1111 PROSPECT PARTNERS v. SECURITY BANK OF KANSAS CITY (1995)

Petitioners 1111 Prospect Partners et al. (Debtors) defaulted on a note owed to real party in interest Security Bank of Kansas City (Lender).   Debtors had pledged both a trust deed and a letter of credit to secure repayment of the note, and Lender enforced its rights to both of those assets.

The issue on appeal is whether Lender violated Code of Civil Procedure section 726 ¹ by drawing on the letter of credit without first judicially foreclosing on the trust deed.   Debtors filed suit and recorded a lis pendens, alleging this course of action did violate section 726, and claiming the violation operated to forfeit any further rights held by Lender under the trust deed.   The trial court disagreed with Debtors' contention and concluded Lender was entitled to pursue nonjudicial foreclosure notwithstanding the previous draw on the letter of credit, and ordered Debtors' lis pendens be expunged.   Debtors petitioned this court for a writ of mandate, and after we denied the writ without comment Debtors sought review in the California Supreme Court.   The Supreme Court granted review, but thereafter returned the action to this court with directions to vacate the decision and “reconsider the cause in light of Stats.1994, chapter 611.”

Pursuant to the direction of our Supreme Court, we proceed to reconsider Debtors' claims in light of the new statutory enactment.

1. Factual and Procedural Background

The dispositive facts are undisputed.   In May 1991, Lender extended a loan to Debtors of over $8 million.   Debtors signed a promissory note and a loan agreement as part of the transaction.   As security for the note and loan agreement, Debtors gave Lender a trust deed encumbering the property, a security interest in all personal property and fixtures, and an “Irrevocable Standby Letter of Credit” (“the LC”) issued by First National Bank (“FNB”) in the amount of approximately $1.7 million.²

In October 1992, Lender gave Debtors notice of default and demanded payment of the past due interest.   Lender notified Debtors that if payment were not made, Lender would accelerate the note and exercise all of its rights under the loan documents, including presentation of a draft against the LC.   On November 16, 1992, Lender presented a demand on the LC, and FNB paid the full amount of the LC to Lender.

During December the parties negotiated an extension of the loan to February 28, 1993.   The extension recited that Lender “properly presented” its demand and draw on the LC.   The extension further contained language waiving the protections of the antideficiency legislation, including the provisions of section 726.

The loan remained unpaid past its extended date.   Lender reacted by nonjudicially foreclosing its trust deed, and the property was acquired on October 26, 1993.   Three days later, Debtors filed this lawsuit seeking declaratory relief and to quiet title to the property.   Debtors principally claimed that Lender improperly collected on the LC and that such improper action caused a forfeiture of Lender's right to foreclose on its trust deed.   On November 10, 1993, Debtors recorded their lis pendens.   Lender demurred to the complaint and moved to expunge the lis pendens.   Lender argued, among other things, that its draw on the LC was not a violation of section 726 and hence Lender's further action in foreclosing the trust deed was permissible.   The trial court agreed and granted the motion to expunge Debtors' lis pendens.³

 Debtors promptly petitioned this court for a writ of mandate and/or certiorari and requested an immediate stay.   On March 3, 1994, this court denied the petition without comment.   However, on direction by our Supreme Court, we now reconsider this matter in light of subsequent legislative action.⁴  We will conclude that when a secured party receives both a letter of credit and a trust deed as security for an obligation, the secured creditor may draw on the letter of credit and thereafter pursue non-judicial foreclosure of the trust deed without offending either the “one-action” or “security-first” principles of section 726.   We reach that conclusion both under the law as it existed at the time of the relevant events and because subsequent legislative action confirms our view of preexisting law.   We therefore conclude the trial court correctly expunged the lis pendens.

