March 19, 2008

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An Arizona Lender's Guide to Commercial Real Estate Foreclosures

By Michael P. Ripp ©
Ryley Carlock & Applewhite


I.     Introduction

At some point during the life of a commercial real estate loan, a lender may need to foreclose upon the project securing the loan.  This Guide describes Arizona commercial real estate foreclosures from the lender's perspective, commencing with the lender's initial decision to demand payment and pursue its remedies, through and including the collection of a deficiency following the foreclosure sale.  While reference may be made in this Guide to residential foreclosures, consumer debt collection, UCC sales or the income tax or transaction privilege tax consequences of foreclosures, this Guide does not purport to address any of those issues in a comprehensive manner.  As Arizona real estate foreclosures are typically accomplished by trustee's sale, rather than sheriff's sale, this Guide often focuses on issues in a trustee's sale context, although many of the same issues would apply in a sheriff's sale context as well.   

II.     Pre-Sale Document Review and Considerations

Prior to enforcing its remedies, a lender must ensure that its file is in proper order to make demand on the obligors,[1] to foreclose upon the collateral and, if appropriate, to collect a deficiency from the borrower, guarantors and other appropriate parties. 

A.     Review of Loan Documents

Before starting the foreclosure process, review all loan documents (including any amendments, assignments and extension or modification agreements) and any important correspondence with the borrower, any guarantors and persons acting on their behalf to confirm that the loan is ready to foreclose.  Your review should include at least the following:

Promissory Note.  Confirm: (a) that the note was signed by all named makers; (b) that the lender is the holder of the note (i.e., the note must have been endorsed to the lender if the lender is not the original named payee); (c) the date of the note (to verify that it corresponds to the date, if any, of the note referenced in the deed of trust and any guaranty); (d) that the note allows the lender to accelerate the debt upon default; (e) the late charges, if any, that the lender is entitled to demand; (f) the default interest rate that the lender is entitled to charge, and the time after which the default rate applies; (g) the maturity date of the note; and (h) the governing law and designated venue for dispute resolution (for example, whether arbitration is required).

Deed of Trust.  Confirm: (a) that the deed of trust properly identifies the trustor and the beneficiary; (b) that the named trustor executed and acknowledged the deed of trust; (c) that the correct legal description is attached to the deed of trust (a survey or assessor's map may assist you in this determination), and that the deed of trust was recorded in the proper county; and (d) the identification of the obligations or documents secured by the deed of trust (confirm date references, dollar amounts and parties).  If the loan has been assigned to the lender, make sure that an assignment to the lender of the beneficial interest under the deed of trust has been recorded.

Guaranty.  Confirm: (a) that all intended parties are identified as guarantors; (b) that all named guarantors executed (and acknowledged, if required by the lender) the guaranty; (c) the identification of the guaranteed obligations or documents (confirm date references, dollar amounts and parties); and (d) the governing law and designated venue for dispute resolution (for example, whether arbitration is required).  If the guaranty is intended bind a guarantor's marital community, the guarantor's spouse must have signed the guaranty or a joinder.  If the guaranty is intended to be a sole and separate guaranty, it should be accompanied by the non-guarantying spouse's disclaimer of any interest in the assets shown in the financial statements that the guarantor has provided to the lender.

Financing Statements.  Confirm:  (a) that each UCC-1 properly identifies the debtor and the secured party; (b) that a UCC‑1 has been filed in each required filing office;[2] (c) that the personal property collateral description in the UCC‑1 corresponds to the personal property collateral description in the deed of trust or other security instrument and/or includes a description such as "all personal property" or "all assets"; (d) that any real property legal description attached thereto is correct; and (e) that the UCC‑1 is still effective (i.e., it has not lapsed or been terminated).  Absent termination, UCC‑1s filed in Arizona are now effective for five years.  If financing statements have been filed in states other than Arizona, confirm that they remain effective.  If necessary, make an initial UCC-1 filing or a "lapse" re-filing prior to foreclosure, but keep in mind that, while your security interest is effective with respect to the borrower as of the date the security interest was granted, it will be "perfected" as against competing creditors and other third parties only as of the date your UCC‑1 is filed or re-filed, and that a UCC-1 filed within 90 days before a bankruptcy filing may be set aside by a bankruptcy trustee (or by the borrower acting as debtor in possession).  Your deed of trust may serve as a fixture filing if it identifies itself as a fixture filing and otherwise complies with the fixture filing requirements (you don't need to record a stand-alone UCC-1 with the County Recorder), in which case your fixture filing will last as long as your deed of trust (you never file a continuation statement).

Title Policy.  Confirm that the title company issued the original title insurance policy and any modification endorsements in the form(s) requested in your closing instruction letter(s) with all requested endorsements. It is generally easier to get policy corrections done before the title insurer becomes aware that a problem exists with respect to the loan. Also bear in mind that your lender's title policy will in most cases also serve as your owner's title policy if you acquire title to the project (see the discussion accompanying footnotes 18 and 19).

