Daily Development for
Monday, June 2, 1997

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

MORTGAGES; FORECLOSURE; SURPLUS: In the absence of agreement between parties as to how proceeds from foreclosed property should be applied, court should distribute proceeds ratably among secured debts of same debtor.

Nestl=E9 Ice Cream Co. v. Fuller, 924 P.2d 1040 (Ariz. App. 1996).

This case deals with allocation of proceeds from a personal property security agreement, but the court's treatment of the issue indicates that it might apply as well to application of surplus from a foreclosure sale.

The debtor here had given a deed of trust on real property to secure a note. Later, the debtor signed a security agreement pertaining to virtually all of debtor's other business assets and receiveables. This security agreement secured the note secured by the deed of trust and in addition another note and an open account, all owed to the same creditor.

The debtor defaulted on all obligations and declared bankruptcy. As the primary secured creditor, the creditor was permitted to liquidate the personal property assets, producing substantial proceeds. It applied all the proceeds to the note that was not secured by the deed of trust and the account debt, and filed suit to foreclose on the deed of trust securing the other note. The debtor defended the foreclosure on the grounds that the creditor had an obligation to apply the proceeds of the personal property liquidation first to the deed of trust note.

The Arizona Court of Appeals acknowledged that there was a triable issue of fact as to whether the parties had agreed in advance of the liquidation that the proceeds would be first applied to the deed of trust note. It held that such an agreement would be valid, if proven. Therefore, the court remanded for a determination of that issue.

But the court also held that, absent agreement, the debtor does not have the right to direct how the proceeds of an involuntary liquidation of collateral will be allocated when the collateral secures more than one obligation to the same creditor. The court further concluded that the creditor also lacked the discretion to allocate the proceeds as it saw fit, although it acknowledged that there is a split in the jurisdictions on the point. Here, as an opinion of first impression in Arizona, the court concluded that the trial court has the authority to determine the allocation, and that in the ordinary case the appropriate allocation should be a ratable one.

Comment: The editor concludes, somewhat tentatively, that the case is wrong to the extent it requires ratable allocation. Absent a binding agreement in advance, why shouldn't the creditor have been able to allocate the proceeds of collateral as it saw fit? Of course, there is the rule of marshalling of assets - designed to benefit other secured parties by stretching available collateral to satisfy the most interests. If there had been junior secured parties in the real estate here, they theoretically would have been able to compel allocation of the personal property liquidation proceeds to the other debts owed to the creditor. But there were no such interests.

Absent concerns about third parties, it is difficult to see how the it makes a big difference how the liquidation proceeds are allocated, since the creditor would have a deficiency claim as to any of the debts if they remained unpaid, and could apply that claim against any surplus resulting from the mortgage foreclosure. But perhaps the debtor saw a tactical advantage in bankruptcy by reducing or eliminating the secured claim against its real estate. Or perhaps there was some other advantage to the debtor, such as the avoidance of default interest on the real estate secured note, that the court does not reveal (default interest in any event likely would not be recoverable in bankruptcy).

In any event, outside of bankruptcy or the interests of other creditors, the editor sees no particular reason to compel the creditor, who, after all, is realizing upon collateral following default, to allocate the proceeds in any fashion other than that most convenient to the debtor. =20

In Arizona, of course, it will now be necessary for creditors to include form language in their security agreements providing a free right of allocation. Probably such language should have been there in the first= place.

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 Stacy Walter at the ABA. (312) 988 5260 or= stacywalter@staff.abanet.org

Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA.