California Lenders Must Be Diligent Not to Get Burned Twice:

A Reminder of the Consequences of the Full Credit Bid Rule in Light of the California Wildfires

by Kathryn A. Moorer, Esq., Wright, Finlay & Zak, LLP

by T. Robert Finlay, Esq., Wright, Finlay & Zak, LLP

Recently, multiple wildfires swept across the State of California leaving a wake of destruction in their path. The fires destroyed a multitude of residential properties and the entire Northern California city of Paradise. While foreclosure moratoriums will temporarily stop all foreclosure activity, they will eventually be lifted, giving lenders the option to foreclose on affected properties that serve as security for defaulted loans. Before going to sale on a fire damaged property, lenders should understand the risks created by their foreclosure bids, including, but not limited to, the potential loss of the lender’s right to insurance proceeds.

Rather than show up with cash at its own sale, a foreclosing lender can make a “credit bid” up to the full amount of the borrower’s indebtedness, “since it would be useless to require [the lender] to tender cash which would only be immediately returned to [it].”1 While the foreclosing lender has the option of bidding up to the full amount of the debt (i.e., a “full credit bid”), doing so can limit the lender’s right to recover additional amounts due to any impairment of the security. Indeed, a successful full credit bid establishes the value of the real property and prevents the lender from claiming that the property is worth less than the amount of the bid.2 This concept, created through case law, has become known as the “Full Credit Bid Rule.”

Pursuant to this rather rigid rule, a full credit bid extinguishes the debt entirely and precludes the lender from recovering any additional amounts to satisfy the debt. If the lender makes a successful full credit bid, it “cannot pursue any other remedy based upon the recovery of any part of the secured debt, or recover from any other security, regardless of the actual value of the property on the date of the sale.”3 Accordingly, the lender is prohibited from recovering fire or other insurance proceeds payable for pre-sale damage to the property, pre-sale rent proceeds, or even damages for the borrower’s waste.4 The Full Credit Bid Rule also bars the foreclosing lender from recovering a condemnation award,5 as well as any amounts that may have been payable from a guarantor of the debt prior to the foreclosure sale.6 The rule also prohibits a lender from recovering title insurance proceeds. This is because the lender’s only interest in the property (i.e. the repayment of the debt) has been satisfied and extinguished by the full credit bid; the presumption is that any further payment would necessarily result in a double recovery or windfall to the lender.7

Due to the foregoing, a lender making a credit bid at a foreclosure sale must be conscientious of its potential rights to rents, additional or supplemental security, insurance proceeds, and/or any damages caused by the borrower’s waste. As stated best by the California Supreme Court, “[t]he lender, perhaps more than a third party purchaser with fewer resources with which to gain insight into the property’s value, generally bears the burden and risk of making an informed bid.”8 California courts have consistently held that the purchaser at a foreclosure sale has the duty to assess the value of property correctly.9

The full credit bid rule can result in harsh consequences for a lender who makes a successful full credit bid on real property with a substantially lower fair market value. It is well established that a lender who purchases an encumbered property at a foreclosure sale by making a full credit bid is not entitled to insurance proceeds payable for pre-foreclosure damage.10 For example, in Altus Bank v. State Farm Fire & Cas. Co.,11 the Court relied on the Full Credit Bid Rule to prohibit the lender from recovering any insurance proceeds resulting from a pre-sale fire that completely destroyed the residence on the property. Despite the fact that the lender made a claim under the insurance policy prior to the sale and maintained that the full credit bid was a mistake, the Court held that the lender was completely barred from recovering anything based on the diminution of value of the property that secured the loan because the credit bid established the value of the property and extinguished the debt in full.12 The Court further noted that it was unreasonable for the lender to “acquire the mortgaged property by choking-off any offers in the range of the true value of the property with a preemptive bid and then…assert that its insurance loss was measured by anything other than the price which it bid at auction to acquire the property.”13

Similarly, in Bank of America v. Quackenbush,14 the Court held that the lender could not recover against an insurer that issued financial guarantee bonds as additional security for a pool of high risk loans after the lender inadvertently made full credit bids on the properties in question, even though the originating lender grossly overinflated the property values in a scheme to defraud investors. In Quackenbush, the Court concluded that it was reasonable to hold the lender to the Full Credit Bid Rule because the lender “controlled the timing of the sales and admittedly knew the true value of the properties [and] nothing precluded it from bidding less than the amount it was owed.”15 As a result, the lender ultimately sustained a loss of approximately $12 million, which it could not recoup.16

