DO NOT MAKE A FULL CREDIT BID AT YOUR FORECLOSURE SALE
WITHOUT CAREFUL ANALYSIS!
NAJAH V. SCOTTSDALE INSURANCE COMPANY; 2014 WL 4827882 (2nd District-CA Sept. 30, 2014)
This is an interesting new case the again echoes the principle that a lender should never make a full credit bid at its foreclosure sale. In this case, the foreclosing lender made a full credit bid and was later prohibited from suing the insurance company for pre-foreclosure damage to the property, even when the damage was intentional.
The Loans Securing the Property
Sellers Najah and Akhavain (collectively the “Najahs”) sold a commercial property to Orange Crest Realty Corporation (“OCRC”) and carried back a note secured by a second deed of trust on that property (the “second note”). The first note and deed of trust was held by a private trust (the “first note”). At the time the loans were originated, there was a structure on the property. It had formerly been an assisted living facility but was vacant at the time. At the time of purchase, the principal of OCRC had professed to the first and second lenders an intention to demolish the building and develop the property.
There was language in the first note that prohibited OCRC from remodeling or doing construction until the first note was paid in full. Likewise, the second note included language that required OCRC to keep the property in good condition and repair, to not demolish any building, and to complete and restore any building constructed, damaged, or destroyed.
The deeds of trust included the standard language requiring the borrower to keep the property in good repair and not to commit waste or permit impairment or deterioration of the property. Both deeds of trust also included standard language requiring the borrower to maintain fire insurance that named both lenders as additional loss-payees.
The Insurance Policy on the Property
The first note provided that OCRC would furnish all risk insurance with replacement cost. OCRC obtained a policy from Scottsdale. The policy named both lenders as mortgage holders. The policy was identified as a “special form” policy, that was supposed to cover all risks except those specifically excluded. However, the language of the policy stated it was a “basic form” policy and that only specific items were covered, such as vandalism, but not theft. The policy included a provision describing Scottsdale’s obligation to the lenders for covered loss or damage if certain conditions were met. OCRC stopped paying premiums in February 2008, but the insurance agent paid them for a short period of time thereafter so the policy remained in place through July 16, 2008.
Default, Assignment of First Note, and Foreclosure of the Najah’s Loan
When OCRC defaulted on the first note, that lender recorded a Notice of Default in January 2008 while the insurance policy was in effect. In March 2008, the Najahs (second note holder) purchased the first note and received a full assignment of the note and first deed of trust. The Najahs then foreclosed on the second deed of trust in November 2008 and made a full credit bid at the sale. They became the owners of the property at their foreclosure sale.
The Insurance Claim by the Najahs to Scottsdale
In February 2008, the Najahs visited the property for the first time since the sale and discovered severe damage to the building and debris everywhere. The Najahs attempted to reach the principal of OCRC about the property damage and the upcoming balloon payment to no avail. The Najahs came back a month later to do a more detailed property inspection. They found electrical wires hanging from the ceiling; broken mirrors, furniture, and bathroom fixtures; damaged walls, ceilings, and carpets; and interior doors removed and askew on the floor. They also found missing HVAC units, appliances, water heater, breaker panels, laundry equipment, lights poles, mailboxes, furniture, tiles and drywall. The principal of OCRC later testified in deposition to the removal of the above items and some slight vandalism of the property.
In May 2008, the Najahs submitted a claim to Scottsdale, which did not formally deny the claim until after the lawsuit below was filed and prior to trial.
The Lawsuit Against Scottsdale
In May 2009, six months after the Najahs became the owners of the property at their foreclosure sale, they filed suit against Scottsdale, claiming breach of contract and tortious breach of the covenant of good faith and fair dealing, including a claim for punitive damages. The Najahs alleged $500,000 as the cost to repair the damage discovered prior to foreclosure.
Scottsdale filed a motion for summary judgment (“MSJ”), contending that the debt was extinguished by the full credit bid of the Najahs and contending that the damage was not covered under the insurance policy. Scottsdale also made a motion for summary adjudication on the issue that the Najahs were not entitled to punitive damages. The trial court denied the MSJ but granted the motion regarding punitive damages because no facts shown entitled the Najahs to such an award.