Other Loan Documents.  Review your other loan documents to confirm: (a) that they contain no provisions that would impair or delay your acceleration of the loan or commencement of the enforcement process; (b) that any notice and cure periods are complied with; (c) whether any additional collateral for the loan exists that should be foreclosed upon concurrently with the deed of trust; and (d) whether any additional defaults exist (these should be referenced in the demand letter and the Statement of Breach described in the "Trustee's Sale Documents" section below).

B. Demand Letter

Prepare and send out a demand letter that complies with all notice and cure provisions (if any) in the underlying loan documents.  The demand letter should generally reference all material defaults known to exist at the time of the demand, and should specify a deadline for payment or performance.  The demand letter should be sent to all obligors (not just the borrower).  Check your file to confirm whether you have any additional or updated notice addresses for any of the obligors.  It is the author's practice to identify in his demand letters any payments or performances that will become due during the cure period and to require that those impending payments or performances, if delinquent when cure is tendered on the original defaults, also be timely made.

C. Consider Enforcement Alternatives

Confirm the means by which you wish to foreclose on the property.  Two enforcement methods are generally available to a lender under an Arizona deed of trust: (i) judicial foreclosure (which culminates in a sheriff's sale); and (ii) non-judicial power of sale (which culminates in a trustee's sale).  The circumstances under which a lender will opt to judicially foreclose are limited.[3]  A brief overview of the two foreclosure options follows:

Judicial Foreclosure.

Judicial foreclosure is commenced by filing a foreclosure complaint in Superior Court (typically, but not necessarily, in the county in which the property is located).  Prior to filing the complaint, you will ask a title company to search the real property records and issue a litigation guaranty setting forth the names and addresses of lienholders, tenants and other parties who must be named as defendants in the foreclosure action and served with your summons and complaint.  The sheriff's sale will not affect senior liens, but to ensure that purchasers and lienholders who acquired their interests after you recorded your deed of trust will receive constructive notice of the filing of the foreclosure action, you must record a notice of lis pendens with the County Recorder when you file your complaint.  You should then request the title company to update its search and issue a "bringdown" endorsement through the date on which the notice of lis pendens was recorded.

If no defendant answers the complaint or otherwise appears by motion, defaults are entered and default judgments are taken.[4]  A sheriff's sale takes place a couple of months after the court enters default judgment and orders the sale of the property under special execution.  Depending upon how long it takes you to serve the defendants, in an uncontested foreclosure, you should allow several months after the filing of the complaint for the sheriff's sale to occur.  If the judicial foreclosure is contested, it will take a longer period of time (perhaps much longer) to conclude.

The foreclosing lender may submit a credit bid (i.e., bid all or part of the secured debt in lieu of cash) at the sheriff's sale.  The highest bidder has five business days to pay its bid price plus statutory fees.  A sheriff's sale may be set aside if the purchase price is so inadequate as to shock the conscience of the court.  The highest bidder at the sheriff's sale does not receive title to the property; it merely receives a sheriff's certificate of sale that can be exchanged for a sheriff's deed after the redemption period has elapsed if the property has not been redeemed (if the property is redeemed, the certificate of sale holder receives the redemption price).  The judgment debtor (borrower) will generally have six months following the sheriff's sale within which to redeem the property.[5]  The existence of the redemption period may inhibit your ability to successfully market the property for several months after the sale, and you may need to separately purchase the redemption rights so that you can control their exercise. 

A lender foreclosing on commercial property (or on a non-purchase money loan on residential property) can generally obtain a judgment against the borrower and any guarantors for the balance of the debt remaining after the sheriff's sale if those parties have been personally served or have appeared in the foreclosure action.  Within 30 days after the sheriff's sale, the borrower may apply to the court for a fair market value hearing.  The court will determine the fair market value[6] of the property as of the date of the sale and will credit the amount due on the judgment with the greater of the sale (bid) price or the fair market value of the property (less prior liens and encumbrances).  If the borrower applies to the court for a fair market value hearing, it forfeits its right to redeem the property (the junior lienholders would continue to have their 5-day redemption periods described in footnote 5, commencing 60 days after the sheriff's sale).  Guarantors, general partners and other direct and indirect obligors on the debt (regardless of whether they were defendants in the foreclosure action) receive the same credit (greater of sale price or fair market value) as the borrower against their respective obligations. 

Trustee's Sale.

A trustee's sale is a less formal means of foreclosure requiring only the recordation, posting, publication and mailing of notices, and is generally a faster and less expensive remedy than judicial foreclosure.  A trustee's sale is commenced by recording a Notice of Trustee's Sale ("NTS") in the records of the County Recorder in which the property is located; the sale date can be no earlier than the 91st calendar day following recordation of the NTS.  The trustee (which in commercial foreclosures is typically an attorney or the bank beneficiary, but may be a title company or a foreclosure service licensed as an escrow agent) is required to mail notices of the sale to other parties with interests in the property by certified mail, to post the NTS on the property and at the courthouse, and to publish the NTS.  All mailing, posting and publishing takes place during the period between recording the NTS and the sale date.  The NTS may not be re-recorded for any reason, so a fatal defect requires canceling the trustee's sale and starting over.

