Compliance Bulletin

New California Law Prohibits Deficiencies On Short Sales
October 25, 2010

This Bulletin was prepared for CBA by Peter Munoz [1], partner with Reed Smith and member of the CBA Legal Affairs Committee. Peter consulted with CBA during the legislative process in connection with SB 931.

A bill, SB 931, adds a significant provision to the California anti-deficiency laws which protect California borrowers from deficiency liability on real estate secured obligations. The purpose of SB 931 as expressed by its sponsors is to facilitate “short sales” of distressed residential property and avoid the burdens of foreclosure sales while preserving for the borrower the anti-deficiency protections that are already set forth in Code of Civil Procedure (hereafter “CCP”) Sections 580b and 580d.

SB 931 adopts new CCP 580e which provides that no judgment shall be rendered for any deficiency on a note secured by a first deed of trust encumbering a dwelling of not more than four units in any situation where the trustor sells the dwelling for less than the remaining balance of the secured indebtedness due at the time of sale if the beneficiary under the first deed of trust consents to the sale in writing. The beneficiary’s written consent to the sale will obligate the beneficiary to accept the sale proceeds as full payment of the secured obligation.

The legislation will not limit the ability of the beneficiary to seek damages and exercise existing rights and remedies against the trustor or any third party if the trustor commits fraud with respect to the sale of the real property or waste with respect to the real property.

The legislation does not apply if the trustor is a corporation or a political subdivision of the state.

Analysis of CCP 580e

The new legislation provides some additional protection for borrowers by supplementing the protections of CCP 580b. However if CCP 580b is applicable to the situation it would provide greater protections to borrowers.

CCP 580b. CCP 580b provides that no deficiency may be obtained on an obligation which secures a purchase money obligation: (i) which financed the purchase of any real property sold by the lender (i.e. a seller-carry-back transaction) or (ii) which financed the purchase of residential property of one to four residential units occupied in whole, or in part, by the purchaser.

CCP 580b provides separate anti-deficiency protection to the borrowers in addition to CCP 580d which prohibits a deficiency on an obligation secured by a deed of trust following a non-judicial foreclosure under that deed of trust. The protections of CCP 580b are not dependent upon a foreclosure sale by the secured party. CCP 580b protection will apply to all purchase money loans regardless of their priority. Therefore, it will apply to loans secured by a second priority or a third priority lien as long as the proceeds of the loans were used to finance the purchase of the real property which is encumbered.

The protections of CCP 580b may be lost (under current law) (i) if the loan is refinanced and the borrower obtains further advances in connection with the refinancing; or (ii) if the loan is subordinated to another loan the proceeds of which are used to improve the property.

Although some lenders disagree, it has been argued that the anti-deficiency protections of CCP 580b would continue to apply even if there were a short sale and the property were released from the deed of trust with the consent of both the lender and the borrower. If a borrower were to execute a promissory note to the lender for the amount of the deficiency following a short sale, it has been argued that such deficiency note would be subject to rescission on the grounds that there was no consideration for such deficiency note since the borrower was not legally liable for any deficiency that is represented by such note.

SB 931. SB 931 does not purport to modify CCP 580b; therefore SB 931 will not alter the anti-deficiency protections under CCP 580b. However, SB 931 would clarify that (at least as regards an obligation secured by a first priority lien) the lender may not obtain a deficiency following a short sale agreed to in writing by the lender whether that loan is a purchase money loan or not.

Therefore SB 931 confirms the protections of 580b (at least as regards loans secured by a first-priority lien) and expands those protections even to loans which have been refinanced and on which further advances were made. In effect it provides the protections of CCP 580d without requiring a non-judicial foreclosure sale.

