Loan Defaults & Deficiencies

By K. Michelle Lind

Posted: September 2009

Most real property loans in Arizona are evidenced by a promissory note and deed of trust. The promissory note is the promise to pay the loan signed by the borrower in favor of the lender. The deed of trust is a separate document that secures the loan with the property. The deed of trust is recorded against the property and contains three parties: the trustor, who is the borrower/property owner; the trustee, who is a person or entity that holds “legal” title; and the beneficiary, who is the lender. There are many types of loans that are secured by real property. These may be purchase loans, refinanced loans, home-equity loans, or one of the various other types of loans.

Lender Options upon Loan Default

The type of loan and type of property will determine what remedies a lender may have if the borrower fails to make the agreed upon payments. The available remedies, the borrower’s overall current or potential future financial strength, the lender’s cost in acquiring the loan and any shared-loss or similar agreement if the loan was acquired by purchase or merger, are some of the many factors that the lender may consider in deciding how to proceed when a loan is in default.

The lender may offer the borrower the option of a loan modification or loan work-out agreement. The lender may agree to a short sale and either discharge the debt or require a promissory note for the remaining balance. In the alternative, the lender may decide to foreclose by exercising the rights in the deed of trust and conduct a non-judicial trustee’s sale or judicial foreclosure. In the majority of foreclosure cases, the lender will conduct a trustee’s sale. The lender may have the option to sue the borrower for the entire unpaid debt without instituting a foreclosure action or sue the borrower for a deficiency after foreclosure.

Deficiency Judgment after Foreclosure

In some cases, a lender is entitled to sue a borrower for any losses, known as a “deficiency,” after a foreclosure. For example: A lender loans a person $200,000 to purchase a property. The property owner fails to make the loan payments and the lender forecloses. When the lender sells the property, it is only able to sell it for $180,000, which results in a $20,000 loss to the lender. If the lender is entitled to sue the ex-property owner to recover that loss, the lender can obtain a deficiency judgment for the amount the ex-property owner owed the lender, minus either the fair market value of the property on the date of the sale or the sale price at the trustee's sale, whichever is higher. A.R.S. §33-814. When permitted, a deficiency action must be instituted within 90 days after the foreclosure sale. A.R.S. §33-814.

Suing Directly on the Promissory Note

If a deficiency action is permitted, the lender is entitled to waive its security by choosing not to foreclose and sue directly on the promissory note instead. A.R.S. §12-1566(E). In Resolution Trust Corporation v. Segal, 173 Ariz. 42, 839 P.2d 462 (1992), the court held that a non-purchase money lender who made four loans secured by deeds of trust on residential property was entitled to waive its security and sue directly on the promissory notes. Further, the court held that the lender's right to sue on the promissory notes was not affected by fact that beneficiaries under first deeds of trust encumbering properties had exercised their right to conduct a trustee’s sale.

Collecting on the Judgment

Once the lender obtains a money judgment, the lender is called the judgment creditor and can collect from the borrower, now called the judgment debtor through various legal means, such as: garnishment of wages and bank deposits; writ of execution in which the sheriff sells non-exempt personal property at public auction to satisfy the judgment; and judgment liens on real property (currently owned or later acquired). See, A. R.S. §12-1570 – 1598; A.R.S. §33-961 et. seq. In the case of a deficiency judgment, A.R.S. §12-1566(D) requires the judgment creditor to proceed first against all other real property of the judgment debtor before proceeding against the debtor’s primary residence.

A judgment is valid for five years and can be renewed for an additional five years. A.R.S. §12-1611. These actions by the judgment creditor can result in the judgment debtor filing for bankruptcy protection. Chapter 7 is the most common form of bankruptcy and is a liquidation proceeding available to individuals, married couples, partnerships and corporations.

Arizona Anti-Deficiency Statutes

If the property is a residential property, the borrower may have protection against a deficiency lawsuit after foreclosure due to two anti-deficiency statues, A.R.S. §33-729(A)¹ (which applies to judicial foreclosure of mortgages) or A.R.S. §33-814(G) (which applies to non-judicial foreclosure of deeds of trusts). The first anti-deficiency statutes in the U.S. were enacted during the Great Depression in the 1930s – “with its dearth of money and declining property values, a mortgagee was able to purchase property at the foreclosure sale at a depressed price far below its normal fair market value and thereafter to obtain a double recovery by holding the debtor for a large deficiency.” Baker v. Gardner, 160 Ariz. 98, 770 P.2d 766 (1988) (citing Cornelison v. Kornbluth, 542 P.2d 981 (CA. 1975). Arizona’s anti-deficiency statutes were enacted in 1971.

