Deficiency Judgments

DEFICIENCY JUDGMENTS AND COMMERCIAL LOAN GUARANTEES: AN AREA OF RISK FOR REAL ESTATE INVESTORS

By Doug Owens

People sometimes ask me about the extent of the protection a limited liability company gives to the investor against claims that seek money from the investor’s other assets. I always answer that “it depends.”

One of the things that the effectiveness of the limit to the investor’s individual liability can depend on is whether the creditor involved has another route to reach the investor’s non-limited liability company investment besides “piercing the veil.” If the investor undertakes a sizable project, such as a development of land, the lender may require the investor to give a personal guarantee of the loan in order to agree to lend on the project. Such a personal guarantee can provide the lender with a contractual way to reach the investor’s individual assets.

In a recent case the investors borrowed about $11.7 million from Horizon Bank to develop two residential areas in 2005 and 2007, as the residential real estate market was booming. The development was to be done in their limited liability company. The bank required the owners of the limited liability company to give a personal guarantee of the amount of the promissory note, which they gave.

In 2008, the market for residential real estate crashed and the development work stopped on the project. The borrowers defaulted on their loan and the investors did not honor the terms of the loan guarantee. A trustee’s sale of the properties involved was held. The lender bought the property for $6 million, based on appraisals showing the market value of the property at approximately $5,045,000. The original lender then went bankrupt and the loan was transferred to Washington Federal. Washington Federal sued the investors as guarantors of the loan made to their entity for the deficiency between the $6 million credit bid at the trustee’s sale and the approximately $12 million that was then owing on the loan.

The reader may ask at this point, why the lender was able to pursue any deficiency judgment against the investors, regardless of the guarantee. After all, the trustee’s sale was held in due course and some readers may know that for some types of loans, this prevents the lender from seeking a deficiency judgment against the defaulted borrower. Unhappily for the borrowers in this case, there is an exclusion in the law that removes the anti-deficiency shield when commercial lending is involved. And clearly this loan was for commercial purposes. This provision of the anti-deficiency law also applies to those who guarantee the commercial loans that are in default.

The investors argued in court that the price the previous lender had bid at the trustee’s sale was too low which meant that the deficiency Washington Federal was trying to collect from them was too high. The investors tried to convince the court to use an old law that had been adopted in 1935, during another period of generally steep declines in the value of real estate. That law, which applied to mortgages, provided that a lender trying to foreclose a defaulted mortgage had to produce proof to the court of an “upset price” that was based on what would have been paid for the property under “normal conditions.” The borrowers wanted to use this argument to say that the $6 million obtained at the 2009 trustee’s sale should have been adjusted higher by the court in the deficiency judgment case because of the drastic fall in the market value of real estate that reflected itself in the comparables that were available for appraisal at that time.

The Court of Appeals rejected this argument, holding that the Deed of Trust Act defines “fair value” as the price to be paid at a trustee’s sale basically by a willing buyer to a willing seller, with both knowing all material facts and not acting under compulsion. There is nothing in this definition that allows or requires a court to adjust the price paid at the trustee’s sale for abnormal market conditions.

The lesson here is that investors who guarantee loans for their entities face some exposure if the entity defaults and they should not rely on abnormal market conditions to help reduce their losses.

The preceding is intended for education and is not legal advice.

Leave a Comment

Your email address will not be published. Required fields are marked *