In effect new CCP 580e will remove barriers to short sales. Many lenders would prefer a short sale to a foreclosure, since it reduces the carrying costs of the property and the expense and delay of a foreclosure. However, many borrowers do not want to agree to a short sale if there is a significant risk of losing the anti-deficiency protections of CCP 580b and 580d. The discrepancy between the secured loan balance and the realizable value of the residence is often too great. CCP 580e will assure the borrower that (as regards a first priority lien) the borrower will in essence retain the protections of 580d.

Waste and Fraud

The anti-deficiency protections of CCP 580b do not protect a borrower against liability for fraud or waste. Therefore SB 931 does not change the law, but merely reaffirms current law. Neither CCP 580b nor CCP 580d would protect a borrower for liability for fraud or waste.

Exceptions for Corporations and Public Agencies

The protections of SB 931 will not apply if the trustor is a corporation or a political subdivision of the state. This provision also does not appear to change current law in most situations. The protections of CCP 580b apply to the borrower who is the purchaser of the real property which was financed and who occupies that real property. In most situations the borrower will also be the trustor under the deed of trust.

However there are some circumstances where the borrower was originally the purchaser of the property, and thereafter (as part of estate planning) the borrower transfers the property to a family trust, limited liability company or corporation while remaining the “borrower” under the purchase money loan and remaining the occupant of the property. Under these circumstances if title to the property is transferred to a corporation (which then becomes the trustor), the language of SB 931 would not protect the borrower.

Under CCP 580b the borrower would retain the protections of CCP 580b.

Open Issues

The clear intent of SB 931 is to protect an individual in connection with a short sale on his or her residence It is not intended to protect an entity or an individual who is a borrower on a commercial loan secured by one or more consumer residences. This would often be the case where an individual or limited liability company or limited partnership is a borrower on a construction loan to build residential units.

CCP 580e is not limited in its protection to individuals, nor does it require that the residential property sold be occupied by the borrower, nor limit the residential property to only one building (of 1-4 units). Therefore some concerns have been raised that CCP 580e could provide a defense for a real estate developer following consensual sales of the residences constructed for less than the outstanding balance of the construction loan.

Further concerns have been raised where a lender has multiple items of collateral and agrees to a short sale of a dwelling. It could be argued that the sale satisfies the obligation covering the entire development that includes the sold dwelling. Such satisfaction of the lien would prevent the lender from foreclosing on its additional collateral. To help avoid these problems the sponsors of the legislation have submitted a letter to the Senate Daily Journal to clarify the legislative history and to clearly state that Section 580e was not intended to apply to commercial loans made to entities secured by multiple residential units. Nor was it intended to extinguish obligations which remain secured by additional collateral.

The full text of the SB 931, which adds Section 580e to the Code of Civil Procedure, reads as follows:

580e. (a) No judgment shall be rendered for any deficiency under a note secured by a first deed of trust or first mortgage for a dwelling of not more than four units, in any case in which the trustor or mortgagor sells the dwelling for less than the remaining amount of the indebtedness due at the time of sale with the written consent of the holder of the first deed of trust or first mortgage. Written consent of the holder of the first deed of trust or first mortgage to that sale shall obligate that holder to accept the sale proceeds as full payment and to fully discharge the remaining amount of the indebtedness on the first deed of trust or first mortgage.
(b) If the trustor or mortgagor commits either fraud with respect to the sale of, or waste with respect to, the real property that secures the first deed of trust or first mortgage, this section shall not limit the ability of the holder of the first deed of trust or first mortgage to seek damages and use existing rights and remedies against the trustor or mortgagor or any third party for fraud or waste.
© This section shall not apply if the trustor or mortgagor is a corporation or political subdivision of the state.

Kevin Gould, Director of State Government Relations, is CBA’s lead lobbyist on SB 931. The effective date of the bill is January 1, 2011.

Peter Munoz is based in San Francisco and can be reached at 415-659-5964 or pmunoz@reedsmith.com.
The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.

© This CBA Regulatory Compliance Bulletin is copyrighted by the California Bankers Association, and may not be reproduced or distributed without the prior written consent of CBA.

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