2. A Draw Upon a Letter of Credit Does Not Preclude Subsequent Nonjudicial Foreclosure of a Trust Deed Securing the Same Debt

 Section 726, subdivision (a) states:  “There can be but one form of action for the recovery of any debt or the enforcement of any right secured by mortgage upon real property․”  The import of this provision is that a secured creditor can bring only one lawsuit to enforce its security interest and collect its debt.  (Security Pacific National Bank v. Wozab (1990) 51 Cal.3d 991, 997, 275 Cal.Rptr. 201, 800 P.2d 557 (Wozab ).)   Section 726, subdivision (a) is part of a broader statutory scheme designed to protect debtors, which requires a creditor to rely first on his security before otherwise enforcing the debt.  (Walker v. Community Bank (1974) 10 Cal.3d 729, 733–734, 111 Cal.Rptr. 897, 518 P.2d 329.)   If a creditor violates section 726, the debtor may invoke the “sanction” aspect of section 726 against the creditor—that is, the debtor may force the creditor to forfeit the security interest in the realty.  (Wozab, supra, at p. 997, 275 Cal.Rptr. 201, 800 P.2d 557.)

Debtors argue that Lender's draw upon the LC before attempting foreclosure of the trust deed violated the protection afforded by section 726 and resulted in a forfeiture of the security.   They contend that a draw upon a letter of credit is an action similar to a demand upon a guarantor of debt which, they contend, constitutes an election which results in loss of the right later to proceed upon security for the guaranteed debt.

 We believe that the correct analysis of this issue starts with a review of the effect of section 726 upon a creditor holding “mixed collateral.”   A single debt can be secured by a security interest in more than one asset;  for instance, a debt can be secured by a deed of trust on real property and also a chattel mortgage on personal property.   It has long been recognized that in such case the creditor may proceed with nonjudicial forms of foreclosure on each of the pledged assets in serial fashion without violating the antideficiency laws.  (Freedland v. Greco (1955) 45 Cal.2d 462, 466, 289 P.2d 463 [creditor may nonjudicially foreclose on trust deed and then pursue personal property collateral];  Hatch v. Security–First Nat. Bank (1942) 19 Cal.2d 254, 258–262, 120 P.2d 869 [serial nonjudicial foreclosure of real and personal property collateral does not violate antideficiency or one-action rules].)

 The collateral here consisted of the realty and the “additional security” of Lender's right to draw on the LC.⁵  The draw on the LC did not violate the “one-action” aspect of section 726, because it involved no judicial activity by the creditor.  (Wozab, supra, 51 Cal.3d at p. 998, 275 Cal.Rptr. 201, 800 P.2d 557.)   The draw also did not violate the “security first” principles embodied in section 726, because Lender did not seize unpledged assets, but instead acted to collect on an asset specifically pledged as security for the debt.   Thus, we perceive no inhibition against nonjudicial realization upon an LC pledged as collateral followed by nonjudicial foreclosure of the trust deed.⁶  (Accord, Comm.Code, § 9501, subd. (4).)

Legal commentators are in accord in recognizing that a draw against a letter of credit followed by nonjudicial foreclosure of the trust deed is not barred by section 726.  (See Gregora, “Letters of Credit in Real Property Finance Transactions,” 9 California Real Property Journal No. 2 (Spring 1991) pp. 4–6;  Sheneman, California Foreclosure Law and Practice (McGraw Hill 1993) § 8.22, pp. 8:86–8:88.)   The core rationale of these commentators is that section 726 is designed to bar preforeclosure actions against the debtor which might threaten his unpledged assets.⁷

 A letter of credit is an asset created for the benefit of the debtor which is an obligation owed independently by the issuing bank (see Lumbermans Acceptance Co. v. Security Pacific Nat. Bank (1978) 86 Cal.App.3d 175, 178, 150 Cal.Rptr. 69).   When that independent asset is created as security, the secured creditor should be entitled to liquidate it without prejudice to his right to pursue nonjudicial foreclosure against other assets.

We believe that this view of the letter of credit as a form of security is supported by the recent legislation to which the Supreme Court referred in remanding the case for our further attention.   The Legislature enacted Senate Bill No. 1612 in 1994 to react to, and with the express intent of abrogating, Western Security.  (Stats.1994, ch. 611, § 5.)   The Legislation added two sections, 580.5 and 580.7, and amended two others, Civil Code section 2787 and Commercial Code section 5114.

