In California, deeds of trust are a common and generally effective means of securing debt and other payment obligations. While the “one form of action” requirement of Section 726 of the Code of Civil Procedure (with its judicially created corollary rule that a creditor must resort to its “security first”) and the anti-deficiency provision of Section 580d of the Code of Civil Procedure severely limit the enforcement options of a real estate secured creditor, the ease and efficiency of non-judicial foreclosure under California law seems a more than fair exchange for the loss of other remedies.

Yet this balance can tilt dramatically when the payment obligations secured are not readily susceptible to acceleration: that is, of being reduced to a single sum certain that can be enforced all at once. Use of real estate to secure non-accelerable or contingent, serial obligations, such as rent payments or indemnification obligations, can easily lead the creditor to a Hobson’s choice, between immediate enforcement of a currently due payment at the pain of forfeiting the balance of the secured obligation, or a long-delayed recovery of the whole.

The obvious solution to this problem—and to similar dilemmas where one deed of trust secures multiple obligations held by multiple creditors—would be to permit serial foreclosures, in which one undivided “layer” of the real estate collateral could be sold to recover amount(s) currently due without disturbing the lien on the whole property securing future payment obligations. As a matter of modern practice, though, this type of layered foreclosure never occurs and, from the lack of any attention paid to such a remedy, one can infer that most California practitioners regard it as impermissible (if they consider it all).  

In fact, precedents exist for exactly this kind of a partial foreclosure: old, but never rejected. There is also a long-ignored statute—Section 728 of the Code of Civil Procedure—that without great strain can be read to authorize layered foreclosures. This article reviews the arguments, legal and practical, for and against a contemporary revival of such a remedy, and shows how it could be usefully applied in situations involving modern structured real estate financings, where the mortgage debt is held by a Real Estate Mortgage Investment Conduit.

The Vanishing Security Interest

Non-lawyers—and lawyers unversed in the complexities of enforcing deeds of trust and mortgages—sometimes hit upon the idea of securing a non-accelerable set of payment obligations with real estate. In one instance, for example, the seller of a company retained ownership of the company’s manufacturing site and after the sale the company leased the property from the seller. Wanting something more than just a landlord’s remedies for breach of lease, the seller insisted that the buyer pledge other real estate as security for rent payments. What the seller and his counsel failed to consider was that, under California (and most other state) laws, a landlord cannot accelerate a tenant’s rent obligation. Under the statutory provisions governing enforcement of California deeds of trust, were the tenant to stop paying rent or otherwise default in a payment obligation under the lease, the landlord would appear to have three legal alternatives, which might be properly called “worst, worse and bad.”

Immediate Foreclosure on Breach by Tenant

Plainly the worst alternative would be for the landlord to seek prompt and (relatively) cheap relief, through a trustee’s sale of the real property collateral under California Civil Code Section 2924. After the so-called non-judicial foreclosure sale has occurred, the tenant (or, more likely, a related party) could purchase the property by paying the delinquent rent installment, plus interests and foreclosure costs. The deed of trust has now been discharged, leaving future rent payments unsecured. But that is the lesser part of the disastrous result. Under Section 580d of the California Civil Code, the seller, having foreclosed non-judicially, is barred from bringing any further action to collect rent; Section 726 of the California Code of Civil Procedure—the “one action rule”—will probably bar any other action (such as unlawful detainer) to enforce the lease. The tenant, at the cost of a few months’ rent and foreclosure expenses, also has obtained a rent-free lease of the property for the rest of the lease term.

