Bankruptcy is Sometimes a Response to Foreclosure

            Some years ago there were a lot of foreclosures. But not all foreclosures are over yet. Some borrowers are still struggling with loans that are “adjusting” or “re-setting” after an initial “teaser” period.  Some of these loans offer an initial term of five years with a low interest rate that’s fixed.  At the expiration of that initial term, the loan “re-sets” to an adjustable loan that is amortized over 20 or 30 years.  However, when the loan “re-sets” the borrowers are often unable to pay the higher payment amounts that result from the re-setting of the loan.  Some of these borrowers intended to refinance their loans when the re-setting occurred.  But with the decline in the real estate market, these borrowers often find they can’t refinance their loan because the property is worth less than the amount of the loan.  A refinance in such situations is impossible, because any new lender would have to lend more money than the property is worth.  As a result, such borrowers find themselves unable to refinance unless they pay down their loans to a level below the value of the property.

Borrowers unable to make their loan payments often want to know if bankruptcy is an option.  The answer is that the attractiveness of bankruptcy usually depends on the borrower’s individual situation.  Bankrutpcy is not a “cure-all” and it is now more difficult to qualify for   Chapter 7 discharge than it was years ago.  In a Chapter 7 proceeding, most or all of a debtors debts can be discharged by the Bankruptcy Court.  However, many or most of the debtor’s assets in such a bankruptcy will be liquidated and paid over to creditors.  As noted in one court opinion, the principal purpose of the Bankruptcy Code is to grant a fresh start to the honest but unfortunate debtor.  Hersh v. U.S. ex rel. Mukasey, 555 F. 3d 743 (2008).

Some debtors don’t necessarily need to liquidate their assets and have their debts discharged in order to get a “fresh start.”  These debtors might have valuable assets, but they might be short of cash with which to pay their debts.  Sometimes creditors press such debtors, and if these debtors had some time or “breathing room” then they would be able to sell or liquidate assets and pay the creditors.  These debtors assets are often worth preserving, and the value of their assets typically exceeds their debts.  However, the debtors can have problems meeting their ongoing monthly payment obligations, and if their creditors are pressing them, then these debtors can risk losing assets that are worth far more than their debts.  Some of these debtors elect to file a Chapter 13 Bankruptcy proceeding.  In these proceedings, the debtor proposes a plan for paying off creditors.  The law provides an “automatic stay” of enforcement proceedings against such debtors, thereby giving such debtors some time or “breathing space” to re-organize their financial situations. Chapter 13 is generally used by individuals seeking some “breathing space.”  Corporations or businesses that need such “breathing space” often file a petition in a “Chapter 11″ bankruptcy.

Interest Never Sleeps

It’s a common experience.  People visit their lawyer – and they often feel better.

Why would that be the case?  Why would anybody go see a lawyer in order to feel better?

There’s a very good reason.  People who are upset or angry either may or may not feel better after they see their lawyer.  But people who are in financial trouble can often feel much better after they see their lawyer.

Why is this so?  It’s because people who are behind in their payments often don’t know what the likely outcome of their situation might be.  Most people don’t exactly know what a creditor can – or cannot – do when a borrower gets behind on their payments.  Many people have a vague, generalized sense that a debtor’s wages can be seized, or garnished.  And there are often stories about cars being repossessed in the middle of the night after an owner gets behind on their car payments.  Debtor’s bank accounts can be frozen or drained, and other assets can sometimes be seized as well.

It’s enough to make a borrower nervous.  So when the pressure gets too high, borrowers sometimes turn to legal counsel to find out exactly what their rights – and liabilities – might be.

It’s a tough position to be in.  Unforeseen events can result in an unexpected loss of income, or significant additional debt.  A prolonged illness, divorce, or job loss can all result in a significant – and sudden – loss of income.  But when something like this happens, the bills usually don’t stop coming – only the income.  This can suddenly place even the most prosperous, thrifty wage earner into a far different position than they ever expected to find themselves in.

