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Hotel Lawyer: California foreclosure traps for unwary lenders: California’s one action and anti-deficiency rules. What one top expert tells lenders about avoiding the pitfalls of foreclosing in California on hotels and other mixed collateral.

07 February 2010

Please see “troubled hotel loans – workouts, bankruptcies & receiverships” for the latest articles on troubled hotels.
Hotel Lawyer with tips for lenders on defaulted California mortgages. California now leads the nation in defaulted mortgages for hotels and commercial real estate. As lenders start to review their options, they must formulate asset plans that will avoid violating California’s tricky one action and anti-deficiency rules, or they may be in for some nasty surprises.


To help lenders avoid unnecessary pitfalls, we asked Guy Maisnik, one of the senior member of our real estate department and Global Hospitality Group® to help us review the essential principles that every lender should know. Guy is one of members of our deep bench who has been through every real estate downturn since the 1980s, and is used to helping lenders and investors maximize the value on billion dollar portfolios or one-off assets.

In Guy’s career, he has worked with lenders to advise on the restructuring and exercising of remedies. These clients include numerous banks, special services, opportunity funds and pension funds on the structuring and/or exercise of their remedies, such as GE Capital, Midland Loan Services, Helios AMC, HSH Nordbank, AG, HSBC, Wells Fargo Bank, BankAmerica, Morgan Stanley, Sumitomo Mitsui Bank, Colony Advisors, Loan Star, Archon Capital, CalPERS and Washington PERS. Such work involved analyzing and assisting in the successful bidding and purchase of loan/asset portfolios, from small portfolios to those exceeding a billion dollars, exercising remedies on the acquired loans, addressing complex workout and guaranties realization issues, addressing tranche disputes, restructuring capital requirements, structuring sales of the acquired loans/assets and addressing tax consequences of note holders to facilitate workout and disposition strategies.

Here is what he has to say. You may also find the rich library of materials on www.HotelLawBlog.com a valuable source of information on this and related subjects. At the top of the blog, check out the tab that says “Hotel Law Topic” and click on the one called “Workouts, Bankruptcies and Receiverships.
mgm@jmbm.comCalifornia foreclosure traps for unwary lenders:
California’s one action and anti-deficiency rules.

Avoiding the pitfalls of foreclosing in California
on hotels and other mixed collateral.

by Guy Maisnik

As hotels loan defaults soar, and California claims more than its share of troubled assets, it is a good time for a quick refresher on some of California’s unique rules that sometimes frustrate foreclosing lenders’ ability to accomplish their objectives.

So here is a quick review of California’s one action and anti-deficiency rules. California’s consumer-oriented laws and a pro-active judiciary often combine to produce some surprising results for real property secured transactions.

Even those of us who practice regularly in this area find that the principles of California commercial finance law can be contradictory, inconsistent and less predictable that we would like. It requires that lenders and their counsel be ever-vigilant for the trouble issues that might jeopardize recovery.

Remember, this is the state where a judge released a guarantor from its debt obligations because the judge did not like a perfectly well-drafted guaranty waiver (so now we have a new form of waiver . . .). This is also the state where a court found a bank’s violation of California’s one action released the security interest in the real property, and also made the debt uncollectible (and a later case sustained the first part of this decision releasing the real property security, and reversed the second part, holding the debt was not uncollectable). Welcome to the sunshine state!

Unless you are a lawyer and regularly work with California law on troubled assets, you will want to understand some essential rules to avoid falling into some dangerous — and unnecessary — traps.

California’s laws: In case you are an avid reader, who likes the details, California’s one action and anti-deficiency rules we discuss below are set forth in California Code of Civil Procedure (“CCP”) section 726, Civil Code (“CC”) sections 580a, 580b, 580d and California Commercial Code (“CCC”) section 9-604.

I.

One action rule

Foreclosures in California are subject to special statutory and judicially created rules. Lenders are well-advised to develop their strategies with these rules and pitfalls in mind. The learning curve is simply too steep and too expensive.

