DEEDS OF TRUST OR MORTGAGES

DEEDS OF TRUST OR MORTGAGES

Security Interest

“Security interest” is a term designating the interests of the lender/creditor in the property of the
borrower/debtor. Certain assets of the borrower/debtor are set aside so that the lender/creditor can reach or sell
them if the borrower/debtor defaults on his or her debt or obligations. The document that describes the rights
and duties of the lender and the borrower is called a security instrument. Deeds of trust and mortgages are
security instruments.

In General

The deed of trust is the security instrument most frequently used in California real estate loan transactions.
Early distinctions between the legal and economic effects of the deed of trust and mortgage have diminished
considerably. In the early 1930’s, the California Supreme Court held in the case, Bank of Italy Nat'l Trust and
Savings Ass'n v. Bentley, 217 Cal. 644, 657 (1933), that deeds of trusts and mortgages were functional
equivalents. Also, Civil Code Section 2920 was amended in 1986 to provide “…mortgage also means any
security device or instrument…that confers a power of sale affecting real property…to be exercised after breach
of the obligation so secured…”. Now, both security instruments may include a power of sale through which a
named or substituted trustee may conduct a trustee’s sale as part of the non-judicial foreclosure procedural law
(Civil Code Section 2924 et seq.).

Unless indicated otherwise, references to “mortgage”, “mortgagor”, or “mortgagee” in this discussion include
“deed of trust”, “trustor”, “beneficiary”, “lender”, or “lender/creditor” and vice versa. Further, references to
“debtor” or “borrower” also may mean “trustor” or “mortgagor”. Further, the terms creditor/lender and
borrower/debtor as used in this Chapter also describe the person or entity funding or making a loan and the
person or entity that obtains the loan. These terms are sometimes used interchangeably with other terms
describing the same parties and other times used distinguishably when so defined.

Differences Between Deeds of Trust and Mortgages

The historical differences between deeds of trust and mortgages have been largely eliminated. What remains
distinguishable are the names of the parties and the terms used to extinguish the deed of trust as compared to
the mortgage as a lien against the security property when the debt or loan is paid. The deed of trust is
extinguished by a deed of reconveyance while the mortgage is extinguished by a certificate of
discharge/satisfaction of indebtedness.

The parties to a mortgage remain identified as the mortgagor (borrower) and the mortgagee (lender or
beneficiary). Even here the terms mortgagor/mortgagee are often used to describe the borrower and the
beneficiary as in the deed of trust. For example, federal government agencies and enterprises interchange the
use of mortgagor and mortgagee with the terms borrower/trustor, and the terms lender/beneficiary/mortgagee
with the terms creditor/lender.

When the mortgage instrument is constructed without power of sale, it may only be foreclosed judicially. When
judicial foreclosure is the only available foreclosure remedy; the statute of limitations, the pursuit of
deficiencies (money claims), and the redemption rights would be distinguishable from a deed of trust that is
foreclosed through a power of sale as a function of the procedural law authorizing the named or substituted
trustee to conduct such sales. However, when the deed of trust or mortgage each includes a power of sale,
distinctions regarding the statute of limitations, deficiencies, and redemption rights no longer exist.

When a power of sale is included in a deed of trust or mortgage, each security instrument is subject to the same
anti-deficiency limitations and to the same reinstatement and redemption rights (if a non-judicial foreclosure is
the selected remedy). Should judicial foreclosure be the selected remedy, the same rules are generally
applicable to both deeds of trusts or mortgages.

The Civil Code was amended in 2006 to make uniform the statute of limitations when a deed of trust or
mortgage contains the power of sale. If the final maturity date or the last date fixed for the payment of the
debt/loan or performance of the obligations is ascertainable from the recorded evidence of indebtedness, an
action for foreclosure may be commenced within 10 years from that date, whether the security
device/instrument for the debt/loan or obligations is a deed of trust or mortgage. If the recorded evidence of
indebtedness does not fix the maturity date or the last date for the payment of the debt/loan or performance of
the obligations, then an action to foreclose may commence within 60 years after the recording of the security
device/instrument. It is important to note that the California Legislature and the Law Revision Commission in
the context of this legislation have deemed deeds of trust and mortgages to be functional equivalents (Civil
Code Section 882.020).

Junior Deeds of Trust or Mortgages

It is often necessary to obtain junior financing (a loan secured by a deed of trust or mortgage recorded after the
recordation of or made subordinate to the deed of trust or mortgage securing the senior financing) to complete a
transaction where the amount of a first conventional loan (senior financing) plus the trustor’s/mortgagor’s down
payment are not sufficient to pay the purchase price.

It should be noted junior financing may not be employed when the security property is subject to a first
conventional loan made by a financial institution or licensed lender at the time of purchase without the approval
of the foregoing. When the senior financing is FHA insured or is a VA indemnified loan made at the time of the
purchase of the security property, junior financing is most often prohibited. Even to further encumber a security
property with junior financing where the senior financing is held by a financial institution or a licensed lender
(or when the loan is FHA insured or VA indemnified), may require prior approval from the financial institution,
licensed lender, or applicable government agency because the existence of due on further encumbrance clauses
or similar provisions.