With respect to the incurring of unnecessary debt, Gordon B. Hinckley, a prominent leader in the Mormon Church, had this to say:

“I commend to you the virtues of thrift and industry. It is the labor and the thrift of people that make a nation strong. It is work and thrift that make the family independent. Debt can be a terrible thing. It is so easy to incur and so difficult to repay. Borrowed money is had only at a price, and that price can be burdensome. Bankruptcy generally is the bitter fruit of debt. It is a tragic fulfillment of a simple process of borrowing more than one can repay. Back in 1938, I heard President J. Reuben Clark, Jr. . . . talk about interest. He said:

“Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours; it never has short crops nor droughts; it never pays taxes; it buys no food; it wears no clothes; it is unhoused and without home and so has no repairs; it has neither wife, children, father, mother, nor kinfolk to watch over and care for; it has no expense of living; it has neither weddings nor births nor deaths; it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands, or orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you.” (In Conference Report, April 1938, page 103.) (Quoting from Gordon B. Hinckley in March, 1990 Ensign magazine).

The ready availability of credit has had a profound impact on the economy of this country over many years.  Freddie Mac was set up by the Federal Government many years ago in order to make money more readily available to the home-buying public.  And the use of credit has made commercial development possible that never could have otherwise occurred. (The construction of Disneyland was made possible through borrowed funds).  Wisely used, loans and credit can be powerful tools.  But unnecessarily used, they can lead to almost overwhelming financial distress.

Lending or borrowing money, the use of credit, and obtaining loans all involve complex legal principles, regulations and considerations.  Persons involved in significant lending, borrowing or debt workouts would do well to consult legal counsel.

Original Promissory Note May Not Be Necessary in Foreclosure

Nothing ventured, nothing gained.

With the unprecedented number of foreclosures that have been occurring over the past few years, borrowers in default on their loans have been faced with the unpleasant – and very real – prospect of losing their homes in foreclosure.

When presented with the likelihood of foreclosure, some borrowers have chosen to sell their properties through a “short sale.”  Others have chosen to simply abandon their homes and allow the foreclosure sale to occur.  Other borrowers have ended up in bankruptcy.

Some borrowers have taken a very creative approach in dealing with a potential foreclosure.  In one case, a homeowner in default chose to file a lawsuit against a lender by claiming that the lender had no right to foreclose because the lender didn’t have the original promissory note. This case was determined by a federal court, and it is identified as Sicairos v. NDEX West, LLC, 2009 WL 385855 (S.D. Cal.)   A “promissory note” is a written promise to pay money, and many loan agreements are evidenced by a promissory note.  In general, a creditor who holds a promissory note should be able to prove that such creditor actually owns the loan by producing the original promissory note.

Home loans get bought and sold by lenders every day.  Sometimes the paper trail is imperfect, and as a result the loan may be transferred to a purchasing bank, but the original promissory note may get lost in the shuffle.  The homeowner in the Sicairos case claimed that because the bank didn’t have the original promissory note, it wasn’t entitled to foreclose on the borrower’s home. But the homeowner’s attorney didn’t have any real legal authority that required the foreclosing lender to actually have the original promissory note.  In the Sicairos case, the court held that California law doesn’t require a lender to actually have physical possession of the original promissory note in order to conduct foreclosure proceedings. The Sicairos court found that California law provides a comprehensive procedures for non-judicial foreclosures, and the Sicairos court wasn’t able to identify anything in the foreclosure statutes that required the lender to actually have the original promissory note.

Some borrower may wonder whether or not they might have a good defense to foreclosure if their lender hasn’t kept a perfect paper trail.  The plaintiff in the Sicairos case certainly made a game effort to halt foreclosure based on this technicality.  But in this case, the court wasn’t impressed, and it dismissed the homeowner’s lawsuit, thereby allowing the lender to proceed with foreclosure.

The Sicairos case was decided by a federal trial court.  This decision wouldn’t be binding on California state courts, nor would it be binding on most other federal courts, including bankruptcy courts.  Sometimes technical arguments can be successful in legal matters. And a different court could potentially have reached a different result.  But in this case, this technical argument failed.

