In late 2010 the California Legislature adopted, and the Governor signed, a bill creating Section 580e of the Code of Civil Procedure. This new section provided essentially that when a holder of a first deed of trust encumbering a 1–4 unit dwelling approves a short sale that is paid according to its terms then the holder (beneficiary) cannot subsequently pursue any form of deficiency liability against the borrower except in limited exceptions (which will be discussed below).
Last month the Legislature approved SB 458 (SB stands for “Senate Bill”). The Governor signed it as an “urgency measure” on July 11. It was filed with the Secretary of State on July 15, 2011. Most laws are effective on January 1 in the year after they are adopted. An urgency measure requires a super-majority vote and goes into effect immediately. Hence, it is currently effective for all short sales that meet its criteria. (Registered readers can receive a PDF copy of the official version of the new law by opening the preceding article.)
The new law expands the applicable rule to holders of notes secured by deed of trust or mortgage solely encumbering a 1–4 unit dwelling regardless of the priority of the deed of trust or mortgage (the “lien”). Therefore, it applies to second, third and subsequent deeds of trust, including HELOC’s (home equity lines of credit). It does NOT apply if the borrower (technically the trustor or mortgagor) is a corporation, limited liability company, limited partnership or political subdivision of the state, nor to deeds of trust securing bonds, such as public utility bonds.
Prior to 2011 a primary anti-deficiency rule applied primarily to purchase money deeds of trusts encumbering 1–4 unit dwellings that were occupied by the borrower (at least at the origination of the loan). The broader new law applied to vacation homes, rental properties, cash-out refinances, and HELOC’s, among others. It also does not fully apply when one loan is secured by more than one parcel of property, what is often called a cross-collateralized loan.
A short sale works only when all lien holders approve; otherwise, the non-approving lien(s) remains against the property in the full amount of the balance of the applicable debt. For practical purposes, this does not happen. The short sale is only complete, and the new law only applies, when title “has been voluntarily transferred to a buyer by grant deed or by other document of conveyance that has been recorded . . .” There must have been written consent by the holder of the note for which the procees of sale have been tendered to the note beneficiaries in accordance with the parties’ agreement (the short payoff letter terms).
The primary benefit of the expanded law is that, “No deficiency shall be owed or collected, and no deficiency judgment shall be requested or rendered for any deficiency upon a note secured solely by a deed of trust . . .”
In addition, the law provides that a holder of a note shall not require the borrower “to pay any additional compensation, aside from the proceeds of the sale, in exchange for the written consent of the sale.” Hence, new notes from the borrower and “seller contribution” payments cannot be required.
Finally, any purported waiver “shall be void and against public policy.” So even if a lender gets a borrower to sign a waiver of the new law, that waiver is void and cannot be enforced.
The new law does not apply if the borrower commits fraud with respect to the short sale. Essentially, if the borrower/seller lies on their short sale application, then their short sale is subject to the laws applicable without this statute. Therefore, a “strategic default” application apparently must disclose the intentional nature of the breach and cannot argue a false hardship.
Another exception applies if the borrower commits waste with respect to the property. “Waste” is essentially intentional or grossly negligent damage to the property. So the seller/borrower cannot rip out appliances, smash windows or holes in walls, ignore leaking roofs, pour cement down the toilets, or similar damages to the property. In those cases, the “holder of the deed of trust or mortgage” is not limited in their ability to seek damages against the borrower. (Ordinarily, the references are to a “holder” of the promissory note who is the “beneficiary” of the deed of trust. It will be interesting to see if any talented litigation attorney can exploit this phrasing.)
Unexpected Benefit or Cancellation?
As an urgency measure, SB 458 applies immediately. This means that outstanding short sale approvals are subject to the new law. If the lenders do not respond otherwise, an existing short sale approval which requires the seller to contribute cash in addition to sale proceeds or to execute a promissory note for all or part of the short sale cannot have those terms enforced. However, the non-deficiency provision is subject to a sale “in accordance with the written consent” of the lender. By not making the cash contribution or nor submitting the promissory note, the terms of the written consent have not been met and the new law does not appear to apply.
