On September 25, 2015, the North Carolina Supreme Court ruled in High Point Bank and Trust Company v. Highmark Properties, LLC. The long-awaited decision affirmed the enlarged the statutory application of §45-21.36 in three significant ways. More on that below. But first, how we got here.
In 1933, the North Carolina legislature in reaction to the Great Depression enacted certain defenses against alleged abuses by lenders exercising remedies under mortgages and against guarantors and sureties. Protection was accorded a purchase money debtor under a purchase money mortgage given to its Seller. This statute was codified by the legislature as NC Gen. Stat. §45-21.38. The 1993 legislature also enacted NC Gen. Stat. §45-21.36 which applies when a lender forecloses on a deed of trust given to secure the indebtedness and subsequently sues the borrower for a deficiency.
The Supreme Court of North Carolina has consistently given broad interpretation in favor of the purchase money anti-deficiency law expressed under §45-21.38, but that law is narrow in its application to the seller of property who receives a purchase money deed of trust to secure a portion of the purchase price from its buyer and does not have wide application in the lending community except when REO is sold and financed.
The other depression era statute: NC Gen. Stat. §45-21.36 was for many years a thought to afford a defense or offset only to the borrower because of the seeming limitation by the 1933 legislature in framing the defense or offset to “the mortgagor, trustor or other maker of any such obligation whose property has been so purchased” (by the lender at the foreclosure sale). The statute in such situation afforded the borrower a defense in a deficiency action to show “as a matter of defense and offset, but not by way of counterclaim, that the property sold was fairly worth the amount of the debt secured by it at the time and place of the sale or that the amount bid was substantially less than its true value, and, upon such showing, to defeat or offset any deficiency against him”.
A plain reading of the words of limitation has persuaded most legal scholars that the application of NC Gen. Stat. §45-21.36 was not available to guarantors and suretys who provided additional security for the loan to a lender because such parties were not “makers” of the debt and were not the parties “whose property has been so purchased” at the foreclosure sale. Certain opinions of the North Carolina Court of Appeals had denied the right of guarantors to assert §45-21.36 as a defense against enforcement of the guaranty for a deficiency arising out of the sale of the security property in which the lender was the high bidder.
However, a careful reading of the North Carolina Supreme Court’s holdings in the application of NC Gen. Stat. §45-21.38 might have signaled that the Supreme Court, given the right facts, might extend the depression era legislative protection to guarantors. In a 1938 case, the Supreme Court had opined that a guarantor could assert the protection afforded the maker of the purchase money deed of trust even though the statute did not refer to a guarantor.
The right facts have now found their way their way to the North Carolina Supreme Court and it has arguably significantly broadened the reach of the depression era anti-deficiency statute to guarantors and surety’s.
In High Point Bank and Trust Company v. Highmark Properties, LLC, the facts were as follows:
- The Bank made two loans in 2007 to a borrower secured by a first deed of trust on a parcel of property in Forsyth County and subsequently made a second loan secured by a deed of trust on an additional parcel.
- The loans were guaranteed by four individual members of the limited liability company debtor.
- In 2010, the debtor defaulted on the loans; the Bank sued the borrower and the guarantors on the two notes for an aggregate debt of roughly $4,900,000.
- Meanwhile, the Bank foreclosed on both deeds of trust and was the sole bidder at the sales. The proceeds of the foreclosure sales left a deficiency of approximately $2,500,000 on the first note and $720,000 on the second note.
- In its action on the two notes, the Bank sought judgment then decided to dismiss the borrower, presumably because the Bank was aware that the borrower would assert the statutory protection of §45-21.36 and defend on the basis that the sales had not brought what was the fair value of the two properties.
- The guarantors moved to join the borrower in the deficiency action and the trial court over the objection of the Bank, allowed the joinder.
- The trial court granted the Bank’s motion for summary judgment against the guarantors but left the issue open as to whether the property had been sold for substantially less than fair value.
