Foreclosing On Mixed Collateral In Federal Court: Tips For Lenders Foreclosing On Vessels and Real Property In A Single Action

[vc_row][vc_column][vc_column_text]Copyright © 2013 Law Office of Alexander T Gruft

Overview:

Despite tough economic times, U.S. boat sales are on the rise.  According to Soldboats.com, between January and August 2013, 23,488 boats have been sold throughout the U.S.  This is an increase of 4 percent from the same period in 2012.  For the year through August the aggregate price of all boats sold was 25 percent higher than in 2012, with $2.8 billion changing hands.[1]

Many, if not most, of these purchases are facilitated with a single loan secured by a preferred mortgage[2] covering the vessel.  Additionally, the lender may require other collateral to secure the loan such as a trust deed covering real estate owned by the borrower.  This article explores the “mixed collateral” situation where a borrower defaults on a loan secured by both a vessel and real property and the lender wishes to foreclose on both collateral while preserving its rights to a deficiency judgment against the borrower.  This article discusses California’s one-action/security-first rule and the pitfalls and procedures lenders must be aware of when it pursues mixed collateral in federal court.[3]

ONE ACTION RULE

California Code of Civil Procedure § 726, commonly referred to as either the security first rule or One Action Rule, requires a secured creditor to first exhaust all of its security in a single foreclosure action before it can obtain a monetary deficiency judgment against the debtor personally.[4]

Section 726 mandates that a secured creditor (1) foreclose on its security and obtain a judgment before proceeding directly on the note, (2) include all of the security in a single judicial foreclosure action, and (3) refrain from exercising self-help remedies after a debtor’s default.[5]

The borrower can raise the rule as a defense thereby requiring the creditor to amend its complaint to include all of its security in the action before it can obtain a money judgment against the debtor.  But even if not raised as a defense, the rule will still act as a sanction: once the creditor obtains a judgment, it will be precluded from foreclosing on any security not included in the foreclosure action.[6]

The One Action Rule does not prohibit a creditor from pursuing nonjudicial foreclosure before resorting to additional security because a nonjudicial foreclosure is not considered an “action” within the meaning of section 726 of the Code of Civil Procedure.[7]  In fact, a creditor may pursue its remedies of a judicial and trustee’s sale alternatively or concurrently.[8]  But by pursuing a trustee’s sale to conclusion, the creditor forfeits its right to a deficiency judgment against the borrower.[9]

MIXED COLLATERAL

Prior to California’s adoption of the mixed collateral statute[10], section 726 applied to any debt secured by a mortgage on real or personal property so that there could only be one form of action for the recovery of debt whether the debt was secured solely by real property, solely by personal property, or by both real and personal property.[11]

Pursuant to the Mixed Collateral Statute, where a single debt is secured by both real and personal property, special “mixed collateral” rules apply.[12]  California Commercial Code section 9604 provides two methods for selling mixed collateral – a nonunified sale and a unified sale.  In a nonunified sale, a lender holding both real and personal property collateral may elect to proceed, in any sequence, to either: (a) foreclose on the real property in accordance with the rights and remedies respecting foreclosure of real property; or (b) foreclose on the personal property in accordance with the rights and remedies under the Commercial Code.[13]  The One Action Rule does not apply to the personal property component where the personal property is foreclosed separate from the real property.[14]

Alternatively, the lender may sell closely-related real and personal property as a single unit in a “unified sale.”[15]  In a unified sale, the foreclosure is governed entirely by statutes applicable to real property collateral.[16]

Given the Mixed Collateral Statute, what are the lender’s options? There is no indication that section 9604 applies in situations other than those covered by the Commercial Code.  And Division 9 of the Commercial Code does not apply to the extent that a statute of the United States preempts it, and federal courts have exclusive jurisdiction to enforce a ship mortgage.[17]  But even if section 9604 was applicable, the lender would still be required to pursue both forms of collateral in a federal action – the lender is thrust into federal court by virtue of the federal court’s exclusive admiralty jurisdiction, and the lender’s desire for a deficiency judgment bars resort to a nonjudicial sale of the real property.[18]   To exclude the real property in the federal action would run afoul of the One Action Rule.