Foreclosure on Expiration of Lease

The second alternative—waiting until the lease expires to foreclose—does not lead to such a disastrous result, but for a long-term lease it may mean years in which when the landlord is unable to collect rent. Having secured the rent obligation with real property, the landlord is barred by Section 726 from bringing any action on the obligation other than a suit for foreclosure and, thus, has cut himself off from other legal remedies, such as a breach of contract action to recover rent. And even though a judicial foreclosure (as opposed to a non-judicial trustee’s sale) does not trigger Civil Code Section 580d, unless the property lends itself to piecemeal foreclosure (see discussion of Civil Procedure Code Section 726, below), it will preclude the landlord from bringing any further action on the rent payment obligation, which is why the landlord must wait until the lease term has almost ended to have an enforceable right to recover all that he is owed.  

Combined Actions

The third alternative, assuming that it works procedurally, is for the landlord to combine a judicial foreclosure action with an action to terminate the lease and recover both accrued rent and future rent loss damages. While this combined action will take longer and almost certainly cost considerably more than either a foreclosure suit or unlawful detainer action alone, it should enable the seller to enforce both the lease and the real property security.

This alternative is available only because California Civil Code Section 1951.2 permits recovery of future rent loss damages (computed as the present value of the excess of the future stream of rents payable under the lease over the reasonable rents that the tenant proves the landlord can receive by re-letting) and then only when the lease expressly provides for such remedy. For other non-accelerable obligations secured by real property (e.g., child support payments, alimony payments, environmental indemnities), the creditor who thinks that securing serial obligations with a deed of trust or mortgage provides a hammer to use against a recalcitrant debtor will find the instrument much more like a millstone around the neck.

Section 728 Of The Code Of Civil Procedure

The Code of Civil Procedure does provide one remedy for the hapless, and ill-advised, creditor who secures non-accelerable payment obligations with a California deed of trust. Section 728 provides:

If the debt for which the mortgage, lien, or incumbrance [sic] is held is not all due, so soon as sufficient of the property has been sold to pay the amount due, with costs, the sale must cease; and afterwards, as often as more becomes due, for principal or interest, the court may, on motion, order more to be sold. But if the property cannot be sold in portions, without injury to the parties, the whole may be ordered to be sold in the first instance, and the entire debt and costs paid, there being a rebate of interest where such rebate is proper.

Under Section 728, if less than all of the encumbered property can be sold “without injury to the parties,” then the property must be sold “in portions” and the foreclosure sale cease when the sale proceeds are sufficient to pay the amount due. The deed of trust or mortgage remains a lien on the unsold portions of the property and, as other of the secured amounts become due, the creditor party may move the court to order further foreclosure sales. If the properly cannot be sold piecemeal, the court may order the whole to be sold and the aggregate amount of the secured obligations paid, after being appropriately discounted so that the creditor does not receive unaccrued interest. Effectively, Section 728 provides a creditor with an acceleration right when the creditor neglected to contract for one.

Unaltered since its enactment in 1872, Section 728 has been only rarely cited in California appellate decisions after 1900 and, then, only for exemplary (as opposed to dispositive) effect. Still, it remains the only statutory provision in California dealing expressly with foreclosure of a real property lien where obligations secured are not then all due.

The remedy preferred by §728—selling off the real property collateral in pieces as sequential payment obligations mature—is not really suited to most types of income-producing properties, which typically are both physically and legally indivisible. For a series of obligations consisting of fixed, non-contingent payments, or even floating-rate interest payments, however, the alternate remedy in Section 728 should work well. Unfortunately, this type of non-accelerable, installment obligation generally results from a lack of care or sophistication on the part of the creditor (or the creditor’s lawyer) and, with the proliferation of form notes and deeds of trust, each with a proper acceleration clause, is rarely encountered even in do-it-yourself transactions. When a deed of trust has been used to secure a set of obligations that are uncertain as to amount, timing, or even occurrence, the “acceleration” remedy of Section 728 will likely be impracticable.