Owners Must Maintain Some Properties

                The number of foreclosures in the late 2000’s was very, very high. Californians probably haven’t seen this many foreclosure sales since the Great Depression of the 1930’s.

Besides the economic upheaval experienced by families in foreclosure, some owners of neighboring properties found that their own properties were being negatively affected by “foreclosure blight.”  If a foreclosed property is left vacant and not maintained, the yard can quickly get out of hand.  Because the foreclosure process takes several months to complete, and because lenders are often delaying foreclosure during workout or short-sale negotiations, a vacant property can quickly become an eyesore.  Properties sold at foreclosure sale can be purchased by investors who don’t move into the property, but who instead hold the property vacant for investment purposes.  Because these owners don’t actually live in the property, they sometimes have an economic disincentive to maintain such properties.

Recognizing that such properties can have negative effects on neighborhood property values, the California Legislature passed a law in 2008 that gives local government the power to address such problems.  Normally, a homeowner isn’t required to cut his or her grass.  And before 2008, there was no law that required a homeowner to trim or prune trees or shrubs so long as sidewalks, roads, and neighboring properties aren’t directly affected and so long as the public health and safety isn’t negatively affected.  But in 2008, the California Legislature passed Civil Code section 2929.3.  That law provides that persons who purchase a property at a foreclosure sale must maintain that property so long as it remains vacant.  If the owner of such property fails to maintain it, then the city or other local governmental entity can assess fines of up to $1,000 per day for each violation.

That’s a substantial fine for not cutting your grass.  If you leave your grass uncut for 30 days, you could end up paying a fine equivalent to the cost of installing a small swimming pool.  Leaving your lawn or your shrubs uncut for two months could cost you the price of a really nice swimming pool  – or a great European vacation.

The statute requires that such owners “maintain” the exterior of their vacant properties.  The new law doesn’t given a detailed description of the maintenance that must be performed, but the law does state that “failure to maintain” includes a failure to trim excess “foliage” that diminishes the value of neighboring properties.  “Failure to maintain” also includes failure to keep trespassers or “squatters” off the property.  And the owner will also be in violation if there’s standing water that results in mosquito breeding.

Pre-Payment Penalties Are Often Allowable

            Money Lending has been around for thousands of years.  And regulation of money lending has also been around for thousands of years.  Some of the oldest known regulations for money lending are found in the earliest parts of the Bible at the Book of Exodus, where certain restrictions are made against charging interest on loans of money.  But in today’s world, loans are bought and sold like many other commodities.  It’s therefore not surprising that many laws and regulations have been passed concerning the lending and borrowing of money.

One regulation about money lending that may be unknown to some people is the lender’s ability to charge a penalty for early repayment of a loan.  At first glance, this may seem like an odd thing.  Lenders generally make loans with an expectation that the loan amount will eventually be repaid with interest.  If a borrower is able to repay a loan early, it could seem like a lender might be very interested in accepting a borrower’s early payments.

But a key aspect of money lending is time.  Interest is generally computed based on the passage of time.  If a lender makes a loan and the borrower repays early, then the lender may lose the interest that would have accrued on the loan.  In addition, tax considerations are often based on time as well.  Repayment of a loan with interest in any given year may create a markedly different tax result for the lender than repayment in a later year.

All of these considerations can play a part in a lender’s decision to include a “prepayment penalty” with a loan.  A “prepayment penalty” provision generally provides that if a borrower repays a loan early, then the borrower will pay a “penalty” for making the early payment.  Such “penalty” is generally in addition to all of the interests, fees, points and other charges that the borrower would have already paid in connection with such loan.

This kind of arrangement can seem burdensome to borrowers.  After all, many borrowers only seek loans because they don’t have the necessary cash to buy a home, a lot, or some other goods.  The borrower already has paid or will pay the lender fees and interest – adding a prepayment penalty can add to the financial burden already being experienced by a borrower.

