Second District Rejects Borrower’s Argument That Contractual Fees Incurred by Lender Are Excluded from Deficiency Calculation.
In this time of subprime lending fallout and rising foreclosures, judicial foreclosures are making a comeback, as they typically do when market values plunge. Lenders on commercial and investment residential projects frequently opt to pursue a deficiency if the loan indebtedness is substantially higher than the market value of the underlying real estate collateral. Are attorney’s fees awardable after a fair value hearing that results in a determination that the market value of the property was higher than the underlying loan indebtedness but where a deficiency existed when attorney’s fees were added to the loan debt total? The next case we consider answers this question with a resounding “yes.”
First, a short primer on judicial foreclosure actions. Except where the lender opts for a nonjudicial foreclosure (trustee’s sale) or where a purchase money loan in involved, a creditor secured by California real estate can bring a judicial foreclosure action to have the court declare the loan in default, order the real estate sold at a sheriff’s sale to satisfy the loan balance, and then enter a deficiency judgment after sale (with the deficiency being the differential between the fair market value of the property and the loan indebtedness). The focal point of this post is whether attorney’s fees are added to the loan indebtedness for purposes of calculating the ultimate “deficiency.”
In First Federal Bank of California v. Blanchard, Case No. B136268 (2d Dist., Div. 7 Oct. 3, 2001) (unpublished), a Second District, Division Seven panel concluded that the fees are added to the loan indebtedness as part of the deficiency calculus.
Borrower defaulted on a refinance loan on an investment property located in Venice, California. Both the note and trust deed had attorney’s fees clauses, with the trust deed expressly providing that attorney’s fees incurred would become additional secured indebtedness. Lender obtained a foreclosure decree and purchased the property by a partial credit bid of $560,000 (even though the loan indebtedness was well over $705,000 about a year earlier). At the fair value hearing, the judge accepted Borrower’s “high” market appraisal of $815,000, indicating that the Lenders’ attorney’s fees and costs would be added to the loan arrearage to determine if there was a deficiency. After two more years of legal maneuvering and a redemption by Borrower, Lender was eventually awarded $151,296.90 in fees and Borrower was awarded a $12,791.11 offset. The court then entered a final judgment in Lender’s favor of $81,477.51, consisting of the difference between the foreclosure sale loan arrearage ($757,971.72) plus attorney’s fees ($151,296.90) less the $12,791.11 offset and the $815,000 fair value credit.
Borrower appealed, and lost.
The Blanchard panel rejected Borrower’s main argument that attorney’s fees and costs are excluded from the debt for purposes of calculating the deficiency. Code of Civil Procedure section 726(b) provides that the deficiency is “the amount by which the amount of the indebtedness with interest and costs of levy and sale and of action exceeds the fair value of the real property …sold as of the date of sale.” The Court of Appeal held that “[t]he statutory inclusion of “costs … of action” with the amount of the indebtedness, we conclude, necessarily refers to the costs of the lawsuit that is a requisite part of the judicial foreclosure process.” The justices also found that this result was proper under Civil Code section 1717 and the trust deed “additional indebtedness” provision, with any other conclusion tantamount “to re-writing both the statute and the parties’ written agreements.” The panel found no fault with the arithmetic of the lower court, finding that the loan indebtedness (inclusive of the fee award) outstripped the fair value determination.
Borrower’s final argument was that the trial court failed to make into account “equitable considerations” that should have warranted a “no fee” award. The appellate court did not find the pleas to equity persuasive in nature. Even though Borrower argued that it was unconscionable to allow Lender a possible “double recovery” in the event the debtor did not contest a low appraisal at the fair value hearing stage, the Second District panel found that the judicial foreclosure protections—the fair value offset and redemption rights—more than compensate for any theoretical fairness. (Also, this argument seemed somewhat misplaced given that Borrower won the fair value appraisal battle, showing the protections indeed work out in the debtor’s favor in the right circumstances.) Borrower further argued that Lender’s failure to accept a deed in lieu of foreclosure at a much earlier junction of the litigation meant that the bank could have achieved its objectives without the expenditure of substantial attorney’s fees. Maybe, said the appellate court, but Lender “had the statutory right to seek a deficiency, and it is only with the benefit of hindsight that its choice of remedies may appear debatable.” Borrower finally contended that Lender could continue to add attorney’s fees indefinitely after the sale without penalty. The appellate court nixed this potential harm by noting “[t]he debtor is fully protected by the requirement that fees must be reasonable, and are fixed by the court.”
Although this unpublished decision is not citable, its reasoning may aid debtors and creditors in evaluating the risks and expenses in engaging in a protracted judicial foreclosure action. We might add that Blanchard was authored by Justice Paul Boland, a fine jurist who unexpectedly passed away after a sudden illness in fall of last year.