PROCEEDING IN FEDERAL COURT

It is against this background that the lender must navigate when foreclosing on a vessel.  The lender must proceed with caution to preserve its security in the real property and its right to a deficiency judgment against the borrower.  It is beyond the scope of this article to discuss the advantages and disadvantages of a judicial foreclosure of a vessel.[19]

We will assume that a judicial foreclosure is the best (and only) option for the lender because the vessel is in the judicial district and thus subject to federal jurisdiction, the value of the vessel exceeds the likely return from a distressed sale, and the lender desires to maximize the sale price by extinguishing other valid maritime liens against the vessel.[20]

Federal courts have exclusive jurisdiction to enforce maritime liens, including preferred mortgages.[21]  Under the federal Commercial Instrument and Maritime Liens Act, the lien holder has the right to arrest the vessel, have it sold, and be repaid the debt from the proceeds.[22]

Thus, the lender’s only option for judicial foreclosure on the vessel is to proceed in federal court.  Once a decision is made to arrest the vessel, counsel must prepare a complaint “in rem”, i.e., against the vessel.[23]   Drafting the complaint requires careful attention to the One Action Rule.  The lender must foreclose all of its security in a single action.  Therefore, the complaint must include separate claims for relief for foreclosure of the vessel and foreclosure of the real property.[24]  The lender cannot obtain a money judgment against the borrower individually except for a deficiency judgment following foreclosure.

Because of the expenses inherent in keeping a vessel under the custody of the court and the inevitable deterioration of the vessel as it sits during the litigation, the federal rules permit an interlocutory sale of the vessel.[25]  An interlocutory sale is a sale before the completion of the litigation and the entering of a judgment.  The sale typically occurs three to five months after the filing of the complaint.  Any sale proceeds, less expenses incurred for the keeping of the vessel and fees to the U.S. Marshal, are substituted for the vessel and deposited into the registry of the court pending final outcome of the litigation.[26]

Once the vessel is sold, the lender should consider moving for summary judgment on the foreclosure claims to reduce litigation costs and to conclude the action.[27]  If money is deposited with the court, a judgment of foreclosure may be necessary before the court orders a release of the funds.[28]

PREPARING THE JUDGMENT

The form of judgment in the federal court should include a judgment for foreclosure against the vessel and the lender’s entitlement to any sale proceeds.  It should also include a decree of foreclosure of a mortgage under Code of Civil Procedure section 726(b) as to the real property.[29]  The decree of foreclosure should direct the sale of the real property, determine the amount to be paid to the lender, determine the personal liability of any defendants, name the defendants against whom a deficiency judgment may be ordered, provide that the property is subject to a right of redemption, and that the court retains jurisdiction to determine the amount of any deficiency.[30]

The judgment is not a money judgment or a judgment for damages.  Only after the court determines that a deficiency remains on the obligation will the court render a deficiency judgment against the borrower.[31]  Although counsel should be aware of the fair market value deficiency rules applicable to nonjudicial foreclosures[32] and judicial foreclosures,[33] those rules likely will not apply in the admiralty proceeding.  Under the Mixed Collateral Statute, the “fair value” limitation applies to deficiency judgments only where the mixed collateral is sold as a unit and the sale is governed by real property law and not the Commercial Code.[34]  Further, the federal court will have already made a fair value determination as part of the sale confirmation immediately after the interlocutory sale.[35]

CONCLUSION

Given the surge in vessel sales and vessel prices, there is likely to be an increase in loans secured by both a vessel and real property.  Unfortunately, it is only when the borrower defaults that the lender realizes the potential minefield involved with foreclosing on mixed collateral.  In practice, lenders and their counsel will have to act fast to initiate a federal court action against the vessel and secure its arrest.  They also must be wary of the One Action Rule and the Mixed Collateral Statute or risk forfeiting their real property security and a potential deficiency judgment against the borrower.[36]

[1] John Burnham, Brokerage Sales Exceed 3,000 for Fifth Month In Row (Sept. 30, 2013), http://www.tradeonlytoday.com.

[2] A preferred mortgage is a mortgage recorded against a vessel documented with the United States Coast Guard.  It is protected under the Commercial Instruments and Maritime Liens Act (formally the Ship’s Mortgage Act of 1920) (46 U.S.C. §§31301-31343), and takes precedence over all liens other than preferred maritime liens.  46 U.S.C. §§ 31301(6), 31322, 31326; Maryland Nat’l. Bank v. Vessel Madam Chapel, 46 F.3d 895, 898-899 (9th Cir. 1995).

[3] This article focuses on proceedings in federal court because the federal court’s jurisdiction over foreclosure of preferred ship mortgages is exclusive of state courts.  See, supra, note 20.

[4] Bank of America, N.A. v. Roberts, 217 Cal.App.4th 1386, 1396 (2013); In re Kearns, 314 B.R. 819, 822 (2004).

[5] Walker v. Community Bank, 10 Cal.3d 729, 733-734 (1974).

