California Supreme Court Expands Lenders’ Deficiency Rights

Lender Sign

Last year, in one of the most consequential California real estate cases in recent memory, Black Sky Capital, LLC v. Cobb, the California Supreme Court resolved decades of conflicting jurisprudence regarding the right of a lender that holds two deeds of trust on the same property to recover a deficiency judgment on a junior lien extinguished by a nonjudicial foreclosure on the senior lien.  The Supreme Court’s ruling has far-reaching implications for lenders, lenders’ assignees, and borrowers.

Under California’s statutory scheme, the only method for recovery of any debt secured by a deed of trust is foreclosure.[1]  In most circumstances, the creditor may choose to pursue either judicial or nonjudicial foreclosure. 

In a judicial foreclosure, if the property is sold for less than the amount of the outstanding indebtedness, the creditor may seek a deficiency judgment against the borrower consisting of the amount of the difference between the amount of indebtedness and the fair market value of the property at the time of the foreclosure sale.[2]  However, in a judicial foreclosure the debtor possesses a right of redemption.  In a nonjudicial foreclosure on the other hand, the debtor possesses no right of redemption, but the creditor who foreclosed may not seek a deficiency judgment.  The statute preventing a creditor from obtaining a deficiency judgment in a nonjudicial foreclosure, California Civil Code section 580d, was enacted in 1940 in order to place the creditor’s two remedies, judicial foreclosure and nonjudicial foreclosure, in parity, or to ensure that neither provided an unfair advantage to the creditor.[3] 

In 1963, however, the California Supreme Court held in Roseleaf v. Chierighino that Section 580d does not apply to junior lienholders whose security has been rendered valueless by the foreclosure sale.[4]  Thus, a junior lienholder whose security has been rendered valueless by a nonjudicial foreclosure sale, known as a “sold-out junior lienholder,” may sue the debtor for the amount of the debt.

The Roseleaf decision created and exposed a means for lenders to circumvent the anti-deficiency protection Section 580d.[5]  If a lender made a loan to a borrower secured by a deed of trust on real property, the lender could not obtain a deficiency judgment under Section 580d if it affected a nonjudicial foreclosure.  However, under Roseleaf, a lender could avoid this limitation by making two loans each secured by a deed of trust on the property, one senior and one junior.  Then, in the event of default, the lender could institute a nonjudicial foreclosure on its senior deed of trust and still sue for any deficiency on its sold-out junior deed of trust under Roseleaf

By this method, lenders could eliminate a borrower’s right of redemption by affecting nonjudicial foreclosure while maintaining their ability to seek a deficiency.  Roseleaf also incentivized manipulation of the purchase price of the property by the lender who intended to purchase the property by credit bid.  The credit bidding lender could attempt to keep the sale price low and purchase the property at a low price while still recovering a substantial amount of the original loan through a deficiency action on the junior lien.

In Simon v. Superior Court, decided in 1992, the California Court of Appeal for the First Appellate District attempted to narrow the Roseleaf rule.  In Simon, a bank loaned the Simons a total of $1,575,000 for which the Simons gave the bank two separate promissory notes.  The first in the amount of $1.2 million secured by a deed of trust on a property (the senior lien) and the second in the amount of $375,000 secured by a deed of trust on the same property (the junior lien).  The bank affected a nonjudicial foreclosure on the senior lien and purchased the property itself for $1,050,000.  Later, the bank sued the Simons for the amount due under the junior lien.  After discussing the history and purpose of California’s anti-deficiency legislation and the governing case law, the Simon court determined that the factors relied upon in Roseleaf to find that Section 580d did not prevent sold-out junior lienholders from obtaining deficiency judgments did not apply in Simon because the bank held both the senior and junior liens at the time of the foreclosure sale.  Accordingly, under Simon, Section 580d does not protect a junior lienholder who also held the senior lien at the time of the foreclosure sale.

California Courts have interpreted Roseleaf and Simon in drastically different ways.  For instance, in Bank of America, N.A. v. Mitchell, decided in 2012, the California Court of Appeal for the Second Appellate District expanded upon Simon, holding that the Simon ruling applied even if the junior lien was assigned after foreclosure to a third party who then sued for the deficiency.[6] 

In contrast, in Cadlerock Joint Venture, L.P. v. Lobelalso decided in 2012, the California Court of Appeal for the Fourth Appellate District expressly declined to extend Simon and even criticized Simon in dicta.[7]  In Cadlerock, the defendant borrower asked the court to expand Simon even farther than Mitchell and hold that, no matter what happened afterward, if the senior and junior liens were originated in favor of the same lender, the Simon rule applied and the junior lienholder could not recover.  The Court of Appeal rejected that argument.  However, the court then stated that it felt compelled to make additional observations based on its review of the relevant case law.  In dicta, the court criticized Simon, stating that California’s anti-deficiency laws simply do not apply to sold-out junior lienholders.  The Cadlerock court argued that Simon and Mitchell improperly “inserted an additional clause into” Section 580d.

