NOTE: This article does not address foreclosure of residential real property with one to four units. Although many of the concepts described in this article apply to the foreclosure of residential real property, laws have been enacted to provide additional protections to homeowners and owners of residential property with one to four units. This article does not attempt to summarize the law that applies to residential property with one to four units.
Many of our clients are experienced bankers who know commercial real estate, but who had not been the officer assigned to loans in default – until recently. Other clients are experienced real estate workout professionals who are based outside of California and who have only heard tales of California’s dreaded “one form of action” and “anti-deficiency” rules. This article discusses the basic concepts underlying foreclosure of commercial real estate in California. In this article, and in others yet to come, we will discuss practical problems that must be handled by workout professionals assigned to collect troubled commercial real estate loans in California. We’ll provide tips from experts in how to approach and collect a troubled commercial real estate loan, and we’ll also explain what should not be done and why.
Because we are starting with the basics, let’s imagine a commercial real estate loan where the lender makes a loan to a company that is secured by commercial real estate. Payment of the loan is guarantied by the company’s owner.
What is the One Form of Action Rule (also known as the One Action Rule and the Single Action Rule)?
In California, a commercial real estate lender cannot waive the security and just file suit against the borrower. Instead, one of the aspects of California’s “one form of action” rule is that the lender must first collect the value of the security by foreclosing its deed of trust. The one form of action rule is also referred to as the “one action” rule or the “single action” rule.
There are two ways to foreclose in California. We commonly refer to them as judicial foreclosure and nonjudicial foreclosure. The one form of action rule requires the lender to pick one or the other. For instance, the lender cannot conduct a foreclosure sale and then sue the borrower for the deficiency because that would be “two” actions. As courts have invoked the one form of action rule over the years, it is very complex, but for our purposes, the one form of action rule means that the lender must choose whether to foreclose judicially or nonjudicially.
First Question: Will There Be a Deficiency?
Almost always, the decision to foreclose judicially or nonjudicially is based on whether there is any equity in the property, and if not, whether the borrower can respond to a deficiency judgment.
In California, if a lender chooses to conduct a nonjudicial foreclosure sale, the lender gives up its right to collect a deficiency from the borrower. Until the recent crash in real estate values, almost all foreclosures were nonjudicial because the lender could expect to be fully repaid by the sale of the property, so there was no deficiency.
Since 2007, real estate values have plummeted, and lenders who once thought they had an ample equity cushion now find themselves undersecured. They have been turning more and more to judicial foreclosure, which is the only way that a California real estate lender can preserve its right to a deficiency against the borrower.
So the first question a commercial real estate lender must answer is “will there be a deficiency?” Put simply, is the property worth enough to pay off the loan? If the answer is that there will be no deficiency, in almost all cases, the best move is to do a nonjudicial foreclosure.
Second Question: Can the Borrower Pay Off the Deficiency?
If the property is worth less than the debt, then the foreclosing lender must ask a second question: “Can the borrower pay off the deficiency?” As we will discuss further, the process to preserve a deficiency judgment in California is long, tedious and costly, so before traveling down that path, it is critical to know whether the borrower has enough assets to satisfy a deficiency judgment.
Many commercial real estate borrowers today are single purpose entities (“SPE”). For various business reasons, they own nothing but the real estate that secures the lender’s loan. In that situation, the answer is usually obvious, as the SPE has no other assets that could generate cash to satisfy a deficiency judgment. Usually, where an SPE is involved, the choice is simple: go nonjudicial.
How Does Nonjudicial Foreclosure Work in California?
Under California’s nonjudicial foreclosure law, three (3) months must pass after recording a Notice of Default before the creditor can instruct the Trustee to sell the property. After that time period has passed, California law requires only 20 days notice before the foreclosure sale takes place. Lenders often instruct the foreclosure company to give 25 days notice, as this is what IRS requires for a foreclosure to cut off any junior lien rights that IRS might have.
If the lender chooses to go forward with a nonjudicial foreclosure sale, the trustee will conduct an auction and sell the property to the highest bidder. The fall of the auctioneer’s hammer will cut off the lender’s right to obtain a deficiency against the borrower. A nonjudicial foreclosure sale is final and cuts off the borrower’s right of redemption. This means that as soon as the sale is over, a third party buyer has title free and clear of all the liens against the property that were junior to the deed of trust that was foreclosed.
The lender can credit bid at the foreclosure sale. I’ll be writing another piece on credit bidding and the strategy that lenders commonly follow.
How Does Judicial Foreclosure Work in California?
As the name implies, judicial foreclosure in California starts when the lender files a lawsuit against the borrower and asks the Court to order foreclosure. The Court will do so only after a trial, at which the lender must prove its right to collect the loan, prove that an event of default exists and establish the amount that is due and owing. If the lender wins the trial, the Court will issue a decree of foreclosure and appoint a person, usually a Receiver, to conduct the foreclosure.
As with nonjudicial foreclosure sales, a judicial foreclosure sale is an auction and the lender can credit bid.