California enacted CCP§ 726, commonly called the “One Action Rule” (or sometimes the “One Form of Action Rule”), to prevent multiple actions when a creditor elects to sue a borrower on a debt secured by real property after the borrower has gone into default. The One Action Rule provides that “…there can be but one form of action for the recovery of any debt, or for the enforcement of any right secured by a mortgage on real property…” Thus, if a debt is secured by real property, the creditor must exhaust all real property collateral before seeking an action against the debtor. This means the creditor must bring a judicial or non-judicial foreclosure action first against the real property collateral. If there is a deficiency between the amount realized on a foreclosure sale and the outstanding debt, then action may be taken to pursue a deficiency judgment against the debtor, subject to the fair value limitations set forth in § 726 and to the limitations of §§ 580b and 580d. Security Pacific National Bank v. Wozab (“Wozab”), 51 Cal. 3d 991 (1990); Walker v. Community Bank, 10 Cal 3d 729, 733-34 (1974).

What is an “action”?

CCP § 22 defines “action” as “an ordinary proceeding in a court of justice by which one party prosecutes another for the declaration, enforcement or protection of a right…” This seems to be a simple enough definition. However, California courts have redefined “action” in an expansive and inconsistent manner. For example, The court in Bank of America v. Daily, 152 Cal. App. 3d 767 (1984), ruled that a bank’s setoff of the debtor’s deposits constituted an “action.” Yet, in Wozab, the California Supreme Court ruled that such a setoff was not an “action.”

Other judicial decisions continue to construe “action” so as to require the exhaustion of all real property security before seeking action directly against the debtor.

Fortunately, there are some limits to the bounds of judicial activism. For example, in Hatch v. Security-First Nat’l Bank, 19 Cal. 2d 254, 258 (1942), the court ruled that a trustee’s sale under a mortgage or deed of trust is not an “action” for purposes of the One Action Rule. And how about seeking appointment of a receiver? Is that an “action”? CCP §564(d) states that an action by a secured lender to appoint a receiver is not an “action” under § 726. Further, § 564(b)(11) states that the appointment of a receiver may be continued even after entry of a judgment for specific performance in that action, if appropriate to protect, operate, or maintain real property encumbered by the deed of trust or mortgage or to collect the rents therefrom while a pending non-judicial foreclosure under power of sale in the deed of trust or mortgage, is being completed.

As anyone knows who is familiar with Rule #1 of Hotels, hotels are more than just real estate. In fact, in any full service hotel, the operating business easily comprises more than half the value of the property. So the question is: does § 564(d)(11) apply to the collection of operating revenues from a hotel if appropriate to “protect, operate or maintain” the hotel pending non-judicial foreclosure? Arguably, revenues from hotel rooms can be construed as “rents.” But what about food service, gift shop proceeds, green fees and proceeds from other amenities? Again, while unclear, the application of § 564(d) to hotels ought to fall within § 564(d)(12), which includes any case “brought by an assignee under an assignment of leases, rents, issues, or profits pursuant to subdivision (g) of Section 2938 of the Civil Code.” More about this in the next article on this subject.

Can a creditor apply collected rents and revenue to the debt without violating § 726?

“No judgment shall be rendered for any deficiency upon a note secured by a deed of trust…in which the real property…has been sold by the…trustee under power of sale contained in the…deed of trust.”

Today, the answer should be ‘yes’ following decertification of Great American First Savings Bank v. Bayside Developers, 284 Cal. Rptr. 194 (1991), decertified 92 C.D.O.S. 2217 (Cal. 1992) (finding a receiver’s selling of condominium units and application of sales proceeds to the debt violated §726), and the Bayside decision in Resolution Trust Corporation v. Bayside Developers, 817 F.Supp. 822, (N.D. Cal. 1993), implicitly approving the application of sales proceeds to the debt before the trustee’s sale. However, the law remains on soft ground and counsel should proceed cautiously.

What happens if the creditor violates the One Action Rule?