The very different approaches expressed in Mitchell and Cadlerock illustrate the unsettled nature of California jurisprudence prior to 2019 with respect to the ability of sold-out junior lienholders to recover deficiency judgments when they also held the senior lien. 

In Black Sky Capital, LLC v. Cobb, decided last year, the California Supreme Court expressly attempted to settle the rights of sold-out junior lienholders by answering the question: “Where a creditor holds two deeds of trust on the same property, can the creditor recover a deficiency judgment on a junior lien extinguished by a nonjudicial foreclosure on the senior lien?”[8]

In Black Sky, Citizens Business Bank loaned the defendants approximately $10 million in 2005 secured by a deed of trust on a commercial property (the senior lien) and loaned the defendants an additional $1.5 million in 2007 secured by a second deed of trust on the same commercial property (the junior lien).  Citizens Business Bank subsequently sold both loans to Black Sky Capital, LLC (Black Sky).  After the defendants defaulted, Black Sky commenced nonjudicial foreclosure proceedings and purchased the property at public auction for $7.5 million.  Black Sky then filed a lawsuit to recover the amount still owed on the junior lien.  The trial court relied on Simon in applying Section 580d to bar a deficiency judgment based on a sold-out junior lien and granting the defendants’ motion for summary judgment.  The California Court of Appeal for the Fourth District reversed and the Supreme Court affirmed the Court of Appeal’s ruling.

In its ruling, the Supreme Court adopted a “strict constructionist” approach, reading Section 580d according to its “plain language” and refusing to read equitable considerations into the statute as the courts did in Simon and its progeny.

Applying the language of Section 580d, the Supreme Court noted that Section 580d bars a deficiency judgment “when the trustee has sold the property ‘under power of sale contained in the … deed of trust.’ (italics added.)”  According to the Court, “[t]he definite article in the phrase ‘the … deed of trust’ makes clear that the statute applies where sale of the property has occurred under the deed of trust securing the note sued upon, and not under some other deed of trust.”  Thus, where no sale has occurred pursuant to a junior deed of trust, the junior lienholder is not barred by Section 580d from obtaining a deficiency judgment.

The Supreme Court also addressed concerns regarding “loan splitting” that appear to have been the driving force behind Simon and its progeny.  Addressing the defendants’ argument that its ruling would allow a creditor to structure what is functionally a single loan as two separate notes in order to recover under the junior note what it could not recover if it had issued a single note on the same property, the Court held that “[w]here there is evidence of gamesmanship by the holder of senior and junior liens on the same property, a substantial question would arise whether the two liens held by the same creditor should…be treated as a single lien…”  However, the Court noted that the two loans at issue in Black Sky were made over two years apart and there was no allegation of gamesmanship in that case.  Thus, the Court held that “[w]here, as here, there is no allegation of evasive loan splitting or recovery in excess of what any junior lienholder would be able to recover, we see no reason to depart from a straightforward reading of section 580d.”

Accordingly, the Supreme Court expressly disapproved of Simon and its progeny and harkened back to Roseleaf, holding simply that where no sale occurred under the deed of trust securing a junior note, Section 580d does not bar a deficiency judgment on the junior note.

Notably, the Supreme Court in Black Sky, like the Court of Appeal in Cadlerock before it, observed that the one-action rule of California Code of Civil Procedure section 726 might bar or limit a deficiency judgment by a junior lienholder who was the same as a senior lienholder and both courts expressly declined to consider whether Section 726 might bar or limit a deficiency judgment in such situations.

By explicitly rejecting the Simon rule, the Supreme Court resolved decades of uncertain jurisprudence for lenders, lenders’ assignees, and borrowers alike.  There is now no question that lenders are not prohibited from obtaining a deficiency judgment based on a junior lien just because they also hold or held a senior lien.  However, the Supreme Court left the door open for future litigation by suggesting that courts may “depart from a straightforward reading of section 580d” where there is evidence of “gamesmanship” or “loan splitting.”

Brian Lauter is a Shareholder at Eanet, PC.  Brian’s practice focuses on business litigation, real estate litigation, and trust and estate litigation.

[1] Civil Code § 726.

[2] Alliance Mortgage Co. v. Rothwell, 10 Cal.4th 1226, 1236 (1995).

[3] Cornelison v. Kornbluth, 15 Cal.3d 590, 602 (1975).

[4] Roseleaf Corp. v. Chierighino, 59 Cal.2d 35, 44 (1963).

[5] Simon v. Superior Court, 4 Cal.App.4th 63, 78 (1992); see, e.g.Union Bank v. Wendland, 54 Cal. App. 3d 393, 406 (1976).

[6] Bank of America, N.A. v. Mitchell, 204 Cal.App.4th 1199, 1207 (2012).

[7] Cadlerock Joint Venture, L.P. v. Lobel, 206 Cal.App.4th 1531 (2012).

[8] Black Sky Capital, LLC v. Cobb, 7 Cal.5th 156, 158 (2019).

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