Skip to main content

Setoff Against Unsecured Deficiency of Debt Owed by Creditor Contravenes Policy Underlying Antideficiency Laws

This year the appellate courts have considered California's antideficiency laws in a number of cases. One such recent case is Birman v. Loeb, 98 Daily Journal D.A.R. 5843 (1998), in which the California Court of Appeal, Second Appellate District, ruled that a creditor could not set off a debt owed to a trustor against a deficiency balance owed to the creditor after a nonjudicial foreclosure sale. The Birman opinion is instructive because it analyzes many cases interpreting various aspects of the antideficiency laws, as well as the legislative intent underlying these laws, which are set forth in Code of Civil Procedure section 580a et seq., and section 726.

Factual Background

In Birman, the defendants sold a warehouse to plaintiffs, taking back a promissory note for $4.45 million secured by a deed of trust against the warehouse. Thereafter, plaintiffs sued defendants for fraud, negligent misrepresentation and failure to disclose in connection with the purchase and sale transaction. Judgment was rendered in favor of plaintiffs, with the trial court reducing the principal amount of the note from $4 million to $3 million and awarding plaintiffs their attorneys' fees and costs in the sum of $306,820.57.

Plaintiffs defaulted on the reformed note and failed to pay real property taxes. As a result, defendants reacquired title to the property as the successful bidders following a nonjudicial foreclosure sale under the deed of trust. Following foreclosure, the unsecured balance remaining on the note exceeded $2 million.

Defendants then filed a motion for equitable setoff and satisfaction of the judgment for attorneys' fees and costs entered in plaintiffs' favor in their earlier action against defendants. The trial court allowed the setoff, which the appellate court overturned.

One Form of Action Rule of Section 726
Not Violated

Section 726 of the California Code of Civil Procedure embodies the "one form of action" rule. In pertinent part, section 726(a) provides:

There can be but one form of action for the recovery of any debt or the enforcement of any right secured by mortgage upon real property or an estate for years therein, which action shall be in accordance with the provisions of this chapter.

Section 22 of the Code of Civil Procedure defines "action" as follows: "An action is an ordinary proceeding in a court of justice by which one party prosecutes another for the declaration, enforcement, or protection of a right, the redress or prevention of a wrong, or the punishment of a public offense."

The court recognized that a nonjudicial foreclosure is not an "action" within the meaning of sections 22 or 726; hence, a nonjudicial foreclosure does not violate the one form of action rule embodied in section 726. Nevertheless, the court found that the setoff contravened the "economic policy considerations" underlying the antideficiency statutes.

The court looked to the policy considerations underlying section 580b of the Code of Civil Procedure. Section 580b precludes a deficiency judgment after foreclosure, judicial or nonjudicial, under a purchase money deed of trust given to the seller. A deficiency judgment is "a money judgment . . . for the balance due upon an obligation for the payment of which a deed of trust or mortgage with power of sale upon real property . . . was given as security. . . ." Code Civ. Proc. § 580a.

In finding that the setoff was the functional equivalent of a deficiency judgment, the court looked to the dual purposes behind section 580. The purposes of that section were to discourage land sales that were unsound because the land was overvalued or, in the event of a general depression, to prevent the aggravation of a downturn that would result if defaulting purchasers lost land and were burdened with personal liability. The setoff contravened the public policy intended to relieve debtors under a purchase money trust deed from any personal liability on the debt.

No Independent Basis of Liability

The Birman court found that the setoff situation at issue therein distinguished the case from other cases in which creditors have been allowed additional recovery against a debtor following foreclosure because those actions did not conflict with the policies behind the antideficiency laws. Such cases include those in which courts have allowed creditors to resort to additional security either following a nonjudicial foreclosure to prevent unjust enrichment, or where an independent tort theory of liability supports the claim.

No Mutual Obligations

Defendants correctly asserted that the nonjudicial foreclosure, at which they reacquired the property for less than the full amount of the outstanding indebtedness, did not extinguish the debt. However, this fact was of no avail to the defendant sellers.

In order to assert a setoff, cross-demands for money must exist between the parties. The right of setoff arises when two parties are mutually debtor and creditor to each other. The right is founded on the "equitable principle that either party to a transaction involving mutual debts and credits can strike a balance, holding himself owing or entitled only to the net difference . . . [citation omitted]."

In the present case, no mutual obligations existed between the parties because the creditors, having foreclosed on a purchase money deed of trust, did not obtain, and had no right to secure, a deficiency judgment. The creditors were thus left with an unsecured, unenforceable claim for the balance due on the promissory note. They had no recourse beyond the security. Absent mutual obligations, there simply was no basis for ordering a setoff.

The court found unpersuasive the defendant sellers' attempt to analogize the setoff situation to section 431.70 of the Code of Civil Procedure, which expressly permits a debt otherwise barred by the statute of limitations to be used as a setoff. The debts addressed in section 431.70 would be enforceable but for the fact that the statute of limitations had run. Here, by contrast, the purchasers' remaining indebtedness to the defendant sellers was unenforceable regardless of any time limits.

Ms. Hutton is a Principal in the firm's Title, Banking and Financial Institutions, and Employment Departments, specializing in Litigation.

Was this helpful?

Thank you. Your response has been sent.

Copied to clipboard