The trial was bifurcated to determine the issue of insurance coverage first. Five issues were to be determined by the trial court. (1) Did the Najahs have an insurable interest?; (2) If so, was this a special form or basic form policy?; (3) If there was an insurable interest, was the loss covered under the policy?; (4) Are the Najahs entitled to coverage under the mortgage holders provisions of the policy?; and (5) If the policy forms include vandalism, what is the meaning as used in the policy?
After trial, the trial court rendered a decision. The court found in favor of Scottsdale that there was no insurable interest and no coverage. It ruled that an owner cannot steal or vandalize its own property and that the damage was caused by the owner.
The trial court also held that any claim of the Najahs on their second note was extinguished by its full credit bid at their foreclosure sale. Any claim of the first note holders, purchased by the Najahs as part of their assignment, was extinguished by that private purchase and that it extinguished any right to insurance proceeds as well.
The trial court awarded costs to Scottsdale that included expert witness expenses because the Najahs had rejected an offer to settle under California law and the judgment was less than the offer to settle.
The Najahs appealed the trial court decision.
First, the Appellate Court reiterated the rules regarding full credit bids at a foreclosure sale and the inability of a lender to pursue any further remedy to try and recoup its debt. The general rule is that a full credit bid satisfies the debt and the payment of additional money would be a double recovery. Thus, a lender is not entitled to insurance proceeds for pre-purchase damage, entitled to pre-purchase rents, or entitled to damages for waste because the debt was paid in full at the foreclosure sale. The rule protects the integrity of the competitive bidding process at a foreclosure sale by encouraging bids brought by third parties that might otherwise be impeded.
Second, the Appellate Court discussed the basic principles governing mortgagee insurance. A lender may recover insurance proceeds even if the mortgagee fails to comply with terms of coverage. This is known as a “standard mortgage clause”. Under that clause, there are two independent contracts of insurance, one for the insured and insurer, and one for the lienholder and insurer. The amount payable to the lienholder is limited to the amount necessary to satisfy the debt, even if it is less than would be required to repair the physical damage to the property. As a result, when a lienholder makes a full credit bid and its debt is satisfied, the lienholder is not entitled to insurance proceeds for pre-foreclosure damage to the property.
The Appellate Court recapped the remedy for the foreclosing lender; underbid their security interest in the foreclosure sale to preserve the lender’s rights.
The Najahs contended that their position was different because they held both the first and second deeds of trust on the property and would not receive a double recovery. The argued that the rule should be different here since they had to pay the first lender in full to obtain an assignment of that deed of trust, they had invested more than the full amount bid at the foreclosure of the second deed of trust and that both liens should be considered in determining whether a full credit bid was made.
The Appellate Court rejected that argument, concluding that it would affect the integrity of the foreclosure process to change the rule just because the lender held two liens on the property. In the foreclosure sale of the junior deed of trust, the purchaser takes the property subject to the first lien. If a lender can add together the two liens it holds for purposes of this rule, then it has an advantage over an outside purchaser, subverting the nature of the foreclosure bidding process by thwarting third party bidding.
The Appellate Court disagreed with the trial court that the assignment of the first note and deed of trust extinguished any claim for insurance money. However, the Appellate Court then affirmed the decision of the trial court under the full credit bid rule and also affirmed the trial court on the issue of costs to Scottsdale.
If you are a lender that is collecting pre-foreclosure rents, or the possibility of an insurance claim for any pre-foreclosure damage, DO NOT MAKE A FULL-CREDIT BID. You must deduct the amount of rents collected either by you or any appointed receiver from your opening bid. You must also deduct the amount of believed damage for an insurance claim (and probably pad that amount) in determining your opening bid at your foreclosure sale.
In the case of rent collection, failure to underbid your foreclosure will likely result in rents going back to the borrower or sold-out junior lender as surplus funds.
In the case of a possible insurance claim, failure to underbid your foreclosure will likely result in an insurance claim being denied to you under the full credit bid rule.