Illustrative transactions

A.  Real property

      1.  Purchase:  An individual or couple desires to purchase a residence, acquire some vacant land in the mountains to construct a vacation home, or purchase a town home near the ocean to rent to vacationers.   A developer desires to purchase some land on which to construct a new hotel, a manufacturer wishes to acquire land adjoining its current facility for plant expansion, or an environmental trust fund wishes to acquire some land for a natural preserve. In each of these transactions and thousands more like them each day, the prospective purchaser of real property often will be unable to pay cash for the entire purchase price. Indeed, even if cash were available, purchase for cash might not be the most desirable option.

     How then does one finance acquisition of real property?   It would be convenient for borrowers if lenders were simply willing to make unsecured loans for the money borrowed to purchase real estate. But because the sums involved are typically large, most lenders will not be content with the remedies available to an unsecured creditor upon default (discussed in Commentary. Enforcement of Judgment).

     Where the prospective purchaser is deemed credit worthy by a lender, usually an institutional lender, the lender will be willing to loan a large portion of the purchase price (e.g. 80%) if the purchaser invests the balance as a down payment.  Such a loan is referred to as "purchase money" because loan funds are being used to acquire property. The down payment will constitute the purchaser's initial equity. The lender will typically require that the debtor sign a promissory note evidencing the obligation to repay the loan.  Typical repayment periods, particularly in the residential purchase context, are 10, 15, 20 or 30 years. The lender will also require security for its loan, generally taking the form of a deed of trust or mortgage on the real property purchased. The security is properly referred to as a purchase money deed of trust (or purchase money lien, or purchase money mortgage) because the property being purchased with the loan funds is serving as the collateral for repayment of the loan. The deed of trust is the typical security instrument used in California. Mortgages are the typical security instrument used in many other states. Although there are some technical differences between the two types of security instrument, we will often use the terms deed of trust and mortgage interchangeably.  Often, lenders will sell packages of their real property secured loans to buyers in the secondary mortgage market to obtain new capital to fund additional loans.  To assure a market for such packages, the terms of the loan may be dictated for the originating lender by the requirements of a prospective purchaser in the secondary mortgage market. Where a borrower's loan has been purchased in the secondary mortgage market, the borrower's obligations then run to the purchaser of the loan. 

     2.  Loan:   Term loans and lines of credit secured by real property are available to both indivduals and commercial entities seeking funds for a variety of purposes (e.g., home improvement, automobile purchase, bill consolidation, medical expenses for an individual or expansion or short term cash needs for a business).  These loans are non-purchase money, that is, the debtor already owns the real property being used as collateral. "Term loans" of specified sums are repayable over an identified period.  "Lines of credit" allow a borrower to draw credit up to a specified maximum for a specified period and require minimum periodic (e.g. monthly) payments and payment in full of the outstanding balance at the end of the loan period.  

     You may be most familiar with both types of loans in the consumer context.  A parent  borrows money for her child's college education, or to pay large uninsured medical expenses, or to finance a trip around the world, or to pay income taxes.  If secured by real property, such loans are available at interest rates lower than unsecured loans for the same purposes. Traditionally, such loans were term loans, but the development of computer technology has opened the real property secured line of credit (often referrred to as an "equity loan" or "equity line") to the consumer market. In an equity loan, an institutional lender makes available an amount of credit (e.g. $50,000) upon which a homeowner may draw by writing checks on an account. Like the typical credit card, the lender sends the borrower a monthly statement of the outstanding balance, the minimum repayment due, and the finance charges accruing on any balance unpaid at the end of the billing period. Unlike the typical credit card, the line of credit is secured by a deed of trust or mortgage on the borrower's residence. Because funds are made available through the mechanism of a check, the funds may be used by the borrower for any purpose for which checks will be accepted.