Layered Foreclosure And Section 728

There is another form of partial foreclosure that does not require a physical division of the real property collateral and that the phrasing, if not the common understanding, of § 728 could accommodate. Rather than foreclose on a parcel of the encumbered property “sufficient” to pay the installment then due, the creditor would foreclose a “layer” of its security—that is, foreclose on all of the interests in the property subordinate to its own lien, but leave that lien undischarged and undisturbed as to all of the secured payments not yet due. Just as with a piecemeal foreclosure, the court’s decree could authorize further foreclosure sales, subject to the remaining future payment obligations, as each installment became delinquent. The landlord with a lease secured by a deed of trust could bring an action to foreclose its deed of trust only insofar as it secured any delinquent rent installments, in effect treating the lien for those installments like a “second” deed of trust subordinate to the lien for rent payments not yet overdue. Then, on motion, the landlord could obtain similar sales of the entire property each time another rent payment was missed.  

Every decision citing Section 728 has assumed that its reference to “portions” requires a physical subdivision of the property, but in both legal and ordinary usage “portion” can mean “share” as well as “part,” and a share commonly refers to a partial interest in an indivisible whole. Under this reading, a “portion” on the property could be a fee interest in the whole property, subject to the continuing lien for the remaining, immature secured obligations. One might argue that such an interpretation would render the less-preferred “acceleration” remedy in Section 728 a vestige, since it would always be possible to apportion the property in this legal, rather than physical sense.  

Yet there could be situations in which such an apportionment could not be accomplished “without injury to the parties,” still leaving a role for Section 728’s understudy remedy to play. Take, for instance, a fixed but relatively small monthly payment obligation extending over many years and secured by real property but lacking any other provision for accelerating future payments upon an installment default. Though serial foreclosures of the entire property would not be as impractical as repeated foreclosures of separate pieces of the property, it would force the creditor to suffer the expense, delay and considerable inconvenience of numerous foreclosure proceedings. In theory, perhaps, the creditor could recover interest and enforcement costs; in reality, however, the cost of such enforcement will likely greatly reduce, if not eliminate, the net recovery, forcing the creditor to wait until enough monthly payments have become overdue to justify the expense. This alone ought to satisfy the condition that partial foreclosures must cause some “injury” to a party before the creditor may resort to Section 728’s back-up remedy.  

Layered Foreclosure And The California Supreme Court

No California appellate court has ever applied Section 728 in the manner suggested here, but the California Supreme Court has not once, but twice, approved of layered foreclosures of an entire mortgaged property to enforce multiple obligations. Curiously, these decisions did not rely upon Section 728, though they clearly applied its principals.  

McDougal v. Downey

An 1872 decision of the court, McDougal v. Downey concerned a series of child maintenance payments. The plaintiff had agreed to advance the annual payments on behalf of the defendant, who was obligated to make them; to secure the repayment of these advances, the defendant gave the plaintiff a mortgage on “certain lands” the defendant owned. When the defendant defaulted in repayment of some of the moneys advanced, the plaintiff obtained a foreclosure decree that expressly “declared a lien upon the land for amounts to be subsequently paid to the minor” under the plaintiff’s agreement with the defendant. Later, the plaintiff brought a second action to foreclose the mortgage with respect to such later payments and the defendant demurred citing the previous action as a bar. The trial court sustained the demurrer “for the reason that a former recovery and judgment had been had on the same mortgage . . . .” The supreme court reversed and remanded with directions to overrule the demurrer.

In its one paragraph opinion, the court based its decision on the fact that, at the time of plaintiff’s first action, plaintiff had no claim for the later payments and thus could receive no relief under Section 248 of the Practice Act (which later became Section 728 of the Code of Civil Procedure). Rather than finding authority for the plaintiff’s serial foreclosure in §728, the court’s justification rested on 728’s not being applicable. The opinion is silent regarding the “one-action rule,” then found in §246 of the Practice Act of 1951, implying that the justices did not find any impediment to serial foreclosure actions in that rule.

Stockton Savings & Loan Soc. v. Harrold et al.

