Archive for November, 2009

Underwater and Not Walking Away – or, Why Don’t Lenders Refinance?

Sunday, November 29th, 2009

I have been approached by numerous potential clients asking if I can help with the restructuring of their mortgages.  The short answer is that I can provide no assurance regarding a refinancing.  The rules are murky, and the literature indicates that lenders are not providing meaningful reductions.

foreclosureA recent article by Prof. Brent White from the University of Arizona law school has provoked heartburn in the lending community.  Prof. White argues that that many borrowers would be better off if they simply walked away from their underwater loans and rented a house.  He cites statistics showing that 71% of mortgages in the Fresno area are underwater as of 2009.  It’s even worse in Bakersfield, where 79% of mortgages are underwater.

Prof. White argues that strong societal and emotional ties keep borrowers from walking away, even if walking away would save them $100,000, $200,000, or even more over the course of the loan.  Lenders know that most persons will do almost anything to avoid a foreclosure.  Here’s his all-too-true explanation of how the refinancing process works in the real world:

“A seriously underwater homeowner with good credit and solid mortgage payment history who calls his lender to work out a loan modification is likely to be told by his leader that it will not discuss a loan modification until the homeowner is 30 days or more delinquent on his mortgage payment.  The lender is making a bet (and a good one) that the homeowner values his credit score too much to miss a payment and will just give up the idea of a loan modification.

“However, if the homeowner does what the lender suggests –  misses a payment and calls back to discuss a loan modification in 30 days –  the homeowner is likely to be told to call back when he is 90 days delinquent.

“In the meantime, the lender will send the borrower a series of strongly-worded notices reminding him of his moral obligation to pay and threatening legal action, including foreclosure and a deficiency judgment if the homeowner does not bring his mortgage payments current.

“The lender is again making a bet (and again a good one) that the homeowner will be shamed or frightened into paying their mortgage.  If the homeowner calls the lender’s bluff and calls back when he is 90 days delinquent, there is a good possibility that he will be told that his credit score is now so low that he does not qualify for a loan modification.

“The homeowner must then decide whether to bring the loan current or face foreclosure.  If the homeowner somehow makes clear to the lender that he has chosen foreclosure, the lender may finally be willing to negotiate a loan modification, a short-sale or a deed-in-lieu of foreclosure – all of which still leave the homeowner’s credit in tatters (at least temporary).

“Most lenders will in other words, take full advantage of the asymmetry of norms between lender and homeowner and will use the threat of damaging the borrower’s credit score to bring the homeowner into compliance.  Additionally, many lenders will only bargain when the threat of damaging the homeowner’s credit has lost its force and it becomes clear to the lender that foreclosure is imminent absent some accommodation.”

That’s a fair reflection of the process, as potential clients have explained it to me.  Lenders have not established clear procedures for refinancing.  Lenders do not want to write down the value of their loans.  Lenders know that there is a strong negative societal cost to the borrower from a foreclosure.  Lenders have made the refinancing process difficult, if not impossible, for most persons.

This is a difficult argument, as it mixes morals and finances.  Like many persons, I think that we have a moral obligation to pay our debts.  Further, there is no legal obligation for the lender to change the terms of the loan.  On the other hand, the way some of these loans are written, the borrowers will end up up paying hundreds of thousands of dollars that could be avoided if they executed a “strategic foreclosure.”  Paying all this extra money might be construed as “waste” in economic terms.

Also, Prof. White points out that the underwater homes are disrupting the labor markets, in that individuals are reluctant to move because they do not wish to take a loss on their home.  When homeowners are unwilling to move because their house is underwater, labor mobility is seriously hindered by the housing crisis.

Cite to:
Brent T. White, University of Arizona – James E. Rogers College of Law

“Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis”

Arizona Legal Studies Discussion Paper No 09-35

King vs. Johnson – Trustee de Son Tort

Tuesday, November 24th, 2009

A decision handed down this month involved an all-too-common situation.  In King v.  Johnson, 2009 DJDAR 15871 (Nov. 9, 2009), the husband provided for a testamentary trust.  After the husband’s death in 1991, his widow became the trustee.  The widow later suffered from declining health.  One of the daughters was apparently close to her mother.  The daughter influenced the widow to transfer property out of the trust.