The trustor, successor owner or any junior lienholder has the right to reinstate the loan prior to 5:00 p.m. MST on the last business day before the trustee's sale by paying all past due sums and enforcement expenses (subject to a trustee's fee limitation of the greater of $600 or 0.5% of the unpaid principal balance of the loan) and curing all other defaults.  However, when the trustee's sale occurs, it will extinguish the interests of the borrower and all junior lienholders in the property, without the right of redemption.[7]  Recent Arizona case law indicates that a trustee's sale may be set aside if the highest bid was "grossly" inadequate (less than 20% of the claimed fair market value of the property).  The purchaser at the trustee's sale is entitled to immediate possession of the property following the trustee's sale.

If a deficiency remains after a trustee's sale and you are not prohibited by the loan documents or by law from collecting the deficiency, you must commence any desired action to collect the deficiency from any or all appropriate obligors within 90 days after the date of the trustee's sale (see the discussion accompanying footnote 20).  If the sale generates proceeds in excess of the foreclosing lender's debt and sale expenses, the trustee may either (i) pay junior lienholders in their order of priority, and then the trustor or record owner, or (ii) deposit the excess proceeds with the County Treasurer and commence an interpleader action in the Superior Court. 

Receivership; Demands for Rents.

You should consider whether you wish to request the appointment of a receiver for the property (this can now be done in connection with either a judicial or nonjudicial foreclosure).  As such an arrangement will require the receiver to obtain a receiver's bond and the lender and/or the property's cash flow to pay legal fees, receiver set-up expenses and a monthly receiver's fee,[8] consider whether the net cash flow you are likely to receive, or the need to protect the property from damage or waste, during the pendency of the foreclosure proceeding will justify the time and expense that the appointment of a receiver will entail.

If your primary goal is to obtain (or at least tie up) the rent payments from tenants of the property, then, as a less costly alternative to seeking the appointment of a receiver, you may wish to make a demand for rents directly upon tenants of the property by certified mail or personal delivery.  Making a demand and receiving rents from the tenants could present some risk to the lender of mortgagee-in-possession or transaction privilege tax liability.

D. Lender Due Diligence

Lenders normally conduct certain due diligence prior to or during foreclosure proceedings:

1.   A lender normally obtains a current appraisal during the foreclosure process to determine the desired credit bid and bidding strategy at the foreclosure sale, for use in a "fair market value hearing" (see the discussion accompanying footnotes 6 and 20) and for possible use in a bankruptcy proceeding.

2.   A lending institution normally requires that a current PhaseI environmental assessment be obtained prior to the foreclosure sale to ensure that the lender can safely take title to the collateral. A lender may become personally liable for contamination clean-up costs if it obtains title to property without having a clean and sufficiently current environmental assessment that complies with the "All Appropriate Inquiry" standards that became effective November 1, 2006.[9]

3.   A lender should review copies of any tenant leases affecting the project to determine whether to: (a) dispense with foreclosure notices to certain tenants (or perhaps affirmatively advise them that the lender wishes to retain them as tenants - if a foreclosing lender chooses not to give notice to a tenant, it should make sure that it has a copy of the tenant's most current lease, including any amendments, and announce at the trustee's sale that the sale will have no effect upon the leases in question); or (b) alternatively, to use the foreclosure sale to scrape off any below-market leases or otherwise problematic tenants (assuming that an SNDA with the tenant would not prohibit the lender from doing so).

4.   A lender should review its title due diligence from its original loan file and any additional title documents that it receives with its TSG to confirm that it understands the nature and extent of any obligations imposed by recorded documents that cannot be eliminated in a foreclosure. Development agreements, special assessments and CC&Rs can impose substantial liabilities on successor owners. The commencement of a foreclosure proceeding could also trigger certain options and rights of first refusal (which may necessitate giving notices to third parties before foreclosure begins), or could constitute a default under a senior lien.

5.   A lender should conduct a physical inspection of the collateral to determine the condition and physical occupancy of the collateral and to evaluate whether seeking the appointment of a receiver to protect the collateral during the foreclosure proceeding would be beneficial.

6.   A lender should check its file to confirm that the borrower's casualty and liability insurance coverage is still in place and will remain in place through the conclusion of the foreclosure proceeding (and the redemption period, in the case of a judicial foreclosure). If insurance has lapsed or will lapse, you will need to consider making a protective advance to either renew the borrower's insurance coverage (if the insurer will allow you to do so) or to procure your own forced placed coverage on the collateral.

7.   A lender foreclosing on an office building, apartment complex or other operating type of project may become liable as successor for any transaction privilege taxes owed by the former owner on account of the project (commercial lease taxes, owner-builder taxes and speculative builder taxes are the most common ones encountered on real estate projects), unless the Arizona Department of Revenue or the applicable city issues a tax clearance certificate in the seller's name. The Arizona Department of Economic Security could also attempt to hold a foreclosing lender liable as the former owner's successor for unpaid employment taxes, penalties and/or interest, especially if the lender retains a substantial number of the former owner's employees. As a practical matter, most lenders foreclosing upon such projects choose to "let sleeping dogs lie," as the owner is unlikely to have paid all of its transaction privilege or employment taxes and requesting a tax clearance letter is likely to alert the taxing authority to check its records and prepare to make demand for tax payment on a more solvent successor owner.

