Daily Development for Monday, November 1, 1999

Daily Development for Tuesday, November 16, 1999

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

Thanks to Jack Murray at First American for this one. Jack was kind enough to put the report into DD format, and the comments are his. I read the case myself, however, and did do some editing of the text of the report.

MORTGAGES; PRIORITY; GOVERNMENT FORFEITURE CLAIMS: Ninth Circuit holds that foreclosure sale extinguishes forfeiture claim of federal government, based on federal forfeiture statute, that attached after recording of deed of trust but before sale.

United States v. Real Property at 2659 Roundhill Drive, 199 WL 820284 (9th Cir. 10/15/99)

The original mortgagors purchased real property in Alamo, California in 1990 for $682,500, financing $300,000 through a mortgage loan with World Savings and Loan Association ("World"). The federal government subsequently alleged that the down payment on the property was made with the proceeds of illegal drugtrafficking activity. The government filed a complaint for forfeiture of the property in October 1994, naming the real property as the "defendant res." Shortly thereafter, the government "arrested" the property and recorded a notice of lis pendens in the county records.

World then filed a claim in the forfeiture action asserting an "innocent landowner" interest of $340,000, the amount owed on the mortgage loan. The government did not dispute this claim. Settlement discussions between the government and World broke down, and World commenced a foreclosure proceeding against the property. Both World and the government opposed the mortgagors' motion to stay the foreclosure, which the trial court denied. The mortgagors then filed a bankruptcy proceeding, but the automatic stay was lifted in April 1995. The property was sold at foreclosure sale in May 1995 to six persons (the appellants in this case), for $354,000. World subsequently withdrew its claim in the forfeiture action, and the purchasers entered their claim. World placed the amount of $14,000 (the sale proceeds in excess of its debt) in interpleader in the mortgagors' bankruptcy case.

Both the purchasers and the government filed crossclaims for summary judgment. The purchasers claimed that the government had abandoned the property by consenting to the foreclosure sale, and that the foreclosure sale had extinguished the government's claim. The purchasers also argued that they were "innocent owners" and thereby immune from forfeiture proceedings under the federal statute.

The government argued that its acquiescence in World's foreclosure action did not constitute a waiver or relinquishment of its forfeiture action, that its interest in the property vested prior to that of World because of the federal statute's "relation back" provision, and that the foreclosure sale purchasers were not "innocent owners" because the notice of lis pendens filed by the government was sufficient to alert them to the nature of the property and the action for recovery.

Although the government's arguments theoretically would have supported a claim to ownership of the property free and clear of any claim of the purchasers, the government, as noted, had elected not to contest the validity of the World claim and consequently made a claim only for the excess value of the property over the World claim. The government did not use the foreclosure sale price as the determinant of value, however, but rather relied upon a higher appraisal figure. The upshot was that the government claimed approximately $92,000 in value in the property. The trial court awarded the government its claim on summary judgment..

On appeal, the Ninth Circuit reversed the holding of the district court. The Ninth Circuit first dealt with a jurisdictional issue, holding that the court retained jurisdiction over the real property "res" because no court order had ever been entered declaring the sale proceeds to be the new res. The court then turned to the issue of "abandonment" raised by the appellants, who claimed the government's "active support" of World's foreclosure action constituted an abandonment or relinquishment of the property res. The court agreed with the government's argument that it had never actually "seized" the property but had merely "arrested" it, and therefore had no right to prevent the foreclosure sale. The court found that the government's actions including a letter to World's counsel after commencement of the foreclosure notifying it of the government's pending forfeiture litigation never evidenced any intention to renounce or waive its interest in the real property.

The Ninth Circuit then dealt with the "relation back" issue. The court, citing numerous California cases, noted that "Under California law, when a person purchases property from a trustee in a nonjudicial foreclosure proceeding, the purchaser's interest 'relates back' to the time the original deed of trust was recorded."

The federal forfeiture statute also has a relationback provision (21 U.S.C. Sec. 881(h)), which provides that the government's interest in and title to the property vest "upon commission of the act giving rise to forfeiture." Although the mortgagors' alleged illegal drug trafficking began well before the execution and recording of the mortgage, the court found that the relationback rights of the government cannot arise before a judgment has been entered in its favor. Therefore, the court ruled, because the foreclosure sale occurred prior to any such adjudication, the interest of the government related back only to the time of the recording of its lis pendens.

Because the lis pendens had been recorded after the recording of the mortgage, the court found that government's interest had been foreclosed and extinguished by the operation of California foreclosure law.

Thus, the purchasers at the foreclosure sale took free and clear of the government's forfeiture claim because their title derived from World's rights.

The purchasers, however, would have lost on their claim that their purchase at the foreclosure sale qualified them as "innocent owners" in any event. Although admittedly not necessary to the its ruling in the case, the court addressed the issue of "innocent ownership" in the property "in order to clarify certain misconceptions of the law." The court noted that the federal forfeiture statute contains an exception (21 U.S.C. Sec. 881(a)(6) that prohibits forfeiture of property if the owner has no knowledge of the illegal act or omission that gave rise to the forfeiture proceeding. However, the court refused to imply a "per se" rule that a purchaser who uses legitimate funds to purchase the property is necessarily innocent. Although the Ninth Circuit acknowledged that most courts apply a standard of actual knowledge, it instead favored employing a standard similar to constructive knowledge, which the Ninth Circuit had established in an earlier holding. According to the court, "an owner cannot avoid actual knowledge through 'willful blindness,' " and must act on notice that would prompt further inquiry. But the Ninth Circuit also refused to impose a "per se" rule that notice of the government's lis pendens imparted notice to the purchasers as a matter of law, or prevented the application of the innocent owner defense. As the court noted, "The existence of a notice of lis pendens may well make it more likely that the purchasers knew of the [mortgagors'] activities, but that is a question of fact, not one of law."

Comment 1: This case provides some much needed guidance to mortgage lenders when dealing with forfeiture issues in the foreclosure context. The news is mostly good for lenders at least where the government has not obtained a judgment before the foreclosure sale but caution is still the operative word. Most sophisticated lenders now insert "antiforfeiture" provisions in their loan documents, whereby the mortgagor represents and warrants that neither it nor any other person in occupancy of or involved with the operation or use of the mortgaged property has committed any act that would result in any governmental entity having a right of forfeiture against the property or any funds payable under the loan documents. Such provisions also customarily provide that the mortgagor covenants and agrees not to commit, permit or suffer any such unlawful activity during the term of the loan, and that the mortgagor will indemnify and defend the mortgagee from and against any loss, damage, or injury occasioned thereby.

Comment 2: In a footnote, the Ninth Circuit notes that, with respect to the jurisdictional issue, the district court "probably should have issued [] an order" shifting the subject matter of the forfeiture action from the real property to the sale proceeds. The federal forfeiture statute authorizes forfeiture of property that is "traceable to" illegal drug activity. However, an interest in property purchased with the use of legitimate funds is not forfeitable because such an interest is not "proceeds traceable" to a drug transaction. Because the appellants did not raise the issue of "tracing the res," the court did not deal with this issue in its holding.

Comment 3: Although the government argued that it never relinquished its forfeiture claim by agreeing to the foreclosure sale (and the Ninth Circuit agreed with this contention), the court noted in a footnote that "Some courts have held that 28 U.S.C.A. Sec. 2409a(b) precludes mortgagees from foreclosing on property that has been seized by the government" (citing cases).

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