Stop me if this story sounds familiar.  The widow also took out a personal loan secured by the property she transferred out of trust.  When the loan went into delinquency, the lender foreclosed and took title to the property.  Not surprisingly, the daughter benefitted from this arrangement, as she inherited 100% of the widow’s separate property, but held only a 30% interest in the former trust property.

Another child, who was also a beneficiary under the trust, brought an action against daughter based on these facts.  The trial court found that “[daughter] actively participated in [widow’s] breaches of fiduciary duty . . . Specifically, the court found that [daughter] was involved in the transactions that resulted in [widow] transferring property out of the trust without consideration at a time when [widow] was in failing physical and mental health, and that [daughter] exercised undue influence over [widow] with regard to these transactions.”

However, the trial court found that plaintiff lacked standing, because a successor trustee had been appointed.  On appeal, the decision was reversed in favor of the aggrieved beneficiary.

The appellate court explained that, “As a general rule, the trustee is the real party in interest with standing to sue and defend on the trust’s behalf.  Conversely, a trust beneficiary cannot sue in the name of the trust.”

This rule did not preclude the action against the daughter.  Thus, “a trust beneficiary can bring a proceeding against a trustee for breach of trust.  Moreover, it is well established [ ] that a trust beneficiary can pursue a cause of action against a third party who actively participates in or knowingly benefits from a trustee’s breach of trust.”

In this case, a successor trustee had taken office, and he had not sued daughter for her wrongful acts.  The court expressly held that “a beneficiary may bring a claim against a third party who participated in a trustee’s breach of trust, despite the appointment of a successor trustee.”

Explained the court, “Ordinarily, when a third party acts to further his or her own economic interests by participating with a trustee in such a breach of trust, the beneficiary will bring suit against both the trustee and the third party.

“However, it is not necessary to join the trustee in the suit, because primarily it is the beneficiaries who are wronged and who are entitled to sue.  The liability of the third party is to the beneficiaries, rather than to the trustee, and the right of the beneficiaries against the third party is a direct right and not one that is derivative through the trustee.”

Even more, the court held that “evidence of a conspiracy is [not] required in order to hold a third party liable for participating in or benefitting from a trustee’s breach of trust . . . Although the trial court in this case determined that [plaintiff] had not proved the existence of an actual conspiracy between [widow] and [daughter], this is of no consequence to [the beneficiary’s] standing to bring a claim against [daughter] for [her] role as a third-party participant in [widow’s] breach of trust.”

The court also addressed the liability of the daughter for her conduct as de facto trustee after her mother’s death.  During this period, the daughter collected rents for which she did not account.  This conduct also gave rise to a claim against the daughter.

Explained the court, “a trustee de son tort [is] a person who is treated as a trustee because of his wrongdoing with respect to property entrusted to him or over which he exercised authority which he lacked.”

Added the court, “It is a well settled rule in the law of trusts that if a person not being in fact a trustee acts as such by mistake or intentionally, he thereby becomes a trustee de son tort . .  A person may become a trustee by construction, by intermeddling with and assuming the management of property without authority.

“Such persons are trustees de son tort just as persons who  assume to deal with a deceased person’s estate without authority are administrators de son tort.  During the possession and management by such constructive trustees they are subject to the same rules and remedies as other trustees.”

Proof yet again that trusts can be a hotbed for litigation.  The lack of court supervision over an estate can lead family members to take advantage of the situation.  This court drew a firm line against such wrongful conduct.

Berg & Berg – California Obligations of Corporate Directors to Creditors

Sunday, November 15th, 2009

A growing body of case law during the past 20 years has addressed the issue of whether and when corporate directors owe fiduciary duties to creditors.  A California appellate court has finally weighed in on this issue, and provided clear guidance on the question.  (We can only hope that the California Supreme Court will not to take the case up for review, because they are sure to muddy the waters.)

In Berg & Berg Enterprises, LLC v. Boyle (Oct. 29, 2009) 2009 DJDAR 15513, the court of appeal explained that “Berg & Berg Enterprises, LLC is the largest creditor of the failed Pluris, Inc. . . . The thrust of Berg’s claim, as finally pleaded, was that the individual directors owed a fiduciary duty to Berg and other Pluris creditors on whose behalf Berg is purportedly proceeding.”

directorThe trial court sustained demurrers to the complaint without leave to amend, which ruling was affirmed.  The appellate court gave a good, clear analysis of the issue, explaining that, “it is without dispute that in California, corporate directors owe a fiduciary duty to the corporation and its shareholders and now [ ] must serve ‘in good faith, in a manner as such director believes to be in the best interests of the corporation and its shareholders.’”