- A jury decided that the properties had been sold for substantially less than fair market value and determined that the first note had been satisfied because the first parcel was worth at the time of the sale, more than the debt remaining due and the deficiency on the second note was reduced because the sale resulted in less than the fair market value of that property but still less than the total debt owed on the second note.
The Bank appealed to the Court of Appeals which departed from earlier decisions of that Court and affirmed the trial court in allowing the guarantors motion to join the borrower as a defendant and to assert §45-21.36 as a defense to the deficiency action.
The Supreme Court in a long awaited decision released on September 25, 2015, affirmed the Court of Appeals and enlarged the statutory application of §45-21.36 in three significant ways.
- First, the Court held the guarantors could join the borrower in a deficiency action and by doing so gain the borrower’s right to assert the defense as a maker of the note, but in addition the Court held that even if the guarantors did not join the borrower, the guarantors could assert in their own right the anti-deficiency defense because the guarantors were among the group who enjoy protection of the statute. This statement finds no basis from the statutory language, but was determined by the Court to be so because of the presumed intent of the depression era legislation.
- Second, the Court held that a waiver of the defense in the express language of the guaranty was not effective in that this equitable defense arising under the anti-deficiency statute was one in which public policy would be paramount. The upshot of this ruling is that all waivers of §45-21.36 either by the borrower or the guarantors are now totally ineffective. The court even stretched the ineffectiveness comment to forbearance agreements even though it had previously recognized a waiver in forbearance agreements of the federal statutory Equal Credit Opportunity Act. Again the court distinguished the two by saying that the Equal Credit Opportunity Act was a mere statutory provision while the anti-deficiency act was a public policy equitable measure to protect against in the Court’s words “overreaching lenders.
- Third, the Court equates the bid at the sale to fair market value by interpreting broadly the phrasing of the statute “substantially less than its true value” to mean that in the event the property at foreclosure sale brings less than the fair market value, the defense is available and accordingly, makes the question of whether the bid at the sale was less than the fair market value an issue for a trial. The Court of Appeals had struggled in several cases with the definition of “less than true value” but had not equated it to fair market value.
The Court based its decision on a mandate by the depression era legislature to “address specific instances of public vulnerability to lender overreach”. In 1933, the stock market had crashed, property values had plummeted and many borrowers had been caught in the financial morass and defaulted on loans; foreclosures were rampant and deficiency actions common. As a result, the North Carolina legislature reacted to populist pressure to protect the public from what was then perceived to be aggressive behavior of banks. Other state legislatures enacted similar measures to protect debtors.
Likewise, in the Great Recession spawned by the financial market collapse of 2008 and the bursting of the real estate bubble, both residential and commercial property values declined substantially in nearly all US markets. In a time of declining values, lenders whose loans are based upon certain percentage of appraised value can on a foreclosure sale experience a real loss. Lenders, who are risk adverse and whose judgment in making loans is subject to questioning by federal and state regulators and bank examiners, rely on the financial strength of guarantors to protect against that potential loss of value of real estate collateral.
The High Point Bank case in regard to the protection of a payment guarantor creates a significant dilemma for a lender in the real estate secured loan. The appellate court decisions allows a guarantor to get to the jury on the question of whether the foreclosure sale brought fair market value.
What is fair market value in a foreclosure context?
In a market where property values are declining fair market value is likely to be less, perhaps substantially less, than fair market value at the time of the loan, however, the lender seeking a deficiency in such circumstances will now be compelled to let a jury decide if the sale brought fair market value. Because the appellate courts of North Carolina have held an owner of real estate is a competent witness to testify as to value, guarantors can be expected to offer the testimony of a borrower that in the opinion of the borrower the property foreclosed was worth more than the debt at the time of the sale and thereby, if the jury concurs, reduce or eliminate the deficiency. This may be so even if the lender has expert appraisal witness testimony that the fair market value of the property was no more or was in fact less than the bid amount.
