A 2003 case decided by the United States Circuit Court for the Ninth Circuit… should cause all lenders and their counsel to review and perhaps revise their standard forms of mortgages and deeds of trust to be sure all proceeds are properly assigned and payable to the lender.

Lenders making loans secured by real estate typically expect their security to include not only an interest in the property and improvements, but also all income and proceeds related to the property. For example, insurance proceeds recovered in connection with a casualty loss to the property are often paid to or controlled by the lender, not the owner. Similar provisions also are common for condemnation proceeds and for proceeds of any cause of action or litigation related to the property. A 2003 case decided by the United States Circuit Court for the Ninth Circuit, however, should cause all lenders and their counsel to review and perhaps revise their standard forms of mortgages and deeds of trust to be sure all proceeds are properly assigned and payable to the lender.

In re Emery, 317 F.3d 364 (9th Cir. 2003) concerns the rights to proceeds of litigation arising from construction defects to property. James and Cheryl Emery refinanced their property with World Savings & Loan Association ("World Savings") in 1993. The loan was secured by a deed of trust on the property in favor of World Savings. Sometime thereafter, construction defects were discovered, and the Emerys retained Kasdan, Simonds, McIntyre, Epstein & Martin ("Kasdan") to pursue an action against the contractor. The construction litigation was successfully settled, and at the direction of the Emerys, Kasdan disbursed the settlement proceeds to certain of the Emerys’ creditors (not including World Savings), to the Emerys, and to itself for attorneys’ fees and costs.

Shortly thereafter, the Emerys defaulted on the loan and filed for bankruptcy protection. World Savings obtained relief from the automatic stay and foreclosed on the property, but did not recover the full amount of the loan. World Savings then filed suit in the bankruptcy court against Kasdan, claiming that it had exclusive rights to the cause of action and resulting settlement proceeds. The bankruptcy court ruled in favor of Kasdan, and World Savings appealed to the U.S. District Court for the Central District of California. The district court reversed the bankruptcy court’s decision and held that Kasdan converted World Savings’ property interest in the settlement funds and was liable to World Savings for damages.

On appeal, the Ninth Circuit reversed the district court. The Ninth Circuit reviewed the language contained in the World Savings deed of trust, which stated "I assign these rights [to bring legal action] and any proceeds arising from these rights…to Lender. Lender may, at its option, enforce these rights in its own name, and may apply any proceeds resulting from this assignment to any amount that I may owe to Lender under the Note…." The court determined that because the Emerys were current in their payments on the loan at the time Kasdan disbursed settlement proceeds, the amount owed to World Savings was zero and therefore World Savings had not suffered any damage for which proceeds should be assigned.

In support of its decision, the court emphasized the language in several other provisions in the deed of trust which provided for acceleration and application of proceeds to all sums secured in instances such as transfer of the property, condemnation and rights to insurance proceeds. The court noted that the reference to "sums owed," contrasted with the phrase "sums secured," was at best ambiguous. "Sums secured" clearly meant the outstanding balance and any other amounts owed. Did "sums owed" mean the same thing? Ambiguous language is construed against the drafter, leading the court to conclude that the phrase "owed to Lender" means amounts currently due and payable. The court also noted that while World Savings’ right to intervene in the litigation had been deprived because neither the Emerys nor the Kasdan firm notified the lender of the litigation, World Savings did not have exclusive rights to pursue the legal action. It perhaps had a breach of contract action against the nowbankrupt Emerys for failing to notify the lender of the litigation, but nothing more.

This decision should surprise and concern financial institutions and other institutional lenders. Common usage and understanding of the phrase "amounts owed" means the outstanding balance of the loan, not the amount due at that particular moment. The result reached in this case, however, can be avoided by assuring that mortgage and deed of trust language is clearly drafted. Different phrases in different provisions is an invitation to engage in the sort of analysis undertaken by the Ninth Circuit. Whether other circuits will follow the reasoning used in Emery is uncertain, but lenders can feel confident that if their "boilerplate" provisions are carefully worded and consistent, they should be able to avoid the Emery scenario.

This article is presented for informational purposes only and is not intended to constitute legal advice.