New California Case Illustrates Peril of Full Credit Bid

In a new California case, a lender that made a full credit bid at a foreclosure sale lost its right as mortgagee under a lender’s insurance policy for damage to the property that occurred prior to foreclosure. This was so even though the lender held multiple deeds of trust, and foreclosed on only one of them. The case provides valuable guidance in devising a foreclosure bidding strategy.

In Najah v. Scottsdale Ins. Co., ___ Cal.Rptr.3d ___, 2014 WL 4827882 (Cal.App. 2 Dist., Sep. 30, 2014), plaintiff (lender) sued defendant (insurer) for failing to pay a claim for property damage that occurred prior to plaintiff’s foreclosure on the property. The trial court entered judgment in favor of the defendant insurer. The Court of Appeal affirmed.

In 2006, plaintiff sold a commercial property, taking back a promissory note secured by a second deed of trust. The note provided that buyer would not perform any demolition, construction, or remodeling until the note was paid in full, and it required the buyer to obtain lender’s insurance, which the buyer did. In January 2008, the buyer defaulted. After the senior lender initiated foreclosure under the first deed of trust, plaintiff purchased the senior lender’s promissory note and took assignment of the first deed of trust. Shortly after the default, but before acquiring the first deed of trust, plaintiff visited the property and discovered severe damage to the building. Plaintiff submitted a claim for the property damage to the defendant insurer, which eventually denied the claim. In November 2008, plaintiff foreclosed on the property under the second deed of trust. Plaintiff took the property on a credit bid including the full amount of principal, interest, fees, and costs due under its promissory note.

The Court of Appeal held that the lender’s right to recover insurance benefits as mortgagee under the lender’s insurance was barred by the “full credit bid rule.”[1] The court explained that the full credit bid rule prevents a lender who obtains property upon a full credit bid from pursuing any other remedies, including collection of insurance proceeds payable for pre-foreclosure damage to the property. The lender’s only interest in the property is the repayment of its debt, and when it takes the property on a full credit bid its debt is repaid in full.

The rule serves two purposes. First, the rule prevents the lender from “double recovery” – a dubious justification given that all the lender recovers in a foreclosure is the value of the collateral irrespective of the amount bid. The lender derives no additional value by over-bidding. To the contrary, an excessive bid merely compromises the lender’s deficiency rights. If anything, the rule gives the insurer a windfall because the insurer has collected the premiums and avoided paying an otherwise legitimate claim based solely on the fortuitous circumstance of the lender’s full credit bid.

Second, the rule “serves to protect the integrity of the foreclosure auction” by preventing lenders from “impeding bids from third parties willing to pay some amount between the value the lender places on the property and the amount of its full credit bid.” The court reasoned that the purpose of the foreclosure process is to enable the property to be sold for its fair market value in a competitive bidding process. This goal is frustrated when a lender discourages competitive third-party bids by making a full credit bid for more than the property’s fair market value. In the court’s view, when a lender intends to make a claim that the property was impaired due to waste covered by an insured claim, it should not be allowed to discourage third-party bids on the strength of its full credit bid while preserving insurance claims.

The court perceived an inconsistency between a lender’s full credit bid and the lender’s insurance claim for property damage because it regarded the lender’s claim for property damage as recognition that the property was worth less than it bid.

The simpler explanation for denying the plaintiff any recovery in this case was that the mortgagee coverage under the insurance policy was limited to the amount necessary to satisfy the debt. Once the debt was satisfied upon the plaintiff’s full credit bid, the plaintiff had no further claim under the policy. But that explanation only resolved the issue as to the lender’s rights under the second deed of trust. The court also concluded that, even as the holder of the first deed of trust, the lender had no claim against the lender’s insurance. To reach that conclusion the court relied upon the policy justifications for the full credit bid rule discussed above.

The lesson from this case is that a lender foreclosing on impaired property should plan its bidding strategy carefully. The lender must closely evaluate its insurance coverage, including all limitations and exclusions. The lender must also carefully assess whether it will assume the borrower’s insurance rights, and whether those rights have been compromised. And the lender must assess the full extent of impairment to the property, the cost to restore it, and the diminution in its value. These steps should be done with the involvement and advice of legal counsel, considering that the lender’s evaluation may be subject to discovery in the event of litigation. To preserve claims against insurers or others responsible for waste or other property damage, the lender should discount its bid by the amount of the claim, or base it upon an appraisal of the property’s “as-is” value taking the impairment into account.

[1] The court did not address whether the lender had a right to pursue the insurance claim in the capacity of a successor to the borrower’s rights. Deeds of trust commonly encompass not only the real property, but the borrower’s associated personal property including contract rights. In this case the trial court found that the property damage was caused almost entirely by the borrower. Therefore, the borrower had no claim against the insurance policy.