Daily Development for Monday, June 9, 2003
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri dirt@umkc.edu
Today's Guest Reporter is Roger Bernhardt, writing in
the California Real Property
Reporter. I have set up the beginning as a typical DD,
but Roger's unique style deserves his own
framing, so I've left his article more or
less intact as a Reporter's Comment:
The case, I think, is one that ought to lead to "belt
and suspenders" redrafting of mortgages
everywhere.
MORTGAGES; INSURANCE; PROCEEDS: Mortgagees have no
claim to settlement monies paid for damages based upon construction defect
litigation when mortgage was not in default, and lawyers not liable for
conversion when they turn proceeds over to mortgagors, who
take the money and promptly default.
Kasdan, Simonds, McIntyre, Epstein & Martin v
World Sav. & Loan Ass'n (In re Emery)
317 F. 3d 1064( 9th Cir 2003)
A law firm settled with its clients' contractor over
construction defects, paid $335,000 of
the funds received over to the clients, and retained
$200,000 for its fees. The clients, trustors under a
deed of trust, pocketed the money,
defaulted on their loan, and filed bankruptcy. The lender got
the stay lifted, foreclosed, underbid, and then went
after the law firm for converting money
that it said belonged to it. The bankruptcy court held
for the law firm, the district court held for the
lender, and the Ninth Circuit ultimately
held for the law firm, on the ground that no funds
belonging to the lender had been
converted.
Reporter's Comments:
I predict that two consequences will flow from the
Ninth Circuit's this decision:
First, no other court is likely to agree with the logic
announced by the court. Second, all
lenders will rewrite their deed of trust forms to
completely escape the reasoning - and its
consequences - anyway. To a large degree,
therefore, this commentary may be an exercise in futility,
although I will try to redeem it by some broader
observations at the end.
I. Was Anything Owed?
The reasoning of the Ninth Circuit in concluding
that none of the settlement belonged to
the lender is so unusual that it forms the basis of
my first opinion that other courts are unlikely to
agree. The deed of trust provision
covering funds arising from any action against third parties
"for injury or damages to the Property . . . and
which arose or will arise before or after
the date of this Security Instrument" clearly included this
settlement, and nobody seemed to contend otherwise on
that issue. But the fact that the funds
were assigned to be applied to "any amount that I
may owe to Lender under the Note and this Security
Instrument" is what killed the lender.
Since other provisions in the document refer to "sums
secured," the court declared that the amount owed was
"zero," so long as the trustors were not
currently in default on their payments. (I must observe with amusement that this same deed of trust, in defining
the note, stated: "The note shows that I
owe Lender U.S. $450,000 plus interest." (I got this and a few other facts from the
underlying file rather than from the
opinion itself.) Well, I wish I could state on my loan
applications that I do not "owe" anything on all my
debts, simply because I happen to not be
in default on them at that moment. And when I asked
two friends how much they owed on their mortgages,
they each replied with the principal
balances on their loans, not the overdue arrearages. A
case I have in my casebook on dragnet clauses says
(Langerman v Puritan Dining Room 21 CA
637, 642, 132 P 617 (1913) ):
"A debt, whether legally
enforceable at the present time or at some future time, constitutes an existing
obligation, and when we refer to a debt we at once understand
thereby that thus there is resting upon some one an obligation to pay
money to another
when the time fixed by the parties, or by law, for its payment
has
ripened."
I take this to mean that money can be owed long before
it is payable. To me, the way the court
uses the word "owe" is not at all what most of us
mean when we use it.
II. Hedging Against Similar Results
But kicking around an opinion just because you think
the judges got it wrong is not productive
activity. (Law professors may delight in doing so, but it too readily seduces students into thinking they can
ignore any rule they don't like.) Even
though people may continue to speak and write the same way as before, it is not impossible for judges to
begin limiting "owed" to "amounts
currently due and payable," despite its common contrary usage, as happened here. Careless inclusion of
that word in a document could become
costly. As a result of this opinion, the
obvious change I would expect this lender to make is to revise its deed of trust provision covering
assignment of litigation proceeds to have
the money applied to all "sums secured"-the term that is used in the related insurance and governmental
taking provisions-and to make sure that
the definition of that phrase is broad enough to cover all possibilities. If the lender lost the Emery
case because of what its deed of trust
said, then saying it differently should let it win
the next one.