The court explained that the potential fiduciary obligations owed by corporate directors to creditors arose from an unpublished 1991 Delaware decision involving the leveraged buyout of MGM, “which laid the ground for the insolvency exception to the general rule that directors owe exclusive duties to the corporation and its shareholders, but not to shareholders.”

The question involves what duties are owed by corporate directors to unpaid creditors when the corporation is insolvent.

The Berg & Berg court squarely held that, “under the current state of California law, there is no broad, paramount fiduciary duty of due care or loyalty that directors of an insolvent corporation owe the corporation’s creditors solely because of a state of insolvency [ ].  And we decline to create any such duties, which would conflict with and dilute the statutory and common-law duties that directors already owe to shareholders and the corporation . . .

“We accordingly hold that the scope of any extra-contractual duty owed by corporate directors to the insolvent corporation’s creditors is limited in California, consistent with the trust-fund doctrine, to the avoidance of actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditors’ claims.  This would include action that involves self-dealing or the preferential treatment of creditors.”

The court further held that a finding of actual insolvency is needed to trigger these duties, rather then the amorphous “zone or vicinity of insolvency.”  Thus, the court held that “there is no fiduciary duty prescribed under California law that is owed to creditors by directors of a corporation solely by virtue of its operating in the ‘zone’ or ‘vicinity’ of insolvency.”

(Note that the court also observed that “there are multiple definitions of insolvency,” adding that “a finding of insolvency by the standard of the debtor not paying debts when they become due requires more than merely establishing the existence of a few unpaid debts.”)

Thus, the court held that, “under the trust-fund doctrine, upon actual insolvency, directors continue to owe fiduciary duties to shareholders and to the corporation but also owe creditors the duty to avoid diversion, dissipation, or undue risk to assets that might be used to satisfy creditors’ claims.”

Even more, the court held that decisions of the directors are presumptively entitled to protection under the business judgment rule.  “The rule establishes a presumption that directors’ decisions are based on sound business judgment, and it prohibits courts from interfering in business decisions made by the directors in good faith and in the absence of a conflict of interest.”

Explained the court, “in most cases, the presumption created by the business judgment rule can be rebutted only by affirmative allegations of fact which, if proven, would establish fraud, bad faith, overreaching or an unreasonable failure to investigate material facts . . . The failure to sufficiently plead facts to rebut the business judgment rule or establish its exception may be raised on demurrer, as whether sufficient facts have been so pleaded is a question of law.”

I for one do not support the expanding toward “tortification” of business law.  The decision in Berg & Berg is a step in the right direction.  The court gives clear guidance, holding that the fiduciary obligations of directors to creditors arise only when the corporation is actually insolvent, and then only when the creditors can plead facts showing that the actions of the directors were in violation of the business judgment rule.  The court also held that it will not intervene in the “ill-defined sphere known as the zone of insolvency.”

This case marks the second published appellate opinion driven by the unpaid creditor.  (The prior opinion is Berg & Berg Enterprises, LLC v.  Sherwood Partners (2005) 131 Cal.App.4th 802.)   Considering that legal counsel included O’Melveny & Myers and Winston & Strawn, it is almost certain that the legal fees to date in this dispute exceed $1 million.

Here’s a point that seems somewhat unfair.  The trial judge based his decision on an unpublished 2006 trial court decision from the federal district court for the Northern District of California.

The problem for trial attorneys is that we cannot cite unpublished opinions as authority in our briefs.  It seems incongruous to have a trial court make a decision based on an unpublished federal court ruling, then have that unpublished ruling cited with approval by the California appellate court.

This problem arises because the two major legal publishers – Lexis and West – continue to make unpublished decisions available via their websites.  When these unpublished decisions become part of the database, it becomes very tempting to cite them, notwithstanding the California Rules of Court.  In this case, the trial court and the appellate court found the temptation to great to resist.