If the junior lien holder did not require a cash contribution or a promissory note, then no deficiency applies – which may not be what the junior lien holder intended. In those cases, the borrower enjoys an unexpected benefit. If the lien holder realizes this before closing, the lien holder might withdraw or cancel the approval and then demand higher payment since it’s potential for a deficiency judgment is gone.
Primary Unintended Consequence
All the commentators who thought they were enjoying a “happy dance” might find that they were actually doing a “rain dance” and the banks will rain on their parade. The published committee reports say that the banking industry supported SB 458. That implies that they don’t expect the new law to impact their returns. How could that be?
A short sale requires the approval of all lien holders. Otherwise, the non-approving lien holder will not release their mortgage against the property and the transaction fails because the buyer is understandably unwilling to close.
For example, let’s assume a property with a $400,000 first deed of trust from a cash out re-fi and a $150,000 HELOC secured by a second deed of trust for a property that would sell in a non-distress sale for $400,000 as if it was free and clear. Under pre-2011 law, the seller could be subject to deficiency liability from both loans.
Let’s assume a very small distress sale discount of 10%. The market would be willing to pay $360,000 (90% of $400,000). Let’s assume the first lien holder approves closing costs and commissions totaling 7% or $25,200 and a $4,500 payment to the second (who would get nothing in a foreclosure) based on the lower of $5,000 or 3% of the loan. This leaves the first with $330,300 net proceeds on a $400,000 note. The first would be getting 82.575% of their note balance, which is probably enough for them to release the seller from deficiency liability in advance.
However, the holder of the HELOC refuses to approve the short sale without some combination of cash and note for $15,000 (10%) in order to release it’s lien or of $22,500 (15%) to also release liability. Now the first counter-offers by saying it will allow a $5,000 payment and not object to a $10,000 note. The seller is thinking they won’t approve a mere release of lien and can’t pay the extra $7,500. The buyer decides he is willing to contribute $7,500 toward the settlement since the gross outlay would be $367,500 for a property that should carry a non-distressed price of $400,000 and a deal is assembled in which the seller has all deficiency waived due to creative structuring, while agreeing to only a $10,000 future liability.
Now, fast forward to the adoption of SB 458 and the newly amended version of CCP 580e. The first trust deed holder approves a $360,000 sales price, 7% combined closing costs and commission, with a $4,500 payment to the second. The second demands $22,500 because that’s it’s 15% threshold to release a borrower from liability.
This increase can now only be accomplished by the first trust deed holder accepting net proceeds because the new law prohibits the seller giving the note to the second and the buyer from making a contribution to the second. However, the first is unwilling to accept only $312,300, which is only 78.075% of its note balance – an level which fails to meet the note holders standards for releasing a borrower from liability.
At this point, the first trust deed holder estimates that they could get close to $312,300, which represents about a 22% discount off the estimated market price of $400,000 – an amount which is in line with the foreclosure auction discount rate – AND still have the seller on the hook for the deficiency.
The new result of this hypothetical is that the short sale fails, the property goes to foreclosure, and the seller is subject to the risks of deficiency liability for BOTH the shortfall of the first deed of trust loan and the full amount of the HELOC.
The new law has put the hypothetical seller in a far worse position and caused a foreclosure that would have been avoided under present law.
I think the adoption of SB 458 as an urgency measure which became effective immediately, without time for the market planning to absorb its impact will have two unintended consequences:
1. Pending short sale approvals in which a junior lien holder had agreed to the short sale subject to an additional cash payment or a promissory note may very likely be withdrawn and new terms must be negotiated. The new dynamics may result in those short sales converting to foreclosures.
2. New and ongoing short sale negotiations in which a junior lien holder holds a higher value note, such as more than $50,000, will be less likely to approve short sales because they will be unable to meet their liability waiver thresholds via the low level of payments approved by the first trust deed holder. This will force the first to foreclose, resulting in the borrower’s potential deficiency liability for both the first and the second.
Maybe the banking industry supported SB 458 because it saw it as a way to reopen access to deficiency liability on the first deeds of trust in these scenarios where that door had been closed by the earlier version of CCP 580e . . . ??
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