Civil Code section 2787, which had abolished the distinction between sureties and guarantors, was amended by Senate Bill No. 1612 to declare that a letter of credit is not a form of suretyship obligation.   This declaration comports with the existing law which views a letter of credit as an independent obligation owed by the issuing bank rather than a form of guarantee or surety obligation.  (See, e.g., 2 White & Summers, Uniform Commercial Code (3d ed. 1988) “Letters of Credit,” § 19–2, pp. 812–816.)

Section 580.5 was added to declare specifically that when an obligation is secured by both a trust deed and a letter of credit, a draw against a letter of credit (whether before or after nonjudicial foreclosure) will not violate section 726 or create a prohibited deficiency judgment.

 The Legislature declared that its intent in enacting these provisions was to confirm existing law.⁸  Indeed, it adopted the statute as an urgency measure “in order to confirm and clarify the law” applicable to obligations secured by realty and a letter of credit.  (2 White & Summers,supra, at § 6.)   Although we are not bound by a legislative declaration that a statute merely confirms or clarifies existing law (In re Marriage of Reuling (1994) 23 Cal.App.4th 1428, 1439–1440, 28 Cal.Rptr.2d 726), we may certainly weigh the legislative declaration in evaluating the operation of the prior statutory scheme (Del Costello v. State of California (1982) 135 Cal.App.3d 887, 893, fn. 8, 185 Cal.Rptr. 582).   When a court must interpret a statutory scheme, a subsequent legislative enactment intended to clarify that scheme may be considered by the court in construing the operation of the pre-amendment statutory scheme.  (Tyler v. State of California (1982) 134 Cal.App.3d 973, 976–977, 185 Cal.Rptr. 49.)

Debtors contend that these statutory amendments operate to change existing law, and hence can be given effect here only if the Legislature intended the new law to apply retroactively.   This argument rests on the premise that existing law prohibits a draw on a letter of credit followed by nonjudicial foreclosure of a trust deed.   As noted above, we reject this argument.

We are not persuaded by the authorities on which Debtors rely.   Debtors cite Walker v. Community Bank (1974) 10 Cal.3d 729, 111 Cal.Rptr. 897, 518 P.2d 329 (Walker ) as supporting their position.   In Walker, the bank held security interests in both personal property and real property;  it judicially foreclosed on the personal property and obtained a deficiency judgment, and then sought nonjudicial foreclosure of the realty.  (Id. at pp. 732–733, 111 Cal.Rptr. 897, 518 P.2d 329.)   The court concluded this violated section 726 and waived the security interest in the realty.  (Id. at pp. 740–741, 111 Cal.Rptr. 897, 518 P.2d 329.)   Debtor's reliance on Walker is misplaced because of two critical distinctions between Walker and this case:  (1) the initial foreclosure in Walker was a judicial action, but a draw on a letter of credit is not a judicial action (the “one action” aspect of section 726);  and (2) the initial action in Walker did create a deficiency judgment against the debtor in favor of the secured creditor which could be enforced through seizure of unpledged assets (the “security first” aspect of section 726), but a draw on a letter of credit does not create such a deficiency judgment.

Debtors also contend that Lender, by drawing on the LC, engaged in conduct proscribed by Wozab, supra, 51 Cal.3d 991, 275 Cal.Rptr. 201, 800 P.2d 557 and Bank of America v. Daily (1984) 152 Cal.App.3d 767, 199 Cal.Rptr. 557 (Daily ).   In those cases the secured party was a bank, which commenced collection action by exercising a setoff against the debtors' general bank accounts.   As Wozab explained, the setoff violated the “security first” aspect (but did not violate the “one action” aspect) of section 726, resulting in waiver of the security interest in the realty.  (Wozab, supra, at pp. 998–1000 and 1004–1006, 275 Cal.Rptr. 201, 800 P.2d 557;  Daily, supra, at p. 773, 199 Cal.Rptr. 557.)  Wozab and Daily are inapposite.   The banks in Wozab and Daily seized unpledged assets of the debtor before seeking to realize upon the pledged assets, in clear violation of the “security first” principles.   Here, however, Lender adhered to the “security first” principles of section 726 by looking to a pledged asset (the LC) to satisfy the debt.