Twenty-eight years later, the California Supreme Court was less reticent. In Stockton Savings & Loan Soc. v. Harrold et al., a unanimous Court declared that “Section 726, Code Civ. Proc., providing that there shall be but one action to recover any debt secured by mortgage, does not . . . prohibit successive foreclosures—when required by the circumstances—for distinct debts secured by the same mortgage.” There, the court approved “[t]he power of a court of equity to direct a sale of property on foreclosure of a mortgage, saving from the effect of the sale a further lien secured by the same . . . incumbrance,” finding this procedure “sufficiently established by authority” in other jurisdictions.  

The Stockton Savings facts are convoluted and, since they offer several grounds (in addition to its age) for distinguishing the decision, merit exposition. McKee, the mortgagee-appellant, had made a series of loans to H. W. Cowell and N. S. Harrold, including a loan of $33,000 to Cowell alone and a loan of $9,941 to Cowell and Harrold jointly. The first loan was secured by a mortgage on, among other property, a 2,240 acre tract of land owned by Cowell and already encumbered by a mortgage to plaintiff Stockton Savings & Loan. The second loan, made a few months later, was secured by a mortgage on a separate tract of 960 acres, owned by Cowell and, apparently, not otherwise encumbered. The later mortgage also served as additional security for the first loan.

A few years later, Cowell defaulted on his note to Stockton Savings, which commenced a foreclosure action naming McKee as a defendant by virtue of his junior lien on the 2,240 acre tract. McKee then cross-complained for foreclosure of his mortgages on both the 2,240 acre tract (as to which his lien was subordinate to the mortgage held by Stockton Savings) and the 960 acre tract (which had no mortgage prior to his). The S&L opposed the cross-complaint, presumably because it expanded the original action by adding other properties and parties, and the lower court struck McKee’s cross-complaint as to foreclosure on the 960 acre tract. At the same time, the court awarded McKee a deficiency judgment on the $33,000 note, notwithstanding that he had not yet exhausted all of the real property security for that note.  

The supreme court reversed, ruling that McKee was entitled by his cross-complaint to foreclose on all of the mortgages securing the $33,000 note. The court’s opinion then went on to state:  

The decree for the sale of the tract of 960 acres to satisfy the note for $33,000, with interest, etc., should direct that the sale be made of that tract subject to the lien of the mortgage of May 23d for the payment of the note for $9,491 . . . .. [emphasis added]  

The May 23rd mortgage, of course, was the same mortgage being foreclosed on the same property to satisfy the larger note.

The Stockton Savings court did make clear, in upholding the power of a court of equity to permit a layered foreclosure, that the circumstances made this a “proper case” for the exercise of that power. The court noted that the $9,491 note represented a “wholly distinct debt” from the $33,000 note and that the mortgage of the 960-acre land, “so far as it regards the smaller note, is therefore, virtually a separate mortgage for the security of that note.” Doubtless, given the attention paid to the procedural aspects of the case, the court also took into account that McKee could not, in this particular action, both exhaust his real property security for the larger note (thus preserving his deficiency rights) and foreclose the lien for the smaller note, which the court implicitly found too unrelated to the original action by Stockton Savings to permit it to be included.

Precedential Value of MCDougal and Stockton Savings

McDougal and Stockton Savings provide clear authority for layered foreclosure of multiple obligations secured by a single deed of trust or mortgage “in a proper case,” but their age and sparse citation history invite skepticism about how much precedential force they retain. One highly respected commentator, citing McDougal and another California Supreme Court decision of similar vintage as upholding successive, piecemeal foreclosure actions, cautions that the court’s 1974 decision in Walker v. Community Bank “is fundamentally hostile to idea of piecemeal judicial foreclosure.” Whatever aversion post-Walker courts may have to piecemeal foreclosure, they presumably will not attempt to overrule Section 728 of the Code of Civil Procedure, despite its age. Still, if the courts accept as an essential part of the holding in Walker the court’s statement that the purposes of Section 726 of the Code of Civil Procedure include preventing “multiplicity of suits” (Walker, supra, at 736), they are likely to limit the Stockton Savings and McDougal precedents as far as the judicial arts of distinguishing and deconstructing prior decisions allow. And that could well be far enough to prevent layered foreclosure from ever again being an available remedy in California.  

