Commercial real estate loans made over the last decade – including retail properties, office space, industrial facilities, hotels and apartments – totaling $1.4 trillion will require refinancing from 2011 through 2014. Nearly half are at present “underwater,” meaning the borrower owes more on the loan than the underlying property is worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Commercial Real Estate Losses and the Risk to Financial Stability, Congressional Oversight Panel, February Oversight Report, February 11, 2010, available at http://cop.senate.gov/documents/cop-021110-report.pdf.
It is also estimated that nearly a quarter of U.S. homeowners are in the same boat (or more accurately, the same submarine). U.S. Housing and Mortgage Trends, CoreLogic, March 2011, available at http://www.corelogic.com/uploadedFiles/Pages/About_Us/ResearchTrends/CL_Q4_2010_Negative_Equity_FINAL.pdf.
Thus, a significant number of loans – both commercial and residential – face the prospect of default, whether because the owner cannot continue to make the required payments, because the owner strategically chooses to default, or because the lender has exercised its option to declare a default based on an “insecurity” clause or the debtor falling outside of specified loan coverage ratios. When the inevitable default occurs, the lender must evaluate its options, including, among other things, pursuing a judicial or non-judicial foreclosure. That decision may ultimately be made based on the financial situation and assets of the borrower or its guarantor(s), weighing whether it is worth pursuing a more expensive, time consuming judicial foreclosure in order to preserve the ability to proceed to recover a deficiency, and considering what limitations may exist under that process.
In a judicial foreclosure, the creditor may proceed against the debtor or guarantor for the deficiency – the amount that remains owing on the debt once the property has been sold. After a non-judicial foreclosure involving a commercial property, while the lender generally cannot proceed against the debtor, the lender may proceed against a guarantor for the deficiency.
This article describes how the statutory concepts of “fair value” and “upset price” can limit a lender’s ability to proceed against the debtor and guarantor for a deficiency after foreclosure.
A. Deficiency Judgments Against Debtors and Guarantors Are Limited by the “Upset Price”
A judicial foreclosure is the exclusive method of foreclosing a straight mortgage, but may optionally be used to foreclose deeds of trust and real estate contracts. Generally, the steps in a judicial foreclosure consist of the following: (1) file a summons and complaint in superior court, naming and serving all the parties whose interests need to be foreclosed (i.e., the debtor, all junior lien holders identified in a title report, etc.); (2) reduce the complaint to judgment against each defendant, either by a motion for default, motion for summary judgment, or proof at trial; and (3) use of the sheriff in the county in which the property is located to execute and sell the real property.
Generally, judicial foreclosures are considered more costly and complicated than non-judicial foreclosures. Further, judicial foreclosures usually result in a redemption period, which allows the debtor and certain junior lien holders to buy the foreclosed property back after the foreclosure by paying the amount paid at the foreclosure sale rather than the amount owed under the debt. The redemption period is generally twelve months, but can be reduced to eight months if a deficiency judgment is waived. However, judicial foreclosures may allow for acceleration of an installment obligation and, as noted above and further discussed below, they may allow for a deficiency judgment.
After a judicial foreclosure, a lender may pursue the debtor or guarantor for a deficiency, or the difference between the sale price of the property and the total debt. However, Washington law provides that the court may, prior to the sale, establish a minimum “upset” price that could trump the actual high bid:
… The court, in ordering the sale, may in its discretion, take judicial notice of economic conditions, and after a proper hearing, fix a minimum or upset price to which the mortgaged premises must be bid or sold before confirmation of the sale.
The court may, upon application for the confirmation of a sale, if it has not theretofore fixed an upset price, conduct a hearing, establish the value of the property, and, as a condition to confirmation, require that the fair value of the property be credited upon the foreclosure judgment. If an upset price has been established, the plaintiff may be required to credit this amount upon the judgment as a condition to confirmation. If the fair value as found by the court, when applied to the mortgage debt, discharges it, no deficiency judgment shall be granted.
The concept of the upset price originated in Washington State during the depression years, National Bank of Washington v. Equity Investors, 81 Wn.2d 886, 925 (1973), when property values were, like today, substantially depressed and bidding on foreclosed properties was likely to be uncompetitive. The aim of the upset price is to give the borrower and guarantor credit for what the foreclosed property would have sold for had genuinely competitive bidding occurred in the foreclosure sale, presumably a fairer reflection of the lender’s actual security in the foreclosed property.
Though guarantor rights with respect to an upset price have not been specifically addressed by case law, the upset price statute (RCW 61.12.060) appears to apply equally to borrowers and guarantors, such that crediting the upset price to the foreclosure judgment will benefit both the borrower and the guarantor. A guarantor looking to take advantage of this should make sure to assert this right prior to the court confirming the foreclosure sale.