Debtors finally argue that drawing on a letter of credit is analogous to the type of conduct held to be improper in Union Bank v. Gradsky (1968) 265 Cal.App.2d 40, 71 Cal.Rptr. 64 (Gradsky ) and Commonwealth Mortgage Assurance Co. v. Superior Court (1989) 211 Cal.App.3d 508, 259 Cal.Rptr. 425.   In Gradsky, the secured creditor nonjudicially foreclosed on the trust deed and then sought to collect the unpaid balance from a third party guarantor.   The Gradsky court concluded the creditor could not pursue the guarantor based on estoppel principles.  Gradsky reasoned that the creditor, by nonjudicially foreclosing, had given the primary obligor a complete defense to any further obligation to pay on the note (by virtue of the operation of section 580d), and hence the creditor had destroyed the subrogation rights the guarantor would otherwise have possessed against the primary obligor.   (Gradsky, supra, at pp. 42–47, 71 Cal.Rptr. 64.)   Because the creditor had destroyed the guarantor's subrogation rights, the Gradsky court estopped the creditor from suing on the guarantee.

 Gradsky is distinguishable for a number of reasons, the principal one deriving from the nature of a letter of credit.  Gradsky gave the guarantor a defense to payment on the guarantee because the principal obligor had a defense (under section 580d) to further liability on the underlying obligation.  Gradsky permitted the guarantor to assert a defense which would have been available to the principal obligor as against the creditor.   However, a cardinal principle of a letter of credit—in fact its primary characteristic—is the “independence principle”:  on proper presentment, the issuer must pay (absent fraud) regardless of any present defenses which have arisen from the underlying transaction between the beneficiary and the party creating the letter of credit.  (See, e.g., Lumbermans Acceptance Co. v. Security Pacific Nat. Bank, supra, 86 Cal.App.3d at p. 178, 150 Cal.Rptr. 69.)   Thus, unlike Gradsky's guarantor, the issuer of a letter of credit is never entitled to defend against payment based on extraneous defenses which might have been available to the primary obligor.

Gradsky is also distinguishable because it addressed section 580d, and specifically noted that section 726 would not have barred the bank from pursuing the guarantor before nonjudicially foreclosing on the realty.   (Gradsky, supra, 265 Cal.App.2d at pp. 43–44 and fn. 3, 71 Cal.Rptr. 64.)⁹

The decision in Commonwealth Mortgage Assurance Co. v. Superior Court, supra, 211 Cal.App.3d 508, 259 Cal.Rptr. 425 is even less in point.   There the debtor provided the secured lender a trust deed and, as additional security, purchased a “mortgage guarantee” insurance policy (issued by CMAC) which insured payment of the note.   When debtor defaulted, the secured lender nonjudicially foreclosed the trust deed and then collected from CMAC on the policy.   The Commonwealth court evaluated whether CMAC, having paid on the policy, could seek reimbursement from the debtor under its indemnification agreement.  (Id. at pp. 512–513, 259 Cal.Rptr. 425.)   The court concluded the insurer could not collect from the debtor because of section 580d.   Commonwealth is irrelevant here because it does not address the rights of the secured party (i.e., whether the secured party can collect from the various assets pledged as security for the note) but instead evaluates whether the insurer/guarantor, having honored its obligation, may pursue the unpledged assets of the principal obligor.

We therefore conclude there is no persuasive authority contrary to the proposition we postulate:  that the draw on the pleged LC is analogous to nonjudicial foreclosure on mixed collateral that does not violate the “security first” principles of section 726.   We are convinced that this was the law before the recent legislation, but are nevertheless happy to cite and rely on the legislative pronouncements to the same effect.

