What starts in California often spreads east across the country. Will that be the case for California’s new short sale anti-deficiency law?

On August 19, 2010, the California Legislature approved Senate Bill 931 (SB 931) which added Section 580e to the Code of Civil Procedure (CCP §580e). It expands existing anti-deficiency laws regarding loans secured by dwellings of one to four units to short sales, but only to the first lien holder. It was not passed as “urgency legislation” or with a delayed effectiveness, so it will take effect on January 1, 2011.

In part, the new law provides that: “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.”

Existing Law

This complements two other anti-deficiency or nonrecourse provisions of CCP §580.

Under CCP §580b, California law provides that “no deficiency judgment shall lie in any event” after a sale of dwelling for not more than four families in connection with a loan “which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser.” Californians loosely refer to this as saying that a purchase money loan for a personal residence is nonrecourse. It applies to purchase money junior liens as well.

Under CCP §580d, California law provides that “no judgment shall be rendered for any deficiency” upon a note secured by real property “in any case” in which the property has been sold “under power of sale contained in the mortgage or deed of trust.” This generally is referred to as California’s anti-deficiency statute. Notice that it is not limited to dwelling units for not more than four families. This applies to all private, non-judicial foreclosures. It is rare to see a judicial foreclosure in California for residential property. Judicial foreclosures are used almost exclusively for commercial properties.

New Law

The new law follows the verbiage of §580d that “no judgment shall be rendered for any deficiency.” The full verbiage of the new law is provided at the end of this article. It contains several important limitations:

1.  It applies only to the first mortgage or deed of trust.

2.  It applies only to dwellings up to four units, but does not need to be owner-occupied nor purchase money.

3.  It does NOT apply “if the trustor or mortgagor” commits either fraud with respect to the sale of, or waste with respect to, the real property. In these cases, “the holder of the deed of trust or mortgage” may still “seek damages and use existing rights and remedies against the trustor or mortgagor or any third party for fraud or waste.”

4.  It also does not apply “if the trustor or mortgagor is a corporation or political subdivision of the state.” (I will only discuss private borrowers.)

Practical Effects

The most important difference in the new law is that it expands anti-deficiency law from purchase money loans to short sales involving all first trust deed loans. Previously, a homeowner with a cash-out refinance would be subject to potential deficiency liability on a short sale unless the short sale processor was effective enough to obtain a statement in the short payoff approval letter that the payoff constitutes a full discharge of the indebtedness.

The Obama Administration’s “Home Affordable Foreclosure Alternatives” (HAFA) program has a similar provision. However, HAFA comes with many other unattractive and undesirable features. This author’s brief review of articles by real estate agents and brokers indicate that HAFA has not caught on to any great degree. Hence, California’s new law provides a key benefit without the drawbacks of HAFA.

A short term effect may be that homeowners try to delay short sales until 2011. Alternately, short sale processors can use the law to argue for release of liability before 2011 when a foreclosure sale cannot occur in 2010 because it has not been commenced or proceeded far enough.

The law has no effect on a cash-out second loans or HELOC’s. (Some HELOC loans were creatively used as purchase money. Although they typically state they are recourse loans, it is this author’s opinion that they fall within the nonrecourse provisions of CCP §580b because they were used “in fact” for the purchase of the property.)

The law does not apply when there was fraud “with respect to the sale.” The most common cases likely occur when the borrower claims a false hardship or otherwise lies about their financial conditions. This is sometimes referred to improperly as a “strategic default.” A strategic default, or more accurately an intentional default, is done with disclosure that it is a financial decision to breach the loan terms, not as a result of hardship. When a hardship is misrepresented to the lender and the lender justifiably relies upon that misrepresentation, then fraud ordinarily occurred.

The new law also does not apply when the trustor commits waste with respect to the property. Too often short sale properties are “trashed.” The owners neglect maintenance and might remove appliances, etc., or even commit intentional damage. In those cases, the “holder” of the deed of trust can “seek damages.” However, that appears to be limited to damages for waste because it doesn’t say that the deficiency risk remains in effect.

Potential Unintended Consequence

I found it interesting in reviewing the legislative history that no opposition was reported to the bill in either the State Senate nor the State Assembly. I don’t think the banks’ lobbyists missed this bill. I think the banks didn’t want to look bad politically. They will simply adjust.

The most likely adjustment is that short sales will become more difficult because the note holders will likely require higher payoffs to offset the potential recovery that used to exist for recourse loans.

A rational note holder evaluates the potential return of a short sale versus a foreclosure that is sold as a “bank-owned property” or REO (“real estate owned” – by the bank). Prior to 2011, note holders of nonrecourse first deeds of trust could require the seller to execute an unsecured note for all or part of the deficiency or they could factor in the right to seek a deficiency judgment. Although these “assets” might not have full value due to a high likelihood of default and subsequent bankruptcy filing in many cases, there is still an asset and net recovery value that can be applied, even if it is as low as 10% – 25% of the face value. By removing this value from the short sale calculation, the new law will make foreclosure more attractive relative to short sales that could have included deficiency liability.