B. When is an Upset Price Warranted?
A minimum price or upset price is warranted when competitive bidding is unlikely to occur at the sale. It is irrelevant whether the bidding will be stifled due to temporary economic fluctuations, local conditions in the particular real estate market, or even a national economic depression. Whether an upset price should be imposed depends on the effect – the absence of competitive bidding – and not with the causes of that effect.
The Washington Supreme Court clearly stated this rule in American Federal Savings & Loan Ass’n of Tacoma v. McCaffrey, 107 Wn.2d 181, 187 (1986), when it wrote that an upset price may be appropriate “[i]f, because of the kind, nature, scope or peculiarities of the property, or a depressed economy, local or general, genuinely competitive bidding will be substantially discouraged or even stifled.”
C. How is the Upset Price Determined?
The upset price is determined by establishing a “fair bid,” as calculated at the time of sale, but under normal (i.e., competitive bidding) conditions. Lee v. Barnes, 61 Wn.2d 581, 587 (1963); McCaffrey at 183. Thus, the upset price mechanism does not ignore present economic conditions, which may well have reduced the fair value of the property. Instead, the aim of the upset price is to ensure that the minimum price of the property is reflective of the value the property would command, at the time of sale, if it were the subject of a genuinely competitive bidding process, not one where bidding would be stifled or discouraged for whatever reason. See McCaffrey at 188.
In fixing an upset price, a court will consider several factors, including (i) the state of the economy and local economic conditions; (ii) the usefulness of the property under normal conditions; (iii) its potential or future value; (iv) the type of property involved; (v) its unique qualities, if any; and (vi) any other characteristics or conditions affecting its marketability, along with any other factors which a bidder might consider in determining a fair bid. McCaffrey at 188-89. Assessed value is not a consideration in determining a fair bid. McClure v. Delguzzi, 53 Wn. App. 404, 408 (1989).
D. How Much Do Upset Prices Differ from Sale Prices or Appraisals in Practice?
There are not an abundance of examples of the effect of the upset price in recent years, at least not in circumstances that have been addressed in reported cases. In past cases in Washington, courts have indeed used the discretion granted to them by statute and fixed upset prices that were significantly higher than the highest bid at a foreclosure sale and sometimes even the parties’ own appraised values.
In McCaffrey, the court set the upset price at $360,000, 25% greater than the price bid at the judicial sale ($288,000). The debtor’s expert had testified to a current market value of $432,000, while the creditor’s expert testified to a market value of $355,000 (but further argued that number would need to be severely discounted in light of the nature of the sheriff’s sale and the possibility of redemption).
In Farm Credit Bureau of Spokane v. Tucker, 62 Wn. App. 196 (1991), the court fixed the upset price at $956,400. The property had been purchased in 1981 for $1,600,000, appraised in 1988 by the creditor’s expert witness at $790,000.00, and appraised by the debtor’s expert at the time of the hearing at $1,065,000 or $1,283,200 under “normal conditions.”
In National Bank of Washington v. Equity Investors, 81 Wn.2d 886 (1973), the trial court refused to confirm the highest bid of $1,880,000, submitted by the foreclosing bank. The court fixed the upset price at $2,247,500.00, nearly 20% above the highest bid. At the time it made the loan, the bank had relied upon an appraisal of $2,500,000. The actual investment made in the property was $2,300,000. And at the hearing, two expert witnesses set the value at $2,000,000 and $2,150,000. The trial court’s upset price was affirmed as a valid exercise of the court’s discretion.
A. Proceeding Against Guarantors After a Non-judicial Foreclosure Is Limited by a “Fair Value” Determination
Unless an exception applies, a non-judicial foreclosure prevents a creditor from seeking a deficiency judgment against the borrower, grantor, or guarantor. RCW 61.24.100(1). The creditor can obtain a deficiency judgment against a guarantor for a deed of trust executed after June 11, 1998 which secures a commercial loan. RCW 61.24.100(3)(c), (4).2 However, when a guarantor is sued for a deficiency they have the right to request that the court determine the “fair value” of the property and credit against the guarantor’s obligation the difference between the “fair value” and sale price at the auction. RCW 61.24.100(5). The statute defines “fair value” as follows:
the most probable price, as of the date of the trustee’s sale, which would be paid in cash or other immediately available funds, after deduction of prior liens and encumbrances with interest to the date of the trustee’s sale, for which the property would sell on such date after reasonable exposure in the market under conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under duress.
