Daily Development for
Tuesday, October 22, 1996

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

MORTGAGES; WASTE; "RENT SKIMMING:" New wave of statutes establishes criminal penalties for diverting rents on defaulted residentail property away from mortgagee prior to foreclosure.

People v. Bell, 53 Cal. Rptr. 156 (Cal. Rptr. 1996)

The practice in question, sometimes known as "rent skimming" or "equity skimming" or "equiteering," has been a target of mortgagees seeking legislative reform of foreclosure practices for decades. It works best in jurisdictions in which the borrower has a substantial post-default (or even post foreclosoure) right of possession, either through lengthy judicial foreclosure periods or statutory redemption periods. But, apparently, the practice also was used successfully in California, with a relatively short deed of trust foreclosure, through use and abuse of bankruptcy filings.

The "rent skimmer" identifies homeowner facing foreclosure of their property and approaches them with an offer to acquire their property for cash. As the homeowner in such cases usually is hopelessly bound up with debts, and has little understanding of the legal situation, the skimmer usually can cut a good price for the property. Having obtained title, the skimmer then proceeds to rent the property out, often taking substantial advance rents or security deposits. The skimmer's purpose is to get as much cash as possible as quickly as possible. Usually, since there is a period of six months to a year available prior to the completion of the foreclosure, the skimmer gets back far more than was paid to the homeowner. The skimmer pays nothing to the mortgagee. As the skimmer has no long term interest in the property, the skimmer pays little attention to whether the tenants will care for the property, and often major destruction occurs in such instances.

In California, where there is no deficiency allowed following many kinds of foreclosures, the skimmer basically is diverting money from the bank, and not adding to a deficiency for the original mortgage. In other states, the skimmer actually increases the risk of deficiency for the homeowner both by the tenants' waste of the property and by extending the period prior to final foreclosure, thus adding to accrued interest obligations.

The California statute addresses these problems by identifying as a crime the practice of "knowing and willful rent skimming" with regard to five or more parcels of residential property within any two year period. The statute defines "rent skimming" as follows:

". . . using revenue from the rental of a parcel of residential real property at any time during the first year period after acquiring that property without first applying the revenue or an equivalent amount to the payments due on all mortgages and deeds of trust encumbering the property."

The court in this case construed the statute to require no specific criminal intent. The "willful" requirement simply connoted that the "skimmer" had to intend the acts of failure to apply the rent in the face of a mortgage default within one year of acquisition. There need be no fraudulent or criminal intent.

The defendants first argued that the statute criminalized the nonpayment of a debt. The California Constitution specifically prohibits imprisonment for nonpayment of debt, and making rent skimming a crime, the defendants argued, would lead to imprisonment for nothing more than failing to pay a mortgage debt. The court held that there was an exception to the Constitutional prohibition on criminalizing debt default. The exception arose when the nonpayment amounted to a "fraud," or, as stated in some cases, an act contrary to "good morals and fair dealing." Earlier cases apparently had upheld criminal penalties when nonpayment occurred because the debtor had "diverted" monies available to pay a just debt and used them for other purposes. The earlier courts had commented that "mere insolvency cannot be a crime" but that failure to pay a debt when money was available to do so could be made criminal.

Following these cases the California court here held that it would have been within the province of the legislature to make a single act of rent skimming (as defined by the statute) a criminal act. It would not be necessary to apply criminal sanctions only to pattern activity as the legislature actually did.

The court also struck down challenges to the statute based upon the Equal Protection Clause and the Due Process Clause. It pointed out that the practices involved had, in the findings of the legislature, caused particular mischief in the residential mortgage field, and it was appropriate to single out debtors secured by residential real estate as the sole parties subject to potential criminal sanction for nonpayment of their debts.

The court also held that the statute was not inconsistent with the federal policies established under federal bankruptcy law, which are designed to provide debtors with additional time to reorganize their affairs free of continued harrassment based upon prior debts. Note that in a number of the cases in which the defendants allegedly involved themselves, the defendants had filed bankruptcies on behalf of the mortgage borrowers. The court held that there was no inconsistency with federal law because the bankruptcies had never been filed for nor pursued for the legitimate bankruptcy purpose of rehabilitation of the debtor, and in fact were always dismissed after the skimmers undertook no real action was taken to pursue them. (Allegedly, in some cases the skimmers in fact forged the prior homeowners' names on bankruptcy documents.)

Note: The court cites five other jurisdictions that also have enacted legislation aimed at rent skimming. These states include Colorado, Kansas, Florida, Washington and some federal legislation.

Comment 1: Note that many home mortgages do not include express assignments of rent or any clear requirement that income derived from the property serve as security for the debt. If that is the case, has the California legislature created a new property interest in the mortgagee? Consider, for instance, what would happen if a California homeowner elected to use rental income to pay debts other than the defaulted mortgage debt, on the notion that the borrower would not be liable for a deficiency judgement anyway, so it would be better to use available funds on which the borrower had personal liability. Isn't such reasoning in fact consistent with California's anti-deficiency scheme? What if, in fact, the borrower assigned rent income to some other creditor? Does a statute making it a crime to divert the rents place some kind of lien on the rents in favor of the mortgagee? If so, does it constitute a "taking" of property?

Comment 2: The editor is symphathetic with the problem that mortgagees face, and with the difficulties in defining only that conduct which violates public policy. But it does seem bizarre that lenders who did not bargain to tie up the rental income flowing from a lawful right of possession should be able to enlist ex post facto assistance from the legislature to get such a right. It seems equally bizarre that a debtor who used the rental proceeds from residential property for, say, an important family purpose would be seen as performing an act "contrary to public morals and fair dealing." The California statute has laudable intentions, but is overbroad, and should have been struck down.

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