.  Because of the dichotomy between the right to rents and the right to possession, problems can arise where there is a third party tenant in possession who defaults on rent payments.

19.       Post-Redemption

If the redemption price is not paid during the statutory period, the levying officer must promptly execute, deliver and record a deed of sale in favor of the execution sale purchaser.  Conversely, should the redemption price be paid, the levying officer must execute, deliver and record a certificate of redemption.

20.       Fair Value Hearing:  CCP §726(b)

Before a money judgment for a deficiency is entered, the Court will conduct a fair value hearing and will reduce the amount of the deficiency judgment to the extent that the fair value is determined to be greater than the foreclosure sale price.  Nothing else will be considered at this hearing.

The purpose of the fair value limitation is to prevent the creditor from underbidding at the foreclosure sale, acquiring the collateral for substantially less than its true value, and then recovering an unfair deficiency judgment against the debtor.  As stated by the California Supreme Court:

"The evil which led to the enactment of this legislation became pronounced during the recent period of the economic depression when creditors were frequently able to bid in the debtor's real property at a nominal figure and also to hold the debtor personally liable for a large proportion of the original debt."

Hatch v. Security First National Bank, 19 Cal.2d 254, 259 (1942).

The fair value limitation of CCP §726(b) was enacted along with the fair market value limitation of Section 580a in 1933 during the initial stages of the Great Depression, when a mortgagee was able to purchase property at the foreclosure sale at a depressed price and thereafter obtain a double recovery by holding the debtor liable for a large deficiency.  Roseleaf Corp. v. Chierighino, supra, 59 Cal.2d 35, 40 (1963); Cornelison v. Kornbluth, 15 Cal.3d 590 (1975).  (Section 580a is largely irrelevant today, as it addresses limitations on a deficiency judgment following a trustee's sale, which is prohibited under Section 580d.)

As originally enacted, CCP §726 provided that a deficiency judgment was limited to "the amount by which the entire amount of the indebtedness due at the time of the sale exceeded the current market value of the real property or interest therein sold ..."  (Stats. 1933, ch. 793, s. 1, p. 2119.)  This formula proved unworkable, however, in that the Depression had severely reduced market values for real property and in many cases there simply was no market at all.  Accordingly, giving the mortgagor a credit against the deficiency judgment for the greater of the sales price or the fair market value was often empty protection.

In 1937, the legislature addressed this problem.  An amendment to CCP §726 was proposed which struck the "fair market value" language and substituted a provision for a court-appointed appraiser in the event a deficiency was sought.  The appraiser was to file with the court an appraisal stating both the intrinsic value and the market value if in the opinion of the appraiser there was a market for such property at the time and place of sale.  Thereafter a hearing would be held to address objections to the appraisal and supporting evidence.  At the conclusion of the hearing, a deficiency judgment would be entered "for not more than the amount by which the entire amount of the indebtedness due at the time of the sale ... exceeded the intrinsic value of the real property or interest therein sold at the time of sale."  In determining intrinsic value, weight was to be given to evidence of market value only after it was established that there was a market at the time and place of the sale for the kind of property sold.  (Assem. Bill No. 1918 (1937 Reg. Sess.) s 1.)  The bill was subsequently amended by the Assembly to delete the provision regarding the court appointed appraiser, and the "intrinsic value" language of the original bill was replaced with the present "fair value".  (Assem. Amend. 2 Assem. Bill No. 1918 (1937 Reg. Sess.) April 14, 1937); Rainer Mortgage v. Silverwood, Ltd., 163 C.A.3d 359 (1985).

The 1937 amendment changing the hearing from a determination of "fair market value" to "fair value" was intended to rectify the then current situation of a lack of willing buyers for real properties, which greatly reduced market value.  It should be noted that the antideficiency statutes, in general, are extremely pro-borrower and are intended to shift some, if not all, of the risk of decreasing property values to creditors.