Lenders typically consult appraisers in the foreclosure of commercial properties and base their bid on the appraisers’ opinion, but can the lender deduct expenses of holding the property for a period after the sale including maintenance, taxes and insurance? Appraisers usually calculate the holding period during which a particular piece of property in a specific market is likely to be held before it could be sold and use that calculation in the determination of value.
During the Great Recession just passed, many lenders experienced long holding periods of REO before it could be sold and in many cases sold the REO for less than the amount bid at the sale. The Supreme Court’s opinion in the High Point Bank case has left open the question of is the lender entitled to reduce the bid amount by its holding cost and other expenses. Furthermore, recent opinions of the Court of Appeals have sanctioned the ability of the borrower to offer nothing more than an opinion that the property was worth more than the bid amount to defeat the lender’s motion for summary judgment on the issue of the amount of the deficiency.
What is the lending community to do?
Possible solutions need to be investigated in reaction to the High Point Bank case. Posed with the new reality that a borrower or guarantor can prolong any deficiency case and send the ultimate question to a decision by a jury of twelve on opinions of fair market value, the lender may want to look to other means to try to protect itself when it decides to make a real estate secured loan, particularly in a declining real estate market or where a specific security property for various reasons, may have declined in value.
The following suggestions may or may not in the context of the High Point Bank decision, absolve a lender from this dilemma.
- First, lenders must carefully evaluate the financial ability of the borrower and the guarantors to pay the debt if the collateral declines in value and the lender decides to abandon the collateral as a means of payment. Lenders must be prepared to sue directly on the note and the guaranty as opposed to foreclosing on the collateral and suing for a deficiency if there is a risk that the sale will result in less than fair market value. Some legal scholars have judged that the lender should pursue a judgment on the note and the guarantys and hold the collateral in reserve until it determines whether the judgment can be collected, however, the difficulty in that approach is the borrower may not maintain the collateral if it is fighting a judgment collection action. Furthermore, the borrower or the guarantors can defer any decision by conducting discovery in any suit on the note or the guarantys which will prolong that action for a significant period of time during which the collateral may decline even further in value.
- Second, in the event the ability to collect a judgment against the borrower and or guarantors is not feasible, then the lender must give more consideration to finding a bidder for the property at the sale so that the lender does not have to be the sole or high bidder. A third party or legitimate straw man bidder whose bid is the highest bid at the sale avoids the application of the anti-deficiency statute and establishes fair market value for the deficiency action without the ability of the borrower or the guarantors to attack the sale price. This is so because the Act only applies when the lender is the high bidder. Under the circumstances of a non-conclusive third party bid, the borrower and the guarantors cannot offer evidence that the bid was not fair market value.
- Third, a lenders inability to now rely on a waiver of the anti-deficiency law as a defense in a guaranty may need to look to the legislature to amend the depression era legislation. In many other states, depression era legislation has been abolished or replaced by a more modern approach to lending and the reality that property values like the stock market, go up and down. As we have seen in the last decade property values both residential and commercial, decline in bad markets and borrowers are just as guilty of speculating on property values as lenders are guilty of making bad decisions on whether to lend to a particular borrower or assess a guarantors ability to pay in the event of default. The statute could be amended to make clear that its application excludes guarantors from the property value question or establish a quantitative methodology for determining fair value (which may not be fair market value) of a property sold at foreclosure taking into account the holding period cost and other costs prior to the anticipated sale of the REO.
- Lastly, lenders must look more carefully at alternative dispute resolution. Many lenders have chosen to include in their loan documents a mandatory arbitration clause. Courts have upheld mandatory arbitration clauses and lenders may consider whether it is better to place the decision of a deficiency in the hands of an arbitrator rather than a jury of twelve, many who may not be familiar with property values or the methodology of determining property values, to determine whether the borrower or a guarantor is allowed an offset or defense to the foreclosure sale bid. This will require in the case of many loan documents and guarantys revisions of the remedies sections of such instruments.