But California law allows lenders to charge prepayment penalties. For example, it’s possible for a lender to absolutely prohibit early repayment of a loan.  One California court has noted that “in the absence of a statute a debtor has no more right to pay off the obligation prior to its maturity date than he does to pay it off after its maturity date.”  Williams v. Fassler (1980) 110 Cal. App. 3d 7, 10.  In the alternative, many lenders can charge a “fee” or a premium in exchange for agreeing to accept early payment.

Pre-Payment Penalty Provisions Can Be Significant

A “pre-payment penalty” is a penalty, or a charge, assessed against a borrower by a lender for the privilege of paying off a loan early.  Unless a lender agrees or unless a statute applies, lenders in California aren’t obligated to accept early payoff on a loan. Instead, in some cases a lender can charge a penalty to a borrower who wants to pay their loan off early.  Such a penalty is commonly known as a “pre-payment penalty.”

California law provides a number of protections for borrowers who have loans secured by residential properties.  This is especially true where a borrower actually lives in the property.  For example, if a single family residential home is occupied by the borrower, then the law provides that most such borrowers can prepay their loan balance at any time, regardless of what the loan documents provide. In most cases the lender on such a loan will be absolutely barred from refusing to accept an early loan payoff.  Such an early loan payoff can be very important to a borrower who wants to refinance, or who needs to move and who wants to pay off their loan early.  However, most lenders on residential loans can still charge a pre-payment penalty if the borrower pays a loan off early.  The amount of the penalty and the borrower’s ability to pay off early depends on several things, such as the terms of the loan documents, whether the borrower actually lives in the property, and whether or not the loan was negotiated by a real estate broker.

If a borrower is an owner-occupant of a single family residential property, then in most cases that borrower will be able to pre-pay up to 20 percent of the loan balance in any given 12 month period.  The law provides that in most cases this pre-payment can be made without penalty, regardless of what the loan documents say about pre-payment penalties.  In these cases, the borrower can also pre-pay more than 20% of the loan balance, but if the borrower pre-pays more than 20% in any given 12 month period, then the lender can charge a penalty that is not more than six months’ worth of interest payments.  In such a situation, the borrower still gets to pay 20% of the loan balance without penalty, and only the prepaid amount over 20% is subject to the six months of interest penalty.  After five years, the lender isn’t entitled to receive any pre-payment penalty at all, even if the borrower pays off more than 20% of the loan balance in any given year.

Different rules apply if the loan was negotiated by a real estate broker or if the borrower doesn’t live in the property.  Different rules also apply if the property consists of five or more dwelling units.  And if a borrower pre-pays a loan after the California Governor has declared a state of emergency, then in some cases it’s possible that no pre-payment penalty may be due at all.

Most of the pre-payment penalty protections that apply to residential property don’t apply to commercial or industrial property.  As a result, pre-payment penalties on commercial or industrial loans can be surprisingly high.


After litigating for more than 30 years, Robert Jacobs now mediates challenging real estate, business, construction, personal injury, trust and probate cases. In 2020 he served as Chair of the Contra Costa County Bar Association ADR section and Co-Chair of the Alameda County Bar Association ADR section.  Since 2017 he has served as one of the update authors for the CEB treatise Real Property Remedies and Damages and is a co-author of CEB Practitioner (Real Property). He holds an AV rating from Martindale-Hubbell and is a designated SuperLawyer. Mr. Jacobs received his mediator training from Northwestern University in Chicago, Illinois.

Pre-Payment Penalty Rates Can Be High

The last two articles discussed pre-payment penalties in loan transactions.  A “pre-payment penalty” is a penalty, or a charge, assessed against a borrower by a lender for the privilege of paying off a loan early.  Unless a lender agrees or unless a statute applies, lenders in California aren’t obligated to accept early payoff on a loan. Instead, in some cases a lender can charge a penalty to a borrower who wants to pay their loan off early.  Such a penalty is commonly known as a “pre-payment penalty.”

