Litigation Proceeds Can Be an               back to articles
Additional Source For Recovery
of a Loan
by Steven Linkon, Esq.
WRIGHT, FINLAY & ZAK, LLP

Envision a borrower who discovers that their property is damaged or suffers from material defects caused by a prior owner or third party. It makes no difference whether these defects were unknown to the lender when it made its loan, or occurred afterward. These defects or damages cause the property's value to fall below the loan balance. What remedies does a lender have?

Both the Property Owner and the Lender can Sue for Damages

It is commonly understood that a third person who harms an owner's real property is liable to the property owner for damages. It is equally true that the lender who holds a security interest in the damaged property may also sue the third party for impairment of the lender's security interest.

If the borrower sues first, they may recover enough to fully repair the damage to the property. With this recovery in hand, what is the borrower's duty to the lender? What if the borrower keeps the recovery and walks away from the property, leaving the lender to foreclose upon a damaged property?

Many deed's of trust assign to the lender all of the borrower's rights in any cause of action relating to injury or damage to their property. In practice, a borrower may pursue these third party claims, without advising the lender of the pending litigation. Later, the borrower settles the case and recovers a settlement, but then neglects to use the proceeds to repair the property.

The Borrower Must Use the Litigation Proceeds to Restore the Property to its Pre-Damaged Condition.

The usual deed of trust contains provisions imposing a duty upon the borrower, who recovers money for damage to property encumbered by a loan, to use the recovery to restore the property to its pre-damaged condition. Common law imposes a similar duty on the borrower, requiring that the money recovered for such damage is subject to the lien of the lender's security interest up to the amount by which the security was damaged. The legal theory involved is known as equitable conversion or substituted property, and the explanation for this result is that the money awarded by the court to compensate the owner for damage to the property must be treated, in equity, as the property itself. The money takes the place of the reduced value and the property, in its damaged condition, together with the monies awarded on account of this damage, collectively stand in the place of the uninjured property.

The Lender Should Intervene in the Borrower's Lawsuit to be sure it Recovers the Damages

The best practice to follow where a lender learns of a borrower's litigation for damage to the security property, is to consider intervening in the lawsuit in order to ensure that any recovery is sufficient to repair the damage, and is actually used to repair the property.

A Lender May Make a Claim for Impairment of its Security Interest, or Impose a Constructive Trust Upon Funds Recovered by the Borrower.

The lender has two sources to recover losses arising in these situations. First, the lender can directly sue the third party responsible for causing the damage. Even if that party fully compensated the borrower for the damage to the property, the lender could argue that it still remained uncompensated for the impairment of its security interest, assuming the borrower failed to use the recovery to repair the property.

If the underlying case is over (i.e. it is too late to intervene) the lender can sue the borrower to impose a constructive trust on the proceeds of the borrower's litigation. Applicable anti-deficiency laws should not act as a bar to this case because the claim concerns the diversion of a portion of the collateral for repayment of the loan, while anti-deficiency statutes are intended to prevent liability to repay an unsecured loan balance. Breach of contract affords another legal theory for the lender, based on the borrower failing to timely advise the lender of possible rights under the deed of trust in time for the lender to intervene in such litigation. Finally, the lender may pursue a tort claim for the diversion of the lawsuit proceeds.

Related Articles:

Evicting Under Rent Control
Idiosyncrasies & Other Things You Need to Know
by Donna LaPorte, Esq.

Commercial Paper and Negotiable Instruments
An Overview
by Stefan Lawrence, Esq.