Yet does, or should, Walker be read as disapprobation by the state’s highest court of layered foreclosures? In Walker, the supreme court held that the creditor bank, by judicially foreclosing first on personal property security and obtaining a deficiency judgment against the borrower in that action, had triggered the sanction effect of Section 726 and forfeited his real property security. By the time Walker was decided, it had been settled that a borrower-trustor did not have to raise Section 726 as an affirmative defense in an action against him personally on the secured debt in order later to invoke the 726 sanction when the creditor attempted to foreclose. It takes no great stretch of the judicial imagination to regard a deficiency judgment in an earlier action as the functional equivalent of a personal action upon the debt. The novel issue raised in Walker was whether enactment of Section 9501 of the California Commercial Code in 1963, coupled with a concurrent amendment of Section 726 to eliminate any reference there to debt secured by a mortgage on personal property, created parallel and mutually non-exclusive rights to foreclose collateral and obtain deficiency judgments. Lacking any legislative guidance, the court held that foreclosure under the Uniform Commercial Code and foreclosure under Section 726 were mutually exclusive, at least where the creditor sought and obtained a deficiency judgment in its UCC action.

In support of its decision, the court’s opinion cites Sections 726, 580a and 580d of the Code of Civil Procedure as “intended to prevent multiplicity of actions, to compel exhaustion of all security before entry of a deficiency judgment and to require the debtor to be credited with the fair market value of the secured property before being subjected to personal liability.” The inclusion of “multiplicity of actions” in this litany has the mark of a make-weight, thrown upon the scale to make it tip even more in favor of the decision but wholly unnecessary to the holding. Section 728 of the Code of Civil Procedure, enacted at the same time as Section 726, plainly belies any purpose on the part of the legislature to prevent multiplicity of actions except in the most formalistic of senses, preferring as it does multiple foreclosure proceedings (if by a series of motions rather than complaints) to the acceleration of otherwise non-accelerable obligations to permit a single foreclosure. In Higgins v. San Diego Sav. Bank the 1900 California Supreme Court gave little weight to the fact that Section 728 requires repeated motions in a single action, allowing piecemeal foreclosure by separate actions to recover annual annuity payments under a husband-wife “contract of separation.” Where the court in a previous foreclosure action did not determine that any future sums would be due under the contract and made no provision in the decree for further sales to recover such not-yet-due installments, “[w]e do not think . . . the mortgagee is compelled to resort to a motion, under §728, supra, nor would it be proper for him to do so [citing McDougal v. Downey, supra].”

Nor has the legislature otherwise signaled that Section 726 was meant to express reverence for judicial efficiency. Originally, 726 and its statutory precursor read “There shall be but one action for the recovery of any debt . . .” and continued to read this way during the period in which McDougal, Higgins, and Stockton Savings were decided. In 1933, the wording was changed to “but one form of action.” According to the Bernhardt treatise, “California courts have ascribed no significance to this revision,” but it would take a semantic contortionist to see in this change a desire to overrule legislatively those prior decisions. In 1985, reacting to the Walker decision, the state legislature amended UCC Section 9501(4) to expressly permit multiple actions in cases of mixed real and personal-property collateral. In effect, the legislature upheld the core holding in Walker, enforcing the Section 726 sanction where a creditor obtained a deficiency judgment in an UCC foreclosure action, while plainly rejecting any requirement that the creditor be limited to a single action, either against its personal property collateral under the UCC, or against all the collateral under Section 726.  