Mexican Land Trust

Sunday, November 8th, 2009

The diverse use of trusts is represented in a recent case from the federal Fifth Circuit Court of Appeals.  In Gale v. Carnrite, 559 F.3d 359 (5th Cir. 2009), the dispute involved tax liabilities arising from the sale of membership interests in a Nevada limited liability company.  The underlying facts were as follows:

bajacaliforniasurIn 1999, Gale expressed interest in purchasing a condominium unit located in San Jose Del Cabo, Baja California Sur, Mexico.  The condominium was owned by Villa Rayos Del Sol, LLC, a Nevada limited liability company.

After inquiring about the purchase, the Gales learned that legal restrictions affected the transaction.  Specifically, as explained in the decision, “under Article 27 of the Constitution of Mexico, only Mexicans by birth or naturalization or Mexican companies may acquire direct ownership of lands or waters within the zone of 100 kilometers along the frontiers and 50 kilometers along the shores of the country.”

The condominium unit was located within such a restricted area.  In order to proceed with the purchase, the Gales were informed that they could not acquire the condominium directly.  Per the decision, “Instead, they would be required to purchase the outstanding membership interests in the limited liability company (Villa Rayos), which was the beneficial owner of the leasehold interest in the condominium under a Mexican Bank Trust arrangement known as a “fideicomiso.”

The court explained that “a fideicomiso is a property-ownership arrangement complying with Article 27 of the Mexican Constitution under which a Mexican Bank Trust obtains legal title to a piece of real property within the prohibited zone, and a foreigner, as the beneficiary of the trust, enjoys the beneficial interest in the property, including all the usual rights of ownership.”

The limited liability company’s sole asset was the beneficial interest in the condominium.  The only purpose of the limited liability company was to serve as the beneficiary of the fideicomiso.

As to the history of the entity, “Villa Rayos was formed in 1996.  Its original members and owners were the Sonenshine Family Trust.  [The Sonenshines] previously purchased the beneficial interest in the fideicomiso from the condominium’s developer in 1991 for $715,000, and subsequently transferred the beneficial interest [in the condominium to the limited liability company] in 1996.  In February 1999, [defendant] Carnrite purchased all of the outstanding membership interest in [the limited liability company] for $1,725,000.”

In December 1999, the Gales purchased all of the membership interests in the limited liability company from defendant Carnrite.  The purchase price was $2,125,000.  The seller warranted that at the close of escrow, “the LLC has and will have no liabilities of the any nature, including without limitation tax liabilities due or to become come due.”

The sale closed in January 2000.  “Neither [the seller] nor anyone else reported the transaction to the Mexican government; no Mexican income or capital gains taxes were paid on the transfer.”

In September 2005, the Gales sold their interest in the limited liability company to a third party for $2,400,000.  According to the case, “a substantial Mexican capital gains tax liability resulted, determined by using the basis of the fideicomiso from 1991.”

The trial court found that the seller breached the warranty made to the Gales in 1999, on the grounds that “at the time of closing, Villa Rayos had a built-in capital gains tax liability equal to the difference between the Gales’ purchase price and the original adjusted basis.”  At trial, experts presented evidence regarding interpretation of the Mexican tax code.

The court of appeal reversed the decision, holding in favor of the seller.  The court assumed that (i) the 1999 transaction was a taxable event and (ii) “any tax liability initially fell on [defendant] Carnrite.”  The question addressed by the court of appeal was “whether, under Mexican law, the LLC was obligated to pay taxes on the 1999 transaction.”

In holding for the defendant, the court held that “the Gales did not show that [the seller’s] failure to pay such taxes resulted in a liability for [the limited liability company].”

The focus of the appellate decision was whether the individual defendant’s “failure to report or pay taxes on the transfer created a tax liability for [the limited liability company].”  Explained the court, “both under [the experts’] analysis and the language of the [contract] itself, the individual defendants’ failure to pay resulted in a tax liability for the Gales (the buyer), not [the limited liability company].”

The court further explained that, “the warranty provision covered only the tax or other liabilities of the LLC.  [However, limited liability company] was neither the buyer nor the seller in the transaction.  The 1999 transaction altered the ownership of the membership interest of Villa Rayos, but there is no factual or legal basis shown by this record that [the limited liability company, i.e.,] Villa Rayos itself became liable for anything or that it would become liable at the default of others.”

The court added that, “by contrast, in 2005 transfer, [the limited liability company] itself sold the beneficial interest in the fideicomiso to [the new purchaser.  In the disputed transaction], Villa Rayos was the seller.”

