By Jones Osborn II

In Arizona, the general rule is that a lender can seek a deficiency judgment after foreclosure if the property securing the loan does not sell for enough to satisfy the debt in full. There is no "one action rule," as there is in California, which precludes a deficiency judgment after foreclosure in many cases. In "one action" states, the lender generally must elect to either sue on the note or foreclose - he can't do both. If he forecloses by means of a trustee's sale, he can't seek a deficiency; he must be satisfied with the proceeds of the sale.

Non-Recourse Loans. The parties can always agree to make a secured loan non-recourse, of course. Such a provision should always be clearly set forth in the mortgage or deed of trust if that is what the parties intend.

Often, commercial non-recourse loans have "carve-outs," which are certain circumstances under which the lender can hold the borrower personally responsible, even though the loan is otherwise non-recourse. The most common "carve-outs" are losses arising from:

(a) Waste caused or permitted by the borrower (i.e., damage to or deterioration of the property resulting from improper care or neglect by the borrower).

(b) Environmental liabilities arising out of the property.

(c) The borrower's failure to pay property taxes accruing against the property when due.

(d) The borrower's misappropriation of rents produced by the property (instead of using them to operate and maintain the property or to pay debt service to the lender).

The reason lenders often insist on these "carve-outs" is that they detract from the lender's security. If the lender's recourse is to be limited to the property, the lender wants assurances that the value of the property will not be depleted by the borrower's acts or omissions.

Fair Market Value Protection. Even though there is not a "one action" rule in Arizona, Arizona does provide some protection for borrowers against liability arising out of the failure of a property to sell for its full fair market value at the foreclosure sale. If the property sells for less than the debt, the borrower has the right to ask the court to determine its fair market value. If the fair market value is found to be higher than the sales price, the borrower is entitled to credit for the higher amount. This protects the borrower from an unfairly low sales price and encourages the lender to make a credit bid equal to or near the fair market value of the property.

Statutory Exemptions. There are also statutory provisions in Arizona that prohibit deficiency judgments in certain cases involving residential real property. These statutes preclude a deficiency judgment where (a) the property is two and one-half acres or less, (b) the property is limited to and used as a single one-family or single two-family dwelling, and (c) the loan is a "purchase money loan," which means it was a loan used to pay all or a portion of the borrower's purchase price for the property. A loan which replaces or refinances a purchase money loan is also considered a purchase money loan. It is not clear, however, what happens if the refinanced loan is larger than the original loan. It is possible that the portion of the loan producing the excess funds might be considered a full recourse loan.

Even if the residential loan is not a purchase money loan, it nevertheless becomes non-recourse if the lender chooses to foreclose by means of a non-judicial trustee's sale. On the other hand, if the lender chooses to proceed by judicial foreclosure the loan is full recourse, meaning that the lender can seek a deficiency. A borrower, therefore, should not automatically assume a loan is non-recourse just because it is secured by qualifying residential property—it must also be a purchase money loan to be non-recourse regardless of the method of foreclosure.

The statutes also provide that there is recourse to the extent the lender suffers a loss from waste committed or allowed by the borrower, even if the loan is otherwise non-recourse.

A Caveat. Sometimes lenders making a commercial or business loan will also take a lien on the borrower's house as additional security. Lenders should be extremely careful when doing this. If the lender should foreclose on the residence by trustee's sale, any unpaid portion of the loan becomes uncollectable as a result of the anti-deficiency statutes. Even though the additional property was designed to provide additional security, it can also create a loss if the lender is not careful with its foreclosure and collection procedures.

Conclusion. A purchase money loan secured by qualifying residential property is automatically a non-recourse loan (except to the extent to which the borrower causes or permits waste). However, if the loan was used for other purposes the loan is non-recourse only if the lender chooses to foreclose by trustee's sale; if he chooses judicial foreclosure, the loan is full recourse. Any other loan can be made non-recourse if the parties so agree.