Earlier case law (Bank of America v. Daily) held that the creditor’s violation applied to extinguish both the real property collateral and the debtor’s obligation. This was an extraordinarily punitive result, particularly since the main purpose behind the One Action Rule was primarily procedural, to prevent multiple actions, and compel exhaustion of all security before a deficiency judgment is entered and ensure that debtors are credited with the fair market value of the secured property before they are subjected to personal liability. However, the Supreme Court in Wozab, modified the earlier decision, holding that the violation of the One Action Rule did not extinguish underlying debt but did terminate the real property collateral interest.

How does California law address mixed collateral?

A hotel creditor typically has multiple forms of collateral such as real property, fixtures, furnishings and equipment and cash collateral? How does the One Action Rule work under these circumstances? Is the creditor required to foreclose on the real property first, even before taking cash collateral or other personal property?

California Commercial Code § 9604(a)(2)(A) provides a broad exception to the One Action Rule for personal property and fixtures included in a “unified sale” conducted under real property rules. Otherwise, the drafters of California’s “mixed collateral” statute clearly intended to insulate personal property collateral from compliance with real property provisions. There is no security-first requirement under California law with respect to personal property collateral. Further, CCP § 730.5 expressly states that except as otherwise provided by CCC § 9604, the anti-deficiency rules do not apply to any security interest in personal property or fixtures governed by the Commercial Code.

What if the creditor applies cash collateral to the debt?

Do payments from a collateralized cash account to a lender (either directly or from a receiver) who holds real property collateral violate the One Action Rule? In re Sunnymead,178 B.R. 809 (9th Cir. BAP 1995), the court found that the creditor’s acceptance of payments from the debtor did not constitute an “action” the “security-first rule.” The court BAP stated that the payments were “cash collateral” and that the lender had not sought “to collect against noncollateral general assets.”

II.

Judicial v. non-judicial foreclosure

The redemption period makes judicial foreclosure a clumsy remedy for lenders since the lender does not have right to possess the collateral after the judicial foreclosure until the redemption period has expired.

There are two ways for a creditor to foreclose on real property in California: judicial and non-judicial.

Judicial foreclosure is the process by which a creditor sues the debtor in court for foreclosure, and obtains a judgment for foreclosure against real property collateral and, presumably, obtains a personal judgment against the debtor for any deficiency amount. This process is usually time-consuming and expensive. Moreover, even after the judicial foreclosure sale, the debtor will retain a right to redeem the real property for a period of one year, frustrating any commercially reasonable sale for that period of redemption. CCP § 729.010.

The redemption period makes judicial foreclosure a clumsy remedy for lenders since the lender does not have right to possess the collateral after the judicial foreclosure until the redemption period has expired. In fact, in such cases the lender is forced to seek a receiver post-foreclosure under CC§ 564(b)(4) to possess the property and collect revenues during such period.

As a result, the preferred remedy for most lenders is typically non-judicial foreclosure. Non-judicial foreclosure is relatively fast and inexpensive, if uncontested. A non-judicial foreclosure is a public sale by the trustee identified in the deed of trust under the private power of sale clause contained in that deed of trust. The process is strictly governed by statute, taking approximately 120 days, unless delayed if the borrower contests the action in court, seeks delays and adjournments of sales
Typically, the lender will acquire the property at the trustee’s sale by credit bidding all or some portion of its secured debt. (There is an art to the credit bid, with potentially serious legal and business implications to the amount of the bid, but that is for another article on another day). The lender’s title is evidenced by a trustee’s deed upon sale.

This sale is final and results in the lender becoming the owner of the property free and clear of all junior liens. The counterbalancing consequences to a lender of a non-judicial sale is foregoing the right to seek a deficiency if proceeds from the trustee’s sale fails to cover the outstanding debt, as discussed below.

Regardless of proceeding with a judicial or non-judicial foreclosure, hotel lenders are cautioned to pay careful attention to whether a non-disturbance is in place with the hotel operator, requiring the lender to honor a hotel management agreement upon the lender’s taking of title. Depending upon the impact of that hotel management agreement to the value (positive or negative) of the hotel, lenders are well-advised to seek legal counsel to address issues concerning that hotel management agreement well before commencing and completing a foreclosure sale on the hotel.

