Conflict Of Interest Challenges To Deeds Of Trust Gaining Popularity But Not Success

The last few years have seen an increase in litigation between borrowers and lenders, due to, presumably in part, current economic conditions. The real estate lending market has followed this trend as well. To avoid impending defaults or foreclosures, borrowers are increasingly filing suit against lenders as a means of avoiding foreclosure on a house that the borrowers realize they can no longer afford. Many borrowers file suit before the lender even declares the borrower in default or begins foreclosure proceedings.

Borrowers are getting more creative in their claims against lenders in their efforts to avoid foreclosure, including attempts to impose heightened standards of care on the participants in the foreclosure of the property. These claims are particularly troublesome in deed of trust states, where the foreclosure of a property involves a third-party trustee that is not regularly subjected to judicial scrutiny. Fortunately for the lenders, however, many of the attempts by borrowers to expand the duties of the trustees in these circumstances have failed.

A. Deeds of Trust.

Two different avenues exist for a lender to secure home loans. The first is a traditional mortgage. This involves a mortgage directly between the lender and the borrower that places a lien on the property in favor of the lender. Should the borrower default, the lender can seek to foreclose only through judicial foreclosure proceedings.

Twenty-one states—Alaska, Arizona, California, Colorado, Georgia, Idaho, Maryland, Mississippi, Missouri, Montana, Nebraska, Nevada, New Mexico, North Carolina, Oregon, Tennessee, Texas, Utah, Virginia, Washington, and West Virginia—provide for an alternative to a mortgage. In those states, the borrower's debt is secured by a deed of trust. The deed of trust involves the borrower conveying his interest in the property to a third party, the trustee, that holds that interest for the benefit of the lender until the borrower satisfies the debt. If the borrower defaults on the debt, the lender can then direct the trustee to sell the property to satisfy the debt. The sale of the property is then completed without the instigation of any judicial proceedings. States employing this system typically regulate the procedure of foreclosing on a property via statute, thereby providing the borrower adequate opportunity to prevent wrongful foreclosure.

Deeds of trust provide a number of benefits that mortgages do not. The goal of a deed of trust system is to promote a nonjudicial foreclosure process that is efficient and inexpensive for the parties involved. The streamlined process also provides for stability in land titles by avoiding drawn out legal proceedings that can cloud title for years at a time.

B. Duties of a Trustee.

States have defined the duties of a deed of trust trustee in different ways. Some states rigorously guard the boundaries of the statutory duties of such trustees. California, for example, continues to limit a trustee's duties to those spelled out by the statute: (1) upon default to undertake the steps necessary to foreclose the deed of trust or (2) upon satisfaction of the secured debt to re-convey the deed of trust. Heritage Oaks Partners v. First American Title Ins. Co., 155 Cal. App. 4th 339, 345 (Cal. Ct. App. 2007). Trustees are not true trustees with common law fiduciary duties, but rather perform ministerial acts to effectuate the transfer of title. Pro Value Properties, Inc. v. Quality Loan Service Corp., 170 Cal. App. 4th 579, 583 (Cal. Ct. App. 2009). The scope and nature of the trustee's duties are thus exclusively defined by the statute and the deed of trust itself.

This limitation on common law duties reflects an adherence to the balance struck in the legislation between borrowers, lenders, and trustees. Heritage Oaks Partners v. First American Title Insurance Co., 155 Cal. App. 4th 339, 345 (Cal. Ct. App. 2007). The lender has an interest in quick and inexpensive recovery of the debt, while borrowers need protection against the forfeiture of valuable property rights. Id. at 346. Consequently, the trustee requires clearly defined responsibilities to enable them to discharge their duties efficiently and to avoid entangling the parties in drawn out and expensive litigation. Id. Some courts have suspended common law fiduciary duties to allow the trustee to even purchase the property for himself at the foreclosure sale, which would otherwise be prohibited by the common law duty to avoid self-dealing. See e.g., Stephens, Partain & Cunningham v. Hollis, 196 Cal. App. 3d 948, 955 (Cal. Ct. App. 1987) (refusing to set aside a foreclosure sale where the trustee purchased the property at the sale for himself, absent a showing of fraud, irregularity or misconduct on the party of the trustee).

Other states have expanded, albeit slightly, on the statutory duties of a trustee in the context of deeds of trust. Many states still adhere to the adage that a trustee to a deed of trust does not owe a fiduciary duty to the borrower based solely on their general relationship under the deed of trust. E.g., Burnett v. Mortgage Electronic Registration Systems, Inc., No. 1:09CV00069DAK, 2009 U.S. Dist. Lexis 100409, at *14 (D. Utah Oct. 27, 2009). However, the trustees in these states do have a duty to act with reasonable diligence and good faith on the borrower's behalf consistent with the trustees' primary obligation to assure payment of the secured debt. Burnett, 2009 U.S. Dist. Lexis 100409 at *14. This may include acting impartially between the borrower and the lender, presenting the sale under every possible advantage to the borrower as well as the lender, using good faith and diligence in conducting the sale, attending to the interests of the borrower and the lender equally, and taking reasonable steps to avoid sacrificing the borrower's property or interest. Paul v. Hanson, Inc. v. Northwest Administrative Services, Inc., No. 57995-9-I, 2008 Wash. App. Lexis 326, at *7 (Wash. Ct. App. Feb. 11, 2008). A trustee cannot allow the urgency of the lender to override the trustee's duty to act with fairness and impartiality to both parties and to conduct the sale of the property with the interest of both parties in mind. Bremer v. Bitner, No. (Chancery) 143320, 1996 Va. Cir. Lexis 509, at * (Vir. Cir. Ct. Mar. 25, 1996) (finding a breach of fiduciary duty where the trustee failed to seek judicial direction before foreclosing on a debt where the borrower challenged the amount of the debt). However, apart from a general duty to act fairly, the trustee's duties are solely tied to the strict compliance with the terms of the deed of trust. Stephenson v. Leboeuf, 16 S.W.3d 829, 837 (Tx. Ct. App. 2000).

