Loan Recovery                                          back to articles
Property Damage Litigation Proceeds
by Steven Linkon, Esq.
WRIGHT, FINLAY & ZAK, LLP

Envision a borrower who discovers that his property is either damaged or suffering 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 if they occurred afterward. The consequence is the same - the defects or damages can cause the property's value to fall below the loan balance. What remedies are available to a lender? It is commonly understood that a third party who harms an owner's real property is liable to the property owner for damages. It is equally true that the lender holding 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, he may recover enough to fully repair the property damage. What then is the borrower's duty to the lender? What if the borrower keeps the recovery and walks away, leaving the lender to foreclose upon the still-damaged property? Many deeds of trust assign to the lender all of the borrower's rights in any cause of action relating to injury or damage to the property. In practice, a borrower may pursue third party claims without advising the lender of the pending litigation. But is the borrower required to use settlement proceeds to repair the property? Recovery Requirements

The usual deed of trust imposes 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 an undamaged 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 interest was damaged. The legal theory involved is known as "equitable conversion" or "substituted property." In other words, 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, taking the place of the reduced value of the property in its damaged condition, together with the monies awarded on account of this damage, collectively stand in the place of the undamaged property. Lender Action

The best practice to follow after learning of a borrower's litigation for damage to the collateral property is to consider intervening in the lawsuit. This helps to ensure that a recovered amount is sufficient to repair the damage, and that it is actually used for that purpose. If the underlying case is over - making it too late to intervene - the lender can sue the borrower to impose a constructive trust on the proceeds of the litigation. Applicable anti-deficiency laws should not act as a bar to this lawsuit because the claim concerns the diversion of a portion of the collateral for repayment of the loan, whereas 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's failure 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. The lender can also directly sue the third party responsible for causing the damage. Even if that party fully compensated the borrower for the property damage, the lender can argue that it remains uncompensated for the impairment of its security interest, assuming the borrower failed to repair the property.

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