Accordingly, the unintended consequence of this new law may be to encourage more foreclosures and fewer short sales.

Open Income Tax Question

The basic income tax rule is that a debtor is subject to cancellation of debt income (CODI) when a debt for which the borrower is personally liable is discharged short of full payment. This only applies to recourse debt, not nonrecourse. Hence, residential purchase money secured loans are always nonrecourse in California at the time they are made as a result of CCP §580b.

I have not researched the question of CODI liability when the note effectively becomes nonrecourse due to the lender’s method of settlement. Under the new law, a debt which was originally recourse debt when it was made (such as a cash-out refi) becomes nonrecourse because the lender agrees to a short sale. Will this avoid CODI treatment? That will need to be a topic for another day. I invite knowledgeable comments below.

Questions Resulting from Poor Draftsmanship

Legislators and even their staff often don’t study the verbiage deeply enough to consider the loopholes and questions that might arise. I see many.

This law applies when the “trustor or mortgagor sells the dwelling . . .” What happens when a buyer purchased the property subject to the existing deed of trust?

In that case, the buyer takes record title and becomes the subsequent seller, not the trustor. In many cases, the sale constitutes a violation of the due-on-sale clause but is not enforced so long as the payments are being made. When the short sale application arises, the note holder might require the original borrower to execute a note for the deficiency, which would not have applied had the trustor been the seller.

The law states, “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.” This ignores the fact that the promissory note and the deed of trust or mortgage are independent legal instruments. Moreover, the term “holder” usually applies to a note, not a deed of trust. The original secured lender is the “beneficiary” of the deed of trust. The note can be assigned without the deed of trust being assigned.

Moreover, the consent to a short sale “shall obligate that holder” to fully discharge the remaining amount of indebtedness on the first deed of trust. The deed of trust merely secures the note, it is not an independent “indebtedness.” The deed of trust usually provides for liability for waste, payment of taxes, insurance, etc. These would be indebtedness “on the first deed of trust or first mortgage,” but not of the note. Maybe the bankers did not object to this law because they know the difference between a note and a deed of trust while the Legislature doesn’t. This could make for some interesting litigation.

Since the law is limited to the “remaining amount of indebtedness on the first deed of trust,” does that necessarily prohibit the creation of a new, independent unsecured note for all or part of the deficiency on the promissory note? I think the law should not have referred to “the indebtedness on the first deed of trust,” but to the “indebtedness secured by the first deed of trust.” Then these questions likely wouldn’t arise. Moreover, the law should have included a specific prohibition against creating a new, unsecured obligation if the Legislature intended to “close the book” on all liability under the original debt.

The waste and fraud limitations might also have considerable oversights in drafting. They require that the fraud or waste be committed by the “trustor or mortgagor,” but they allow for “damages” to be sought against “the trustor or mortgagor or any third party.”

What happens when a tenant or other occupant of the property (including a family member), but not the “trustor” named on the deed of trust, trashes the property? The damage is not committed “by the trustor,” so it does not appear to be subject to the recovery for damages.

What happens when a third party, such as the short sale processor or the buyer, commits fraud in the short sale? The law provides for “damages” but only if the trustor or mortgagor commits the fraud. So why does the law allow for damages from third parties when the “wrong” must be committed by the trustor or mortgagor? Looks like poor draftsmanship to me.

The statute does not address the issue of fraud in the origination of the loan. Will a borrower remain liable for fraud, such as having overstated income on a “liar’s loan” application? This law only relates to fraud in the short sale. Conceivably, the lender can still pursue the borrower for fraud in the loan origination. Accordingly, the smart seller will seek a full written release in the short payoff approval despite this law.

This evidences the problem with most legislative and regulatory “solutions” to perceived “problems” in the “housing crisis:” they are superficial and incomplete because the legislators and regulators lack the depth of knowledge held by those “in the trenches” who are dealing with these transactions on a daily basis. Unfortunately, most of the people working “in the trenches” are too busy solving problems to redirect their time to legislative and regulatory matters. This emphasizes the need for more active and ongoing input from entrepreneurs who understand the issues more deeply.

Time to Wait and See

Although the law was well intended to avoid the “surprises” when short sellers are subsequently pursued for deficiency liability and to encourage short sales over foreclosures by putting cash-out refinances on equal footing in short sales as purchase money loans with respect to the borrower/seller, I don’t think there will be a big rush by other States to do the same. It will be prudent for other States to see how this works out in reality.

Other States will be prudent to see how the loopholes and poor drafting are exploited by various players in the short sale transaction so they can draft more effective laws.

Moreover, the net effect of the law is to reduce the potential recovery to note holders on short sales. They will need to offset this decrease by either pushing the payoff too high to make the sale feasible or by simply foreclosing faster and selling the property. Just because the banks didn’t oppose this legislation, it doesn’t mean that they will respond in the way the Legislature hopes they will.

Text of the new Section 580e of the California Code of Civil Procedure:

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.

(c) This section shall not apply if the trustor or mortgagor is a corporation or political subdivision of the state.