     Data gathered in 1998 by the University of Michigan Survey Research Center reveals the following about home mortgage debt: (1) nearly 40% of all homeowners nationwide report no debt whatsoever secured by any mortgage or deed of trust (20% of homeowners between the ages of 18 and 34, 50% of homeowners between the ages of 55 and 64, and 80% of seniors 65 years or older);  (2) approximately 5% of all homeowners have a traditional second mortgage and approximately 8% of all homeowners have an equity line of credit;  (3)  66% of those using an equity line of credit put at least some of the money into improvement, remodeling or expansion of the home, 39% use money from an equity line to purchase an automobile, 38% use money from an equity line to pay off credit cards (for which the typically higher interest rate is, unlike interest on the equity line, not tax deductible), and 11% of those using an equity line use some of the money for medical expenses.  (San Jose Mercury News, p.1F, October 31, 1998)    

     3.  Default, foreclosure and sale:   

     Upon default (frequently but not always consisting of a failure to make timely payments on a debt), the secured creditor is entitled to foreclose on the real property ("foreclose on the deed of trust" or "foreclose on the mortgage") by selling it, although a negotiated solution is much more common.   Following a foreclosure sale, the purchaser (either the secured creditor itself through a credit bid or an third party through a cash bid) may evict the debtor from possession of the property.  Two types of foreclosure are recognized in California: judicial foreclosure, requiring litigation from complaint to judgment, and non-judicial foreclosure (frequently referred to as a trustee's sale or private sale), in which the property is sold by a trustee without judicial involvement. Non-judicial foreclosure is not permissible in some jurisdictions, and, where permissible, may occur only if the security instrument (deed of trust or mortgage) contains a clause, known as a power of sale, granting the lender a right to non-judicial foreclosure. Locate such a clause in our sample deed of trust. In California, non-judicial foreclosures are the more common.  They are considerably less time consuming and less expensive than judicial foreclosure, and California anti-deficiency rules often preclude a deficiency following judicial foreclosure, thus eliminating any benefit from pursuing a judicial foreclosure.   Even though non-judicial foreclosure deprives the debtor of property without the benefit of any hearing, the process does not violate the due process guarantees of federal and state constitutions because it does not involve state action. See, e.g., Garfinkle v. Superior Court, 21 Cal.3d 268 (1978).

     In brief, the steps involved in a non-judicial foreclosure of a deed of trust in California are as follows: 

     a.  Notice of Default:  The trustee sends a Notice of Default to the trustor and other specified parties and records the Notice with the County Recorder of the county in which the real property is located.   The trustor or other interested parties (e.g. a subordinate lienholder) may stop the foreclosure by timely redeeming the property from the lien (paying the entire outstanding idebt in default, including accrued interest, penalties, and permissible charges), by timely reinstating the debt ("bringing the loan current" through payment of all delinquencies and certain other allowable charges), by obtaining an injunction against foreclosure, if justified, or by filing a bankruptcy petition prior to the foreclosure sale. 

     b.  Notice of Sale:  The trustee sends a Notice of Sale to the trustor and other specified parties and records the Notice with the County Recorder of the county in which the real property is located. It may not be sent until the expiration of three months following the recording of the Notice of Default and must provide at least 20 days advance notice of a sale. See the web site of the Bates Foreclosure Report for an example of listing of foreclosure sales nationwide. 

     c.  Foreclosure Sale: If the foreclosure is not stopped, the trustee conducts an auction sale of the real property subject to the deed of trust. The foreclosing lienor (the beneficiary under the deed of trust) often opens the bidding with a "credit bid." Other bidders must bid cash. Often bids will be made by professional investors who purchase the property for the purpose of making a profit on resale (perhaps after repairs or improvements to the property).  The high bidder, either the foreclosing lienor or some third party, receives title to the property through a Trustee's Deed and thereafter may exercise all of the rights of ownership, including the right to evict any person, including the debtor, in possession.

     Instead of non-judicial foreclosure, the holder of the lien may commence judicial foreclosure, especially if the creditor is  entitled to a deficiency judgment.   Judicial foreclosure commences with the filing of a complaint for foreclosure seeking a judgment ordering the sale of the property and, if allowed, a judgment for any deficiency following the sale. Once the judgment is obtained, the sale, unlike the non-judicial foreclosure sale, is subject to court supervision. Because of the costs and attorney's fees involved, judicial foreclosure is a considerably more expensive process than non-judicial foreclosure.

     B.  Personal property

          1.  Purchase:   Purchases of personal property that are secured by the property being purchased ("purchase money secured debts") are common. From among the wide variety of such secured transactions, we select two as initial illustrations.

