City of Sierra Madre vs. SunTrust Mortgage, Inc. (Cal.App.) – Deed of Trust Securing Receiver’s Remediation Loan is Granted Super-Priority Over Refinancing Lender’s Earlier Deed of Trust

The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

A California appellate court has held that a trial court had the power to authorize “super-priority” status for a loan to a receiver, which enabled the receiver to remediate illegal conditions on a parcel of real property, even though the new loan pushed the refinancing lender’s lien into second place. [City of Sierra Madre vs. SunTrust Mortgage, Inc., 2019 Westlaw 926096 (Cal.App.).]

Facts: Two homeowners dug huge pits around and under their home, without obtaining the required city permits. Apparently while that illegal work was continuing, the homeowners refinanced their home loan. After an alley near the property collapsed, the city filed an action against them and the lender, seeking injunctive relief and the appointment of a receiver.

After the homeowners failed to remediate the property, the trial court appointed a receiver. As part of the receiver’s plan of remediation, the receiver proposed to borrow money from a new lender in order to finance the repair of the property. The receiver also asked for super-priority status for that loan.

Over the refinancing lender’s objection, the court approved the receiver’s plan. The receiver was authorized to borrow approximately $250,000, with a first-priority lien in favor of the new lender. The refinancing lender appealed.

Reasoning: The appellate court affirmed, holding that the trial court had correctly approved of the super-priority lien. The court first noted that the trial court had the power to authorize such an arrangement:

Courts . . . have substantial discretion to authorize a receiver to borrow money to fund the preservation and management of property in the receivership estate, particularly where, as here, the estate does not produce income. In that circumstance, the receiver may ask the court to authorize the issuance of a receiver’s certificate to the lender as security for money loaned to the estate. Typically, such a receivership certificate will have priority over all other liens—even preexisting liens . . . . This too is a matter committed to the sound discretion of the court . . . . But as the receiver points out, use of super-priority liens should be infrequent because the disturbance of preexisting liens may bring harsh consequences . . . .

The refinancing lender argued that there was no specific statutory authority for the issuance of a super-priority lien. The court observed that the receiver was appointed under both California Code of Civil Procedure section 564, a general receivership statute, and Health and Safety Code section 17980.7, which authorizes the appointment of receivers to remedy building code violations.

The court acknowledged that the Health & Safety Code section authorized borrowing by a receiver but did not explicitly authorize super-priority status. Nevertheless, long-standing California case law had interpreted the powers of a general receiver to include borrowing under a super-priority arrangement.

Finally, the court concluded that under the facts of this case, the authorization of super-priority status was not an abuse of discretion: “[The refinancing lender] chose to take no action against the [homeowners], despite the fact the [homeowners] were plainly in breach of the deed of trust.” The lender argued that it had no duty to monitor the behavior of the borrowers. But the court reasoned that the issuance of the super-priority lien did not really harm the refinancing lender, since it was already so far underwater:

[The refinancing lender’s] lien on the . . . property was worthless (or nearly so) well before the court authorized the receiver to issue a super-priority lien. The [homeowners] persisted with unpermitted excavation and construction on the property and created the public nuisance which required remediation so costly it exceeded the value of the unimproved land. As a result, [the refinancing lender] had an inadequately secured loan and, due to California’s anti-deficiency statutes, also had an extremely limited ability to obtain payment from the [borrowers] directly. Stated differently, the imposition of a super-priority lien by the receiver did not substantially prejudice [the refinancing lender] because prior to the remediation, [the lender] was the senior lienholder on a property with minimal (or perhaps negative) value and was unlikely to be repaid in any event.

Author’s Comment: Given the scanty case law on point, it is significant that the California receivership statutes have never been amended to explicitly authorize super-priority borrowing by a receiver. It would not surprise me if the refinancing lender in this case were to seek a hearing before the California Supreme Court, on the theory that if the Legislature had wanted to authorize such an extreme remedy, it would have done so expressly.

One could argue that this case is restricted to its facts: the court indicated that the refinancing lender went ahead with the funding, even though the homeowners had already begun the illegal excavation. Although the court does not say so, perhaps a physical appraisal of the property prior to the refinancing might have revealed the illegal behavior. Therefore, if this case simply stands for the proposition that a lender who extends credit on the strength of already-noncompliant property is subject to a priming lien in favor of a receivership lender, that result is not particularly alarming.

Assuming, however, that this case stands for a broader proposition (i.e., that every mortgage lender is at risk of being primed), that would theoretically force mortgage lenders to become somewhat more vigilant in monitoring the ongoing condition and use of the property, even after the loan has been funded. In the real world, that is not going to happen. The occasional risk of “priming” would be outweighed by the huge aggregate cost of those inspections.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.