In re Brock, 494 B.R. 534 (Bankr. D. Colo. 2013) –

Individual chapter 11 debtors objected to a deficiency claim filed by a bank. They argued that California's anti-deficiency laws prevented the bank from making a claim against the debtors under their guaranty after it foreclosed on real property securing the debt in a non-judicial foreclosure sale.

The first issue was whether California or Colorado law applied. (If Colorado law applied, the bank won.) The court noted that a federal court applies the choice of law rules of the state where it sits. Colorado adopted the Restatement (Second) of Conflict of Laws approach to contractual choices of law – meaning that generally the parties' choice of law will be respected unless either (1) there is no substantial relationship or other reasonable basis for the choice or (2) the chosen law would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state.

In this case, California was the choice of law in the loan documents, and the court saw no reason why it should not apply California law. Turning to California law, the court's obligation when applying the law of another forum is to try to determine and apply the applicable state law, and if there are no controlling state decisions, to predict what the state's highest court would do.

As background, the court noted that California's anti-deficiency statutes date back to the Great Depression and are intended to protect debtors from both losing property at a depressed price and then also incurring a large deficiency judgment for the balance. In this case the relevant statute provided:

No judgment shall be rendered for any deficiency upon a note secured by a deed of trust or mortgage upon real property... hereafter executed in any case in which the real property... has been sold by the mortgagee or trustee under power of sale contained in the mortgage or deed of trust.

Thus, if a lender elects to foreclose non-judicially, it may not pursue the primary obligor for any deficiency between the value of the property and the amount owing on the debt secured by the mortgage.

As for waiving the anti-deficiency protection, under applicable case law:

  • The primary obligor may not waive the protection.
  • A guarantor may waive.
  • However, a guarantor's waiver is not effective if it is also deemed a primary obligor.

In other words, for a guarantor's labor to be effective, it "must be a true guarantor and not merely the [primary obligor] under a different name."

In this case, the borrower was an inter vivos revocable trust, and the guarantors were the settlors, trustees, and beneficiaries of the trust. Under these circumstances, the trust and the guarantors were essentially the same.

The bank argued that a statute as recently amended a trustee was not personally liable for the debt of a trust unless liability was provided by contract. However, the trust "is not a legal entity; it is simply a collection of assets and liabilities." Rather, it is recognized as a probate avoidance device. The property owned by a revocable trust is deemed to be property of the settlor and subject to claims of the settlor's creditors.

The court acknowledged that case law did not establish the per se rule applicable to all living trusts that associated parties could not be true guarantors. For example, in one case the guarantors were the settlors of the trust, but they were secondary (not primary) beneficiaries and they used a limited liability company as trustee (thus limiting their personal liability for trust obligations). Under those facts, the settlors were treated as true guarantors.

However in this case, the guarantors were primary beneficiaries of the trust, and did not use any intermediary such as a LLC or other entity, to provide separation between the debtors and the trust. Consequently, the bank was out of luck and could not pursue the guarantors for its ~$1.3 million deficiency claim.

There are various ways that a guarantor can be let off the hook. In exercising remedies in connection with loans secured by real property, it is particularly important to consider any applicable state laws that might affect the ability to collect from a guarantor – including anti-deficiency and one action rules.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.