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A recent U.S. District Court decision illustrates how the Pennsylvania Deficiency Judgment Act can tie the hands of a foreclosing lender when it tries to collect on other collateral that it holds. In that case, Luis Munoz and Deborah Munoz v. Sovereign Bank, Chief U.S. District Judge Harvey Bartle III held that a bank could not recover proceeds paid on a second mortgage held by the bank on another property owned by the borrowers. That collection was barred because the bank had foreclosed on another property owned by the borrowers, which it had taken over at the Sheriff’s sale. On the face of it, the decision does not seem surprising because the Pennsylvania Deficiency Judgment Act is designed to protect borrowers against lenders who acquire a borrower’s property upon foreclosure, and still proceed to collect the debt without full credit for the acquired property. The act is similar to many other consumer-protection acts inspired over 70 years ago by depression tactics used by lenders to take advantage of defaulting borrowers by foreclosing on their homes and then continuing to dun the unfortunate homeowners for collection of the debt without proper credit for the value of the acquired homes. Two Mortgages However, the use of the Deficiency Judgment Act in the Munoz case may surprise and alarm some lenders, and should inspire more thought about how lenders should proceed after default when they are fortunate to have more than one piece of collateral for the loan. In that case the borrowers sought a declaratory judgment that the bank had violated the act when it collected proceeds from a sale of a second property on which it held a second mortgage. As stated by the court, the borrowers defaulted on a loan from Sovereign Bank secured by a commercial property and a going business at 4401 Castor Ave. in Philadelphia. The bank started foreclosure and obtained a default judgment for $1.116 million against the borrowers and their business. At the sheriff’s sale the bank purchased the property for $31,000 and received a sheriff’s deed, which was recorded on Sept. 24, 2005. The borrowers’ residential property in Moorestown, N.J., was then sold four months later in a judicial sale by the first mortgage holder; and Sovereign, which held the second mortgage on that property, received $587,000 from that sale toward the satisfaction of its earlier judgment. The borrowers alleged that the bank failed to comply with the Pennsylvania Deficiency Judgment Act because it continued to execute on their residential property without crediting the fair market value of the previously sold property to the balance due on that judgment. The court pointed out that under the Act creditors must file a petition with the court to fix the fair market value of the real property within six months of the sale, and that period begins on the date the deed is delivered to the lender. If the lender fails to file a petition to fix the fair value within the six-month period, the court must mark the judgment satisfied. The bank argued that it had not violated the act. First, it did not take action against the borrowers’ residential property in New Jersey on which the first lender had foreclosed. The money it received resulted from the proceeds at the sheriff’s sale of another foreclosure by a senior lender. Second, at the time that the residential property was sold, the bank still had two months to petition the court to fix the fair value of the Castor Avenue property under the terms of the act. Fair Market Value Bartle rejected the bank’s arguments and held: “The six-month period a creditor has to file a petition to fix fair market value under the act does not give the creditor a six-month window in which to undermine the protection the act affords a debtor. The creditor during that period is not given carte blanche to collect the difference between the judgment and the price that the creditor paid at the sheriff’s sale of the first property subject to foreclosure. . . . Without a court first determining the fair market value of the commercial property on Castor Avenue, it is impossible to know what, if any, deficiency remains in the judgment against the plaintiffs.” If one looks at the legislative intent of the Deficiency Judgment Act, the court’s reasoning is not unreasonable. Unless the lender has gone through the procedure to set fair market value, there is arguably no way to protect borrowers against a bank double dipping. If the bank winds up with the property foreclosed upon, conceivably it could have an asset worth more than the full debt, so when the second property is sold, it could be unfair for it to get paid anything more towards the debt. The court then held that the borrowers’ petition for declaratory judgment should survive the bank’s motion to dismiss the complaint for failure to state a claim upon which relief can be granted. That means that the borrowers’ claim for breach of contract, conversion and fraud may now be litigated. Superior Court Precedent The problem with the District Court’s opinion is that it seems to be contra to the decision of the Pennsylvania Superior Court in Horbal v. Moxham National Bank, where a majority of the court held that the Deficiency Judgment Act did not act to bar a bank from cashing in on additional security after the bank had foreclosed the loan and taken over the real estate. In that case the additional collateral was a certificate of deposit, and therefore the Horbal case may be distinguishable, because the majority maintained that the bank’s right to possession of the CD proceeds predated the purchase of the real estate at the sheriff’s sale. However, in reaching that conclusion, the majority rejected the bank’s argument that the liquidation of the CD was proper because it occurred within six months of the sale and receipt of the deed, which was within the time allowed before a deficiency needs to be established. According to the dissent in Horbal, the majority opinion had rejected that argument, and the dissent maintained that it was necessary for the bank to file a petition before it sought recovery of any additional property. This losing argument by the dissent seems to be the same argument now adopted by Bartle. The Horbal case is not mentioned in this Sovereign Bank decision and one is left to wonder whether the district court has elected to distinguish that case or merely ignore it, even though the earlier case is a Superior Court decision that interprets a Pennsylvania statute. Unanswered Questions One of the questions that are unanswered by the Sovereign Bank decision is what will finally happen to the $587,000 that the bank was paid from the sale of the New Jersey residential property. Remember, Sovereign Bank apparently did not take any action to create those proceeds. It merely received payment as a result of a sale triggered by another party because Sovereign Bank held the second mortgage on the sold property. Nothing in the Deficiency Judgment Act provides for secured liens to be terminated as a result of a foreclosure sale. The act speaks only of what happens to the debt that may be secured by other liens or encumbrances. Perhaps as the case proceeds, the court may still permit Sovereign Bank to petition for fair value, and if the fair value of the Castor Avenue property is less than the total debt, any short-fall or deficiency can be made up by all or part of the $587,000 proceeds from the sale of the New Jersey residence. In light of the uncertainty about how the Deficiency Judgment Act affects lenders’ rights to proceeds from other collateral, foreclosing banks should seriously consider whether they want to proceed against the other collateral that they hold before they complete a foreclosure on a defaulted loan. That foreclosure could force them into fair-value litigation that might last for years before they are able to collect on the other collateral. For example, if the bank had held off the foreclosure on Castor Avenue while the other lender foreclosed on the New Jersey residential property, it could have received the $587,000 from that sale, and applied it against the debt without having to go through a deficiency judgment procedure. HARRIS OMINSKY is with the law firm of Blank Rome and is a former president of the board of the Pennsylvania Bar Institute.

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