Fallout from the Foreclosure Crisis: An Anti-Deficiency Law Update

[1]While the flood of residential foreclosures that characterized the Great Recession has dried up, appeals challenging the rights of lenders to recover their post-foreclosure loan balances are still finding their way through the appellate process. Anti-deficiency laws — which either prohibit lenders from suing for a deficiency judgment or limit the amount of such judgments — are at the forefront of such appeals. This article summarizes some of the most recent and significant appellate opinions interpreting and enforcing anti-deficiency legislation, as well as covering amendments to anti-deficiency laws themselves.

Waiver

Perhaps no issue has been more divisive, and resulted in more conflicting decisions, than the issue of whether the protections of a state anti-deficiency statute may be waived. In some cases, the answer to that question has turned on what type of anti-deficiency legislation is at issue and upon who was charged with having waived the protection of the statute.

This article analyzes two basic types of anti-deficiency laws. The first is composed of laws that completely prohibit lenders from filing a lawsuit to recover any portion of an alleged post-foreclosure deficiency. The second is composed of laws that limit the amount of the deficiency the lender may recover, which is generally the difference between the outstanding loan balance and the greater of (a) the fair market value of the property, or (b) the price obtained at the foreclosure sale.[2] Between both types of laws, there is considerable variation among the states as to whether the laws apply only to borrowers, or whether they also apply to secondary obligors such as guarantors.

Courts have been somewhat more reluctant to enforce advance waivers of laws that merely provide “a fair market value credit” against the lender’s recovery than those that prohibit deficiency lawsuits altogether. They also have been more reluctant to enforce waivers by borrowers than by guarantors. For example, the Arizona Court of Appeals held that a borrower’s prospective waiver of A.R.S. § 33-814(G) — which provides that “no action” may be maintained to recover a deficiency judgment following a nonjudicial foreclosure of certain residential properties — is unenforceable as violating Arizona public policy.[3]

More recently, however, the court held that guarantors could prospectively waive the protections of that statute.[4] It reasoned that “individuals who guarantee loans do not appear to be the type of consumers the Legislature intended to protect, primarily because a guarantor who is not the borrower does not face the risk of losing a home to foreclosure in the wake of a default.”[5]

  While the flat prohibition on deficiency actions of A.R.S. § 33-814(G) applies only to loans secured by certain residential properties, Arizona also has a statutory “fair market value” credit that applies to loans secured by all types of property.[6] The Arizona Supreme Court refused to enforce any prospective waiver of this fair market value credit, by either borrowers or guarantors. The court held that the statute “protects against artificially inflated deficiencies by preventing windfalls resulting from below-market credit bids.”[7] Because the public policy served by the statute “clearly outweighs the interest in enforcing prospective waiver terms,” the court held such waivers unenforceable.[8]

The Supreme Court of North Carolina reached a similar result. It held that guarantors are within the protections of N.C. § 45-21.36, which allows an offset against a deficiency balance equal to the fair market value of the property sold.[9] The court went on to hold that because the statute “is so narrowly tailored to address specific instances of the public’s vulnerability to lender overreach, waiver of this statutory protection as a prerequisite to receipt of a mortgage or as a condition of a guaranty agreement would violate public policy.”[10]

The Supreme Court of Texas, however, upheld a guarantor’s waiver of that state’s statutory fair market value credit, Tex. Property Code § 51.003. It held that “Texans have long embraced the principle of freedom of contract,” and therefore contractual waivers of statutory rights should generally be upheld.[11] While the court recognized that sometimes “the Legislature decides that some benefits are too important — and thus may not allow them — to be waived,” it held that the legislature must “speak clearly” if it wishes to prohibit waiver. Because the Texas legislature did not expressly prohibit waivers of the fair market value credit, the court would not decline to enforce such a waiver.[12]

The Colorado Court of Appeals also upheld a guarantor waiver of Colorado’s statutory fair market value credit, C.R.S. § 38-38-106(6). The court held that the power to declare contractual provisions unenforceable as violating public policy “is a very delicate and undefined power … [that] should be exercised only in cases free from doubt.”[13] Because the guarantors in Hicks “have not suggested an absence of equal bargaining power or overreaching by the lender rendering the agreement unconscionable at the time it was made, nor did they allege that the bank's bid violated an implied duty of good faith,” exercise of the power to declare the waiver unenforceable was not appropriate under the circumstances.[14] Worth noting, however, is that Hicks involved a guaranty of a $6 million loan to build a condominium complex. The result might have been different if the defendants were borrowers under a standard residential mortgage.

Finally, in a diversity-of-citizenship case involving the interpretation of Oklahoma’s statutory fair market value credit, the U.S. District Court for the Northern District of Oklahoma held that Okla. Stat. tit. 12, § 686, does not expressly apply to guarantors.[15] While a separate statute, Okla. Stat. tit. 15, § 341, provides that if the principal’s debt is set off, the guarantor’s debt must be set off as well, the protections of that statute may be waived. Because the guarantees at issue waived any defense of setoff that would otherwise be available to the borrower, the court held that the guarantors had validly waived their fair market value credit defense.

Conflict with Federal Law

Nevada has a unique anti-deficiency statute. In 2011, Nevada enacted N.R.S. § 40.459(1)(c), which caps the amount that a person who purchases a loan from the original lender (or any successor) can recover when suing for a deficiency following the foreclosure of a borrower or guarantor’s principal residence. In general, the plaintiff’s recovery is limited to the difference between the amount it paid to acquire the loan and the fair market value of the property. But in Munoz v. Branch Banking,[17]

Anti-Deficiency Legislation

The bursting of the housing market bubble hit Arizona particularly hard, and the resulting deficiency lawsuits left large numbers of borrowers vulnerable to substantial judgments that they could not afford to pay. The Arizona Court of Appeals responded with several opinions that increased consumer protections. Among them, the court held that A.R.S. § 33-814(G) prohibits deficiency judgments whenever a lender nonjudicially forecloses on property that the borrower intends to occupy as his principal residence — even if construction of the property was never completed.[18] The opinion was notable in light of its apparent conflict with the statute, which by its express terms applies only when the statute “is limited to and utilized for either a single one-family or a single two-family dwelling,” and prior Arizona Supreme Court law precluded application of the statute to unfinished homes.[19]

The intermediate appellate court’s decision in Mueller was ultimately overturned by the Arizona Supreme Court.[20] But Mueller also touched off a movement to amend Arizona’s anti-deficiency statutes to bring them back in line with their original intent and limited reach. As a result of this movement, the Arizona legislature enacted legislation that limits the reach of Arizona’s statutory prohibition against deficiency judgments by clarifying that (a) the prohibition applies only when the residential property foreclosed upon has been substantially completed and has actually been utilized as a dwelling (as opposed to simply being intended for use as a dwelling), and (b) developers and spec builders who build a home for the purpose of selling it at a profit, rather than residing in it, are not entitled to the protections of the statute.[21] The statutory amendments apply only prospectively, to mortgages originated on or after Jan. 1, 2015. They do not impact the rights of borrowers or guarantors to a fair market value credit against the deficiency judgment where such judgments are permitted.

Conclusion

As the flood of foreclosures has turned to a trickle, the impact of the decisions discussed above may have less practical impact over the course of the next few years. But if history is any indication, there are more bust cycles yet to come. And when they do, the decisions and legislative enactments discussed above will play a significant role in determining the outcome of deficiency lawsuits, and in influencing whether such lawsuits are filed at all.