The effect of a pre-payment penalty loan provision can be significant. In one case, a borrower purchased a small ranch on 20 acres of land.  The Seller agreed to finance the sale by taking back a promissory note from the buyer.  The contract provided that the Buyer would only make limited payments to the Seller during the first five years after the sale.  The Seller wanted to stretch the payments out over several years because the Seller’s tax payments would be considerably smaller than if the purchase price were all paid at once.  The loan documents   provided that if the Buyer paid off the loan early, then the Buyer would pay the Seller a significant pre-payment penalty.

Several months after buying the ranch, the Buyers filed suit against the Seller and sought to invalidate the pre-payment penalty portion of the loan documents.  The Buyers wanted to build a new home on the ranch, and they needed to pay off the loan from the Seller in order to get a new loan to finance the construction of their new home.

The Buyers claimed that the pre-payment penalty was so high that it was unreasonable.  The Seller demonstrated to the court that if the Buyer paid the loan off early, the Seller would suffer severe negative tax consequences.

The Court reviewed the applicable law, and noted that several code sections provide Borrowers with pre-payment penalty protections for residential property.  But apparently because this property was primarily a ranch instead of a residence, the court didn’t apply the protections available to residential homeowners.  Instead, the Court upheld the pre-payment penalty amount provided in the loan documents.

The amount of the pre-payment penalty?  Fifty percent.  This means that the lender could legally charge and collect from the Borrower a penalty of fifty percent on all prepaid amounts as provided by the loan documents.

A fifty percent increase in the amount needed to payoff a loan is significant.  A fifty percent penalty on early loan payment would usually seriously alter the attractiveness of a loan. Not all pre-payment penalty rates are as high as fifty percent.  But in the appropriate circumstance, a pre-payment penalty of even fifty percent can be legal.

Pre-payment penalties, like many loan terms, are complex and are governed by several different statutes. Loan terms and documents can be complex and may be unfavorable or misleading.  Persons interested in signing loan documents and borrowing money do well when they consult competent legal counsel.

Proper Advice Can Make A Difference

            “Penny wise and pound foolish.”

Maybe it’s an old saying.  But there can be truth in it.

I constantly see the practical application of this saying in the real estate foreclosure market.

In California, some loans are “non-recourse.” With “non-recourse” loans, the borrower generally won’t have personal liability after a foreclosure for any shortfall or deficiency in the foreclosure sale price.  In other words, if the property is worth less than the loan, the borrower won’t have to make up the difference if the property is sold in foreclosure.

Most borrowers don’t know the law with respect to foreclosure.  Foreclosure can seem mysterious, and somewhat foreboding. The phrase “Short sale” sounds so much less foreboding than the word “Foreclosure.”

But many homeowners who can’t meet their payments have a choice between foreclosure or a short sale.  There are often tens of thousands, or sometimes hundreds of thousands, of dollars at stake in such a decision. The net economic difference to a homeowner between selling their home in a short sale as compared to losing their home through foreclosure can be very significant.  Sometimes a short sale yields a better result.  Sometimes foreclosure is better.  But it’s difficult when I hear that homeowners facing such decisions are unwilling to spend a few hundred dollars to get some professional advice on which course of action makes the most sense for them and which one is likely to yield the better result.

It’s tough.  Homeowners facing a short sale or foreclosure are already losing their entire down payment.  And they are also often losing all of the work, money, and improvements they’ve put into their property.  The thought of spending additional money on attorneys fees only to lose more money can seem like throwing good money after bad.

What these homeowners often don’t realize is that the money they spend for professional help is being spent in the nature of “damage control.”  Homeowners who choose a foreclosure or short sale can end up being surprised at the end of the day when they think that the short sale or foreclosure is the end of the process, only to learn too late that the lender has preserved a claim against them following foreclosure and intends to pursue it.  This can often happen in situations where there are two loans against a property, but it can happen in other situations as well.  A short sale or foreclosure can both be thought of as a transaction, though such transactions may be made under pressure. Even though a homeowner will most likely lose money in such a transaction, there can sometimes be an opportunity to lose even more.  Competent, qualified, professional advice can sometimes make a big difference on helping homeowners minimize their losses and can help them avoid losing even more.

