California Appeals Court Belts Borrowers With Personal Liability On Non-Recourse Mortgage For Committing 'Bad Faith' Waste

From a client alert from the California law firm Farella Braun & Martel LLP:

• Borrowers and their constituents generally benefit from certain limitations on personal liability for indebtedness secured by California real property. California’s one action and anti-deficiency rules require a lender faced with a borrower default to proceed against the real estate first and prohibit a deficiency judgment following a nonjudicial foreclosure or in the case of a purchase money loan.
  
  In addition, various corporate forms generally provide principals and employees with comfort that they will not be personally liable for an entity’s debts. A recent California appellate court decision, however, delivered a sobering reminder that, despite these protections, even the well-intentioned may face unexpected (and involuntary) liability.
  
  In Fait v. New Faze Development, Inc., 207 Cal. App. 4th 284 (2012), the appellate court considered whether a borrower corporation, its sole owner and certain of its key employees could be held liable to a foreclosing purchase money lender for a deficiency relating to nonpayment of a loan where the borrower demolished a building prior to securing construction financing for the redevelopment.
  
  The trial court had granted summary judgment in favor of the defendants with respect to all claims. The appellate court reversed, holding that there were triable issues of fact as to whether the borrower, as well as its representatives, could be held liable to its purchase money lender for “bad faith” waste.
  
  The court relied, in part, on the California Supreme Court’s decision in Cornelison v. Kornbluth¸ 15 Cal.3d 590 (1975), holding that the anti-deficiency rules (i.e., California statutory rules barring a deficiency judgment following a nonjudicial foreclosure or in the case of a purchase money loan) would not bar recovery against the borrower where the borrower has committed “bad faith” waste as opposed to waste resulting from “the depressed condition of the general real estate market.”
  
  In ruling that the borrowers (and its owners and representatives) could be liable, the Fait court adopted a more expansive interpretation of “bad faith” waste, stating that “‘bad faith’ waste . . . is any waste that is not the result of economic pressures of a market depression” and noting that it did not require a showing of reckless, intentional or malicious conduct.
  
  The court found that the developer’s decision to demolish the building before it had the financial means to complete development or repay the promissory note was not comparable to a mere decline in property value due to market forces.

***

• The Fait case serves as an important reminder to real estate professionals that the risk of personal liability to lenders for property damage should not be taken lightly.

For more, see Hidden Liability Traps in Real Estate Loans.