The anti-deficiency statutes apply to a specific, limited group of residential mortgages and deeds of trust. Id. The anti-deficiency statutes may not apply to VA or FHA insured loans. See e.g., Shepherd v. Derwinski, 961 F.2d 132 (Ariz. 1992).

The legislature’s objective in enacting these statutes has been interpreted to abolish the personal liability of those who give trust deeds encumbering properties of two and one-half acres or less and used for single-family or two-family dwellings. Baker, 160 Ariz. 98, 770 P.2d 766. Therefore, generally, a lender cannot sue for a deficiency after a trustee’s sale if the:

• Note and Deed of Trust encumbers real property
• Property is single one-family or single two-family dwelling
• Dwelling is limited to and utilized as a residence
• Dwelling is on two and one-half acres or less

(Note: a lender cannot sue for a deficiency after a trustee’s sale even if the loan was non-purchase money. However, as noted above, if the loan was non-purchase money, the lender could elect not to conduct a trustee’s sale and sue the borrower on the promissory note.)

The dwelling does not have to constitute the borrower’s residence for the anti-deficiency provisions to apply. Northern Arizona Properties v. Pinetop Properties Group, 151 Ariz. 9, 725 P.2d 501 (App. 1986). However, the anti-deficiency statutes do not apply to loans secured by houses owned by a developer, where the houses have not yet been used as a dwelling and are not yet susceptible to being used as a dwelling. Mid Kansas Federal Savings & Loan Ass'n v. Dynamic Development Corp., 167 Ariz. 122, 804 P.2d 1310 (1991). The Mid Kansas court held that commercial residential properties held by the mortgagor for construction and eventual resale as dwellings are not within the definition of properties “limited to” and “utilized for” single-family dwellings. Id. at 129, 804 P.2d at 1317.

Banking Industry Attempts to Change Arizona’s Anti-deficiency Laws

SB 1271 was passed by the legislature in the first regular session of 2009 to change the trustee’s sale statutes to allow a deficiency judgment unless the property had been utilized “BY THE TRUSTOR UNDER THE DEED OF TRUST FOR AT LEAST SIX CONSECUTIVE MONTHS AND FOR WHICH A CERTIFICATE OF OCCUPANCY HAS BEEN ISSUED.” The bill was due to become law on September 30, 2009. Fortunately, AAR and others recognized the unintended consequences of the bill. In the third special session, HB 2008, which was signed by the governor, contained a repeal of SB 1271 and its change to the anti-deficiency statute. Had SB 1271 become law, there could have been a dramatic increase in deficiency judgment litigation.

The banking industry will continue to lobby for changes to the anti-deficiency laws the next time the legislature is in session. The Arizona Association of REALTORS® CEO/Chief Lobbyist Tom Farley, VP of Government Affairs Meghaen Duger, and members serving on the legislative committees will actively monitor any future proposals and work to make sure that any future changes to these laws are prospective, fair, and based on sound economic policy.

¹ A.R.S. § 33-729(A) applies only to purchase money mortgages; however, the Arizona Supreme Court construed it to apply to purchase money deeds of trust that are foreclosed judicially as well. Mid Kansas Federal Savings & Loan Association v. Dynamic Development Corp., 167 Ariz. 122, 126, 804 P.2d 1310, 1314 (1991). A purchase money mortgage (or deed of trust) is one “given to secure the payment of the balance of the purchase price, or to secure a loan to pay all or part of the purchase price.” A.R.S § 33-814(G) applies to deeds of trust foreclosed by trustee’s sale, whether or not they are purchase money.

Always Consult Legal Counsel

As discussed above, a lender’s rights and remedies, including the right to sue for a deficiency, are complex and are affected by a variety of factors. Anyone with questions about this issue should consult with knowledgeable legal counsel.

K. Michelle Lind, Esq. is General Counsel/Assistant CEO to the Arizona Association of REALTORS® (AAR). She serves as the primary legal advisor to the association. Michelle oversees AAR’s Risk Management Committee, which includes professional standards administration for twenty of the state’s local REALTOR® associations, and the development of standard real estate forms. She is the author of Arizona Real Estate: A Professional’s Guide to Law & Practice and a regular contributor to the Arizona REALTOR® Magazine and the Arizona Journal of Real Estate & Business.
Please note that this article is of a general nature and may not be updated or revised for accuracy as statutory or case law changes following the date of first publication. Further, this article reflects only the opinion of the author, is not intended as definitive legal advice and you should not act upon it without seeking independent legal counsel.