I would also suggest that attorneys make a computer
scan of all of their documents for the
word "owed" to see if it appears in any dangerous
context. (For instance, if interest is to be charged
on all sums owed, do you really want to
make the unpaid balance due interest-free?) Too often,
one paragraph of a document is revised in response to
some recent adverse ruling without due
consideration of all the companion paragraphs in the instrument.
III. Don't Let Consistency Trump
Sensitivity.
The above advice does not, however, mean that the
three paragraphs in a deed of trust
covering insurance, condemnation, and settlement proceeds
should be identical in all respects. Based on past
cases, there are different lessons to be
learned for each, a few of which I will mention here in the
remaining space allotted to me.
1. Insurance Proceeds. Property insurance proceeds are
products of private contracts, so
insurance proceeds paid after a casualty to the trustors'
property do not belong to the lender. The lender can
reach them only if the deed of trust was
properly worded. If the particular risk was not required
to be covered - as is true of earthquakes, for
example-then a trustor who has
independently elected to insure against that risk can keep the
proceeds despite the effect on the
lender's security. See Ziello v Superior Court 36
CA4th 321, 42 CR2d 251 (1995) ; Foothill Village
Homeowners Ass'n v Bishop 68 CA4th 1364,
81 CR2d 195 (1999) . (However, a back door route to these funds may exist if the deed of trust assigns all
insurance proceeds to the lender, even
for hazards that were not required to be covered. See JEM Enters. v Washington Mut. Bank99 CA4th 638,
121 CR2d 458 (2002) ; Martin v World Sav.
& Loan Ass'n 92 CA4th 803, 112 CR2d
296 (2001) ) Emery, of course, advises lenders that such
assigned insurance proceeds should not be
limited to being applied to what the trustor then owes. On the other hand, in Schoolcraft v Ross 81 CA3d
75, 146 CR 57 (1978) , the judges'
refusal to allow a lender to claim the proceeds when the trustor wanted to use them to rebuild is probably
not a result that better drafting can
overrule. But the permission granted to lenders by CC 2924.7(b) to reach the funds, regardless of
any impairment of security issue, seems
to mean that even the amply oversecured
lender can take the entire award without needing a special
clause to that effect.
2. Condemnation Awards. Because these awards
constitute substitute security, a lender
has a claim to them even when the deed of trust is
entirely silent on that issue. But here the doctrine
of impaired security may come into play
and limit that claim to only what is necessary to
restore the lender's previous loan-to-value ratio.
See Milstein v Security Pac. Nat'l Bank
27 CA3d 482, 103 CR 16;(1972); People ex rel Dep't of
Transp. v Redwood Baseline 84 CA3d 662, 149 CR 11
(1978) . The elimination of the
impairment requirement in CC 2924.7 applies only to
insurance awards, and I cannot really say whether
good language will let the lender keep
the entire award, even when its loan is quite safe anyway.
3. Litigation Awards and Settlements. This situation
got off to a bad start in 1968 when
Justice Traynor held that a deed of trust provision covering
damages awarded for injury to property did not apply
to the money received by the trustors in
settlement of their fraud claims against their sellers. American Sav. & Loan Ass'n v Leeds68 C2d 611, 68 CR
453 (1968) . That probably explains the
far broader language used in Emery, as
well as why that clause goes on to say that "injury or damages"
includes claims for breach of contract,
fraud, concealment, and negligent or intentional acts. Without this provision, some of those recoveries
might qualify as substitute security, but
many would not. And-if impairment of security is a factor-when does the security become impaired upon
the discovery of a previously unknown
defect?
Finally, all of this still leaves open the very
interesting question that the Ninth
Circuit left unresolved: To what degree must the borrowers'
lawyers take steps to ensure that the
security interests of their clients' lender remain protected. When is the last time you thought it wise to tell
your homeowner clients that you felt duty
bound to notify their bank in order to make sure that their recovery would be taken away from them by the
bank as soon as they got it?
Readers are encouraged to respond to or criticize this
posting.
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