Last year, the California Legislature enacted a statute that prohibits a deficiency judgment under a note secured by a first deed of trust against a dwelling of not more than four units that is sold at a short sale with a written consent of the lender. The existing statute, codified as Code of Civil Procedure Section 580e, also provides that once the secured lender consents to the short sale, the lender agrees to accept the sale proceeds as full payment and that the short sale fully discharges the remaining amount of the indebtedness on the note. In my capacity as Secretary to the Financial Institutions Committee of the Business Law Section of the State Bar of California, I became active in conjunction with a working group from the California Bankers Association Legal Affairs Committee who was attempting to address the many shortcomings of the statute as enacted. In addition to careless draftsmanship, the statute has serious negative unattended consequences. Apparently, the authors were thinking only of a typical residential loan secured by one single family residence. Unfortunately, the language of a statute was not so limiting.
Almost immediately, one of our clients called with questions about a loan secured by a residential subdivision with only two remaining unsold lots. A model home stood on one lot, but the other lot was vacant. The borrower wanted the Bank's approval for a short sale on the model home. Under the new law, if the Bank agreed to the short sale on the model home, the debt would be fully extinguished and the Bank would be unable to collect any further sums for sale of the vacant lot or to foreclose on the vacant lot. This is because the existing law does not limit applicability to a homeowner.
Another of our clients immediately raised a question about a farm loan, where the Bank's collateral included two parcels, one of which was only farmland and the other which was farmland including the farmhouse in which the borrower resided. The Bank could not accept a proposal to sell off the parcel that included the farmhouse for less than the total amount of the debt because that would be a short sale. Under existing law, the sale of the farmhouse would eliminate the balance of the debt and make it impossible for the Bank to fully collect the loan by foreclosure or sale of the remaining farmland secured by the deed of trust.
What if a lender makes a commercial loan, restructures the loan and takes a deed of trust on the residence of the owner of the business? The owner then proposes to sell his residence to pay down the debt but not to pay it off in full. Such a transaction, even if all parties consented, would be deemed a short sale under existing law and would result in disaster for the Bank.
The working committee of lawyers spent time with Kevin Gould, Senior Vice President and Director of State Government Relations for the California Bankers Association. The goal was to preserve the essential concept behind the existing law: by consenting to a short sale of a personal residence, a secured lender agrees to take only the proceeds of the short sale and to write off the remainder of the debt. The solution was to add a new subdivision (b) that defines a "note" as being made only by a natural person or a trust created for personal, family or household purposes. It also specifically excludes from the definition of the word "note" any loan made primarily for agricultural, business or commercial purposes, including a loan to finance the construction of a residential subdivision.
(d) For purposes of this section, "note" means a note made by a natural person or by a trustee of a trust created by a natural person for a loan made primarily for personal, family, or household purposes. "Note" does not include a note made for a loan primarily for agricultural, business, or commercial purposes, including a loan to finance the construction of a residential subdivision.
The proposed legislation is currently pending as SB 412 and is being carried by Senator Vargas. We will keep you apprised of the progress of the bill through the California Legislature. Kevin Gould informs us that there are likely to be amendments proposed and it is still uncertain whether the bill will pass and what the final version will look like.
Until a new bill passes and is signed into law, California secured lenders whose collateral includes a dwelling of four or less units must be fully aware that by consenting to a short sale, they will extinguish the debt. For our commercial lending clients, as noted above, the real concerns are:
- Loans to developers that have been worked down to a handful of unsold units;
- Agricultural loans that include a dwelling house on the property (even one that is unoccupied or rented or occupied by someone other than the borrower); and
- Commercial loans that are partially supported by deeds of trust on a personal residence of the maker of the note.
There may be means by which restructuring and short sales can be closed despite the existence of Section 580e as presently enacted, but there are risks and care is required. Please let us know if we can be of any assistance to you in addressing these matters.