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Written By: Roger J. Brothers, Esq. and Dominic V. Signorotti, Esq.

Buchman Provine Brothers Smith LLP

Walnut Creek, California

Borrower beware. A recent decision by the Third District Court of Appeal (Fait v. New Faze Development, Inc., No. C067630 (June 27, 2012)) significantly limits the traditional anti-deficiency protections afforded to borrowers under California law, after a lender non-judicially forecloses on their property.

In general, under California's anti-deficiency statutes (Cal. Code of Civ. Proc. § 580a-580e), a borrower has no further liability to a lender after a non-judicial foreclosure of the borrower's property. There is an infrequently used exception to this rule, Civil Code §2929, which provides that a lender may recover damages from the borrower, after a non-judicial foreclosure, arising from the borrower's pre-foreclosure conduct which "substantially impair[ed] the mortgagee's security." In 1975, the California Supreme Court held that a "substantial impairment" of the security occurs when the borrower has committed "bad faith waste." (Cornelison v. Kornbluth(1975) 15 Cal.3d 590.)

In Fait, the definition of "bad faith" was significantly expanded to include "any waste that is not committed solely or primarily as a result of the economic pressures of a market depression." The plaintiff in Fait was New Faze Development, an entity who in 2005 purchased a parcel of real property which included an existing structure housing two tenants. Shortly after the purchase, New Faze evicted the tenants and demolished the building, with the intent of redeveloping the property into a mixed use development. New Faze's plans would never come to pass, and New Faze eventually defaulted under the promissory note and failed to pay property taxes and insurance.

The lender initiated a non-judicial foreclosure process, and the property was eventually sold via foreclosure sale. After the sale, the lender sued New Faze to recover the deficiency by alleging that New Faze had committed bad faith waste by demolishing the existing structure and failing to pay property taxes. New Faze moved for summary judgment, on the ground that there was no evidence that it acted in "bad faith" when it demolished the building or failed to pay property taxes. The trial court agreed, and reasoned that New Faze did not demonstrate any "bad faith" when it demolished the building. Instead the building was demolished based on New Faze's belief that the property could be redeveloped, and that the demolition would ultimately increase the value of the property. Consequently, the trial court granted the motion for summary judgment.

On appeal, the trial court's decision was reversed, on the ground that a triable issue of material fact existed with respect to whether New Faze acted in "bad faith." The appellate court focused not on New Faze's intent when the building was demolished, but instead explained that "the pertinent question is whether the demolition of the building…was caused by the economic pressures of a market depression." It was not New Faze's intent that mattered when the structure was demolished, it was what caused New Faze to demolish the structure. In reaching this conclusion, the court read Cornelison narrowly to provide that "‘bad faith' waste occurs whenever the owner's impairment of the value of the security is not caused by the economic pressures of a market depression, whether the owner acts recklessly, intentionally, maliciously or with some other mental state."

What does the court's decision in New Faze mean? For one, it means that borrowers should exercise extreme caution when altering, let alone destroying and/or damaging, any part of the property. This is especially true for redevelopers, who by their very nature destroy existing structures on the property for the purpose of increasing the property's value. Even if a redeveloper destroys an existing structure with the intent of improving the property, underNew Faze, this may constitute "bad faith" waste in the event of a default under the existing mortgage if the destruction was not related to market pressures. Consequently, New Fazeestablishes that a borrower's a "good faith" belief that destroying a structure on the property will ultimately increase the value of the property is irrelevant.

In an effort to help avoid liability for "bad faith" waste, borrowers, and especially redevelopers, may wish to consider (1) drafting loan agreements to exclude certain activities on the property from the definition of "bad faith waste"; and/or (2) seeking permission from their lenders before destroying any existing structures on their property. Both the modified loan documents and a consent from a lender may create an estoppel defense against a lender who later sues for "bad faith" waste.

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