Legal Update

Jun 22, 2020

When the Workout Doesn't Work—Enforcement of Commercial Mortgage Loans in California (Part 3: One Action Rule and Anti-Deficiency Protections)

California's one action rule and anti-deficiency protections, together with the related fair value limitations, are procedural rules with substantive effects that establish limitations on the manner of enforcing rights and remedies in connection with real property secured loans and the amounts of recoveries under those loans. These statutes were not enacted as part of a comprehensive, unified legislative plan, and California courts have filled in legislative gaps and interpreted legislative intent. The reported cases are not entirely consistent, and there remain many unsettled issues. Accordingly, the potential for confusion in these areas can be high and predictability low. Two consistent guiding principles for courts in this area have been: (1) the statutes are to be interpreted liberally to protect debtors and (2) courts will look through the form of a transaction to the substance to avoid circumvention of the protections provided by the statutes. A lender should always consult counsel concerning the application and effects of these laws prior to taking any enforcement steps.

The following briefly addresses: (1) the one action rule and its aspects or applications (viz., the security first and sanction aspects), judicially created exceptions to the application of the rule (viz., worthless security, environmentally impaired property and sold out junior[1]) and the consequences of taking an “action” or violating the one action rule, (2) the anti-deficiency protections (viz., the private sale prohibition, the purchase money prohibition, the short sale prohibition and the fair value limitations) and judicially created exceptions to the application of the protections (viz., bad faith waste, fraud and in certain cases sold out junior status), (3) issues relating to enforceability of a borrower's contractual waiver of the one action rule or the anti-deficiency protections and a lender’s unilateral waiver of the one action rule, (4) the interplay of the one action rule and the anti-deficiency protections and (5) the dangers of sham guarantees.

One Action Rule (California Code of Civil Procedure Section 726(a))

Under the plain language of the statute that embodies the one action or one form of action rule,[2] the rule appears merely to restrict judicial actions on debt or other rights secured in whole or in part[3] by real property to foreclosure actions conducted in accordance with statutory requirements. Judicial glosses on the rule have significantly expanded the scope of the application of the rule. Practitioners have devised various constructs to rationalize or conceptually organize the judicial interpretations of the rule. One of the most widely used constructs, which enjoys judicial support, interprets the rule as having two applications or "aspects": (1) the security first (or affirmative defense) aspect, and (2) the sanction aspect.

One Action Rule: Security First Aspect—Affirmative Defense

The security first aspect of the one action rule is an affirmative defense that bars a real property secured lender from suing on the secured debt. That is, if the lender attempts to sue on the note or take another "action" before foreclosure under the deed of trust, the borrower can raise the one action rule as a defense to compel the lender to resort first to the real property security.

One Action Rule: Sanction Aspect

Under the sanction aspect, if a lender takes an “action” or otherwise violates the one action rule by appropriation of the borrower’s non-collateral assets, then the lender is deemed to have elected its remedy. By so electing its remedy, the lender waives any security for the loan that was not included in or realized upon through that action or appropriation. If the borrower fails to raise the affirmative defense of the security first aspect of the rule, it can still invoke the sanction aspect of the one action rule. If the lender fails to join all defendants or fails to include all real property security for the loan in a judicial foreclosure action, after the foreclosure is completed, the sanction aspect will bar the lender from pursuing the defendants not joined and realizing on the collateral not included.

What is an Action or Violation of the One Action Rule and When is the One Action Rule not Applicable?