8.   A lender should consider whether it must qualify to do business in Arizona. An out-of-state lender generally need not qualify to do business for the sole purpose of conducting a trustee's sale, but would normally need to qualify (a) before using either state or federal courts in Arizona to judicially foreclose, collect a deficiency or obtain the appointment of a receiver, or (b) in owning and either operating or leasing the property following foreclosure. Because a lower threshold of activity will subject an out-of-state corporation to Arizona income taxation than to characterize a corporation as "doing business" in Arizona, some out-of-state lenders resist registering to transact business as a foreign corporation based upon a concern that such a registration would be construed as an implicit admission that the State of Arizona has a sufficient nexus to subject the lender's activities to Arizona income taxation. If a lender is not registered to do business in Arizona, it should confer with its corporate counsel with respect to this issue prior to commencing a foreclosure proceeding.

III.     Trustee's Sale Process

A.     Trustee's Sale or Litigation Guaranty

If you elect to proceed with foreclosure, the trustee or your legal counsel that is conducting legal proceedings for your benefit must order a trustee's sale guaranty (in the case of a trustee's sale) or litigation guaranty (in the case of a judicial foreclosure) from a title company.  The guaranty will inform the trustee or legal counsel that, according to the County Recorder's records, certain specifically identified parties must receive notice of the sale or be named as defendants in the foreclosure proceedings (and, in the case of a trustee's sale, will identify acceptable newspapers for the publication of the NTS).  The guaranty will insure against loss sustained if the information provided by the title company proves to be incorrect.  However, a trustee's sale or litigation guaranty is not a title insurance policy, and will not insure lien validity, access, marketability of title, vested ownership, lien priorities or other matters that are covered by a title insurance policy.

When you receive a trustee's sale guaranty ("TSG"), review it for at least the following:

(a)   Confirm that both the lender and the trustee are named as insureds.

(b)   Confirm that the effective date of the TSG extends through at least the recording of the NTS (if necessary, the TSG should be updated by a bringdown endorsement).

(c)   Review the various exceptions to title listed in Schedule B of the TSG. The title company should provide you with copies of all pages of all of the underlying title documents referenced in those exceptions. Make sure that no unacceptable title exception will remain following the foreclosure,[10] and that acquiring title to the property will not expose the lender to unacceptable liability. Pay particular attention to past due property taxes (which may be represented by certificates of purchase if tax lien sales have already occurred), as they have priority over even earlier recorded mortgages and deeds of trust and may be foreclosed upon without allowing the owner or other lienholders a right of redemption. If your deed of trust is a junior deed of trust, review the senior deed(s) of trust to confirm whether commencing or completing your trustee's sale will trigger a default under the senior deed(s) of trust. Also check recorded documents for options and rights of first refusal that your foreclosure could trigger. Also consider whether you wish to preserve (rather than extinguish) any junior interests, such as tenant leases and public utility easements, so that the holders of the junior interests can be advised accordingly.[11]

B. Trustee's Sale Documents

For an Arizona trustee's sale, the trustee would typically prepare (a) a Statement of Breach or Non-Performance and Election to Sell, (b) a Notice of Substitution of Trustee, if required, (c) a NTS, and (d) a Notification of Disposition of Collateral (if relevant), each of which is more specifically described below.

Statement of Breach or Non-Performance and Election to Sell.  This document must be signed by all holders of the secured note to advise the trustee of the nature of all existing defaults and to instruct the trustee to commence a trustee's sale.  Exercise care to identify all known material defaults, as you will arguably need to cancel the sale if the identified defaults are cured prior to the date of the sale.  You should also provide the trustee with: (i) your itemization and calculation of the total amount due under the note and the amount needed to reinstate the debt (i.e., to bring the debt current as if it had not been accelerated); (ii) a description of all existing defaults under your loan of which you are aware; (iii) the street address or other identifiable physical location of the property; (iv) the County Assessor's tax parcel number(s) for the property; and (v) any updated names and addresses you may have in your files for the borrower, any other obligors, any parties who may have acquired title to the property "subject to" the lien of your deed of trust, and any tenants, junior lienholders or mezzanine lenders on the property.  This information will be needed to complete the various trustee's sale notices and to supplement the listing of names and addresses that the title company provides in its TSG.

Notice of Substitution of Trustee.  This document must be signed by all holders of the note secured to substitute an attorney, title company or foreclosure service in as successor trustee for the purpose of conducting the trustee's sale.  Determine whether an attorney, a title company or a foreclosure service should conduct the sale as trustee.  If the sale involves a small dollar amount (particularly if it relates to property located in another county), it may be more cost effective for a title company or foreclosure service to serve as trustee, perhaps with counsel reviewing the notice documents that the title company or foreclosure service prepares and, if appropriate, providing a sale script to the title company or foreclosure service.[12] 

Notice of Trustee's Sale (NTS).  This document must be executed and acknowledged by the trustee and recorded to commence the trustee's sale.  If material fixtures or personal property collateral are to be sold together with the real property, consideration should be given to describing those items in the NTS so that they are included in the published NTS.[13] 

Notification of Disposition of Collateral.  If you have personal property collateral[14], you will need to determine whether you wish to (a) proceed with a unified real property and personal property sale,[15] or (b) sell the personal property in a separate UCC sale.[16]  If a unified sale is desired, either (i) the personal property collateral should be described in the NTS (which could substantially increase your publication costs) or (ii) a Notification of Disposition of Collateral should be completed and included with the 5- and 30-day notices described below.

