Daily Development for Thursday, September 16, 2002


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




MORTGAGES; FORECLOSURE; VALIDITY; PRICE INADEQUACY: Arizona adopts rule that court may set aside trustee's sale for gross inadequacy of price - following position of Restatement of Mortgages.


In re Krohn, 2002 WL 1969665 (Ariz. 8/27/02)


This case was certified to the Arizona state court system by a federal bankruptcy court in which the trustor/debtor had filed her second Chapter 13 petition.  At the time of this petition, a trustee's sale of her residence had been held, and a third party bought the property for a price of $20,000.  Trustor alleged that the value of the property was $57,000.


Although there was some evidence that there were irregularities in the lender's conduct in notifying the debtor of the sale, this case addresses a more fundamental problem.  Debtor  argued that, whether or not there were any irregularities in the process of the foreclosure, a court should have equitable discretion to set aside a foreclosure sale on the basis of a "grossly inadequate price."


The court agreed with this proposition, concurring with the position set forth in the relatively new Restatement of Mortgages, despite the fact that there was no statutory authority for any discretion in the court regarding setting aside private foreclosures and despite the fact that there was no judicial precedent in Arizona supporting this position.  A lone dissenter noted that in fact there is only one other case standing for this proposition in American law.


The common law in Arizona already permitted judicial discretion to set aside judicial foreclosure sales on the basis of inadequacy of price, even though the court found no irregularity in the foreclosure process, where "the inadequacy is so gross as to be proof of fraud or shocks the conscience of the court."  The question was whether this rule should be extended to private sales, and the court concluded that this extension was appropriate.


The court acknowledged one important difference between the two cases, and this is that, unlike in a judicial sale context, there is no existing legal action in which the debtor must bring the objection.  Consequently, there is no ending of the foreclosure process that would serve as a clear bar to the debtor's seeking judicial review of the price.


Here's what the court said on this issue:


"There is, of course, no statute of limitations as to when the question of gross inadequacy must be raised, though the legislature could certainly enact such a statute. Of course, the doctrine of laches applies, and we seem to have survived despite there being no statute limiting the time when gross inadequacy may be raised as a ground for setting aside a judicial sale. Moreover, the balance of equities would be considerably different if the person who acquired the property for a grossly inadequate price sold it to a bona fide purchaser."


The court went further and defined what would constitute inadequacy of price, apparently in a ruling that would provide guidance to courts both in judicial and non-judicial foreclosure formats, and, incidentally, would not necessarily justify setting aside the sale if the facts proved out as the debtor alleged:


"As to the guidance provided by this opinion in defining grossly inadequate price, we can only point out that the RESTATEMENT indicates that twenty percent of market value is generally considered a grossly inadequate price. The parties, of course, are free to argue under the facts of a particular sale that a different percentage is or is not grossly inadequate. See RESTATEMENT 8.3 cmt. b and illus. 6."


Here is an excerpt of the court's justification for its conclusion give readers the flavor of the court's opinion:


"The mortgage banking and lending industry is of great importance to our economy, but lenders are primarily and vitally concerned with getting their money back with the agreed upon interest payments. The health of their industry depends on repayment, not on foreclosure. Borrowers are justifiably concerned with legitimate protection against inequitable loss of their property if there is a foreclosure. To the extent that judicial oversight to prevent gross inadequacy of bidding at trustee's sales may actually increase prices realized, both lenders and borrowers would benefit. . . . There are, of course, those waiting for opportunities based on individual misfortune, and we believe this makes it even more important that courts of equity are open to assure debtors receive not only procedural but fundamental fairness. Windfall profits, like those reaped by bidders paying grossly inadequate prices at foreclosure sales, do not serve the public interest and do no more than legally enrich speculators. We doubt this serves the legitimate interests of trustees any more than it serves the legitimate interests of lenders or borrowers."


Comment 1: The editor has enormous respect for the Reporters of the Restatement on Mortgages, but they were wrong to propose this rule and the Arizona Supreme Court was wrong to adopt it.  The saving grace for the editor is the certain knowledge that this case presents such an unworkable scheme that lenders will have little difficulty getting the rule reversed or substantially modified in the legislature.


The fundamental problem is one that the court identifies - the opinion guts the finality and certainty that is the heart of the concept of the power of sale by providing an unlimited time period within which a debtor may sue to set aside the sale based upon a trial court judge's view of the equity of the price (note that the 20% is only a benchmark).


There is little doubt in the editor's mind that this rule would in fact be bad for most debtors because it will dissuade lenders from spending as much time and effort working this out with the debtor while unpaid interest continues to accrue.  When there is a swift and certain method of resolution of the lender's problems, the lender can afford to be generous. Here, however, the process may drag on and on.  Note that once the foreclosure is set aside, it is not necessarily the case that there will be a new foreclosure immediately.  More likely, as was the case here, there will be a pending bankruptcy proceeding which will then tie up the creditor's remedies for a substantial period of time thereafter.


Comment 2: Note also that the court makes no effort to differentiate between debtors who bid in the debt and those who do not.  In fact, the case does not indicate whether the lender participated in this sale, since a third party bid.  The net impact is that lenders who are owed less than the value of the property in effect have no certainty of process unless they choose to pay off the debtor completely for the value of the property -

acquiring property they never sought at a price they never intended to pay.


Although the court makes a passing reference to unscrupulous lenders who try to create deficiencies by underbidding property, there is no indication that this was true in the case at hand, and no attempt by the court to limit the rule to that situation.


Comment 3: Not only will lenders be less likely to attempt to work things out with the borrowers, but, needless to say, should lenders decide that they do want to attempt a workout, the borrower will have less incentive to cooperate.  Deeds in lieu of foreclosure will be harder to obtain, at least where borrowers are well advised, since the borrower can bargain harder, since the lender has much more to lose by going to foreclosure.


Comment 4: Note, finally, that the court does not limit the rule to residential or consumer foreclosures.  General Motors can invoke this rule, and, more to the point, commercial borrowers will have the threat of a virtually interminable uncertainty in title as a weapon in negotiating with commercial lenders to resolve defaults.


Comment 5: And what about the interests of the bona fide purchaser at the foreclosure sale: Well, the court deals with this issue in what strikes the editor as an unbelievably naive fashion:


[W]hile bona fide purchasers have not been deterred by the possibility of a vacated sale caused by circumstances out of their knowledge and control before the sale, the price paid is completely within the purchaser's control. Knowledgeable purchasers can reasonably evaluate the fair market value of a property to make an appropriate bid that is not grossly inadequate. . . "


And what, pray, is the "appropriate bid?"  Anyone who has worked with appraisers in disputed cases even one time will certify that the variances in estimates of value can be huge, and this is true especially in bankruptcy, where these cases will in many cases be resolved.


Comment 5: In short, the case is one more example of the editor's oft- expressed view that modern appellate courts, overladen as they are with former tort lawyers and former prosecutors, have no business making commercial law.  In their unrestrained crusade to do good wherever injustice is found, appellate courts are straining the fabric of the common law to the breaking point, driving more and more issues toward legislative solutions, and thus depriving us of the fundamental flexibility that the common law has traditionally provided.


This particular, case, note, was decided less than three weeks ago, and it may be possible for parties interested in the well being of foreclosure laws to ask the court to reexamine the analysis here, if not the result.


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

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