I recently had an interesting email exchange with a couple of fellow bankruptcy attorneys on the subject of foreclosure. The specific question we discussed was whether a second mortgage holder’s claim is extinguished after the holder of the first mortgage conducts a foreclosure sale.
The question is complicated by the fact that there are three relevant statutes at work, and they don’t have the same foci.
I. The “One-Action” Rule
The first statute is Cal. Civ. Proc. Code § 726, which states in relevant part:
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 or an estate for years therein, which action shall be in accordance with the provisions of this chapter.
This means that if a creditor holds a mortgage on a piece of property, it has one bite at the apple: it can either foreclose on the property, or sue the borrower to collect on the debt, but not both. Thus, if the lender conducts a foreclosure sale and comes up short, it cannot sue the borrower to collect the post-resale deficiency. The shortfall has to be cancelled, which is why the (former) homeowner can face a nasty tax bill after losing the home.
Suppose, for example, that the holder of the first deed of trust, ABC Bank, sold the house in a foreclosure sale. Then it has had its one action. It cannot sue the borrow to collect the post-resale deficiency. Suppose further, that there is a second deed of trust held by DEF Bank — a different entity from ABC. Then DEF has not had its bite at the apple. Is it left out in the cold? The answer depends on the nature of the debt.
II. Cal. Civ. Proc. Code § 580d
The second statute in the puzzle is Cal. Civ. Proc. Code § 580d, which states in relevant part (with emphasis added):
No judgment shall be rendered for any deficiency upon a note secured by a deed of trust or mortgage upon real property or an estate for years therein hereafter executed in any case in which the real property or estate for years therein has been sold by the mortgagee or trustee under power of sale contained in the mortgage or deed of trust.
That somewhat opaque passage could be interpreted as saying that every entity holding a mortgage against the foreclosed property is prevented from seeking to collect on any post-resale deficiency. If this view is correct. then if ABC Bank has a first mortgage, and DEF Bank has a second mortgage, and ABC sells the property in a foreclosure sale, then DEF would be prohibited from seeking a judgment against the debtor for the unpaid balance on the second. As we shall see, if the debt is not purchase money debt (i.e., the debt is a refinancing rather than a loan used to purchase the property) the law says otherwise.
On the other hand, if the mortgage is a purchase money debt, then there is a statute directly on point:
III. Cal. Civ. Proc. Code § 580b
The third statute is Cal. Civ. Proc. Code § 580b, which provides in relevant part (with emphasis added):
No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of 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.
As you can see by my highlighting, the focus here is on purchase money mortgages rather than nonpurchase money mortgages, such as refinances.
If your name is Marty McFly, you’re saying, “English, Doc, English.”
The gist of this statute is, if the property is sold for less than the debtor owes, then no lender who held a purchase money security on the property can come after the debtor to collect the post-resale deficiency. This even includes a lender who had nothing to do with the foreclosure sale. Thus, the holder of a purchase money second doesn’t get its one action.
Let’s see how the courts have interpreted these statutes.
IV. The Case Law
A. Cal. Civ. Proc. Code § 580d
Consider, for example the following holding from a very recent case (with emphasis added):
Section 580d “precludes a judgment for any loan balance left unpaid after the lender’s nonjudicial foreclosure under a power of sale in a deed of trust… on real property.” (Western Security Bank v. Superior Court (1997) 15 Cal.4th 232, 237 [62 Cal.Rptr.2d 243, 933 P.2d 507].) On its face, section 580d contemplates a single loan. Thus, when two separate loans are secured (via separate deeds of trust) by the same real property, section 580d does not prevent a junior creditor from obtaining a money judgment for the full amount due on the underlying junior debt obligation when the senior lienholder conducts a nonjudicial foreclosure that extinguishes the junior lienholder’s security interest. (Roseleaf Corp. v. Chierighino (1963) 59 Cal.2d 35, 43-44 [27 Cal.Rptr. 873, 378 P.2d 97] (Roseleaf); Bank of America v. Graves (1996) 51 Cal.App.4th 607, 611-616 [59 Cal.Rptr.2d 288] (Graves).)
That language is pretty clear: Cal. Civ. Proc. Code § 580d, which does not distinguish between purchase money and nonpurchase money mortgages, leaves the holder of the junior lien free to go after the debtor for the post-resale deficiency.
