Deficiency Judgment Ban After Short Sales (SB 931)

This bill requires the holder of a first mortgage or deed of trust that is secured by residential real property to accept, as full payment, the proceeds of a short sale to which it agrees in writing, and obligates that note holder to fully discharge the remaining amount of the borrower's indebtedness on the deed of trust or mortgage following the sale. Assembly Amendments specify the bill does not apply if the trustor or mortgagor is a corporation of political subdivision of the state.

Existing law is as follows:

1. Prohibits a lender from using pursuing a borrower for a deficiency judgment on a purchase money mortgage or deed of trust that is secured by single-family residential real property (Code of Civil Procedure 580b). Note: There are some disagreements among legal professionals about the circumstances under which the purchase money protection provided by CCP 580b applies. However, it is generally believed to provide protection to a purchase money note that becomes the subject of a judicial or nonjudicial foreclosure action or a short sale.

2. Prohibits a lender from pursuing a borrower for a deficiency judgment on a note on which that lender exercised its power of sale through the nonjudicial foreclosure process (Code of Civil Procedure 580d). Note: There are some disagreements among legal professionals about whether this statute additionally applies to notes that become the subject of a judicial foreclosure.

3. Defines a deficiency judgment as a personal judgment against a debtor for a recovery of secured debt, measured by the difference between the debt and the net proceeds received from a foreclosure sale (case law).

4. Defines waste, in the context in which it is used in this bill, as any unlawful act or omission, by the tenant or other person in possession of land, that causes a permanent injury to the inheritance, by injuriously affecting the market value of the property. There must be a permanent diminishment or depreciation in the value of the property for waste to have occurred (case law).

5. Prohibits any person whose interest is subject to the lien of a mortgage from performing any act that will substantially impair the mortgagee's security.

New law is as follows:

1. Provides that no judgment shall be rendered for any deficiency under a note secured by a first deed of trust or first mortgage for a dwelling of not more than four units, in any case in which the trustor or mortgagor (i.e., the borrower) sells the dwelling for less than the remaining amount of the indebtedness due at the time of sale, with the written consent of the holder of the first deed of trust or first mortgage.

2. Provides that written consent of the holder of the first deed of trust or first mortgage to that short sale obligates that holder to accept the sale proceeds as full payment, and to fully discharge the remaining amount of the indebtedness on the first mortgage or deed of trust.

3. Provides this bill does not limit the ability of the holder of a first deed of trust or first mortgage to seek damages or use existing rights and remedies against the trustor or mortgagor or a third party, if the trustor or mortgagor commits fraud, with respect to the sale of, or waste, with respect to, the real property that secures the first deed of trust or first mortgage.

4. Provides this bill does not apply if the trustor or mortgagor is a corporation of political subdivision of the state.
Background on the Bill:

A short sale is a real estate transaction in which a lender allows a borrower to sell his or her home for less than the full amount the borrower owes on their mortgage. For example: John owes his mortgage lender $275,000. John's mortgage lender agrees to let John sell his house for $225,000, with the understanding that the lender receives all of the proceeds from the house sale. John avoids foreclosure. John's lender loses out on $50,000 in principal to which it was entitled under the provisions of John's mortgage, but the lender avoids the costs of foreclosure, and has one less bank-owned property on its hands.

Short sales have begun to increase in popularity among both lenders and borrowers, since California's mortgage troubles first became apparent in early 2007. According to the California Association of Realtors, there were approximately 90,000 short sales in California during 2009, up from only a few thousand in 2008, and a negligible amount in 2007.

Some of the advantages of short sales are summarized above. One of the other key advantages: negative equity is wiped out. The new property owner is not saddled with a mortgage worth far more than the house; if the new owner even holds a mortgage (some short sales are paid fully in cash), the size of that mortgage is in line with the fair market value of the property.

However, as short sales have become more popular, lenders have become more creative in what they require from borrowers, as a condition of agreeing to the short sale. Several lenders are now requiring borrowers to agree that the lender may pursue them for the difference between the sales price of their home and their unpaid mortgage balance (to agree, in other words, to a sort of hybrid short sale, where the lender temporarily agrees to accept less than the amount they are owed on the mortgage, but reserves the right to pursue that borrower for the full amount at some point in the future).

California Code of Civil Procedure Section 580b and case law provide that original, purchase money loans are non-recourse. A non-recourse loan is one on which the borrower is not personally liable. If the borrower defaults on a non-recourse loan, the lender can seize the collateral securing the note, but the lender's recovery is limited to the collateral. If the value of the collateral is insufficient to cover the outstanding loan balance, the difference between the value of the collateral and the unpaid principal balance of the loan becomes a loss for the lender.

Some borrowers (particularly those who purchased homes during the boom years of the early to mid 2000s) took out both a first mortgage and a second mortgage when they purchased their homes. If both loans were taken out at the time of purchase, both are purchase money loans, and both are considered non-recourse.

Refinanced loans are typically recourse in nature (the one exception is a scenario in which the borrower refinances a purchase money loan with the same lender and takes out no additional money, other than money to pay closing costs). Thus, in most cases, if a borrower refinances one or more of their purchase money loans, the refinanced mortgage(s) are considered recourse loans. Recourse loans give the lender the right to pursue a debtor's personal assets, to collect the unpaid principal balance of the loan.

California also has what is known as the "one form of action rule," which is found in Section 726(a) of the Code of Civil Procedure. The one form of action rule is complex and embodies a variety of related, but distinct rules and principals, all of which have been litigated. However, for purposes of explaining the impact of this bill, the one form of action rule may generally (and simply) be described as follows. Under the one form of action rule, a lender may take only one action to collect on a mortgage or deed of trust. Thus, if a lender chooses to foreclose, that lender may not pursue the borrower in court to collect the difference between the foreclosure price and the loan amount; the lender's "one form of action" was foreclosure.

According to the Housing Opportunities Collaborative, many real estate licensees who assist homeowners with short sales are not fully aware of how the various scenarios work, and some short sellers are likely to be surprised in years to come, when collection agencies and attorneys attempt to collect or obtain judgments corresponding to the personal liability the short sellers incurred. The Housing Opportunities Collaborative asserts that short sales prevent the vacancies that often follow foreclosures, keep the real estate market moving, and save banks millions in foreclosure costs and costs associated with REO properties. They also observe that on several occasions, homeowners with non-purchase money loans have been surprised and torn by the financial outcomes that can result from a short sale. After learning of these outcomes, "many decide that a short sale just isn't the smart decision."
 
It is highly recommended that you enlist the services of a professional to perform negotiations on your behalf, and always remember a short sale isn’t for everyone. Situations will vary with each borrower, and each loan.