The court concluded that, “the seller provided a warranty that the asset being transferred did not itself have any liabilities.  If the act of transferring created liabilities or passed on a pre-existing liability of the seller, that risk was not covered by the warranty.

“A warranty that the buyer was not getting any liabilities of any nature from any source would be a valuable one.  We conclude, though, that this war they did not provides comprehensive protection.  Because Carnrite’s failure to pay taxes for 2000 is the only breach the Gales allege, Carnrite is entitled to judgment on the breach of contract claim.”

The decision seems to apply a narrow interpretation of contract law.  However, it illustrates the thorny tax issues that can arise when trust assets are transferred.

All Sizzle, No Burger

Sunday, November 1st, 2009

A recent federal case started off with an intriguing headnote – “Lawyer does not breach of fiduciary duty or contracts by advising termination of co-counsel where advice was privileged and protected by agreements.”  From the Ninth Circuit Court of Appeals, no less.  In the end, the court tackled the issues on narrow grounds, giving rise to a puzzling result.

In Crockett & Myers, Ltd. v.  Napier, Fitzgerald & Kirby, LLP (9th Cir. October 21, 2009), the dispute arose between two lawyers, both of whom represented the same client in a personal injury matter.  The decision explains that, in 2001 “Wendi Nostro retained Brian Fitzgerald, a New York lawyer known to her family, to investigate whether the death of her husband in Nevada was due to potential medical malpractice.”

The dispute arose after Mr. Fitzgerald (the New York lawyer) was able to locate a J.R. Crockett, a Nevada lawyer who was apparently skilled in personal injury matters.  The client and the two attorneys entered into a written retainer agreement.  The written retainer agreement with Ms. Nostro expressly provided that  “attorneys fees were to be divided equally between Crockett and Fitzgerald.”

At the end of the day, the court refused to enforce this provision, although its rationale is not clear.  According to the court, Mr. Fitzgerald, the New York lawyer, requested that plaintiff pay her share of the court costs.  This request occurred while the litigation was ongoing.  Plaintiff then contacted her Nevada attorney, Mr. Crockett, “who advised her that ‘it was their policy not to go after client for court costs’ and that ‘she could fire Mr. Fitzgerald.’”

That’s what plaintiff did – she terminated the New York lawyer.  The underlying case later settled, but the Nevada lawyer did not forward 50% of the attorneys fees to Mr. Fitzgerald.  The New York lawyer filed suit against the Nevada lawyer, alleging “breach of an oral referral agreement, breach of the written retainer agreement, breach of the duty of loyalty and as a fiduciary by reason of the joint venture, and breach of fiduciary duties by reason of joint representation.”

Now, that would be an interesting legal issue.  Do attorneys owe each other fiduciary duties when two attorneys jointly represent a client on the same issue?  Unfortunately, the court sidestepped this interesting issue.  Instead, the court held that the claims based on breach of fiduciary duty were barred because, under Nevada law, the communications between the Nevada lawyer and plaintiff were privileged.

Explained the Ninth Circuit, “It is in the public interest attorneys speak freely with their clients, even if attorneys occasionally abuse the privilege . . . Nevada [recognizes a] policy of granting officers of the court the utmost freedom in their efforts to obtain justice for their clients.”

For reasons that are not entirely clear, the court next held that the Nevada lawyer was not liable for breach of the written retainer agreement, specifically, that a breach did not arise out of the failure of the Nevada attorney “to include [the New York lawyer] in the discussion with [plaintiff] regarding [payment of] costs.”

Big question here – why didn’t the New York lawyer set forth a claim based on interference with his contractual expectancy?  The opinion does not address this issue, and it does not seem to have been plead as a cause of action.

Finally, the court held that the New York lawyer was entitled to recover damages under a quantum meruit theory based on “the reasonable value of the services.”  The appellate court remanded the matter for a determination of such reasonable value, but expressly rejected the New York lawyer’s “argument that he was entitled to 50% of the fees as contemplated by the retainer agreement.”

This seems like an unfair result for the New York lawyer.  He helped secure competent local counsel and obtained a written agreement with the client and the other attorney providing for an equal division of attorney’s fees.  What more could he do?  After the local attorney recommended that the New York attorney be fired, the originating lawyer lost his right to recovery of fees.  There must be something missing, because the opinion controverts the contractual expectations of the parties, without good cause.