The Cadelrock quote cited to two other cases which echo this general principle without distinguishing between purchase money and nonpurchase money mortgages. The first case cited, Roseleaf Corp. v. Chierighino, 378 P. 2d 97 (Cal. 1963), is the seminal case, the well from which all the subsequent case law on the subject appears to draw. The second case cited, Bank of America v. Graves, 51 Cal. App. 4th 607 (Cal.Ct. App., 4th App. Dist., 2nd Div. 1996), provides a nice précis of Justice Traynor’s Roseleaf holding, along with a particularly relevant quote from a treatise discussing the subject (with emphasis added):
In the leading case of Roseleaf Corp. v. Chierighino, supra, 59 Cal.2d 35, Chief Justice Traynor held, “The `one form of action’ rule of section 726 does not apply to a sold-out junior lienor [citations], nor does the three-months limitation of section 580a. . . . Justice Traynor further explained: “The position of a junior lienor whose security is lost through a senior sale is different from that of a selling senior lienor. A selling senior can make certain that the security brings an amount equal to his claim against the debtor or the fair market value, whichever is less, simply by bidding in for that amount. He need not invest any additional funds. The junior lienor, however, is in no better position to protect himself than is the debtor. Either would have to invest additional funds to redeem or buy in at the sale. Equitable considerations favor placing this burden on the debtor, not only because it is his default that provokes the senior sale, but also because he has the benefit of his bargain with the junior lienor who, unlike the selling senior, might otherwise end up with nothing.” (Roseleaf Corp. v. Chierighino, supra, 59 Cal.2d at p. 41.). The leading texts on real property set forth the same principles. “The prohibition against a deficiency judgment does not apply to the beneficiary of a junior deed of trust whose security has been rendered valueless by a foreclosure sale of the property under a senior encumbrance. After the security has been lost by the foreclosure sale of the senior lien, the junior lienor can sue the debtor directly on the promissory note, which is then considered unsecured.” (4 Miller & Starr, Cal. Real Estate (2d ed. 1989) § 9:156, p. 531; see also 3 Witkin, Summary of Cal. Law (9th ed. 1987) Security Transactions in Real Property, § 159, pp. 658-659.)
Based on this case law one might conclude that any time there is a foreclosure sale, junior lien holders who had nothing to do with the foreclosure are free to collect from the debtor. And this blanket statement would hold were it not for Cal. Civ. Proc. Code § 580b.
B. Cal. Civ. Proc. Code § 580b
The key § 580b holding is from the California Supreme Court case, Brown v. Jenson, 41 Cal. 2d 193, 196-7 (Cal. 1953), where the court held (with emphasis added):
Section 580d goes further and provides that no judgment shall be rendered for any deficiency on a note secured by a trust deed where the property has been sold under the power of sale (as distinguished from a sale in a foreclosure action) contained in the trust deed. . . . Next comes section 580b, supra, here involved, which deals with a special type of security transaction, a trust deed, given to secure to the vendor of property the purchase price agreed to be paid by the vendee. That section is necessarily intended to provide a protection for the trustor because if it were intended to cover only the situation where there has been an actual sale of the security under the power of sale in the trust deed, it would be superfluous. Section 580d covers precisely that situation in all trust deeds, whether purchase money or otherwise. The broad protection provision (Code Civ. Proc., 580b) for purchase money trust deeds stands on a reasonable footing. A purchase money trust deed is not like an ordinary trust deed and note upon which only one action may be brought under section 726. Under section 726, as above stated, it is held that whether there is a security is determined as of the time the action is commenced and if the security is lost or has become valueless, an action on the note will lie because the events which caused it to become valueless were beyond the control of the trustor and were not contemplated at the time the money was loaned and the trust deed given. With purchase money trust deeds, however, the character of the transaction must necessarily be determined at the time the trust deed is executed. Its nature is then fixed for all time and as so fixed no deficiency judgment may be obtained regardless of whether the security later becomes valueless.
Thus, if the second mortgage is a purchase money debt, then after the sale the holder of that second mortgage cannot attempt to collect any post-resale deficiency, even though it had nothing to do with the sale.
In summary, if you have two mortgages on your home, with two different lenders, then if the first sells the house in a foreclosure sale and comes up short, it cannot sue you to collect the post-resale deficiency. Instead, it will report the loss to the taxing authorities, and you might face a tax liability on the cancelled debt.
The second mortgage holder is still free to collect its shortfall from you if the second was a refinance. However, if the second was a loan you took out for the original purchase of the home, then it too is barred from going after you, so it will report the loss to the taxing authorities.
If you are facing a foreclosure sale, you may wish to file for bankruptcy protection before the sale takes place. This will avoid the potentially nasty tax consequences. If you already lost the home in foreclosure and you have the second coming after you to collect on the refinanced loan, you should consider using bankruptcy to get rid of that liability.
But don’t go it alone. This is a complicated area of law. Retain the services of a good bankruptcy attorney to help you navigate these tricky waters.