C. Commencing and Noticing the Trustee's Sale

A trustee's sale is commenced by recording the NTS (preceded, where necessary, by a Notice of Substitution of Trustee).  The trustee's sale cannot occur sooner than the 91st day after the NTS is recorded.

5-Day Notices.  Within five business days after the NTS is recorded, copies of the trustee's sale documents must be sent via certified mail to all parties to the original deed of trust except the trustee.  The normal local practice is to also send 5-day notices to known successors of the original trustor or beneficiary. 

30-Day Notices.  Within 30 calendar days after the NTS is recorded, copies of the trustee's sale documents must be sent via certified mail to each person who, at the time the NTS is recorded, appears on the records of the County Recorder to have an interest in the trust property (regardless of apparent record priority), or who has recorded a request for notice.

Location of Sale.  Sales must be held (i) at the trust property, (ii) at any building that serves as a Superior Court location, or (iii) at a place of business of the trustee, if located in the county in which the property is located.  (This may influence your selection of the party to serve as trustee for the purpose of conducting the sale.)

Publication of NTS.  The NTS must be published once a week for four consecutive weeks in a newspaper of general circulation in each county in which trust property is situated.  The last publication can run no fewer than ten days prior to the trustee's sale.

UCC Search.  If you are selling personal property collateral, conduct UCC searches with the appropriate Secretary of State covering the period through the date that the NTS was recorded.  If the personal property constitutes a substantial or critical portion of the collateral being sold, consider obtaining a UCC search from a commercial search service (rather than simply doing your own on-line search).  Remember to search in the correct UCC filing office(s) (see footnote 2 of this Guide). 

Posting Notice.  At least 20 days before the date of the sale, a copy of the NTS must be posted (i) in a conspicuous place on the trust property, and (ii) at a place provided for posting public notices at a building serving as a Superior Court location in the county in which the trust property is to be sold.

IRS Notices.  Only the IRS has the right to redeem the property following a trustee's sale, and that right will expire 120 days after the sale date if the IRS has been properly noticed.  If the IRS has not been properly noticed, your trustee's sale will not extinguish the IRS lien.  The IRS also benefits from special notice rules which require the trustee to order a bringdown search for IRS liens no more than 30 days before the sale and, if a federal tax lien has been recorded, to provide to the IRS, at least 25 days before the sale, a separate certified mailing described in the Treasury Regulations.  If the trustee's sale is postponed for any reason, you must remember to order a new bringdown search for IRS liens as of the 30th day prior to the new sale date (and, if necessary, postpone the sale to allow a 25-day notice period to the IRS prior to the new sale date).

Sale Postponement.  The trustee postpones a sale by appearing at the scheduled sale and announcing the time and date to which the sale will be postponed.  No other notice or publication is required.  A trustee's sale can be postponed for up to 90 days from the current sale date. 

Requests for Information.  A foreclosing lender must be prepared to provide:  (a) within 14 days after receipt of written demand, a payoff statement for the loan; (b) upon receipt of a written request at any time that the deed of trust is subject to reinstatement (but no sooner than 30 days after recordation of the NTS), information regarding the unpaid principal balance of the loan, the name and address of the record owner of the property, and a list of all liens and encumbrances upon the trust property as of the date the NTS was recorded (the trustee will assist you with this disclosure, and may charge the requesting party a fee of $30 to $100 for providing this information); and (c) within five business days after receipt of a written request from the trustor or any person entitled to a 30-day notice, an itemized list of the exact amount necessary to reinstate the deed of trust.

IV.     Conduct of Trustee's Sale

A.     Preparing to Conduct Sale

When the actual trustee's sale finally arrives (it is often postponed several times), you should:

1.   Provide the appropriate credit bidding instructions to the trustee. Consider the opening bid that you wish to make (the foreclosing lender almost always makes the opening bid), the increments in which you are willing to bid (if you will not be present at the sale and the bidding becomes competitive) and the highest bid that you are willing to make. You will need to coordinate with the trustee to calculate the maximum credit bid that you are able to make (you are entitled to include the trustee's sale expenses in your credit bid). You must bid cash (which will go to the junior lienholders and then the trustor) if you wish to bid more than the maximum credit bid amount.[17]

2.   Determine whether you will be bidding in the name of the lender or a title-holding affiliate of the lender. If an affiliate will be bidding, determine whether (a)the note and deed of trust will be assigned to the affiliate so the affiliate can credit bid, or (b)the affiliate will bid cash (which would then go to the lender to the extent the affiliate's cash bid does not exceed the maximum credit bid). The title-holding affiliate approach is sometimes used by lending institutions, especially if the property may present environmental issues (however, this approach is not a panacea, as the lender may still possess sufficient control over the affiliate to subject the lender to potential personal liability for the environmental problem).