Packaged or Mixed Collateral Deeds of Trust or Mortgages

A package or mixed collateral deed of trust or mortgage involves a loan on real property that is secured by
more than just the land and improvements thereon. It may include fixtures (appliances, carpeting, drapes, and
air conditioning units) as well as other items of business or household personal property. As a cautionary note,
MLBs are not licensed to make or arrange loans to be funded by private investors/lenders secured by business
or household personal property. This restriction does not apply to depository institutions or certain licensed
lenders, i.e., the California Finance Lender (CFL).

In California, the license that specifically authorizes making and arranging loans secured by business or
household personal properties are issued under the Finance Lender Law to CFLs. In loan transactions where
business personal property represents an essential part of the security for the real property loan, MLBs should
seek the prior advice of knowledgeable legal counsel prior to proceeding.

Blanket Deeds of Trust or Mortgages

A blanket deed of trust or mortgage is a loan which covers more than just one parcel of property. Usually, the
loan contains a “release clause” providing for release of a particular parcel upon the repayment of a specified
portion of the loan. Typical use of blanket security instruments is in connection with subdivisions of homes
built on speculation.

Initially, one blanket deed of trust covers the entire subdivision or the particularly defined and authorized unit
or phase of the subdivision. Releases from the blanket encumbrances may not occur until the
developer/subdivider/builder has complied with the requirements imposed pursuant to the Subdivision Map Act
and, if a common interest development (as defined), with the requirements of the Subdivided Lands Law. The
Subdivision Map Act is found in the Government Code commencing with Section 66411. This law delegates
primary responsibility of regulating the development of residential subdivisions to local government (cities and
counties). Each condition imposed by local government as a prerequisite to issuing the required entitlements
and authorizing the development of a residential subdivision must be met or satisfied in an acceptable manner
prior to releasing from the blanket financing any individual lot or parcel within the subdivision, or the
authorized unit or phase thereof.

The Subdivided Lands Law is found in the Business and Professions Code commencing with Section 11000.
The regulatory and enforcement oversight of this law is the responsibility of the DRE. Prior to releasing any lot
or parcel within a subdivision from the blanket financing, compliance with the requirements of the Subdivided
Lands Law must occur, including the issuance of the Public Report, or in accordance with an applicable
exemption from such required issuance.

It is unlawful to sell, offer to sell, lease or offer to lease, finance or offer to finance any lot or parcel of real
property or commence construction of any building for sale or lease (except for model homes), or to allow any
occupancy of a lot or parcel within the subdivision until a final map has been recorded in full compliance with
the Subdivision Map Act. It is also unlawful to sell or offer to sell, lease or offer to lease, or to finance any lot
or parcel in a subdivision subject to the Subdivided Lands Law without compliance with this law (including
notice to the Real Estate Commissioner of the provisions of such financing). Further, the issuance of a Public
Report or an Amended Public Report by the DRE must first occur prior to offering any lot or parcel for sale or
for lease unless an applicable exemption exists for such required issuance (Business and Professions Code
Section 11000 et seq.).

The manner in which blanket financing/encumbrances are handled in common interest developments is also
subject to the Subdivided Lands Law. The statutory penalties for violating these provisions may result in fines,
in jail or prison terms, or both not to mention discipline of the real estate licensee who may be acting in an
agent or in a principal capacity (or both) in such transactions (Business and Professions Code Sections 11013 et
seq. and 11023).

Open-End Deeds of Trust or Mortgages

An open-end deed of trust or mortgage involves a loan arrangement whereby additional amounts of money may
be lent in the future (an advance) without affecting the priority of the security instrument. In California, the law
provides that additional advances retain the priority established by the recorded deed of trust or mortgage, if the
advances qualify as obligatory as opposed to optional (Civil Code Sections 2882 and 2884).

Construction loan advances made pursuant to construction loan agreements and evidenced by a construction
promissory notes and deeds of trust or mortgages are obligatory. For example, a supervised institutional or
licensed lender operating under government regulation and with sufficient net worth and reserves may well be
able to establish that the draws or voucher payments made during the construction period will retain the priority
of the recorded documents and instruments, including the construction loan agreements and deeds of trust or
mortgages. If properly documented, the same standards should apply to HELOCs.

MLBs should exercise caution when structuring land acquisition and development, vertical construction loans,
or HELOCs to adequately address the obligatory or optional advance issue and to establish under what fact
situation such loans may be partially funded or funded in stages by private investors/lenders. Partially funded
loans when relying on fractionalized note interests to be held by private investors/lenders pose significant
problems, including the loss of priority in connection with mechanic’s liens occurring during the staged funding
and the possible result of a “Ponzi” scheme (even if inadvertent). The question of advance fees also is at issue
when such loans are partially or staged funded. Partial or staged funding of construction or rehabilitation loans
are expressly prohibited in transactions subject to Business and Profession Code Section 10238(h)(4), the
“multi-lender” statutory “quasi-private placement” exemption from qualification under the Corporate Securities
Law of 1968.