Generally speaking, for purposes of the one action rule, an “action” is a judicial proceeding on the secured debt prosecuted to a judgment.[4] In addition, courts have found a lender’s judicial or non-judicial appropriation of the borrower's non-collateral assets to be a violation of the one action rule. “Actions” for purposes of the one action rule or violations of the one action rule include the following:

attachment of non-collateral real property of the borrower in another country
prejudgment attachment on the borrower’s bank account
exercise of rights against the borrower’s bank account pursuant to statutory banker's lien
set off against the borrower’s bank account
entry of default against the borrower
stipulated judgment against a co-borrower
action taken against a general partner in the general partnership borrower
execution on assets of the borrower not pledged as security for the loan

California courts or bankruptcy courts applying California law have held that the following do not constitute an “action” for purposes of the one-action rule or violations of the one action rule:

non-judicial foreclosure
mere commencement of judicial foreclosure
mere commencement of action to collect the secured debt
violation of an assignment of rents provision pursuant to which the lender collected but did not apply rents to reduce the secured debt
money judgment for attorneys' fees in unsuccessful action by borrower to enjoin non-judicial foreclosure sale
action for rescission of note based on fraud
summary adjudication of a cause of action not pertaining to foreclosure in an action for foreclosure

In addition, by statute, the following do not constitute an “action” for purposes of the one action rule:

drawing on or seeking and enforcing the reimbursement for a draw under a standby letter of credit
action to appoint a receiver.[5]

When the One Action Rule Does Not Apply

The one action rule will not apply to prevent a lender from suing the borrower on the debt under the unusual circumstance in which the security property has become legally worthless.[6] In addition, the rule does not apply to prohibit a sold out junior lienholder from suing on its note, but if the sold out junior is the successful bidder at the foreclosure sale, its recovery will be limited by the fair value limitation, as discussed below.

Consequences of an Action or Violation of One Action Rule

Courts have not been entirely consistent as to the consequences of a lender’s taking an action or the violating of the one action rule. Under some decisions, the consequences have been the dual sanction of the lender’s waiver of the security and inability to sue on the underlying obligation. Under other decisions, the consequences have been only the lender’s waiver of the security.

Anti-Deficiency Protections

There are four major pieces of anti-deficiency legislation in California: (1) the private sale prohibition, (2) to purchase money prohibition, (3) the short sale prohibition and (4) the fair value limitations. The private sale prohibition is the most important anti-deficiency protection in a commercial mortgage loan context.

Private Sale Prohibition (California Code of Civil Procedure Section 580d(a))

Under the private sale prohibition, a real property secured lender may not seek a deficiency judgment against the borrower if the lender has foreclosed non-judicially.

The private sale prohibition does not apply to prevent the lender from suing the borrower following a non-judicial foreclosure if there is bad faith waste (e.g., waste committed maliciously or recklessly) or fraud by the borrower (e.g., for diversion of loan proceeds or misrepresentations regarding or adversely affecting the value of the property or concealed junior financing), if the lender is a sold out junior (except under some circumstances if the lender also held the first deed of trust). In addition, it does not prohibit an award of attorney’s fees in an action brought after non-judicial foreclosure, a claim against rents collected by the lender’s receiver before foreclosure, a quiet title action or a draw under a standby letter of credit.

Purchase Money Prohibition (California Code of Civil Procedure Section 580b)

Under the purchase money prohibition, a real property secured lender may not seek a deficiency judgment against the borrower if the loan is a purchase money loan (i.e., the proceeds of the loan were used in whole or in part to pay the purchase price of the security property), irrespective of whether the lender foreclosed judicially or non-judicially on the security property, and (1) the lender was the vendor of the security property to the borrower or (2) the security property is a 1-4 family owner-occupied residence.

The purchase money prohibition does not apply to prevent the lender from suing the borrower following a non-judicial foreclosure if there is bad faith waste or fraud by the borrower or to a sold out junior in a non-standard transaction (e.g., where the vendor/lender subordinated its carryback deed of trust to a construction loan the proceeds of which are used to change the use of the property). In addition, it does not protect a loan made for the borrower to acquire a dwelling to rent to others that was only later by the borrower.

Short Sale Prohibition (California Code of Civil Procedure Section 580e)

Under the short sale prohibition, a real property secured lender may not seek a deficiency judgment against a borrower following a short sale of a 1-4 family dwelling.