B.     Conduct the Trustee's Sale

1.   The trustee should circulate a sign-in sheet to potential bidders, asking them to list their names, the company or person for whom they are bidding, and a phone number at which they can be contacted. It is important that the trustee be able to contact the next highest bidder (which remains liable to pay its bid price) if the highest bidder fails to timely pay its bid price.

2.   The trustee must require every bidder except the beneficiary to provide a $10,000 deposit (in form satisfactory to the trustee) as a condition of entering a bid (the deposits of all unsuccessful bidders are returned to them after the sale). The trustee will typically "cry" the sale by reading the NTS aloud and asking for bids.

3.   If a party other than the foreclosing lender is the highest bidder, it must generally pay its bid by 5:00 p.m. MST on the business day following the trustee's sale. Appropriate wiring instructions should be furnished to the highest bidder. The author prefers to state the bid payment terms and deadline in his sale script so that all bidders are on the same footing with respect to payment of the bid price and the trustee does not open the sale to potential challenge on the basis that the highest bidder was given more favorable terms than another bidder would have reasonably expected.

4.   If property is divisible, the trustee must conditionally sell the known lots or parcels described in the NTS if the trustor or beneficiary present at the sale recommends such a sale, and then determine which sale or combination of sales will produce the highest price for the property.

5.   If the highest bidder fails to timely pay its bid, the trustee may either continue the sale to reopen the bidding (unless the trustee designates a time and place for the new sale, the sale is deemed continued to the same time and place 28 days later) or immediately offer the property to the next highest bidder.

6.   If a trustee's sale is conducted after the filing of an unknown or undisclosed bankruptcy, it is considered automatically continued until 28 days later.

V.     Post-Trustee's Sale Issues

A.     Following the conclusion of the trustee's sale, if you were the highest bidder, you should:

1.   Confirm that the trustee delivers a trustee's deed to you for recording (or, alternatively, records a trustee's deed in the correct county). If you also foreclosed on personal property, request the trustee to deliver a trustee's deed and bill of sale conveying both real and personal property.

2.   Consider whether to obtain an owner's title insurance policy to insure your interest in the property. The ALTA extended coverage loan policy that most lending institutions obtain at the time of the loan closing provides that title insurance coverage continues in favor of a lender who acquires the property by foreclosure, trustee's sale or conveyance in lieu of foreclosure.[18] Therefore, your existing ALTA loan policy should effectively convert to an owner's policy and automatically continue to cover you, as of the date of the original policy, to the extent of the lesser of (a) the stated amount of insurance, or (b) the unpaid principal balance of the secured debt plus interest, foreclosure expenses and protective advances incurred. Bear in mind, however, that the policy will continue to be subject to the lender's title insurance loss rules, which essentially require the lender to establish an impairment of its security as a result of the claimed title defect.

If the continuation coverage under your loan policy is or may be inadequate, you may wish to procure an owner's title insurance policy following the trustee's sale.[19]  Purchasing an owner's policy may be desirable if, for example: (a) you wish to increase the amount of coverage above the outstanding principal balance of your loan or update the effective date of the coverage described in the policy; (b) the foreclosure is complicated or bankruptcy filings or other events raise questions as to whether a particular title issue affects the property; (c) the issuer of your loan policy no longer exists or is no longer sufficiently creditworthy to handle a claim in the amount of your exposure to the project; (d) you acquire the property in the name of a title-holding affiliate that does not fall within the affiliate coverage provisions (see footnote 18); or (e) you propose to accept a deed in lieu of foreclosure (you take a deed in lieu of foreclosure subject to all junior interests and you will not have the opportunity to extinguish those junior interests if you release your deed of trust or it is considered to "merge" into the fee title).

Regardless of which alternative you choose to title insure your interest following foreclosure, (i) any matters to which your deed of trust may have originally been subject, (ii) any matters to which you later consented as lender, (iii) any junior interests (such as public utility easement holders or tenants) that were not given notice of the trustee's sale or named as defendants in the judicial foreclosure action, and (iv) any title matter arising after you become the owner, will become additional exceptions to your owner's title insurance coverage.

3.   Write the County Treasurer to advise it that you recently acquired title at a trustee's sale and request that all future property tax notices and statements be sent to you. Because delinquent property taxes bear interest at a rate of 16% per annum and have priority over even earlier recorded mortgages and deeds of trust, you will want to pay any delinquent taxes as soon as possible after you acquire the property.

4.   Confirm that the property has been added to your blanket casualty and liability policies for real estate owned.

5.   You or your property manager should:

(a)   Contact the various utility and service providers and project vendors of whom you are aware (pest control, landscaping, security, etc.) to either terminate them or to ensure that all services will continue to be provided to you on an uninterrupted basis;

(b)   Arrange for invoices to be sent directly to you or your property manager;

(c)   Arrange for the transfer to your name of the various certificates, permits, licenses, warranties, utility deposits or bonds, leases and other arrangements affecting the property of which you are aware; and

(d)   Change any locks in or about the premises.

