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

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

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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