B. How is Fair Value Determined?
Under general rules of statutory construction, the courts must interpret the legislative intent of a statute by first examining the language of the statute itself. The phrase “reasonable exposure in the market” eliminates the possibility that “fair value” is simply the price established by a fair auction or fair trustee’s sale. However, the remainder of the definition appears to leave the courts with significant discretion in determining the meaning of “fair value.” For example, it could be argued that “fair value” was intended to establish a value more akin to “fair market value.” The definition of “fair value” under the non-judicial foreclosure statute is in many ways similar to case law definitions of “fair market value.” State v. Kleist, 126 Wn.2d 432 (1995) (stating that “market value” or “fair market value” is “the price which a well-informed buyer would pay to a well-informed seller, where neither is obliged to enter into the transaction.”) In fact, other states use identical definitions of “fair value” in similar statutory schemes, but use the phrase “fair market value” instead of the phrase “fair value.” E.g., ARIZ. REV. STAT. § 33-814(A). However, in the context of a corporate shareholder’s rights of dissent, a Washington court held that the use of the phrase “fair value” in RCW 23B.13.020 did not, without further definition, equal “fair market value.” See Matthew G. Norton Co. v. Smyth, 112 Wn. App. 65 (2002). Although valuation of less than full ownership of a corporation is distinguishable from an entire fee ownership in real property, this opinion supports an argument that the legislature’s use of “fair value” is not intended to mean “fair market value.”
It could be argued that the use of the phrase “upset price” in the judicial foreclosure statute and the use of the phrase “fair value” in the non-judicial foreclosure statute represent the legislature’s intent that the valuation of real property under each statute be evaluated under distinct concepts. This argument could be supported by the fact that the definition of “fair value” under the non-judicial foreclosure statute does not include specific references to economic factors and property specific facts that are discussed in the body of case law that has evolved in the context of the “upset price.” RCW 61.24.100(5) may also lend further support to the argument for distinct valuation concepts in providing that the guarantors right to establish “fair value” is “in lieu of any right … to establish an upset price pursuant to RCW 61.12.060 prior to a trustee’s sale.”)(3)
On the other hand, as noted above, the definition of “fair value” includes concepts that are very similar to “fair market value” and specifically references the “most probable price… after reasonable exposure in the market under conditions requisite to a fair sale.” Thus, it is also arguable that the “upset price” case law should apply to the determination of “fair value” because the definition of “fair value” incorporates many of the economic and property specific factors discussed in that case law. This argument is further supported by the fact that this body of case law is interpreting the meaning of “upset price” under RCW 61.12.060, a statutory provision that specifically provides (a) “that the fair value of the property be credited upon the foreclosure judgment; and specifically refers to the (b) “fair value as found by the court.” (emphasis added).
Conclusion and Practice Pointers
Although a significant number of commercial and residential loans are presently underwater, and therefore at risk of going into default and possibly foreclosure without adequate security to cover the debtor’s obligations, there are procedures available that can limit a lender’s ability to proceed against the debtor or guarantor for a deficiency after a judicial or non-judicial foreclosure.
A debtor or guarantor whose property is being foreclosed judicially may reduce or even eliminate a possible deficiency judgment by asking the court to invoke its discretion and fix an upset price. Likewise, in a non-judicial foreclosure, a guarantor may request that the court determine the fair value of the property as of the time of the sale, and in that event the deficiency judgment against the guarantor shall be limited to the difference between the amount owed and the fair value.
Secured creditors should be cognizant of the possibility of an upset price or fair value when negotiating workouts, as it may reduce their negotiating leverage. They should also consider the possibility of an upset price when bidding at a judicial foreclosure sale, as a low bid that takes advantage of and is reflective of uncompetitive bidding is more likely to encourage a debtor to invoke the upset price mechanism.
Likewise, debtors and guarantors should be aware of these options when negotiating workouts and obtain their own appraisals, as their potential exposure may be less than a creditor’s calculation. A debtor or guarantor having its own appraisal may give the court the evidence it requires to fix a higher upset price or fair value, thereby limiting or eliminating the possible deficiency.
(1) After the sale, the sheriff files a return of sale with the clerk and the clerk notes a motion for the “confirmation” of the sale. RCW 6.21.110. The court can establish the upset price prior to the sale or after the sale and prior to confirmation.
(2) Other important prerequisites to holding a guarantor liable remain. RCW 61.24.100(3)(c) and RCW 61.24.042 (requiring special notice to guarantor); RCW 61.24.100(4) (generally requiring commencement of an action against the guarantor within one year of the sale); RCW 61.24.100(6) (providing for application of the homestead exemption if the property is the guarantor’s principal residence); RCW 61.24.100(7) (discharging the obligation of the guarantor if the creditor accepts a deed in lieu of foreclosure without the guarantor agreeing to an ongoing obligation).
(3) A guarantor looking aggressively for defenses could potentially argue that RCW 61.24.100(5) provides a right in a non-judicial foreclosure for the guarantor to request that a court establish an upset price prior to a trustee’s sale. However, while RCW 61.24.020 generally applies the law of mortgages to deeds of trust, RCW 61.12.060 contemplates establishing an upset price by the court when “ordering the sale” or “upon application for the confirmation of sale.” Neither of these events occur in a non-judicial foreclosure. Thus, an ambiguity remains that could be leveraged by a guarantor looking for defenses in a non-judicial foreclosure.
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