Adding insult to injury, lenders who have tried to rescind or reform the foreclosure sale in an effort to avoid the effect of the Full Credit Bid Rule, are rarely successful. In Universal Mortgage Co., Inc. v. Prudential Ins. Co.,17 the foreclosing lender made a successful full credit bid based on its agent’s external observations of the property. However, it was subsequently discovered that the interior had extensive damage due to the borrower’s removal of most of the fixtures and appliances.18 The lender sued the insurer, who denied the lender’s claim under the operative insurance policy in reliance upon the Full Credit Bid Rule.19 The lender sought to amend its complaint to allege a cause of action for reformation of the trustee’s deed to reflect a lower bid; however, this request was denied by the trial court and judgment was ultimately entered in favor of the insurer.20

On appeal, the Ninth Circuit upheld the judgment and denial of leave to amend, reasoning that reformation was not a proper remedy under the circumstances since “there was no mistake” because the lender clearly intended to make the full credit bid based on its exterior inspection.21 The Court further held that the lender’s lack of actual or constructive knowledge of a loss at the time of a full credit bid was irrelevant to the policy or application of the Full Credit Bid Rule.22

Even something short of a full credit bid can have dangerous consequences. As explained above, the credit bid at the foreclosure sale establishes the value of the property for purposes of recovering fire or other additional proceeds. Therefore, a bid of $300,000 when the amount owed is $500,000, effectively limits the lenders’ right to recovery insurance proceeds to $200,000 [$500,000 less the established value of the property ($300,000)]. Accordingly, it’s important to establish an accurate bid, after factoring in the extent of the damage to the property.

Despite the harsh consequences of a full credit or other limiting bid, the courts have only carved out two very limited exceptions. The first exception applies where the lender’s full credit bid is induced by the lender’s reliance upon fraudulent misrepresentations.23 In Alliance Mortgage Co. v. Rothwell, 24 the lender sued a real estate appraiser and a broker, among others, claiming that they fraudulently induced the lender to originate several loans secured by properties that were insufficient collateral for the debt. The California Supreme Court identified an exception to the Full Credit Bid Rule, holding fraud claims against third parties who fraudulently induced the lender to make the loans were not barred by the full credit bid rule.25 However, this is a limited exception. Absent fraud affecting the bid, the Full Credit Bid Rule will apply.

The second limited exception applies where the lender incurs damages caused by negligent construction of improvements. Under these circumstances, the lender may be entitled to recover damages even though it has purchased the property at a trustee’s sale following a full credit bid. In Sumitomo Bank v. Taurus Developers, Inc.,26 the foreclosing lender discovered several latent defects on the property due to faulty construction and brought suit against the borrower/developer for failing to adequately oversee the construction and notify the lender of the defects known to him. While the Court held that the lender could not recover based upon fraud, bad-faith waste, or breach of contract, it found that a cause of action for negligence could be maintained by the lender regardless of its full credit bid.27

Given the strict nature and application of California’s Full Credit Bid Rule and its very limited exceptions, it is imperative that lenders consider every potential source of recovery on the unpaid debt before making a credit bid at a foreclosure sale. A failure to do so will limit or completely deny the lender’s ability to recover insurance or other proceeds that would otherwise help offset its loss. Thus, where property values have been affected by natural disaster, such as those destroyed in the recent California wildfires, lenders and their servicers should consider the damage to the property, the value of the property in its current state and the amount of available insurance proceeds in determining its intended credit bid at the foreclosure sale.

Disclaimer: The above information is intended for information purposes alone and is not intended as legal advice.