Anti-deficiency rules

The One Action Rule and the anti-deficiency protections are supported by strong public policy, and, as a result, cannot be waived in advance by a borrower.

The main purpose of the anti-deficiency rules is to place the risk of overvaluation and inadequate security on lenders who stand to profit directly from the loans they make. The One Action Rule together with the fair value and anti-deficiency rules are designed to protect borrowers from being taken advantage of by lenders and require lenders to rely on property values. Thus, if the proceeds from the sale of real property are insufficient to cover the debt, the lender’s right to a deficiency judgment may be limited or barred under one or more of these statutes. This statutory scheme works against a creditor who wants to choose at its liberty, either to enforce a security interest through foreclosure, or avoid the anti-deficiency statutes and sue on the underlying debt.

CCP §580d — No deficiency after a non-judicial sale

“No judgment shall be rendered for any deficiency upon a note secured by a deed of trust…in which the real property…has been sold by the…trustee under power of sale contained in the…deed of trust.”

The law is designed to prevent a creditor from underbidding at a non-judicial foreclosure sale, thereby maximizing a deficiency to be recovered in later action. § 580d only refers to a “note” secured by mortgage or deed of trust. Thus, arguably, a deficiency judgment may be obtained after a non-judicial foreclosure sale where the obligation is evidenced by other than a note. However, California courts have applied § 580d even when a note was not involved (Willys of Marin v. Pierce, 140 Cal. App. 2d 826 (1956)).

Thus, the trade off for a lender who chooses to foreclose non-judicially on the property is surrendering any right to recover any deficiency from the debtor after a non-judicial foreclosure sale.

Unlike a judicial foreclosure which allows a lender to pursue a deficiency judgment against the debtor, a non-judicial foreclosure limits the lender’s recovery against the debtor to the value of the property.

A non-judicial sale does not, however, preclude the lender from foreclosing on other collateral, whether real or personal property, provided the lender has not credit bid (or received in the case of a third party purchase) the full amount of the debt at the foreclosure sale.

CCP § 580b: deficiency protection for purchase-money borrowers

CCP § 580b states: “No deficiency judgment shall lie…after a sale of real property…under a deed of trust…given to the vendor to secure payment of the balance of the purchase price of that real property….” Thus, CCP § 580b precludes a deficiency judgment after judicial or non-judicial foreclosure of a “purchase-money” deed of trust.

A few exceptions to § 580b

A foreclosed out junior purchase-money lienholder who subordinated it’s lien to a construction loan may be an exception to § 580b. Bad-faith wastes committed by a debtor may also be an exception. Cornelison v. Kornbluth, 15 Cal. 3d 590 (1975). The 9th Circuit found that wastes committed from a debtor’s economic hardship were not committed in bad faith, even though the debtor diverted the hotel funds to other uses. However, in another case where a debtor diverted funds instead of paying property taxes was found liable for bad faith wastes, and the court assessed compensatory and punitive damages against the debtor. Nippon Credit Bank Ltd., Los Angeles Agency v. 1333 North California Boulevard, 86 Cal. App. 4th 486 (2001).

Can borrowers validly waive the One Action Rule and Anti-deficiency rule protections?

The One Action Rule and the anti-deficiency protections are supported by strong public policy, and, as a result, cannot be waived in advance by a borrower. CC § 2953. Thus, contemporaneous waivers (contemporaneous with making the loan) of the California anti-deficiency statutes (CCP §§ 726, and CC 580a, 580b, and 580d) are generally prohibited both by statute on and public policy grounds. Some cases have discussed subsequent waivers of certain anti-deficiency statutes. Although it may be possible for these protections to be waived subsequent to the initial loan – typically in connection with a workout after an event of default, or in connection with a loan modification. The validity of such waivers have not been fully explored by the California courts. Many issues remain unanswered. Note, waivers of the protections of CC § 580b have so far not been permitted.

Can guarantors validly waive One Action Rule and Anti-deficiency rule protections?

