Daily Development for Friday, April 26, 2002

I'll be discussing this case, and the one for Wednesday's DD, Stanton, and several others at the California Bar Real Property Section Retreat this Saturday.

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

MORTGAGES; INSURANCE; FULL CREDIT BID: Mortgagee's full credit bid precludes resort to insurance proceeds for pre-foreclosure damage.

Norwest Mortgage, Inc. v. State Farm Fire & Casualty Col, 188 Cal. Rptr.2d 367 (Cal. App. 2002)

Borrowers were in default and in bankruptcy. Mortgagee obtained relief to foreclose, but prior to foreclosure the property was severely damaged by fire. The borrowers' claim was $81,000 and the probable value of the property was around $11,000. Borrowers maintained an insurance policy with a mortgage clause providing that the mortgagee would receive the loss payable "as interests appear." The court does not indicate whether the policy included other language consistent with a "standard mortgage clause," but modernly it would be extraordinary if the policy did not contain such language. Further, the way the case works out, the rest of the language of the clause likely made little difference.

The borrowers didn't even bother to submit a claim, aware that the mortgagee likely would absorb any insurance proceeds. But the mortgagee got wind of the situation and did submit a timely claim.

Thereafter, prior to the insurer's processing of the claim, the mortgagee foreclosed on the property.

In California, in a nonjudicial foreclosure, no deficiency judgment is available. Perhaps for this reason, when mortgagee retained a foreclosure agent to carry out the foreclosure, neither party spent much time evaluating whether the property was worth the amount of the claim, and the agent, on behalf of the mortgagee, simply bid in the $81,000 debt at the foreclosure sale. There were no other bidders. (What a surprise!!)

Shortly thereafter, the insurance company - the only party that was paying attention to what was happening - denied the claim on the grounds that the property had not been reduced in value below the amount of the mortgagee's interest. Since the mortgagee's recovery for pre-foreclosure damages is limited to any injury to its security interest, the mortgagee had no claim.

Nothing loathe, the mortgagee simply notified the foreclosure agent to "rescind" the prior sale and to notice up another foreclosure sale and to "publish" another bid. The court is not clear what "publish" meant in this context. In any event, the mortgagee's letter made clear to the agent that the value of the property, due to the fire damage, was only $11,000, and that the agent was to bid that amount at this new sale. The mortgagee then notified the insurance company that it had rescinded the sale and that a new sale was scheduled.

By the time of the new sale, the mortgagee had replaced the original agent with a new one, even though it had had extensive correspondence with the original agent. Perhaps the parties were already circling wagons concerning liability for the prior error. In any event, the new foreclosure agent leapt right into the breach and, contrary to lender's instructions, again bid in the debt. When mortgagee discovered this, it instructed the agent not to record the foreclosure deed and to hold a new sale. The agent nevertheless, apparently negligently, recorded the deed. (Can you say "comedy of errors?)

Ultimately, the second agent scheduled a third sale, and this time bid the reduced amount. One suspects that no one was surprised when the insurer refused to honor this third sale and rejected the insurance claim.

What is surprising, however, is that the mortgagee elected to litigate the issue, and to appeal when it lost below. The only fact that could explain such an expedition is that some California appeals courts have been very hostile, in other contexts, to the concept of the full credit bid marring mortgagee's rights, can explain this excursion. See, e.g. Kolodge v. Boyd, 2001 WL 328564 (Cal. App., 1st Dist. 4/5/01) (the DD for 4/13/01; Alliance Mortg. v. Rothwell, 34 Cal. Rptr.2d 700 (Cal. App. 1994), (which the editor excoriated in a DD for 4/27/95, and which was significantly modified on appeal, 44 Cal. Rptr. 2d 352 (Cal. 1995) (the DD for 4/27/95).

In any event, the mortgagee didn't manage to get to those judges this time, and the California Court of Appeals, following California precedent, held that the mortgagee was bound by its full credit bid in the first sale. It could not unilateraly rescind that sale. The mortgagor's consent was required, and of course the mortgagor probably had never even been made aware of what was going on. (Note that the mortgagor conceivably might have had a claim here, but it would have had to show that the value following the fire was other than that suggested by the mortgagee's bid.)

Here, of course, the mortgagee was aware that the fire had occurred. But the court, in dicta, (following Supreme Court dicta) went on to conclude that notice of the damage is irrelevant: "Actual or constructive notice of property damage is irrelevant because the full credit bid, once made, extinguishes the debts secured by the insurance policy."

Comment 1: As suggested, the result was foreordained. But the dicta at the end, holding that the lender would be precluded from demonstrating lack of any notice of the injury, is a result to which the editor objects.

The editor has expressed these views in his article on this subject: "The Mortgagee's Interest in Casualty Loss Proceeds; Evolving Rules and Risks," 32 ABA Real Property, Probate & Trust Law Journal, 1 (1997).

The editor believes that where the damage occurs so close to the time of foreclosure, is hidden by mortgagor, or is otherwise undiscoverable by virtue of reasonable efforts to inspect, the mortgagee ought to be permitted to avoid the sale and to resell the property in order to preserve its insurance claim. (The editor expressed no opinion as to whether the mortgagee ought to seek judicial validation of its actions before conducting the new sale - which the mortgagee did not do here, and which might have been a good and money-saving idea.)

The result in the case is consistent with the Restatement of Mortgages, which posits that the lender should be barred by its bid even where it had no knowledge. The rationale for the Restatement of Mortgages position is that the benefits of finality are worth the small risk of the lender occasionally not becoming aware of damage prior to foreclosure, since careful lenders can obtain the right to inspect the property in the mortgage instrument and can conduct a final inspection just prior to sale.

The editor readily admits that his position would not have resulted in a different outcome here. One would assume that a $70,000 fire likely would have been readily observable simply by a drive by inspection of an $80,000 house.

Comment 2: As the author has indicated in comments to the DD cited above, the mortgagee does presumably obtain an advantage by bidding the full credit amount. Other bidders are deterred from participating.

The fact that other bidders don't appear at the sale is not necessarily conclusive. It would not be too unusual for a potential bidder with an interest in the property to call the foreclosure agent to inquire whether the lender is bidding in the debt and, if the answer was affirmative, thereafter ignoring the sale.

In any event, even if it is true that most of the time the foreclosure sale is a mere formality, and that few other bidders show much interest in most of these sales, the fact is that it is a required formality, and not an idle exercise. Although we have reduced the elimination of the equity of redemption to a relatively simple ritual, we are still carrying out an important legal act and the rituals have meaning.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1‑6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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