After the property is sold, the lender returns to Court and asks the Court for a money judgment against the borrower in the sum that is the difference between the amount of the indebtedness (principal, interest, fees and costs) and the “fair value” of the property at the time of the sale. “Fair value” is not the sale price at the foreclosure sale. Instead, “fair value” is the amount that the Court finds after taking evidence of the value of the property at the date of sale. This means that a second trial must take place to establish the value of the property on the date of the sale. The lender will then obtain a judgment against the borrower and will be able to start collection efforts against other assets of the borrower.
There is one more wrinkle to judicial foreclosure in California. After a judicial foreclosure sale, the borrower gets a second bite of the apple to pay off the loan and get property back. This is called the “Redemption Period.” At any time within one year after a judicial foreclosure Sale, the borrower can pay off the loan and get the property back.
During the Redemption Period, the lender cannot sell the property to a third party free and clear of all liens. Instead, what usually occurs is that the Receiver who conducted the foreclosure sale continues to manage the property and a third party buyer that takes possession, does so with the understanding that it could be ousted if borrower redeems the property.
The process of judicial foreclosure is rare, slow and costly, and thanks to the Redemption Period, uncertain. It requires expensive expert testimony and multiple court hearings. Almost always, it should not be used unless the lender is certain that the borrower is capable of paying the deficiency and the likely amount of the deficiency is substantial.
Can the Lender Collect the Deficiency Against the Guarantors?
In most cases, however, California commercial real estate lenders can collect deficiencies against the guarantors of a secured loan, even after a nonjudicial foreclosure. Years ago, some California courts held that once a lender conducted a nonjudicial foreclosure sale, the lender was estopped (not allowed) to collect the deficiency against the guarantors because the lender had destroyed the right of redemption described above. Since then, California lenders have included waivers in their standard forms of guaranty, and in 1996, the Legislature added Section 2856 to the California Civil Code to formalize this practice. Section 2856 added “safe harbor” language that preserves a secured lender’s right to enforce a deficiency judgment against a guarantor after a nonjudicial foreclosure sale. Now, nearly all California form guaranties include the safe harbor language prescribed by Section 2856.
In the event the lender chooses to foreclose nonjudicially, there is case law authority that if the lender tenders the debt to the guarantors before the foreclosure sale, the lender’s rights to collect the deficiency are preserved, regardless of Section 2856. This is done by sending a letter to the guarantors before the Notice of Trustee’s Sale is given and recorded.
Lenders holding troubled commercial real estate loans in California face a number of strategic decisions at every step. Often, the decisions are easy and the means of enforcement is straightforward, but in these difficult economic times, we are seeing many deals that require thought and analysis right from the start. The JMBM Special Assets Team™ has the experience and track record that lenders need to provide the right counsel where troubled commercial real estate loans are involved. We’ve worked hand in glove with our lender clients over the years to develop a strategy for the successful recovery of troubled commercial real estate loans that are more complicated than usual. We’ve handled many judicial foreclosures over the years, and we can tell you from experience when to choose the judicial route and when to stick to the more common nonjudicial method.
This article just scratches the surface of the many twists and turns that might arise in dealing with problem commercial real estate loans. It is a subject that can fill many volumes, and of course, as we always say here in the Special Assets Lawyer Blog, general advice is no substitute for the considered analysis we give to each and every loan that our clients bring to us. In the future, we’ll be bringing you more practical, down to earth, articles that focus on particular aspects of commercial lending, including many strategic considerations a workout professional must address in collecting commercial real estate loans.
This is Dick Rogan, bank lawyer and author of www.SpecialAssetsLawyer.com, signing off for now. Join us again soon to check out what’s new in the World of Workouts.
Year after year, day after day, workout professionals in the know rely on JMBM’s Special Assets Team™ to handle problem commercial and real estate loans. Whatever problem loans you have, chances are, we’ve seen it. Give us a call.
Our Perspective. JMBM represents commercial banks, special servicers, private lenders, asset-based lenders, hard money lenders and factors. We help lender clients throughout the United States craft business and legal solutions to their commercial and real estate troubled loans. For more information, please contact Dick Rogan at RRogan@JMBM.com, or (415) 398-8080.
Richard A. Rogan is Chair of the JMBM Special Assets Team™. He also serves as the co-managing partner of JMBM’s San Francisco office and co-chair of its Bankruptcy Practice Group.
JMBM’s Special Assets Team™ has represented hundreds of lenders in California and throughout the United States. We regularly appear in bankruptcy courts, district courts and superior courts. We are proud to serve as trusted counsel and advisors who look for a business solution and try to help lenders find the best possible resolution for each troubled loan. Whether a loan is being newly documented, restructured or litigated, JMBM’s Special Assets Team™ has the skill, know-how and experience to solve your problem in a practical no-nonsense way.
NOTE TO CONSUMERS: As a matter of Firm policy, JMBM does not represent individual consumers who have disputes with their lenders. Many lenders have specialized consumer workout professionals who have the time to help consumer borrowers. There are many fine attorneys who specialize in representing consumers. Individuals with consumer lending problems should contact a lawyer or law firm who specializes in consumer insolvency and bankruptcy in their local area. When in doubt, we suggest you contact your local bar association’s Lawyer Referral Service. [For example, see Bar Association of SF or LA County Bar Association Lawyer Referral Services]
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