These same public policy protections that benefit borrowers do not extend to guarantors. CC § 2856. Earlier case law has not been consistent as to what would constitute an effective guarantor waiver. Some courts allowed general guarantor waivers; others required very specific waivers. The California legislature clarified matters after the judicial decision in Cathay Bank v. Lee, 14 Cal. App. 4th 1533 (1993) by enacting (in 1994 and 1996) a specific statute which sets forth what would qualify as an effective waiver. See CC § 2856(c) and (d). Most guaranties quote this statute verbatim in the waiver sections of the guaranty.

Still, lenders should be remain cautious as California courts can and do find ways to protect guarantors. Bank of Southern California v Dombrow (ordered not published March 14, 1996; former opinion at 39 Cal. App. 4 th 1457 (1995) (court avoided awarding a deficiency judgment after the lender foreclosed on the real property security, stating the guarantor was entitled to a judicial hearing to determine the fair market value of the property as of the date of foreclosure, regardless of the amount bid at the foreclosure sale, and any judgment against the guarantor could not exceed the difference between the total amount of the debt and the greater of the foreclosure sale price or the fair market value of the property determined by the court).

Errant judicial decisions notwithstanding, and with few exceptions, a lender should be able to proceed against the guarantor independent of any action against the borrower, and the guarantor should not be able to hide behind the collateral and require a lender to pursue the collateral first. Still, with the complexities and unique structures presented in modern day real estate secured transaction
s (e.g., structured finance, CMBS market), there is little doubt the opportunity will continue to exist in California for further judicial interpretation and legislative refinement of California’s famous and complex real property secured transaction laws.

California foreclosures can be tricky for lenders, particularly for hotels and mixed collateral.

Foreclosures in California are subject to special statutory and judicially created rules. Lenders are well-advised to develop their strategies with these rules and pitfalls in mind. The learning curve is simply too steep and too expensive.

MGM.Photo.jpgGuy Maisnik is a partner and senior member of JMBM’s Global Hospitality Group®. Guy advises clients on hotel transactions, representing lenders, opportunity funds, banks, special servicers, owners, REITs and developers in hotel transactions, including senior and mezzanine financing, workout and debt restructure, co-lender, participation and securitization arrangements, joint ventures, management agreements, buying, selling and ground leasing of hotels, complex mixed used resort development, fractional and timeshare. For troubled hotels, Guy develops and executes strategies for CMBS and whole loans, and REOs. He also assists investors with recapitalization of distressed borrowers and purchases of troubled assets. Guy has recently assisted 3 major lenders in completely revising and structuring hotel lending programs and documentation, including a hotel construction lending. Guy’s practice is both domestic and foreign, where he has advised on hotel matters all throughout the United States, Mexico, Canada, South America, Caribbean, Europe and Asia. He has been recognized in California Real Estate Journal’s Best Real Estate Lawyers, Los Angeles magazine’s Top Southern California Lawyers, as well as a Top Real Estate Lawyer in Real Estate Southern California magazine. For more information, please contact Guy Maisnik at 310.201.3588 or mgm@jmbm.com.

This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We’ve done more than $60 billion of hotel transactions and have developed innovative solutions to unlock value from troubled hotel transactions. Who’s your hotel lawyer?

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Our Perspective. We represent hotel lenders, owners and investors. We have helped our clients find business and legal solutions for more than $60 billion of hotel transactions, involving more than 1,000 properties all over the world. For more information, please contact Jim Butler at jbutler@jmbm.com or 310.201.3526.

Jim Butler is a founding partner of JMBM and Chairman of its Global Hospitality Group®. Jim is one of the top hospitality attorneys in the world. GOOGLE “hotel lawyer” and you will see why.

JMBM’s troubled asset team has handled more than 1,000 receiverships and many complex insolvency issues. But Jim and his team are more than “just” great hotel lawyers. They are also hospitality consultants and business advisors. For example, they have developed some unique proprietary approaches to unlock value in underwater hotels that can benefit lenders, borrowers and investors. (GOOGLE “JMBM SAVE program”.)

Whether it is a troubled investment or new transaction, JMBM’s Global Hospitality Group® creates legal and business solutions for hotel owners and lenders. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them.