C. Conflict of Interest Challenges.

Despite the strong policy arguments in favor of limiting the scope of duties for a trustee in the context of a deed of trust, borrowers continue to attempt to expand the duties owed by the trustee. An increasingly common challenge is one that alleges the trustee breached his fiduciary duty, not through his actions, but because he had a disqualifying conflict of interest as a result of his relationship with the lender. Lenders commonly use attorneys and even employees as trustees due to the volume of deeds of trust generated and the efficiency of using a common trustee in such transactions. Borrowers, taking from common law fiduciary duty law imposing heightened duties upon trustees, argue that the agency relationship between the trustee and lender renders the trustee incapable of being impartial and fair in the foreclosure process. See e.g. Paul v. Hanson, Inc., 2008 Wash. App. Lexis 326 at *5 (challenging a foreclosure on a deed of trust where the trustee was also the attorney for the lender).

Courts have generally rejected such an expansion of the trustee's duties. First, several states enacted statutes specifically allowing for a trustee to also be an agent for the beneficiary. See e.g. Va. Code Ann. § 26-58 ("The mere fact that a trustee in a deed of trust to secure a debt due to a corporation is a stockholder, member, employee, officer or director of, or counsel to, the corporation, does not disqualify him from exercising the powers conferred by the trust deed nor does it render voidable a sale by such trustee in the exercise of the powers conferred to him by the trust deed . . . "). Second, in many states, the conflict of interest must be an actual conflict between the trustee and the borrower, not a potential conflict or a conflict between the lender and the borrower. In re CMR Mortgage Fund, LLC, No. 08-32220 TEC, 2009 Bankr. Lexis 2615, at * (Bankr. N.D. Cal. Sept. 4, 2009); Truong v. Rutherford, No. 21668-3-III, 2003 Wash. App. Lexis 2715, at *11-12 (Wash. Ct. App. Nov. 18, 2003); Meyers Way Develop. L.P. v. University Savings Bank, 910 P.2d 1308, 1315-16 (Wash. Ct. App. 1996).

The Mississippi Supreme Court outlined the policy underlying the rejection of the conflict of interest theory in Wansley v. First National Bank. 566 So. 2d 1218 (Miss. 1990). In Wansley, the trustee for the deed of trust was general counsel for the lending bank and also one of the lender's largest shareholders. 566 So. 2d at 1220. The borrowers made no allegations of fraud or any other allegation of misconduct on the part of the trustee—they simply argued that the foreclosure should be set aside due to the trustee's disqualifying conflict of interest. See id.

The Mississippi Supreme Court at first invalidated the foreclosure, but, upon rehearing, reinstituted the sale by holding that allegations of a conflict of interest, without more, were insufficient to justify the voiding of a foreclosure sale. Id. at 1225. The court recognized that there had always been the issue of protecting borrowers from unfairness and over-reaching in the context of foreclosures, but to hold that a trustee must be independent of all parties was practically unworkable. Id. at 1220-21. The court reasoned that even if the lender were to appoint a complete stranger, the stranger would likely become "infected" with interest after two or three foreclosures. Id. at 1222. To introduce a question of how interested a trustee is in the lender would introduce a question of fact, generating a litany of judicial challenges that the deed of trust system is designed to avoid. Id. Moreover, an independent trustee does not afford any further protection of the borrower than an interested trustee who conducts the sale in a commercially reasonable manner. Id. at 1221. Consequently, the Mississippi Supreme Court reversed its prior decision and upheld the foreclosure sales, as they were commercially reasonable in nature. Id. at 1225.

While not all states have tackled the issue of disqualifying conflict of interests for deed of trust trustees, the ones that have seem to reject the idea. The precedents of the states who have addressed this issue will likely have some bearing on the courts of other deed of trust states that may be faced with this issue as a matter of first impression.

D. Conclusion.

Lenders would be wise to understand the content of a trustee's duties as defined by the courts in the jurisdictions where the lender conducts business. Such knowledge can allow the lender to proactively avoid challenges to foreclosures through its choice of trustee. It can also provide a quick resolution to claims made by borrowers incorrectly asserting the existence of common law fiduciary duties of trustees in jurisdictions that strictly construe the duties as those provided by the governing statute. As not all deed of trust states have addressed these issues, this area of law will continue to evolve and lenders will need to tread lightly as they implement common practices in each state.

Posted by: Michelle R. Maslowski

Categories: Foreclosures