Short Sale Considerations Are Complex

    The concept of a short sale is simple.  A “short sale” occurs when the sales price of a property isn’t enough to pay off the mortgage.  The sales price is “short” of the amount needed to fully pay off the mortgage.  If the bank agrees to a “short sale” then the property is sold for less than the amount due on the mortgage and the bank receives less than the amount that is owed.  When the Bank receives less than the amount owed, the property is sold “short” of the amount due, and this is known as a “short sale.”

The concept of a “short sale” is simple.  But the decision whether or not to short sell a property can be quite complex.  Each potential short sale situation is unique, and the decision to short sell must be carefully made and evaluated for each borrower.

There are many considerations involved in deciding whether or not a property should be short sold.  Three important considerations involve potential lender liability, tax issues, and credit concerns.

When a property is short sold, the bank won’t receive the full amount due on the loan.  In some situations, the bank forgives the unpaid balance with the result that the borrower won’t be personally liable to the bank for any unpaid amount.  In other situations, the bank may retain a claim against the borrower for the unpaid amount, and in these situations the borrower may be personally liable for the “short” amount.  In still other situations, the bank may neither expressly forgive the debt nor retain a claim against the borrower.  In these situations, the borrower may still be liable to the bank for the unpaid amount after the short sale.

A short sale can involve significant tax considerations.  Some of these tax considerations can be quite complex.  The amount of time a borrower has lived in a property can have important tax consequences in a short sale situation. Sometimes a short sale can result in a significant tax liability, and sometimes a borrower can avoid these taxes by moving back into the property for a period of time.  Many borrowers have refinanced their homes.  Sometimes these borrowers have taken equity out of their property in connection with their refinance.   In some situations these equity withdrawals can create a significant tax liability following a short sale.

A foreclosure will almost always result in negative credit reporting on a borrower’s credit report.  But in many cases the negative credit effects from a short sale will be less than the credit damage from a foreclosure. Whether or not credit is important can vary between borrowers.  The likely negative credit effect of foreclosure versus short sale must be evaluated for each borrower depending on their specific circumstances.

There is no single correct answer as to whether or not a short sale is the best answer for any specific borrower.  Each borrower’s specific situation must be separately evaluated.  Borrowers would do well to seek competent, professional tax and legal advice in connection with any anticipated short sale.

Foreclosure a Reality

          When I started practicing law in 1987, two of my very first projects involved judicial foreclosures on agricultural property.  There had been a downturn in real estate values in the central valley, and a number of vineyard properties had been purchased on a speculative basis during the boom years.  It’s a familiar cycle – investors see huge gains in real estate prices, and they want to participate in these gains and so they buy properties hoping that the prices continue to increase.  But if a market drops, or adjusts, investors who purchase such lands aren’t able to sell or refinance their properties.  When investors can no longer make their payments, lenders foreclose.

Some foreclosures are conducted judicially, which means that the borrowers can be personally liable for unpaid amounts due on the loan (in some circumstances, borrowers can be liable following non-judicial foreclosures as well).    This is a hard experience for investors to go through.  Most investors don’t buy real estate so that they can lose money.  But when property values depreciate, borrowers can lose the down payment and their property.  With some loans, borrowers can also have personal liability for the unpaid amounts due on the loan.

After the mid-1980s, it seemed like property values stabilized and then increased dramatically.  In the 1990s, there was what seemed like a small drop in values, but this drop didn’t seem too dramatic.  As a result, I wasn’t involved in many foreclosures in the following years.

That’s all changed over the past several years.  This enormous market readjustment has resulted in record numbers of foreclosures and short sales.  Banks continue to struggle with handling these foreclosures, and homeowners are faced with challenges that seemed unthinkable a few years ago.

Foreclosure and short sale matters involve complex considerations of lender liability and tax law.  Many homeowners don’t realize the complexity or the significance of the issues involved.  Because hundreds of thousands of dollars of potential liability or debt forgiveness can be involved in a foreclosure or short sale, the risks to homeowners can be significant.  Homeowers do well to consult professional, competent legal and tax advice in connection with any proposed foreclosure or short sale.