6.   If the collateral is an income-producing property, you or your property manager will also need to obtain a sales tax license and prepare and file sales tax returns with the Arizona Department of Revenue and the applicable city to pay commercial lease transaction privilege taxes on any rents received from the property while you own it.

B.     Following the conclusion of the trustee's sale, regardless of whether you were the highest bidder, you should:

1.   If the proceeds of the sale (or your credit bid) were less than the amount owed and the collection of a deficiency is not prohibited by the loan documents or by law,[20] you may file an action to collect the deficiency, but must do so within 90 days after the date of the trustee's sale. The deficiency is limited to the total debt secured by the lien foreclosed minus the greater of (a) the fair market value of the property at the time of sale (less prior liens and encumbrances), or (b) the sale (bid) price. The collection of a deficiency requires you to file a separate judicial action, and, if you plan to pursue a deficiency, the property's fair market value should be established as of the sale date by an appraisal report prepared by an appraiser knowledgeable in the local real estate market. The rules governing the determination of fair market value, collection of a deficiency and other parties entitled to the benefit of the fair market value credit are essentially the same as those discussed in the text accompanying footnote 6 with respect to judicial foreclosures (disregarding issues relating to redemption, which, except in the case of the IRS, is inapplicable to a trustee's sale).

2.   Confer with your accountants or other tax advisors regarding income tax reporting, including the preparation of federal Forms 1099-A (Acquisition of Abandonment of Secured Property) and/or 1099-C (Cancellation of Debt). The income tax treatment for both lender and borrower will vary depending on whether the loan is a recourse or non-recourse loan.

The goal of the RC&A Arizona Lending Guides is to provide helpful substantive discussion and insights, based on the author's 25 years of experience in Arizona commercial real estate lending, loan workouts and enforcement, regarding a number of general legal issues of concern to commercial real estate lenders.  Opinions expressed in the RC&A Arizona Lending Guides are the author's and do not constitute legal advice regarding any specific matter or situation.  Legal advice can be given, and an attorney-client relationship can be formed, only on the basis of specific facts discussed between client and attorney pursuant to an engagement to perform legal services.

Michael P. Ripp
Ryley Carlock & Applewhite

[1]  As used in this Guide, the term "obligors" refers to not only your present borrower, but also to guarantors, general partners, collateral pledgors, prior owners and other parties who may be (or whose property may be) obligated to pay the loan in any fashion. 

[2]  Under the revised UCC Article 9 provisions governing the perfection of personal property security interests, the proper UCC‑1 filing location for a "registered organization," such as a corporation, limited partnership or LLC, is the state in which the entity is registered (normally its state of formation), while the proper filing location for other entity types is the entity's place of business.

[3] Judicial foreclosure may become attractive, for example, to deal with a "chronic" default situation or a lien priority dispute, where reformation of documents is first needed to effectively foreclose, or where the debt is a non-purchase money debt secured by anti-deficiency property (see footnote 20) and a deficiency is expected following foreclosure.

[4] Although individuals who are members of the military are not often encountered in commercial real estate loans, a mortgage lender should be aware of the federal Servicemembers Civil Relief Act (formerly known as the Soldiers and Sailors Civil Relief Act).  The SCRA generally provides service members with protection from default judgments and suspends judicial and administrative hearings of civil suits against service members (including an action based on a mortgage or deed of trust filed during or within 90 days after a service member's period of military service).  Upon application by the service member, the SCRA also forgives interest (which includes certain fees and charges) in excess of 6% on pre-service debts, and requires a creditor to reamortize the payments under the loan based on the 6% rate.  The SCRA covers all persons on active duty, Reserve and National Guard personnel who are on federal active duty, and Reserve components who have received orders to report; the spouses and children of service members also receive certain protections under the SCRA.  A third-party trustee or your counsel will likely require you to provide an affidavit of non-military service to establish that, to your knowledge, none of the persons against whom you are proceeding are entitled to the benefits of the SCRA. 

[5] The six-month redemption period is cut to 30 days if the property is both abandoned and not used primarily for agricultural or grazing purposes.  To redeem the property, the judgment debtor must pay the amount bid at the sheriff's sale, plus 8% of that amount, plus the amount of any taxes or assessments the purchaser lawfully paid after purchase, plus interest on that amount.  If the judgment debtor does not redeem the property within 6 months, then junior lienholders on the property will have 5-day periods, in order of priority, within which to redeem by paying the foregoing amounts plus the amount of the foreclosed lien plus the amount of the lien of any prior redeeming party who has actually redeemed the property (but not the additional 8%). 

[6] "Fair market value" is defined by the Arizona statutes as "the most probable price, as of the date of the sale, in cash, or in terms equivalent to cash, or in other precisely revealed terms, after deduction of prior liens and encumbrances with interest to the date of sale, for which the real property or interest therein would sell after reasonable exposure in the market under conditions requisite to fair sale, with the buyer and seller each acting prudently, knowledgeably and for self-interest, and assuming that neither is under duress."  Note that the statutes do not provide a credit for carrying costs that the lender anticipates incurring, although lenders often deduct carrying costs from the appraised value in reaching their own conclusions as to the actual fair market value of the property. 