Arguments Against Layered Foreclosure

Assuming that preventing “multiplicity of actions” or proceedings is not, standing alone, sufficient reason for a court of equity to abandon a full-hearted love of doing justice, what other reasons might justify a rule forbidding layered foreclosure? Consistent with what is more usually named as the central purpose of Section 726—requiring the real estate secured creditor to exhaust his collateral before seeking person recourse against the borrower—the following appear to be the most cogent arguments against layered foreclosure:  

  1. Allowing the property to be sold subject to a continuing lien for the remainder of the secured debt may “chill” the bidding at the foreclosure sale, thus reducing the sale price and increasing the borrower’s personal liability.  
  2. Layered foreclosure “clogs” the borrower’s equity of redemption since it denies the borrower the opportunity to redeem the property fully until after the final foreclosure sale.  

The “fair value hearing process” required under Section 726(b) as a pre-requisite to the creditor’s obtaining a deficiency judgment does not contemplate, nor easily accommodate, a series of foreclosure sales under the same mortgage. Permitting the creditor to seek a deficiency judgment and obtain a fair value hearing after each foreclosure sale would seem clearly to violate the requirement that the lender first exhaust the real property collateral before having recourse to the borrower personally. On the other hand, deferring any deficiency judgment until the final foreclosure sale would violate the express requirement of Section 726(b) that the creditor file its application for a fair value hearing within three months after the date of the foreclosure sale.  

The first argument exalts the ideal of a real estate foreclosure sale over the reality of such a sale. It may once have been true that real bidding—that is, multiple bids by qualified buyers—occurred at these sales and the property had a good chance of being sold to a third party. In modern practice, however, the lender is the successful (if not only) bidder nine times out of ten in residential foreclosures, and in foreclosures of commercial property that proportion quickly approaches 100% as the value of the property increases. For a host of reasons, not the least including the requirement that any bidder other than the foreclosing lender must bring cash (or its equivalent) to the auction, purchase out of foreclosure is an impractical way to acquire larger commercial properties. As a practical matter, then,, there is usually no bidding to chill at a foreclosure sale. The California legislature long ago recognized this, when (in 1933) it enacted Section 726(b). The debtor’s real protection rests in that statute’s limitation of any deficiency judgment to the excess of the secured debt over the greater of the amount bid at the foreclosure sale and the “fair value” of the property at the time of sale.  

If anything, were actual, competitive bidding the rule, rather than the rare exception, a layered foreclosure might encourage third-party bidding, especially for more valuable properties. One of the chief obstacles to serious third-party bidding at foreclosure sales is the requirement for payment in cash at the time of purchase. The foreclosure process makes it difficult, if not wholly impractical, to arrange any contemporaneous debt financing, unless by the foreclosing creditor. Layered foreclosure would supply a mechanism for providing a third-party purchaser with concurrent, insured debt financing (in the form of the remaining and still secured debt).  

Nor is there any clear basis for concluding that a layered foreclosure would discourage third-party bidding (if at all) more than the piecemeal foreclosures that Code of Civil Procedure Section 728 indisputably authorizes. In some easy-to-imagine circumstances—half-finished lots in a half-completed subdivision project gone south, for example—piecemeal foreclosure would plainly be a far worse alternative than a layered foreclosure for any lender or borrower hoping to attract bidders to a foreclosure sale (the cost per lot of completing infrastructure and other finishing work being prohibitive if spread over only a few of the lots).

That a succession of layered foreclosures can have no worse effect than a succession of piecemeal foreclosures also answers the second argument against permitting the former procedure. While the borrower gets to retain the unsold pieces of the real property collateral, for a while, they remain encumbered with the debt and beyond the borrower’s immediate right to redeem them. A more powerful counter, though, is that a borrower with the means to redeem mortgaged property must also have the means to pay the secured debt as it falls due. The “equity clogging” effect originates not with the foreclosure process, but with the borrower’s undertaking of a serial obligation that, by inadvertence or express agreement, cannot be prepaid. Certain kinds of serial obligations that are secured by property may well constitute an unpermitted clog on the borrower’s equity of redemption—e.g., an interminable obligation to pay “additional interest” measured by operating cash flow—and the imprudent lender that structures such an obligation risks the borrower being able to avoid it by defaulting on the debt and forcing the borrower to foreclose.