[6] Security Pacific National Bank v. Wozab, 51 Cal.3d 991, 1004-1005 (1990); Shin v. Superior Court, 26 Cal.App.4th 542, 547 (1994) (Korean action including a writ of attachment on unencumbered property violates the “multiplicity of actions” aspect of the “one form of action” rule).

[7] Western Security Bank v. Superior Court, 15 Cal.4th 232, 252 (1997) (stating that a creditor that resorts to additional security nonjudicially “does no more than call on all the security pledged for the debt”); Coppola v. Superior Court, 211 Cal.App.3d 848, 866 (1989) (creditor secured by a trust deed on real property may recover full amount of debt upon default through three mutually exclusive remedies: suit for a personal judgment on the full amount of the debt; private trustee sale; or action for judicial foreclosure).

[8] Oxford Street Properties, LLC v. Rehabilitation Associates, LLC, 206 Cal.App.4th 296, 304 n. 3 (2012).

[9] Cal. Civ. Proc. Code § 580d; Oxford Street Properties, LLC, 206 Cal.App.4th at 304 n. 3; Coppola, 211 Cal.App.3d at 866.

[10] Cal. Com. Code § 9604 (formerly Cal. Com. Code § 9501(4)).

[11] Walker, 10 Cal.3d at 734; O’Neil v. General Security Corp., 4 Cal.App.4th 587, 597 (1992).

[12] Cal. Com. Code § 9604; Florio v. Lau, 68 Cal.App.4th 637, 644-645 (1989).

[13] Cal. Com. Code § 9604(a)(1)(A).

[14] Cal. Com. Code § 9604(a)(2)(A); Cal. Civ. Proc. Code § 726; Oxford Street Properties, LLC, 206 Cal.App.4th at 304 n. 4.

[15] Cal. Com. Code § 9604(a)(1)(B); Aspen Enterprises, Inc. v. Bodge, 37 Cal.App.4th 1811, 1818-1819 (1995) (interpreting “unified foreclosure” under predecessor statute as applying “only where a debt is secured by collateral which consists of closely related elements of real property and personal property, such as business premises plus the fixtures and inventory of the business located on the premises.”).

[16] Cal. Com. Code § 9604(a)(1)(B); Florio, 68 Cal.App.4th at 642.

[17] Cal. Com. Code § 9109(c)(1); Detroit Trust Co. v. The Thomas Barlum, 293 U.S. 21, 42 (1934) (“If a mortgage is within the [ship mortgage] Act, there can be no suit to foreclose it in a state court; if the mortgage is not within the Act, there can be no suit for foreclosure in the admiralty.”); Crimson Yachts, et al. v. Betty Lyn II Motor Yacht, et al., 2010 A.M.C. 1414, 1417, 603 F.3d 864 (11th Cir. 2010) (“[a]n in rem suit against a vessel is…distinctively an admiralty proceeding, and is hence within the exclusive province of the federal courts.”).

[18] Cal. Civ. Proc. Code § 580d; Coppola, 211 Cal.App.3d at 866.

[19]  Bank of America National Trust & Savings Association v. Fogle, 637 F.Supp. 305 (N.D. Cal. 1985) (barring lender from seeking a deficiency against borrowers after private, nonjudicial sale because federal law provides exclusive means to foreclose ship mortgage).  But see, Dietrich v. Key Bank, N.A., 72 F.3d 1509 (11th Cir. 1996) (holding that parties to a ship’s mortgage could agree to incorporate self-help provisions in mortgage) and comments in the Congressional Record related to the 1996 amendment to 46 U.S.C. § 31325(b)(3) stating, “Section 1124(a) of the Senate bill adds a new paragraph (3) to section 31325(b) … to clarify that the remedies currently available under section 31325(b) do not preclude the exercise of other lawful rights and remedies available to mortgagees, including extrajudicial, “self-help” remedies.”  142 Cong. Rec. H.11485-02, 11522.

[20] 46 U.S.C. 31326(a) (“When a vessel is sold by order of a district court in a civil action in rem brought to enforce a preferred mortgage lien or a maritime lien, any claim in the vessel existing on the date of sale is terminated….”); HGN Corp. v. Vessel Coinseco Alfa, 1985 A.M.C. 1083, 1087 (S.D. Cal. 1984).

[21] Detroit Trust Co., 293 U.S. at 42 (“If a mortgage is within the [ship mortgage] Act, there can be no suit to foreclose it in a state court; if the mortgage is not within the Act, there can be no suit for foreclosure in the admiralty.”);Crimson Yachts, et al., 2010 A.M.C. at 1417, 603 F.3d 864 (“[a]n in rem suit against a vessel is…distinctively an admiralty proceeding, and is hence within the exclusive province of the federal courts.”).

