The risks in buying a delinquent mortgage

Loans among businesspeople are not uncommon in northern Nevada. Such loans are often secured by a lien on real property owned by the borrower. Not surprisingly, recent economic conditions have lead to defaults on many of these notes. Today, lenders often wonder whether their loans can be sold so someone else can do the dirty work of collection.

Collecting on a delinquent loan to a family member, business associate or partner is often undesirable because of the personal relationship between the lender and the borrower. Generally speaking, buyers of promissory notes seek to purchase a note at a discount in order to build in some profit in the event that collection becomes necessary. Likewise, the seller trades some potential future income for a lump sum today. For example, when purchasing a $100,000 promissory note, the purchaser may only want to pay $90,000 after considering the risk that the borrower will default. While it is possible to sell a note secured by a deed of trust, a peculiarity of Nevada law limits the marketability of these notes.

Unfortunately for the buyer of the note and deed of trust, Nevada law limits the amount which can be collected after foreclosure by the buyer of the note. Under Nevada's statutes, the amount constituting a lien is limited to the amount of the consideration paid by the lienholder. This means that the buyer of the note only has a lien for the amount paid for the note, even if the principal balance of the note is more. After a foreclosure, if the proceeds of sale are insufficient to satisfy the principal balance of the note, the lender may wish to sue the borrower for the balance. This suit is called a "deficiency action." Further, Nevada law provides that the amount collectable in a deficiency action is limited to the amount by which the indebtedness which was secured exceeds the fair market value of the property sold at the time of the sale, with interest from the date of the sale. For the purchaser of a promissory note, these two provisions cap the amount that the purchasing noteholder can recover in a deficiency action to the amount of the secured indebtedness, which in turn is limited to the consideration paid by the lienholder.

Stated plainly, there is no way to discount the purchase price without correspondingly discounting the maximum recovery. There is simply no way for buyers and sellers of mortgage notes to trade the notes at a discount without correspondingly reducing the buyer's maximum recovery.

These provisions were adopted by the Nevada Legislature in 1969 in response to a 1967 ruling by the Nevada Supreme Court, Nevada Land and Mortgage Co. v. Hidden Wells Ranch, Inc. In Nevada Land and Mortgage, the Supreme Court clarified that a deficiency action foreclosure of a deed of trust was permissible under Nevada law.

Unfortunately, when the Supreme Court ruled that deficiency actions were permissible after exercise of the power of sale, there was no statutory guidance about how those deficiency actions would be conducted. The Legislature remedied this gap in 1969 with the adoption of Assembly Bill 493. The legislative history of AB 493 indicates that the Legislature was worried about borrowers being dealt with unfairly if notes were enforced by assignees. Minutes of the hearings on AB 493 reveal that the drafters intended to cap deficiency rights after sale of a mortgage to prevent unfair dealing from the purchaser of the mortgage note.

Although there are no reported court cases interpreting these provisions of Nevada law, a recent district court ruling from Judge Patrick Flanagan in Kuhl v. Carrington Mortgage Services, LLC (March 7, 2011), zeroed in on the issue in the context of an appeal from a residential foreclosure mediation. In the case, the borrower asserted that the lender had failed to participate in the foreclosure mediation in good faith, because the lender failed to disclose how much it had paid for the note. Judge Flanagan ruled that the amount that the foreclosing lender paid for the note was relevant to the borrower where the lender was refusing to waive its right to bring a deficiency action. Judge Flanagan explained that knowledge of the scope of the potential deficiency is a material fact which is necessary for the borrower to make an informed decision whether to renegotiate a loan or let a home go to foreclosure. The Judge went on to explain that the borrower has a material interest in knowing how high the deficiency judgment could be, and that asking for the lender to disclose how much it paid for the note was not unreasonable.

Judge Flanagan's March 7 ruling is not binding precedent, except within the case in which it was decided. However, the ruling is instructive on an esoteric provision of Nevada law. Importantly, this recent ruling confirms that investors seeking to acquire notes secured by real property at a discount do so at their peril. It seems highly unlikely that an assignee who purchases a mortgage note at a discount would ever be able to recover more than the amount paid for the note in a deficiency action.

Shawn Pearson is a shareholder in the law firm of Woodburn and Wedge in Reno. Contact him by email at spearson@woodburnandwedge.com, or at 688-3017.