The third argument advanced is the strongest, though the question of how to accommodate successive foreclosures under the same mortgage is one that Section 728 already begs, even if that provision is limited to piecemeal foreclosures. Attempting to preserve both the lender’s deficiency rights under Section 726(b) and the right to foreclose piecemeal when the secured obligation consists of a non-accelerable series of obligations leads to two possible solutions. In one, the deficiency is established on a foreclosure sale by sale basis, treating the mortgage or deed of trust as severed into two separate liens each time the property is partitioned for sale so as to avoid violating the rule that, for any debt secured by a mortgage, the collateral must be exhausted before a deficiency judgment is awarded. The other solution would be for the court to require a fair value hearing after each sale, but to refrain from determining the amount of recoverable deficiency until the last piece of the property has been sold. Either way, to protect the borrower, the “fair values” determined from the various sales would have to be cumulated, so that any excess of fair value over the greater of the bid or debt amount for one sale could be set off against any deficiency in another. Otherwise, piecemeal foreclosure could result in a legal deficiency considerably greater than the actual amount by which the total secured debt exceeded the aggregate value of the property.  

In practice, the difficulties posed by any reconciliation of Sections 726(b) and 728 may be mostly academic. Lenders generally do not choose judicial foreclosure to seek a deficiency judgment, because doing so preserves the borrower’s one-year right of post-foreclosure redemption and this right effectively clogs the lender’s equity in the property. Until the redemption period runs, the lender (or other foreclosure purchaser) cannot truly act as the owner of the property: the borrower’s pre-emptive right to redeem inhibits any sale, financing or improvement of the property. To avoid this, a creditor finding it necessary or advisable to foreclose judicially will usually waive its right to a deficiency judgment, thereby cutting off the borrower’s right of redemption when the hammer falls at the foreclosure sale. If the creditor does not waive deficiency rights, a court might well conclude that the complications presented by a series of inter-linked fair value hearings, over months or years, posed sufficient risk of “injury to the parties” to justify accelerating the debt and holding a single foreclosure sale under the second part of Section 728.  

Modern Application of the Layered Foreclosure

Granting that statute and precedent—though both hoary with age—as well as logic support layered foreclosures, judicial opposition could still form around the banner of “why bother?” Stockton Savings & Loan has been cited by California appellate courts only twice in the last 50 years—in one instance merely in paraphrasing the appellant’s argument and in the other to describe the holding in Stockton permitting serial foreclosure as dictum on which the appellate court expressed no opinion of its own. Section 728 of the Civil Procedure Code appears to have been last cited by a California appellate opinion in 1932. The conspicuous lack of citation history plainly indicates that there has been no pressing need in California for judicial attention to the question of non-accelerable obligations that have been secured by real property.  

Yet, there is at least one very contemporary context in which a clear approval of layered foreclosure could offer a general economic benefit. Structured real estate financings, whose excesses nearly tumbled the world’s financial system, have left behind a mounting debris flow of overleveraged hospitality, multi-family and commercial real estate. Most of the structured debt for these properties ended up being (in part) “securitized” and the securitization vehicle of choice, at least for larger income-producing real estate, is a Real Estate Mortgage Investment Conduit, or REMIC. REMICs are tightly corseted by a rigid frame of tax laws and regulations, which they break on pain of substantial tax liability. One of the statutory limitations essentially prevent REMICs from acquiring or making any new loans.  