     Purchase of a new or used car from an automobile dealer is a familiar experience. Thousands of such purchases, many of them on secured credit, occur daily. Suppose you wish to purchase a car for $20,000, are willing to trade in a car for which the dealer gives a $2,000 allowance, and can contribute $3,000 in cash toward a down payment.  Assuming credit worthiness, the dealer will take your trade-in and your $3,000 and finance the $15,000 balance over a period of time, generally not to exceed 5 years. You will sign a retail installment contract that, among other things, grants the dealer a security interest in the car purchased to secure payment of the debt.  In most cases, the dealer immediately will assign the contract, including the security interest, to a financial institution with whom it has an existing relationship and who authorized the transaction after finding you credit worthy. The financial institution pays the dealer for the contract and collects payment from you, making its profit on the interest you pay on the loan. The security interest will be reflected on a Certificate of Title, issued by the state's department of motor vehicles, identifying the financial institution as lienholder (or, sometimes, as "legal owner").  See our sample Certificate of Title. The financial institution will hold the Certificate of Title pending full payment of the debt and, upon full payment, will release its interest in the car, by signature in the appropriate location on the Certificate of Title and surrender of the Certificate of Title to the buyer.

     In a common variation from the foregoing scenario, you arrange a loan from a lender of your own choice (credit union or bank). Your lender pays the car dealer and retains a security interest in the car, again reflected on a Certificate of Title, to secure your repayment of the loan.

     In either case the transaction results in the creation of a purchase-money security interest : when you finance through the dealer, because the car secures an obligation incurred for its purchase price, and when you finance through your own lender, because the car secures an obligation incurred for value given to enable the debtor to acquire rights in the car.  See U.C.C. 9-103(a), (b)(1).

     You may be less familiar with the use of security in the context of the purchase of a business. The facts of Lovelady v. Bryson Escrow Inc. provide one example. The Loveladys operated a restaurant on leased real property. They decided to sell the restaurant to Loop's Hospitality Corporation, perhaps because they wished to retire, perhaps because they had tired of running the restaurant, or perhaps because Loop's offer was too good to turn down. Loop's gave the Loveladys a promissory note for $214,000 of the purchase price. The Loveladys were, understandably, unwilling to take an unsecured note. Accordingly, they required Loop's to secure the note both with the leasehold (which, with the landlord's consent, was being assigned from the Loveladys to Loop's as part of the purchase agreement) and with the fixtures and equipment of the restaurant.

     2.  Loan:   Imagine a manufacturer of Christmas ornaments. Receipt of revenue is seasonal. Production of ornaments must begin and workers must be paid. Last year's excess revenue has been reinvested in plant modernization, new employee benefits, and research and development and the manufacturer needs a temporary source of funds now. Convinced of the health of the business, lender is willing to loan those funds based on the security of inventory produced and accounts receivable generated from the sale of inventory.

     Individuals may find themselves in analagous situations, needing funds to meet unexpected expenses (e.g. uninsured medical expenses), to consolidate bills, to pay for a vacation or a college education. Loans for these purposes may, in some cases, be unsecured, especially given increasing debt limits extended by lenders to many holders of credit cards. In other cases, the lender may insist on collateral. Until 1985, household goods could stand as collateral. However, in 1985, the Federal Trade Commission severely restricted the permissible scope of non-purchase money security interests in household goods. See Commentary.FTC Rule. Since 1985, such loans are more commonly secured, if at all, by vehicles owned free and clear by the debtor, or by real property, through the mechanism of a home equity loan in which the debtor's use of checks draws against a line of credit. 

     3.  Default, foreclosure and sale:

     Like its real property secured counterpart, the personal property secured creditor is entitled to foreclose on the collateral upon default, although here, too, a negotiated solution is much more common.

     In the case of tangible personal property (e.g. inventory, equipment, consumer goods, farm products), foreclosure presupposes possession. Occasionally the secured party will be in possession of the collateral from the inception of the transaction (e.g. a pawnbroker holding jewelry as collateral for a loan).    More often, the debtor will remain in possession of the collateral from the inception of the transaction (a debtor manufacturer needs the equipment to run the business, a consumer debtor needs the car to drive to work). When the secured party decides to foreclose, the debtor may be willing to surrender possession of the collateral voluntarily. If not, the secured party must wrest possession through self help or by use of judicial process. Upon obtaining possession, the secured party will typically conduct a non-judicial sale of the collateral. Proceeds of the sale will be applied to reduction of the debt and the creditor is generally entitled to the balance owing (the deficiency). In some cases, the secured party may foreclose without sale, reserving ownership of the collateral to itself in exchange for a discharge of the debtor's obligation.

     When personal property collateral consists of an obligation owed to the debtor by others (e.g. an account of the debtor or a debt to the debtor evidenced by a promissory note naming the debtor as payee), the secured party is entitled to collect the obligation upon notification to the obligor.