Last year, in response to the current economic crisis and its ramifications for homeowners who owe more on their mortgage than their homes are worth, California enacted Civil Code ("CC") Section 580(e). This statute extinguishes the right of a junior lienholder who agrees to a short sale to pursue the obligor for a deficiency judgments, if the real property collateral is a one to four unit family dwelling. Prior to this time, the effect of a short sale on a junior lienholder was the same as a nonjudicial foreclosure by a senior lienholder: the junior liens were wiped out and the junior lienholder was able to sue the obligor on the obligation, which was now deemed to be unsecured.
Pursuant to CC §580(e), if a junior lienholder agrees to a short sale, its rights to pursue a deficiency are now terminated, regardless whether or not there is additional collateral in addition to the one-to-four family dwelling. Consequently, any junior lienholder that consents to a short sale, no longer has any further recourse against an individual obligor, other than disposition of its other collateral. Such action could operate as a release of the guaranty of the SBA loan, thus jeopardizing the SBA guaranty.
It is important to note, however, that this statute does not apply when the trustor or guarantor on the deed of trust is a corporation, limited liability company, limited partnership, or political subdivision of the state. The statute is also inapplicable if the grantor engaged in fraud or waste with respect to the real property. However, even if the new law is inapplicable, Lenders must keep in mind that if it wishes to pursue a deficiency judgment, it will be bound by California's one-action rule under California Code of Civil Procedure ("CCP") Section 726 which requires a judicial sale to occur.
While CC §2856 allows other California anti-deficiency statutes to be waived by a guarantor, CC §580(e) specifically states this protection cannot be waived because of the public policy goals it serves. California legislators clearly enacted CC §580(e) as the direct recent result of the increase in short sales due to the collapse of the real estate market. Prior to its enactment, despite a senior lender reaching an agreement with the borrower, junior lienholders could release their deed for nominal consideration and still pursue the obligor. No longer. This statute's implications for guarantees secured by residential properties not purchased with the loan proceeds is therefore unclear, and no case law has yet addressed this specific issue.
What are the ramifications of this law on SBA Loans secured by residential real property of four units or less? The most likely scenario where this statute would come into play is when an individual guarantor has pledged his/her residence to secure the personal guaranty.
Technically, given the purpose for the enactment of this statute, an agreement by a junior lienholder to release its lien on the guarantor's residence should not trigger the provisions of this anti-deficiency statute because the loan funds were not used to purchase the residential property.
This does not mean, however, that a guarantor will not raise this statute as an affirmative defense if the lender seeks a personal judgment after it agreed to a short sale. In times where loan defaults increase and lenders commence collection actions, guarantors often raise new and novel affirmative defenses. How a court would interpret this statute given the public policy reason for its enactment is unclear. Because there is no case law to date, in the event this situation arises (an individual's guarantee is secured by a residential property and the lender is in a junior position), the safest course for a lender to refuse to consent to a short sale, thereby requiring the senior lender to foreclose. The guaranty then becomes an unsecured debt on which the guarantor can be sued in the event of a default. If the loan itself is current, no action against the guarantor would need to be taken, even if a nonjudicial foreclosure occurs by a senior lienholder on the residential collateral. If the loan subsequently goes into default, the lender would have the right to sue the guarantor directly for breach of guaranty and obtain a personal money judgment. Additionally, there would be no impact on the lender's ability to pursue the borrower and collateral which secure the note itself.
What is a lender's best course of action at this time? If a guarantor is an individual whose guaranty is secured by his/her personal residence, the best course of action for the lender at this time is to not consent to any short sale. If a senior lender nonjudicially forecloses, the lender whose junior lien has been wiped out can generally still pursue the guarantor under California law. If a junior lender refuses to consent to a short sale, unless the purchasing party is willing to take the property subject to the junior deeds of trust, the short sale cannot be completed. A lender cannot be compelled to agree to a short sale.
For more information on protecting your SBA guaranty in the face of a California short sale, please contact Camilla at (215) 542-7070 or at CAndrews@StarfieldSmith.com.
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