Wrap-Around Deeds of Trust or Mortgages (Over-Riding or All-Inclusive Trust Deeds or AITDs)

A word of caution is required before discussing this type of financing. Prior to using this security instrument, it
is essential that an analysis of the existing financing (typically a conventional loan) be undertaken to learn
whether the deed of trust or mortgage includes due-on-sale or due on further encumbrance clauses. Most loans
made by depository institutions or licensed lenders, including FHA insured or VA indemnified loans, contain in
their loan documents (promissory notes and security instruments), acceleration provisions that either include or
substantively describe due-on-sale or due on encumbrance clauses/provisions. These clauses preclude the
transfer of the security property to a new owner or the further encumbrance of the property by the owner
holding title without the existing lender’s prior approval.

Practitioners should be aware that the full implementation of the Federal Deposit Institutions Act of 1982
(Garn-St. Germain Act) has resulted in federal preemption of state law that restricted the right of lenders to
accelerate the maturity date of loans secured by real property (regardless of the maturity date set forth in the
loan documents) in the event the borrower either transferred the title to or further encumbered the security
property, as defined. This includes AITDs and real property sales contracts.

When the security property is an owner-occupied residence, certain exemptions from the exercise of this right
were included in the Garn-St. Germain Act. This preemption has limited the ability to lawfully use AITDs and
real property sales contracts. Implementing an AITD and a real property sales contract in violation of a due-on-
sale or due on further encumbrance clause may result in an allegation of fraud upon the existing creditor/lender
and/or professional negligence, including a breach of fiduciary duty. Accordingly, the advice of knowledgeable
legal counsel is recommended to ensure the transaction is being conducted lawfully and each party is receiving
what they intended and for which they bargained.

During periods of credit shortages and/or “tight-money,” it is may be impossible for some potential buyers to
qualify for conventional loans and for other borrowers to refinance existing loans secured by commercial real
estate (as defined) held for the production of income or for investment. Often the purpose for refinancing is to
raise additional capital or to improve the rate and terms of the financing. The opportunity to refinance may be
severely limited. For example, the existing loan may be “locked” precluding prepayment for a prescribed
period. Further, the existing loan may not be locked but may include a substantial prepayment penalty or
include a yield maintenance agreement that imposes substantial costs for the owner of the property at the time
of refinance or prepayment of the existing loan. In addition, loan-to-value ratios established by depository
institutions and licensed lenders may limit the ability to refinance. In such circumstances (among others), these
owners and their agents may elect to use an AITD as a means of further encumbering or selling the security
property.

An AITD, like a junior deed of trust or mortgage, should not disturb the existing loan, yet the debtor is able to
borrow an additional amount against the security property to obtain cash or to permit the sale of the property.
After the AITD has been arranged, the new lender typically assumes payment of the existing loan while
funding a new loan in an increased principal amount at a higher interest rate. The increased principal amount of
the AITD includes the unpaid principal balance of the existing loan plus the loan funds advanced (or the AITD
reflects the amount of the purchase price being “carried back” by the owner as the seller of the security
property).

The borrower makes payment on the AITD to the new creditor/lender that in turn makes payment to the holder
of the existing loan, which remains the senior encumbrance against the security property. Although the AITD
“wraps around” the existing loan, it is in effect a junior encumbrance that secures the repayment of the
debt/loan representing the difference between the unpaid balance of the existing loan and the principal loan
amount secured by the AITD. This method has also been used to finance a sale of real estate where the
purchaser has only a small down payment. In the case of a seller “carry back”, the AITD evidences the time
differential payment of the purchase price. The buyer/borrower executes an AITD to the seller who will collect
a larger loan payment from buyer/borrower, and the seller will continue to make payments on the existing loan.
The interest rate spread between the amount required under the AITD and the nominal rate on the underlying
promissory note evidencing the debt/loan results in an expected profit for the creditor/lender.

Pledged Savings Account Deeds of Trust or Mortgages

Under the pledged savings account loan, also known as the flexible loan insurance program mortgage, or FLIP,
part of the borrower’s down payment is used to fund a pledged savings account. The savings account is
maintained as cash collateral for the creditor/lender and a source of supplementary payments for the borrower
during the first (usually two) years of the loan. Interest on the account is typically paid to the borrower.

Pledged savings account loans are used by depository institutions as additional collateral to reduce otherwise
required equity or down payment for residential as well as commercial loans. Pledged savings accounts may
also appear in construction loans made by depository institutions as additional collateral to cover performance
of obligations that may include the payment of interest during construction.