21.       Judicial Interpretation CCP §726(b).

Case law addressing applicable standards for the fair value hearing provided for in Section 726(b) is very sparse.  Only three reported decisions have interpreted the meaning of "fair value" in this context.  This lack of precedent permits some creativity in persuading a court that the fair value of the property is significantly greater than the amount of the foreclosure sale price.

(a)        Nelson v. Orosco, 117 C.A.3d 73 (1981).

In Nelson, the court ruled that the determination of fair value must include the decrease in the value of property which has a lis pendens recorded against it.  After a third party placed a lis pendens on the property, the junior secured creditor foreclosed and purchased the subject property at the judicial foreclosure sale for $1,000 above the $100,000 amount of the existing senior encumbrance.  The judgment determined that the borrower owed the lender $67,116.35 on the second trust deed.  At the fair value hearing, three expert witnesses testified as to the fair market value of the property, but none considered the depressing effect of the lis pendens.  Nevertheless, the trial court found that the "fair value" of the property was $180,000, an amount greater than the total debt, meaning that no deficiency judgment was obtained by the lender.

The appellate court reversed the decision of the trial court, holding that fair value was to be determined by all of the circumstances attending the property at a foreclosure sale, including the state of its title and merchantability.  Id. at 79.  The court felt that no willing buyer in the open market would have paid the full value for the property where there was a recorded claim against the property, and that the fair value must reflect that fact.  Significantly, there is very little mention of legislative intent, or the effect of the right of redemption on the value of the property.  The court simply felt that the lis pendens must be considered in determining fair value, but it gave no further guidance to the trial court for determining fair value.

(b)    Rainer Mortgage v. Silverwood, Ltd., 163 C.A.3d 359 (1985).

This is the most important case interpreting "fair value", and the one with the most thorough analysis.  In Rainer, borrowers appealed the amount of a deficiency judgment entered against them following judicial foreclosure sales and a subsequent fair value hearing.  At that hearing, evidence was taken from several appraisers as to the market value of the properties in both a free market (fee simple absolute), and in a situation where all the circumstances attending foreclosure sales were considered.  In one appraisal, the market value of one property was speculated to be approximately 30% lower where the circumstances of the sale was considered.  Id. at 363.  The borrowers contended that fair value meant the fair value of the properties, undiminished by any of the disabilities attending a judicial foreclosure sale.  The lender, predictably, argued that the appropriate measure of the properties' worth must include the restriction of marketability due to the borrower's right of redemption.

The court first examined Nelson v. Orosco, 117 C.A.3d 73(1981), to determine its precedential value, but held that the holding of Nelson had limited value to this factual setting, as concerned the effect on value of an external factor, the filing of a lis pendens, rather than an internal factor affecting the foreclosure sale itself, such as the right of redemption.  Finding no other California case which discussed the meaning of fair value, the court examined the language of the statute.  After discussing the policy and legislative history behind CCP ' 726(b), the court stated that its purpose is to protect the defaulting borrower, and that to do this "the Legislature found it necessary to credit the borrower with the intrinsic or underlying value of the property ...  The Legislature therefore determined not to let the protection afforded a foreclosed mortgagor depend entirely on the vagaries of the marketplace."  Id. at 366.  The court then stated in a footnote that the
language in Roseleaf which gratuitously equated CCP §580a (referring to fair market value) and 726(b) (referring to fair value) as each limiting a deficiency judgment to the difference between "the amount of the indebtedness and the fair market value of the property at the time of sale" was "improvident dicta" and not precedential in determining if "fair value" is "fair market value", as used in Section 726.

The court concluded that fair value of foreclosed property is its "intrinsic value" or the potential worth of the property on the open market, taking into consideration all of the circum­stances affecting the underlying worth of the property as the time of the sale, but without considering the impact of the foreclosure proceedings on that value.