[7] However, as mentioned elsewhere in this Guide, the IRS has 120 days after the sale to redeem the property following a trustee's sale if the IRS has been property noticed.

[8] Receiverships will be covered in more detail in a separate Guide.

[9] The new standards are embodied in new ASTM E1527-05, which is stricter in a number of respects than the former ASTM E1527 standard.  For example, the new standard specifies certain minimum qualifications of the "Environmental Professional" who performs or supervises an assessment, requires the updating of components of a Phase I assessment that is dated more than 180 days before the acquisition of title, and generally doesn't permit the use of an assessment that is more than one year old.  More stringent requirements are also imposed on the users of Phase I assessments to qualify for the innocent landowner defense, contiguous landowner defense or bona fide purchaser defense to personal liability under the environmental laws.  The author can provide you with more specific information regarding the new standards if you have any questions in this regard.

[10] In the author's experience, many internally documented loans are closed and title exceptions are approved without reviewing (or even obtaining copies of) the underlying title exceptions referenced in Schedule B of the title commitment or policy.  A review of unrecorded documents that are referenced in recorded memoranda is even more unusual.  However, those documents can vitally affect the value of the collateral to the lender if the financial or other obligations they impose upon subsequent owners of the collateral are too onerous. 

[11] If you elect not to provide notices to tenants or other parties that the TSG designates as required notice parties, advise the title company and confirm that the title company will still be willing to insure your trustee's sale and will, if requested, be able to insure your ownership interest following foreclosure.  The Arizona trustee's sale statutes do not expressly require that notice of the sale be given to tenants under unrecorded leases, but general Arizona real property law is clear that a grantee of property takes subject to parties in possession and interests that would have been disclosed by an inspection of the property.   Consideration should therefore be given to sending trustee's sale notices to all tenants, or at least tenants whose leases post-date your deed of trust (especially those who may be paying below market rents).

[12] In the author's experience, title companies and foreclosure services have difficulty getting the unified sale procedures described in the discussion accompanying footnote 15 right, as they are accustomed to dealing with only real property.  If a lender wishes to have a title company or foreclosure service conduct a unified sale of real and personal property that is likely to survive legal challenge, it should probably involve a knowledgeable lawyer.

[13] In the interest of holding down publication costs, the author generally does not publish the entire collateral description from the granting clauses from the deed of trust, although consideration should be given to doing so if the non-real property collateral (or particular items thereof) constitutes a sufficiently important component of the collateral. 

[14] Construction lenders (especially those financing residential construction) often neglect or choose not to file financing statements in the personal property records, even though important components of their collateral, such as building materials not yet incorporated into the improvements, rights under construction and architectural contracts and utility deposits, are clearly personal property. Given the frequency with which homebuilder and other home construction projects are now ending up in bankruptcy and the "hypothetical lien creditor" lien avoidance rights that the federal Bankruptcy Code automatically grants to a bankruptcy trustee, a construction lender clearly undertakes some business risk by not filing financing statements.

[15] The right to conduct a unified sale technically applies only if the security agreement (the deed of trust) covers both real and personal property.  If your personal property collateral is encumbered only in a separate security instrument, you may not be able to take advantage of this provision and you may need to reserve a portion of your permissible credit bid to acquire any desired personal property collateral that you may wish to be able to resell as a unit with the real property collateral.

[16] If you conduct a separate UCC sale, it will need to be done in a "commercially reasonable" manner under the UCC.  If the personal property collateral is closely related to the real property collateral and could be sold together with the real property, one could challenge the commercial reasonableness of a separate UCC sale.

[17] "Overbidding" by the foreclosing lender typically occurs not because the lender wants the property, but because the lender is seeking to maximize the amount recovered on a junior lien position that it also holds.

[18]  The continuation coverage of the 1992 ALTA policy form is also made available to a corporate lender's parent corporation or wholly owned subsidiary to which the property is so conveyed.  The 2006 ALTA policy form includes a slightly broader affiliate coverage provision. 

[19]  The title company will charge an additional premium for the new owner's policy (many local title insurance companies will also require you to provide them with a recent survey prior to issuing an extended coverage owner's policy, unless you are willing to accept a general survey exception).  Some local title companies allow a credit for a portion of the TSG premiums paid against the cost of a subsequent owner's policy, whether issued to you or your buyer, within a year or so after the trustee's sale.

[20]  If the collateral consists of two and one-half  acres or less and is limited to and utilized for either a single one-family or single two-family dwelling (commonly referred to as "anti-deficiency property"), you cannot recover a deficiency (i) following a trustee's sale or (ii) on a purchase money loan (even if you judicially foreclose).  Arizona law does not limit anti-deficiency protection to owner-occupied properties, and Arizona case law has expressly extended anti-deficiency protection to an investment condominium that did not constitute anyone's permanent residence or normal place of abode.