Fair Value Limitations (California Code of Civil Procedure Sections 580a and 726(b))

The fair value limitation applicable to judicial foreclosures was discussed in Part 1 of this series of updates. A similar fair value limitation may apply (a) if the obligation secured is other than a note and (b) to a sold out junior lienholder that acquires the property at a foreclosure sale. Other potential applications of this fair value limitation remain open to question.

Interplay of One Action Rule and Anti-Deficiency Protections—A Security Only Rule?

If a real property secured lender attempts to sue on the debt, under the security first aspect of the one action rule, the borrower may compel the lender to resort first to the security. The lender then has the option of foreclosing judicially or non-judicially. If the lender elects to foreclose non-judicially, which is the typical means of foreclosing in California, then it cannot seek a deficiency judgment. As a result, the interplay of the two statutory schemes is sometimes referred to as a “security only rule.”

Issues with Waiver of One Action Rule and Anti-Deficiency Protections by Borrower and Waiver of Real Property Security by Lender

A borrower may not waive the purchase money prohibition at any time. A borrower may not waive the one action rule and the fair value limitations at the time of making or renewing a loan. Although there is some authority to the effect that a borrower may otherwise waive the one action rule and the fair value limitations and may waive the private sale prohibition, this issue is not free from doubt.

Generally speaking, the lender may not unilaterally waive its real property security and sue on the debt. However, it may do so if the property is legally worthless (as noted above) or If the security property is environmentally impaired. Because the hurdles to establishing environmental impairment and satisfying the statutory conditions to suing on the debt secured by environmentally impaired property are very high, lenders rarely resort to this remedy.

The Danger of Sham Guarantees

A “sham guaranty” is a guaranty given by a party that is the alter ego of the borrower or otherwise has unlimited liability on the real property secured debt. A typical example of a sham guaranty is when a general partner in a partnership borrower guarantees a real property secured loan. A guaranty by the trustee of a revocable trust borrower may also be a sham guaranty under most circumstances. Subject to any limitations under the guaranty and provided that the guaranty is properly drafted to include applicable waivers of suretyship rights and defenses, a lender may ordinarily exercise its rights against the guarantor of a real property secured loan before (or as an alternative to), during or after a foreclosure. However, this is not the case with sham guarantees. Courts will not enforce a sham guaranty because it is viewed as an impermissible attempt on the part of the lender to circumvent the private sale bar. In addition, if the lender takes an action or otherwise violates the one action rule with respect to the sham guarantor, then the lender may be deemed to have violated the one action rule with respect to the borrower and may be subject to the dual sanction discussed above or be deemed to have waived its real property security.

[1] A “sold out junior,” also referred to a “foreclosed out junior,” is a junior lienholder whose junior lien has been extinguished by the foreclosure of a senior lien.

[2] “There can be but one form of action for the recovery of any debt or enforcement of any right secured by mortgage upon real property or an estate for years therein[.]” Cal. Code of Civ. Proc. §726(a).

[3] The one action rule will apply to any payment or performance obligation secured by a deed of trust, including those in which a deed of trust was taken out of an abundance of caution or the collateral for the loan is mixed real and personal property and the real property security constitutes only a small portion of the value of the collateral. This update will discuss the one action rule only in the context of payment obligations or debt.

[4] “Action” is statutorily defined as “an ordinary proceeding in a court of justice by which one party prosecutes another for the declaration, enforcement or protection of a right, redress or prevention of a wrong, or the punishment of a public offense.” Cal. Civ. Proc. §22. For purposes of the one action rule, courts have not limited “action” to this definition.

[5] Also by statute, it does not constitute an “action” for purposes of the one action rule for a real property secured lender to attach personal property of the debtor if the real property security is valueless or has declined in value to less than the amount owed through no fault of creditor. This remedy is rarely used, and a lender’s failure to comply strictly with the applicable statutory requirements for the attachment can result in the lender having taken an action.

[6] Legally worthless property is property that doesn’t exist or can’t be mortgaged or wasn’t owned by the trustor under the deed of trust and is to be distinguished from property that has become economically valueless.

These materials have been prepared by Seyfarth Shaw LLP for informational purposes only and do not constitute legal advice.