Borrower can be Liable for                     back to articles
"Bad Faith" Waste Despite
having a Non-recourse Loan
by Steven Linkon, Esq.
WRIGHT, FINLAY & ZAK, LLP

Does your borrower have a non-recourse loan for which there are no non-borrower guarantors? If so, all is not lost when your borrower fails to pay the real estate taxes leaving this obligation with the lender following a foreclosure sale. In a recent California case, a jury found that a borrower who failed to pay a single installment of real property taxes was liable to the lender for damages for "Bad Faith" waste, and the jury awarded the lender punitive damages.

The case involved a limited partnership that borrowed $73 million from a lender to refinance an initial construction loan of approximately $55 million made from another lender and to complete the construction of an office project. Roughly $10 million from the new loan was used to cash out the partnership's investment. The loan was non-recourse.

The Deed of Trust obligated the borrower to pay real property taxes. Although the property's rents were sufficient to pay such taxes, the borrower decided to divert the money to other uses. There was evidence that the diversion occurred in the midst of negotiations between the borrower and lender to modify the loan and the borrower skipped the real property tax payment in order to pressure the lender into agreeing to a reduction of the loan interest rate. The borrower also stopped making the monthly loan payments.

In due course the lender foreclosed non-judicially, acquired title to the property following the sale and later paid the skipped real property taxes. Afterward the lender sued the borrower for bad faith waste based upon borrower's failure to pay the one installment of property taxes. The lender alleged that the failure to pay was not due solely or primarily to an economic downturn, but was a deliberate act taken by borrower intended to harm lender, and did harm the lender because the unpaid taxes accrued as a senior obligation against the property and the lender had to pay them in order to protect its collateral. The jury agreed with the lender and awarded lender $394,713.56 (This was the amount of unpaid taxes) as compensatory damages for "bad faith" waste. The jury also found by clear and convincing evidence that the failure to pay the taxes was done with malice, and awarded $8,333,333.33 in punitive damages. (An appellate court ordered a new trial on the punitive damages issue).

A Borrower May Drain Money from a Property in Order to Squeeze out as much Money as Possible before a Foreclosure Sale.

The waste doctrine in the context of real property developed under English common law to mediate between the competing interests of life tenants and remaindermen. If the income-producing property were a forest, the life tenant would want to cut down the trees before their maturity even if the present value of the timber would be greater if the logging were postponed beyond the tenant's expected lifetime. Carrying this concept forward to today's times, the owner of a distressed property is tempted to scavenge whatever it can for its own benefit and squeeze as much money out as possible before the property is lost, with no regard to the property's resulting condition.

Such "milking" of the security has been recognized as a form of waste. "Bad faith" waste is a concept unique to California because of its anti-deficiency laws. A lender using a non-judicial foreclosure sale is not permitted to seek a deficiency judgment. But where the court finds that waste was committed in "Bad Faith," the lender can assert a claim against the borrower even after a non-judicial foreclosure sale.

A California Court first recognized a tort of Bad Faith waste in a case that involved the sale of a residence where the seller took back a note and deed of trust. The buyer subsequently sold the residence to a third party subject to the carry back loan. Eventually the property was condemned as unfit for human habitation. The original seller caused the property to be sold at a trustee's sale, and bought it for a full credit bid. She then sued the last owner for waste. Seller lost the case but the California Supreme Court concluded that the Seller might have had a claim for bad faith waste had she not made a full credit bid for the property at the foreclosure sale.

Keep in mind that a lender's damages are limited to the amount of the unpaid debt. A full credit bid at a foreclosure sale results in the debt being fully satisfied and would extinguish any waste claim because the lender is deemed to have been repaid in full.

The court noted the existence of a common law action for waste, and despite California's anti-deficiency statutes, a borrower could still be held liable if the loss caused by the waste resulted from "reckless," "intentional" or "malicious" conduct.

A subsequent California case held that a lawsuit for waste could be based on the borrower's failure to pay real property taxes because the borrower owes a duty to properly and adequately care for the property.

Outside of California, courts in Illinois and New York have held that the willful failure to pay property taxes is actionable waste. There remains a split of authority among other states as to what constitutes waste. Many courts will limit a waste claim to destruction (i.e. trashing), alteration or neglect of the property.

The lesson is that if the property generates sufficient funds to pay the property taxes, a borrower who diverts the rents from this purpose could be exposed to personal liability. The lender has to be sure that its foreclosure sale bid leaves enough of an unpaid balance so that a claim for waste can be pursued.

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