An effect of this limitation is that, after a REMIC forecloses on a defaulted mortgage loan, it can only dispose of the “REO” property for cash: it cannot, without severe tax consequences, provide any seller financing to the buyer. For smaller properties and in times when debt financing for commercial real estate is more readily available, this stricture may not greatly impede an orderly disposition of REO properties in REMIC portfolios; in the current credit famine, however, and for larger or more challenged properties, the inability of REMICs to finance sales of their REOs may unleash a chain of consequences that will further damage the real estate market. If REMICs, for lack of financing alternatives, must dispose of REO properties at fire sale prices, this will depress market values for the classes of assets affected and force institutional lenders, such as banks, pension funds and insurance companies, to write down the values of similar properties—and loans secured by such properties—that they hold. In turn, this may drive some of those lenders into insolvency, triggering further discounted sales.  

One way a REMIC can work around the “no new loan” limitation is to arrange with the borrower for a “short sale” of the defaulted mortgage property in which the borrower conveys the property, still encumbered by the loan, to the buyer. Because the loan is in default, the REMIC is allowed considerable latitude in modifying it and, by negotiating the terms of modification with the buyer, it can effectively provide financing for the sale. Obviously, though, such a transaction requires borrower cooperation and that cooperation is likely to have a price, including waiver by the lender of any claims it may have under any guaranties or indemnities against the borrower or its affiliates.  

The availability of layered foreclosure would give REMICs and their servicers a means of accomplishing the same result without borrower cooperation. For debt structures in which the mortgage loan has been split into a securitized “A” note and one or more unsecuritized, subordinated notes, a “B” note holder could, for example, play the foreclosing lender while the “A” note holder kept its loan, unaccelerated for the moment, in place. If the entire mortgage loan had been securitized and there was but a single note, the lender might elect not to accelerate and instead foreclose only as to payments already due.

Admittedly, either of the scenarios just envisioned would require a considerable judicial leap forward, even if the court took as its launch point the decision in Stockton Savings and the broader reading of Code of Civil Procedure Section 728. Section 728 describes the secured obligations to which it applies simply as “debt . . . not all due,” and this could include debt that the lender has not elected to accelerate as well as an obligation that the lender has no right to accelerate, but it is unlikely anyone has looked at the provision in this way. McKee, the mortgagee in Stockton Savings, did apparently have the right to accelerate both of the notes secured by his mortgage; however, the procedural toils in which he had become entangled prevented him from foreclosing on both in the same proceeding. Applying either the statute or the precedent to a lender’s voluntary election to foreclose in layers rather than all at once would be pushing hard on an old and brittle envelope.  

As a practical matter, no REMIC lender or servicer who can accelerate is likely to find an attempt to expand the law of foreclosure worth the time or expense. If the borrower is acquiescent and no one else is likely to object or bid at the foreclosure sale, the loan servicer might explore the possibility that the foreclosure court would be willing to experiment with a layered foreclosure decree—one that expressly preserves the remainder of the lien. Res judicata would then protect the lender from any afterthought on the part of the borrower or any other party named as a defendant in the foreclosure action. Still, it is hard to imagine that the quicker and cheaper, not to mention surer, option for the lender would not be to buy the borrower’s cooperation in a short sale. Of course, there is always the possibility that Congress will see fit to amend the Internal Revenue Code to permit REMICs to provide some kind of seller financing of REO properties (assuming that Congress can agree on any changes in the tax code—something it has found difficult for several years now).

Conclusion

California courts have looked upon Section 728 of the Code of Civil Procedure—when they have looked at all—as providing a partial foreclosure remedy only when it can be applied to a physically severable portion of the real property security. This article has argued that logic, language and case law support a broader application of Section 728, to permit foreclosure on an undivided “layer” of the real estate collateral while leaving the security interest intact as to the remaining, undivided fee interest in the property. If the occasion arises for California appellate courts to entertain the revival of layered foreclosures in the modern era, they should address the question understanding that both precedent and practicality favor a flexible approach.

First published in the California Real Property Journal, a quarterly publication of the Real Property Law Section of the State Bar of California.