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Court Decision Reaffirms Foreclosure Right in Deed in Lieu Cases

Sometimes projects fail. Its a reality of real estate. When lenders and borrowers are faced with a failing project and a loan in default, they have options. One is foreclosure. If the borrower and lender are in a contentious relationship, foreclosure may be the only option, and it can be a costly and lengthy process. If the relationship is more cooperative, however, under some circumstances, the parties may be able to negotiate a deed in lieu of foreclosure transaction. This involves a two step process where, first, there is a consensual transfer of the title from the borrower to the lender, which is followed by a non-judicial foreclosure. This can be beneficial to both parties. Unfortunately, during the recession, some title companies refused to insure sales following these transactions. A recent court decision reaffirms that these title companies’ decisions were based on faulty reasoning.

The Case of Deacon Group, Inc. v. Prudential Mortgage Capital Co. LLC

This important case, which the California Court of Appeal decided, is called Decon Group, Inc. V. Prudential Mortgage Capital Co. LLC. In the case, Wellesley owned real property in Los Angeles that was subject to a first deed of trust and a junior mechanic’s lien. Wellesley defaulted on the loan secured by the trust deed. Rather than going through a standard foreclosure, Wellesley and the trust deed beneficiary agreed to a deed in lieu. The beneficiary then foreclosed, eliminating all junior liens, and bought the property at the foreclosure sale and later sold it to a third party.

The holder of the mechanic’s lien sued to foreclose its lien, arguing that it was not eliminated by the foreclosure because, when the beneficiary accepted the deed in lieu, its two interests merged destroying the senior lien and preventing its foreclosure. The trial court agreed with this reasoning, but the appellate court did not. It held that, in California, it is well established that there is no such merger if there are junior lienholders of record. In doing so, it relied on a decision from the 1800s called Davis v. Randall. The Davis decision said, “Merger is always a question of intent when the question is as to whether a mortgage lien is merged in the fee, upon both being united in the same person…Equity will keep the legal title and the mortagee’s interest separate, although held by the same person, whenever necessary for the full protection of the person’s rights. If there is an intervening mortgage, the acquirement of the title will not operate as a merger.”

What About the Junior Lienholder’s Rights?

This does not mean that junior lienholders have no rights. The Court points out in its decision that junior lienholders always risk the elimination of their claims due to a foreclosure by a senior lienholder. Even so, they have the right to bid at the foreclosure sale, and, if the property sells for more than the senior lien’s value, then the excess is paid to the junior lienholder.

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