"This correlation is not fixed, however, and market value is only one factor the court should consider when determining fair value.  As discussed in Nelson v. Orosco, supra, fair value is to be determined by all of the circumstances affecting the intrinsic value of the property at the time of the sale, including the state of its title and merchantability.  This necessarily excludes the circumstances of the foreclosure sale.  These are not factors that affect the intrinsic worth of the property.  Most notably, the right of redemption is limited to a year.  After that time, it no longer serves to depress the marketability of the property.  Accordingly, we conclude the Legislature intended that fair value, as used in Civil Code [sic] section 726, subdivision (b), be construed as the intrinsic value of real property subject to judicial fore­closure, taking into consideration all the circumstances affecting the underlying worth of the property at the time of the sale, without consideration of the impact of foreclosure proceedings on this value."  Id. at 367.  (Emphasis added.)

As to the risk of loss occasioned from the properties' decreased value on the lender:

"it was not the purpose of ... Section 726 to insulate commercial lenders from the risk of loss where encumbered property declines in value.  If the lender overvalues property for purposes of a loan, or misjudges the commercial viability of a real estate project, it is entirely proper that the risk of loss be with that lender.  The same risk is always present in purchase money mortgages for residential dwellings, where deficiency judgments are barred.  (Code Civ. Proc. §580b.)  The lender's control over the situation, and its own protec­tion, is at the time the loan is made and the risk of loss generated at that time cannot be shifted to the borrower by construction of a statute designed to protect the borrower."  Id. at 368.  (Emphasis in the original.)

The court further stated that this risk of loss is placed on the lender, in part, by its decision to proceed with a judicial, rather than non-judicial, foreclosure, and that "it is the lender who makes a conscious decision as to the value of property prior to making the loan.  That this decision is faulty should not relieve the lender of the consequences of the decision by shifting the loss to the borrower.  The Legislature has allocated the 'risk of loss' in foreclosure proceedings and the trial court herein erred in attempting to shift this balance."  Id. at 369.  The court thus ruled that construing "fair value" to include all the disabilities of a foreclosure sale would be unreasonable, because it would permit the lender the double recovery the statute was meant to prevent.

(c)       City Bank of San Diego v. Ramage, 266 C.A.2d 570 (1968).

Ramage, a case cited by neither the Rainer or Nelson           courts, discusses the types of evidence which may be admitted to prove fair value under Section 726. The property at issue was raw land upon which a 94-unit apartment building was allegedly going to be built some time in the future. The trial court determined that the fair value of the property was $125,000 based on an indebtedness of $175,122 and a bid price at the foreclose sale of $60,000. Each party appealed the finding on value.

The lender appealed on the basis that there was insufficient evidence to support the $125,000 figure, even though one witness testified that the fair market value or fair value (the terms were used interchangeably) of the property was $200,000, and another testified that such value was $140,000. Because the lender had failed to object to admission of that evidence, the court held that the trial court was qualified to assess the credibility of the appraisal testimony and rule accordingly.

The borrowers cited as error certain evidentiary exclusions, all of which were affirmed on appeal. The first exclusion concerned testimony of what the raw land, apart from improvement value, would have been worth if purchased for improvement with a 94-unit apartment building scheduled to produce certain fixed rents, as well as a chart prepared to show the cost of such improvements when the loan originally was made, the gross yield from the improvements, and other factors entering into a net return that permitted a capitalization figure necessary to produce that net return.  In other words, the borrower wanted to introduce evidence of what the value of the land would be once improved. The court ruled that "testimony posited upon a capitalization of purely speculative nonexistent income was properly excluded." Id. at 586. The court went on to state, however, that "in the case of property actually yielding an established regular income, the capitalization of the net income, taking into account the replacement costs of improvements as of the relevant date, is a highly significant index of market value as of that date."  Id.  The borrower also objected to exclusion of a graph showing trends in land values in Southern California for the six years preceding the foreclosure sale, as well as the exclusion of an appraisal performed by one of the lender's witnesses at the time the loan was made, 2 ½  years prior to the foreclosure sale.  The court ruled that it was proper to show the witness' knowledge of trends in land values, but that past values were not probative as to the value of the property on a given date.  The appellate court made no mention of the propriety of introducing the earlier appraisal.