[22] 46 U.S.C. § 31342(a); Trans-Tec Asia v. M/V Harmony Container, 518 F.3d 1120, 1128 (9th Cir. 2008); Capital Bank PLC v. M/Y Birgitta, 2010 WL 2902740 (C.D. Cal. 2010) (“[A] court may order the sale of a vessel to enforce a preferred mortgage on that vessel.”).

[23] Supplemental Admiralty Rule C(2).

[24] Federal subject matter jurisdiction over the real property foreclosure exists either based on diversity of citizenship and a principal indebtedness of more than $75,000, or supplemental jurisdiction by virtue of the admiralty claims.  28 U.S.C. §§ 1331, 1332 and 1367(a).

[25] Rule (E)(9)(a) of the Federal Rules of Civil Procedure, Supplemental Rules for Admiralty or Maritime Claims permits interlocutory sale of vessels if the vessel (1) is perishable, or liable to deterioration, decay, or injury; or (2) if the expense of keeping the property is excessive or disproportionate; or (3) if there is an unreasonable delay in securing the release of the vessel.

[26] 46 U.S.C. § 31326(b) (upon the vessel’s sale the maritime lien created by the preferred mortgage transfers to the sale proceeds in rem).  If the lender credit bids at the auction and is the high and successful bidder, there will be no sale proceeds to deposit in the court registry.  In other words, no money will change hands.  This is the ideal outcome because it eliminates the need to obtain a judgment before the court will order the court registry to release the funds to the claimant.  C.f. United States District Court, Southern District of California, Local Rules, Civil Rule 67.1.

[27] Fed. R. Civ. P. 56.

[28] Fed. R. Civ. P. 67(b); 28 U.S.C. § 2042; United States District Court, Southern District of California, Local Rules, Civil Rule 67.1.

[29] It is beyond the scope of this article to discuss whether recovery of attorneys’ fees and costs constitutes a money judgment on the debt resulting in a waiver of security under the One Action Rule.  The Mixed Collateral Statute gives some guidance in California Commercial Code section 9604(a)(6):

“Monetary judgment on the debt” does not include a judgment which provides only for other relief (whether or not that other relief is secured by the collateral), such as one or more forms of nonmonetary relief, and monetary relief ancillary to any of the foregoing, such as attorneys’ fees and costs incurred in seeking the relief.

[30] Coppola, 211 Cal.App.3d at 867-868.

[31] Cal. Civ. Proc. Code §726(b); Kinsmith Financial Corp. v. Gilroy, 105 Cal.App.4th 447, 453-454 (2003) (holding that foreclosure decree is not the only final judgment in an action for judicial foreclosure; thus, only a deficiency money judgment must be renewed within ten years).

[32] Cal. Civ. Proc. Code § 580a.

[33] Cal. Civ. Proc. Code § 726.

[34] Cal. Com. Code § 9604(a)(2)(A), (8); Florio, 68 Cal.App.4th at 644-645.  Counsel would be hard pressed to argue that the vessel and real property are so closely related as to constitute a single unit.  This designation is typically reserved for situations where real and personal property comprise a single package, such as a hotel, and a unified sale of the real property, fixtures and inventory would enhance the “going concern” value.  Aspen Enterprises, Inc., 37 Cal.App.4th at 1818-1819.

[35] The local admiralty rules for the Southern, Central and Northern Districts of California contain provisions for confirmation of the vessel sale.  The provisions provide for a short period of time (e.g., 3 days in the Southern District) after which, if no written objection to the sale is filed, the sale will stand confirmed as a matter of course.  See also, Bank of Am., NT & SA v. Pengwin, 175 F.3d 1109, 1118 (9th Cir. 1999) (sale may be set aside on a showing of (1) fraud on the part of the purchaser, the officer conducting the sale, or any other person connected with the sale; (2) collusion; or (3) inadequacy of price, provided the inadequacy is gross and is such as amounts to either fraud or unfairness.”).

[36] For additional discussion of the interplay between section 726 and the Mixed Collateral Statute, see John R. Hetland and Charles A. Hansen, The ‘Mixed Collateral’ Amendments to California’s Commercial Code – Covert Repeal of California’s Real Property Foreclosure and Antideficiency Provisions or Exercise in Futility?, 75 Cal. L. Rev. 185 (1987) and Morris W. Hirsch et al., The U.C.C. Mixed Collateral Statute – Has Paradise Really Been Lost?, 36 UCLA L. Rev. 1 (1988).[/vc_column_text][/vc_column][/vc_row]