When a lender forecloses on a defaulted debt and the foreclosed security does not net enough money at the foreclosure sale to fully repay the debt, the difference is called a deficiency. It is well understood that the lender cannot seek to enforce or collect a deficiency following a trustee’s sale. This is because the anti-deficiency statutes, specifically Code of Civil Procedure § 580d, prohibit pursuit of a deficiency following a non-judicial (trustee’s sale) foreclosure.
So, while the lender cannot pursue the borrower for a deficiency following a trustee’s sale, what recourse does the lender have, if any, against a third-party guarantor of the loan? Do the anti-deficiency statutes preclude the lender from seeking a deficiency against the guarantor as well as the borrower?
The June 2008 case of Talbott vs. Hustwit reaffirms the well settled rule that, although a non-judicial foreclosure (trustee’s sale) wipes out any deficiency as against the borrower, the lender still has recourse against the guarantor for any deficiency. This is in part because Code of Civil Procedure § 580d says, “No judgment shall be rendered for any deficiency upon a note . . .”, and case law has interpreted guarantees as being separate agreements from the note, and thus suing to enforce the guarantee is not an action on the note.
In the Talbott case the lender, Talbott, sued the guarantor, Hustwit, for a deficiency following Talbott’s non-judicial foreclosure of property securing a loan to the Hustwit’s trust, Pacific West Investment Trust. The Hustwits, as guarantors, appealed the judgment against them for a deficiency in the amount of the difference between what Talbott credit bid at the trustee’s sale and the outstanding balance of the loan. The Hustwits contended on appeal that C.C.P. § 580a required that an appraisal be conducted to determine the value of the secured property in order to establish the amount of the deficiency, because such valuation is required by § 580a in those situations where a deficiency is allowed, such as after a judicial foreclosure if not otherwise prohibited. The Hustwits also contended that because they, as individuals, and their trust were substantially identical, they should be afforded the same anti-deficiency protection as the borrower.
The appellate court dispatched these contentions with little difficulty because legions of past case law have established that C.C.P. § 580a relates solely to actions for a deficiency judgment against the borrower and has no application to actions against guarantors. The appellate court also had little difficulty with the contention that the Hustwits as individuals and their trust were so substantially identical as to be one in the same. The court said that the Hustwits were secondary, not primary, beneficiaries of their trust and that they had set up a limited liability company as the trustee of the trust, and thus the trust had its own identity sufficiently distinct from the Hustwits as individuals.
So, what is interesting about this case is not its ratification of well-established principles, but instead is the well-researched and well-written concurring opinion by Justice Sills, in which he points out an apparent conflict between statutes relating to guarantees and the well-established case law that allows pursuit of deficiencies against guarantors. Justice Sills calls for legislative reformation of this conflict.
Justice Sills separate opinion concurs with the majority because he says their conclusions are compelled by existing decisions of the Supreme Court. However he goes on to show that the path by which the Supreme Court arrived at the conclusion that guarantors can be held liable for deficiencies was perhaps casual and flawed. He suggests that in this time of the subprime mortgage crisis the legislature might want to revisit this issue because lenders might use personal guarantees to circumvent antideficiency protections.
Civil Code § 2809 provides that the obligation assumed by guarantors “must be neither larger in amount nor in other respects more burdensome” than the obligation of the principal obligors. The case law that evolved into the rule that guarantors could be held liable for deficiencies evolved from case law decided before the antideficiency statutes were enacted in 1933. Those earlier cases held that a guarantee is a separate and independent obligation from the loan obligation – a separate contract. However, Justice Sills points out that the cases have never squarely addressed the apparent contradiction that this is in apparent direct violation of Civ.C.§ 2809 because it exposes guarantors to an obligation “more burdensome” than that to which the principal debtor faces. The principal debtor has anti-deficiency protections, but the guarantor does not.
The other interesting issue in the Talbott vs. Hustwit opinion is the Hustwits’ argument that they and their trust were so substantially the same that they should not be exposed to greater liability as guarantors than the trust was as principal debtor. Justice Sills sums up this argument saying, “the Hustwits simply outwitted themselves. They have to take the rough with the smooth, and, more specifically, cannot avail themselves of the protections of limited liability corporations and at the same time claim an obligation is really theirs at the same time.”
However, the court in its majority opinion discusses several cases in which courts have drawn a distinction between true, independent guarantees and sham guarantees executed by the primary obligor. “It is well established that where a principal obligor purports to take on additional liability as a guarantor, nothing is added to the primary obligation.”
In Torrey Pines Bank vs Hoffman the bank sued the Hoffmans as personal guarantors on a construction loan made to their revocable living trust in which the Hoffmans were the trustors, trustees, and primary beneficiaries. The court held that the structure of the trust made any distinction between the guarantors and the debtor insignificant, and thus barred the bank from recovering on the guarantee.
In Riddle vs Lushing, partners in a general partnership guaranteed a partnership note. The court held that because partners of a general partnership are jointly and severally liable for partnership obligations the guarantee did not change their status as principal obligors. Thus the guarantee was unenforceable.
So the lesson to be taken from this case is that, at least for now, a lender’s trustee sale foreclosure on a defaulting borrower’s security will not operate to bar pursuit of a deficiency against guarantors of the loan, notwithstanding the C.C.P. § 580d prohibition against a deficiency following a non-judicial (trustee’s sale) foreclosure. C.C.P. § 580d anti-deficiency protection accrues to the borrower (or obligor) under the loan and does not bar recovery from guarantors.
Lenders must remain mindful, however, of the case of Union Bank v. Gradsky (1968), which denied the lender its deficiency judgment against the guarantor based on estoppel.
The Gradsky case reasoned that because the lender elected to pursue a nonjudicial (trustee’s sale) foreclosure, the borrower was thereafter protected from liability for a deficiency because of the C.C.P. § 580d prohibition against a deficiency following a nonjudicial (trustee’s sale) foreclosure. That protection gave the defaulting borrower immunity for deficiency liability not only against the lender, but also against any suit by the guarantor for the losses that the guarantor suffered as a result of the borrower’s default.
The court held that once the lender elected its remedy to foreclose non-judicially it had impaired the guarantor’s ability to step into the shoes of the lender and go after the security judicially and to recover any deficiency. Accordingly, well-written guarantees now routinely include a “Gradsky waiver” requiring the guarantor to waive its estoppel defense, along with a number of statutory provisions listed in California Civil Code §2856.
Furthermore it is critical to scrutinize the relationships and the distinctions between the borrowers and the guarantors because a near identicality of interests may defeat the guaranty. Be certain your guarantor is a distinctly different entity than your borrower.
And one final caution, be careful about the drafting of your Deed of Trust. They often broadly provide that the DOT secures all the obligations of the “Loan Documents.” If the guarantee is defined as one of the Loan Documents, then the guarantee is secured by real property which may give rise to additional protections including anti-deficiency and a necessity to exhaust the security before bringing an action on the guarantee.
Returning to the Talbott vs. Hustwit case, Justice Sills challenged the historical basis for treating a guarantee as a separate contract and called for legislative consideration. In today’s financial crisis our politicians are rushing to pass any legislation that credits them with protecting consumers. It is quite possible that guarantees may, under certain circumstances, be construed as an end-run around some consumer protection, so do not be surprised if we see some successful challenges to guarantees.
This article written and © Peter N. Brewer, Esq.
Peter Brewer is an active member of CMA and an occasional speaker, and is the grand poobah of The Law Offices of Peter N. Brewer. The firm serves the legal needs of homeowners, real estate and mortgage brokers and agents, property managers, loan servicers, title companies, developers, investors, other real estate professionals and their clients.