Security first
Under Article 9 of the Commercial Code, the consensual secured creditor with a security interest in personal property or fixtures may foreclose on the collateral, sue on the underlying obligation, or do both in any order. See U.C.C. 9-601(a). If the secured creditor first obtains a judgment on the underlying obligation, it may then attempt to enforce the judgment in the same manner as any other judgment creditor, including through execution on any assets of the debtor, including but not limited to the assets subject to the security interest. See Commentary.Enforcement of Judgment. If the secured creditor obtains a money judgment and executes on the collateral that secured the debt, the execution is considered a form of foreclosure of the security interest and the execution lien relates back in time to the date on which the consensual security interest was perfected or the date on which a financing statement covering the collateral was filed, whichever first occurred. See U.C.C. 9-601(e). If the creditor first forecloses on the collateral and sells the collateral for an amount insufficient to retire the debt, the creditor is generally entitled to recover the deficiency (the balance owing on the debt), by judgment and execution if necessary. By definition, unless additional collateral secures the debt, the deficiency is unsecured. We study elsewhere the circumstances under which the creditor's right to a deficiency may be limited or entirely precluded.
In many jurisdictions the secured creditor with a deed of trust or mortgage on real property is afforded these same options. In California, however, the consensual real property secured creditor is much more severely restricted: it must pursue the collateral first and in a significant number of circumstances it cannot seek a deficiency. The requirement to pursue the collateral first is a "security first" rule, commonly referred to in California as the "one action" rule or the "one form of action" rule. The security first rule and rules limiting recovery of a deficiency are complex and it will take us some time to work our way through them. Moreover, lenders with mixed collateral (both real and personal property or fixtures) whose actions are governed by California law are faced with some especially difficult and complicated issues because Article 9 permits a choice of remedies where the collateral is personal property or fixtures but the "one action" rule restricts the choice of remedies where the collateral is real property. We explore those issues elsewhere in these materials. See Commentary.Foreclosure on Mixed Collateral.
We begin by exploring California's "security first" rule. This rule, like the right to reinstate, is a cornerstone of California real property security law. The rule is embodied in Cal. Code Civ. Pro. 726. The language of section 726 does not expressly state that the secured creditor must pursue security first. Rather, the language speaks of one form of action permitted the secured creditor. The one form of action contemplated is a judicial action in which the secured creditor files a lawsuit seeking foreclosure, sells the collateral pursuant to a judicial decree of foreclosure, and thereafter, in the same action, unless barred by anti-deficiency legislation, obtains a judgment for any deficiency as a personal liability of the debtor. After the foreclosure sale, the court will determine the amount of any deficiency, if deficiency is allowed, by deducting the fair value of the property sold (which may well be higher than the amount of the highest bid at the foreclosure sale) from the amount of the underlying obligation (including interests and costs). Note that in California a lender whose deed of trust contains of power of sale need not (and often will not want to) foreclose through use of the judicial process. Instead, the lender will non-judicially foreclose. Non-judicial foreclosure is not considered to be "an action" (i.e. a judicial action) and therefore its use is not precluded or in any way affected by the security first rule.
Courts have consistently construed section 726 to require that the real property secured lender pursue its real property security first, if it is filing an action. As we shall see, the case law makes clear that the word "action" refers to a judicial proceeding. The section does not apply to the secured creditor who chooses non-judicial foreclosure because such foreclosure does not involve an action. We will explore the reasons why a secured creditor may not wish to pursue a non-judicial foreclosure and must thus endure the rigors of the security first rule.
Until California's adoption of the Uniform Commercial Code, including Article 9 of the Commercial Code, in 1963, the security first rule of section 726 also applied to security interests in personal property. However, as suggested above, Article 9 does not include, and never has included, a security first rule. Review U.C.C. 9-601(a). When it adopted the Uniform Commercial Code, the California legislature chose to conform on this issue to the uniform version of Article 9; accordingly, concurrently with adoption of the Commercial Code, the legislature deleted language in section 726 which had made that section applicable to personal property security.
The commands of section 726 have been implemented through two judicially developed corollaries:
(1) If a real property secured party sues a debtor solely on the underlying obligation, the debtor may raise section 726 as an affirmative defense, forcing the secured party to amend its complaint to pursue judicial foreclosure prior to obtaining any money judgment. This doctrine is known as the "affirmative defense" aspect of the rule. We see section 726 applied in this way in Barbieri v. Ramelli and Pacific Valley Bank v. Schwenke.
(2) The debtor waives the affirmative defense if it fails to assert it in an action on the underlying obligation. In this event, however, the secured party is penalized by forfeiting any subsequent right to foreclose on the real property which served as collateral. This doctrine is known as the "sanction effect". We see section 726 applied in this way in Salter v. Ulrich and Shin v. Superior Court. In some cases the creditor may even face a double sanction for violation of section 726: loss of the right to foreclose and loss of the ability to collect on the underlying obligation. This possibility is explored in Security Pacific National Bank v. Wozab.
The case law on section 726 suggests that it serves several purposes: (1) it fulfills a debtor's expectation that personal liability is conditioned upon the creditor's prior recourse to the collateral; (2) it minimizes the debtor's exposure to personal liability by testing the value of the collateral in the market place; (3) it prevents the debtor's exposure to a multiplicity of actions; and, (4) it at least temporarily preserves unencumbered assets of the debtor which the debtor may need for other purposes, including to finance a defense to a foreclosure action. We present four cases that articulate these purposes of section 726 in reaching conclusions about the applicability of the section in a variety of factual circumstances: Savings Bank v. Central Market Co. (the sold-out junior); Pacific Valley Bank v. Schwenke (the effect of one debtor's waiver of section 726 on a co-debtor); Security Pacific National Bank v. Wozab (the effect of set-off by the secured party); and Shin v. Superior Court (the effect of pre-judgment attachment).
We harbor some reservations about the announced justifications for section 726 and about the extent to which section 726 accomplishes the objectives attributed to it. First, while some debtors may expect their personal liability to be conditioned upon the creditor's prior recourse to the collateral, we doubt that this is a universal expectation and suspect that it may not even be a general expectation. And, if that is not the debtor's expectation, the debtor should no more be entitled to preserve unencumbered assets until after foreclosure than any other debtor. Perhaps it would be more accurate to state that section 726 imputes such expectations to the debtor.
Second, while the fair value limitation of section 726 minimizes the debtor's exposure to personal liability to the foreclosing lender, it does not minimize the debtor's exposure to personal liability to sold-out junior lienors. As we shall see, a junior lienor whose lien is extinguished by foreclosure by a senior lienor is not subject to section 726; the sold out junior may sue on the underlying obligation. The senior's foreclosure rarely will have generated bids approximating the fair market value of the property. Often, only the senior lienor will bid at the foreclosure sale and it will bid, at most, the amount of its claim against the debtor. Hence, the foreclosure sale will only rarely generate any surplus proceeds that would be directed toward reduction of obligations owed to junior lienors.
Third, as the foregoing scenario illustrates, while section 726 does protect the debtor against a multiplicity of actions by one lienor, it does not protect against additional actions taken by sold-out junior lienors. For these and perhaps other reasons only a handful of states in addition to California have adopted a security first rule.
Note, finally, that the real property secured party is relieved from the security first rule in cases where the real property is environmentally impaired. See Cal. Civ. Pro. Code 726.5.