Endnotes

  1. Cornelison v. Kornbluth (1975) 15 Cal. 3d 590, 607 (citing Central Sav. Bank of Oakland v. Lake (1927) 201 Cal. 438, 447-448)
  2. Smith v. Allen (1968) 68 Cal.2d 93, 95; Alliance Mortgage Co. v. Rothwell (1995) 10 Cal. 4th 1226, 1238-39.
  3. Miller & Starr, Cal. Real Est. § 10:218 (3d ed.).
  4. Alliance Mortgage Co. v. Rothwell (1995) 10 Cal. 4th 1226, 1246; see also, Cornelison v. Kornbluth, supra, 15 Cal.3d at pp. 606–607 (“[T]he [lender] is not required to open the bidding with a full credit bid, but may bid whatever amount [it] thinks the property is worth. Indeed, many creditors continually enter low credit bids … to provide access to additional security or additional funds. In such a case, a deficiency balance of the debt would have remained for which [the lender] would have had an entitlement out of the insurance policy. The extinguishment of the mortgage or deed of trust by the foreclosure would not have affected [the lender’s] right to be paid the remainder of the debt under the policy.”) (internal citations and quotations omitted).; Caruso v. Great Western Savings (1991) 229 Cal.App.3d 667, 673–674; Duarte v. Lake Gregory Land and Water Co. (1974) 39 Cal.App.3d 101, 105; Washington Mut. Bank v. Jacoby (2009) 180 Cal. App. 4th 639, 646-47.
  5. People Ex Rel Dept. of Transportation v. Redwood Baseline, Ltd. (1978) 84 Cal. App. 3d 662, 676.
  6. White v. Seitzman (1964) 230 Cal. App. 2d 756, 765.
  7. Alliance Mortgage Co., supra, 10 Cal. 4th at 1246; see also, Track Mortgage Grp., Inc. v. Crusader Ins. Co. (2002) 98 Cal. App. 4th 857, 866.
  8. Alliance Mortgage Co. v. Rothwell (1995) 10 Cal. 4th 1226, 1246.
  9. Sumitomo Bank of California v. Taurus Developers (1986) 185 Cal.App.3d 211, 221 -222 (“Given the characteristics of a trustee’s sale where control over the sale rests primarily in the beneficiary, trustee, and bidders, the trustor cannot be characterized as a ‘seller’ under a duty to disclose known defects as exists in the normal vendor-vendee relationship.”)
  10. See, e.g., Track Mortgage Group, Inc. v Crusader Insurance Co. (2014) 98 Cal.App.4th 857 at 864–867; Najah v. Scottsdale Ins. Co. (2014) 230 Cal. App. 4th 125, 142 (“claim against Scottsdale for preforeclosure damage was therefore precluded by the full credit bid rule.”).
  11. (C.D. Cal., 1991) 758 F. Supp. 567, 568-570, aff’d, 979 F.2d 854 (9th Cir. 1992).
  12. Id.
  13. Id. at 570-571.
  14. (1997) 56 Cal. App. 4th 1167, 1173-74.
  15. Id. at 1174.
  16. Id. at 1170.
  17. (9th Cir.1986) 799 F.2d 458, 460.
  18. Id. at 459.
  19. Id.
  20. Id.
  21. Id. at 459.
  22. Id. at 460; see also, Rosenbaum v. Funcannon (9th Cir. 1962) 308 F.2d 680, 684; Reynolds v. London & Lancashire Fire Ins. Co. (1900) 128 Cal. 16 (holding that the lender holding title to property after the foreclosure sale, but before the period wherein the borrower could have redeemed the property by paying the purchase price, was not entitled to insurance proceeds as a result of a post-foreclosure destruction of the property by fire due to the full credit bid rule).
  23. 4 Miller & Starr, Cal. Real Est. § 10:218 (3d ed.).
  24. (1995) 10 Cal. 4th 1226, 1246.
  25. Id. at pp. 1246–1247. (“[T]o the extent Alliance’s full credit bids were proximately caused by defendants’ fraudulent misrepresentations …, Alliance’s bids cannot be deemed an admission of the properties’ value…. Hence the full credit bid rule would not apply.”)
  26. (1986) 185 Cal. App. 3d 211, 226.
  27. Id. at 227-228.

  28. Kathryn A. Moorer, Esq.
    kmoorer@wrightlegal.net
    Kathryn Moorer is a Senior Associate in WFZ’s California office.

    T. Robert Finlay, Esq.
    rfinlay@wrightlegal.net
    Robert Finlay is a founding Partner of WFZ.