22.       Application of Legislative History and Case Law.

The relative infrequency of reported fair value hearings presents both problems and opportunities in creating a strategy for maximizing the court's determination of fair value, thus limiting (or eliminating) the available of a deficiency judgment.

It is a widely held belief that commercial property values while in the process of recovery, have been recently been at an all-time low, such that both past and future values are greater than present property values. Thus, to the extent that either past or future values can be included in "fair value," that amount will be higher. Ramage suggests that past property values are inadmissible evidence with no probative value of "fair value...as of the date of sale" under Section 726(b).  However, that case, as well as standard appraisal methodology, seems to permit inclusion of future rents as an element of present value, through the capitalization method. Therefore, to some degree future rents will be included in a "fair value" determination as of the date of sale.  One plausible approach consistent with the "as of the date of sale" requirement would be to project current leases into the future, and then discount them to present value, thus arriving at a value "as of the date of sale." Yet that method uses the currently deflated market, with its high vacancies and lower rents, as the basis for the fair value. It would be preferable to include evidence of the expected commercial property recovery in the calculation, to assume lower vacancy and higher rental rates, and then discount that amount back to a present value. This approach is much more speculative, however, and begins to look like the type of evidence also excluded in Ramage.  Still, to the extent that the court can be convinced that fair value equals intrinsic value, perhaps it can also be convinced to consider the eventual recovery in its valuation of the property.

Another theory by which to reduce a deficiency judgment rests on the intrinsic value concept of Rainer Mortgage.  That court interpreted fair value to mean intrinsic value, at least in part due to the 1937 amendment to CCP §726(b) which changed the test from "fair market value" to "fair value." This change apparently was a direct result of the lack of a real estate market during the worst phases of the Great Depression. This lack of a market allowed a lender to lowball a bid at the foreclosure sale, recover the collateral, and then hold the borrower to a large deficiency judgment. Limiting a deficiency judgment to the fair market value of a property is hollow protection where there is no market, so the change was made to give borrowers credit for the property's value in a more stable period. The entire anti-deficiency legislative scheme was enacted around this time to protect borrowers from the incredible fall in real estate values.

The recent real estate market has qualified at the least as a recession.  Many of the same policy justifications for enacting CCP §726(b)  have existed in that market. Fears that the borrower would be exposed to a double hit have been very real.  Thus, from a policy perspective, every reason existed to define fair value in such a way as to give a borrower some protection based on an expected economic recovery, as the Legislature enacted the fair value limitation for just such an economic climate, and contemplated a hearing to determine the value of the property as if the current economic malaise were not in effect.

Another strategy is to rebut the inference that the foreclosure sale price is an approxi­ma­tion of fair value.  If the foreclosure and antideficiency scheme worked in practice as envisioned in theory, the sale price would be similar to the fair value, as the lender would have an incentive to bid up the price to lessen the opportunity and profitability of a debtor's redeeming the property. In practice, however, the foreclosure sale price is rarely if ever indicative of fair market value, and "foreclosure sale prices are often greatly below actual fair market values because they reflect the fact that the sale is a forced sale rather than an arm's length, free market sale between a willing buyer and a willing seller."   Washburn, The Judicial and Legislative Response to Price Inadequacy in Mortgage Foreclosure Sales, 53 So.Cal.L.Rev. 843, 848 (1980).

            In addition, the borrower's right of redemption also depresses the price obtained at the sale, in that it is in effect an option to purchase for the sale price at any time within one year.  Since the right of redemption is actually an option, it should be valued as such, increasing as the value of the property increases during the redemption period. Thus, to determine the value of the right of redemption, evidence of future value of the property (for at least the length of the right of redemption) is relevant.  This may be a back-door method for introducing evidence of the expected continued rise in property values over the next few years. This valuation, as well as the structural problems with foreclosure sales, may require the testimony of a real estate economist or some similar professional, rather than an appraiser, to prove to the court these complex theoretical assertions.

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