In California the requirements to conduct a trustee’s sale are very strict. Between the recording of the Notice of Default and the actual foreclosure sale, often times the property does not go to sale on the date set forth in the Notice of Trustee’s Sale. Additionally, under new legislation in California amending Civil Code Section 2924 et seq., lender requirements to notify the borrower of the foreclosure sale have increased and the time periods to conduct a foreclosure have been lengthened. Another common reason for the postponement of the trustee’s sale is that the property owner files a bankruptcy petition.
The filing of the petition creates an absolute automatic stay on all creditor acts and thus halts the foreclosure sale. In order for a lender to conduct the sale, the lender must seek relief from the automatic stay from the Court. With the Court Order terminating the stay as to that lender, the lender may proceed with conducting the foreclosure sale.
How Does a Debtor Sell the Property While in Bankruptcy?
Once in bankruptcy, depending on the type of bankruptcy petition filed, the debtor may decide to list the property for sale on the fair market. For example, a debtor filing under Chapter 13 or Chapter 11 is seeking a reorganization of their debt, and part of their plan for reorganization may be to sell the property (or properties) if the sale will realize some equity to pay unsecured creditors. The debtor would seek approval from the court to appoint a listing broker (RealtorTM) and market the property. Under those circumstances, there is a presumption that there is some equity in the property and that the secured creditors are adequately protected and willing to wait for the transaction to close to recover their investment.
However, in a declining market, the equity erosion is rapid and property values are falling. If the borrower is not making post-petition payments to adequately protect the lender, the lender may seek relief from the automatic stay to conduct its foreclosure sale.
If there is a dispute over the value of the property, and consequently the remaining equity, the Court may set a valuation hearing where the appraiser for the lender will offer evidence of value. The debtor may offer contrary evidence and parties can cross-examine the witnesses. The purpose of the valuation hearing is to assist the Court in determining what equity, if any, remains and if there are grounds to lift the automatic stay for lack of adequate protection.
What If There Is Little to No Equity in the Property?
If the debtor receives a short sale offer, the lenders will still need to agree to accept a short payoff. In a sense, it is an identical fact pattern to any short sale without the context of the bankruptcy. The difficulties have always been with regard to the junior lenders. Many debtors have a Home Equity Line of Credit or private money loans in 2rd or 3rd position.
What if the Junior Lienholder is 100% Underwater?
With the present economy many junior lienholders are virtually wholly unsecured. This means a short sale offer provides little to zero payment for the junior mortgage. For example, if a house in San Jose, California was worth $750,000.00 in 2005 at the time of the loan, with an institutional first for $450k and the home equity line of credit for $200k, the total encumbrances against the property at the time of the loan would have been $650k and thus wholly secured. However, presently that same house may only be worth $450k and the Home Equity Line of Credit is totally under water. Accordingly, the buyer’s offer will not be accepted by the junior lienholder and escrow is not going to close.
If a junior lender refuses the short sale offer, then it becomes a race to the courthouse between the lender seeking relief to move forward with a foreclosure sale or the debtor’s attorney seeking to file a motion to avoid the lien (“lienstripping”) and treat it as an unsecured claim. Debtor’s motion for lienstripping can be a protracted battle.
What if the Debtor has Filed Chapter 7?
A Chapter 7 is a liquidation, not a reorganization. That means if there is equity, the Chapter 7 Trustee will likely list the property for sale. The purpose of the sale would be to realize net profits to pay some unsecured creditors as well. If there is no equity, the Chapter 7 Trustee will abandon the asset and the creditors can move for relief from the automatic stay to complete the foreclosure sale. In the present economy, a property may start out with equity at the time of the bankruptcy petition filing, but as the property stays on the market and prices decline, the Trustee may ultimately abandon the asset.
What Does This Mean For the Buyer?
Negotiation of these transactions takes patience and persistence. As discussed above, short sale offers in bankruptcy are not likely to be successful when a junior lienholder is involved. Often the prospective buyer may end up waiting for the lender to seek relief to conduct the foreclosure sale and then bid at sale. If however there is only a first mortgage, the likelihood of success increases.
Julia M. Wei publishes commentary on issues such as mortgage lending, bankruptcy, lien priority and more on her California Real Estate and Lending Law blog: http://www.dirtblawg.com
Julia is an associate with The Law Office of Peter N. Brewer. The firm serves the legal needs of homeowners, real estate and mortgage brokers, agents, brokerages, title companies, developers, investors, other real estate professionals and their clients. Mr. Brewer and his firm also represent clients in debt collection, breach of contract matters, and other litigation and transactional work. The firm’s client range from homeowners, brokers and lenders based in Santa Clara County, San Mateo County, San Francisco County and Alameda County, as well as throughout other counties in California. You can contact us at: 2501 Park Blvd, 2nd Floor, Palo Alto, CA 94306, Ph: (650) 327-2900, Fax: (650) 327-5959, or on the web at: http://www.brewerfirm.com