DISPOSITION

The petition for writ of mandamus is denied.

FOOTNOTES

FOOTNOTE.  

1.    All statutory referencesare to the Code of Civil Procedure unless otherwise specified.

2.   In a separate transaction to which Lender was not a party, FNB required R. Michael Murphy (a general partner of Debtors) to execute a promissory note in favor of FNB to secure repayment of a proper demand under the LC.   As additional security, FNB obtained a guaranty from R. Michael Murphy secured by a trust deed on his house.   FNB also obtained a guaranty from William Jeffrey III (a limited partner in 1111 Prospect Partners), on whose house FNB already held a trust deed.

3.   Lender's motion to expunge contained other grounds.   Lender argued that Debtors, as part of the December 1992 extension agreement, had explicitly waived the protections of section 726, and had explicitly agreed Lender's draw on the LC was proper.   Lender also argued that to the extent the lawsuit purported to pursue claims by Jeffreys against Lender, Jeffreys had no standing to assert those claims.   While both of these arguments were cited by the trial court as additional grounds for expunging the lis pendens, the principal ground for the trial court's order was that Lender's draw on the LC was not violative of section 726.

4.   Although we previously disposed of this case in 1994 by peremptory denial of the petition, it has returned to us via a circuitous route.   After we denied the initial petition, Debtors petitioned for review in the Supreme Court, noting that another petition for review was pending in Western Security Bank v. Superior Court (1993) 25 Cal.Rptr.2d 908 (Western Security) which involved parallel issues, and arguing that if review were granted in Western Security then the Supreme Court should grant so-called “grant and hold” review (Cal.Rules of Court, rule 29.2(c)) in this matter.   On April 13, 1994, the Supreme Court did grant review in Western Security, and on May 12, 1994, it also granted review in this matter.However, during 1994, in response to Western Security, the California Legislature considered and adopted Senate Bill No. 1612 as an urgency matter.   That measure (enacted as Stats.1994, ch. 611) amended various sections of the Commercial Code, the Civil Code and the Code of Civil Procedure to declare definitively that a draw on a letter of credit would not trigger application of section 726.   Accordingly, the Supreme Court remanded both the present action and Western Security to their respective courts with directions to vacate the decision and “reconsider the cause in light of Stats.1994, chapter 611.”

5.   We perceive no substantive distinction between pledging a letter of credit and pledging a certificate of deposit.   Both forms of instruments represent undertakings by the issuing financial institution to pay funds from its assets on proper demand.   There appears little question that had Debtors pledged a certificate of deposit (rather than the LC) as additional security, Lender would have been entitled to realize upon the certificate of deposit and then nonjudicially foreclose on the realty.

6.   Although we have described the LC as “collateral,” we caution that we use the term “collateral” in its colloquial rather than technical sense, and our opinion should not be construed as holding an LC is “collateral” as defined by Article 9 of the Commercial Code.   We cite to and rely on cases such as Freedland v. Greco, supra, and Hatch v. Security First Nat. Bank, supra, not because an LC qualifies as “collateral” within the meaning of Article 9, but solely because Freedland and Hatch illustrate the principle that the “security first” aspect of section 726 is not offended when the creditor looks solely to pledged items to satisfy the debt.

7.   Other writers have come to a contrary conclusion based on the Western Security decision.  (See note “Western Security Bank v. Beverly Hills Business Bank:  The Vanishing Utility of Letters of Credit in Real Estate Transactions ” (1994) 31 San Diego.L.Rev. 775;  Murray, “What Should I Do With This Letter of Credit? ” (1994) 17 CEB Real Property Law Reporter No. 3.)   Since these writers premised their analysis on Western Security, which is no longer citable, we deem their conclusions of little present force.

8.   For example, the statute declared:  “It is the intent of the Legislature in enacting [section 580.5] to confirm the independent nature of the letter of credit engagement․  [¶] The Legislature also intends to confirm the expectation of the parties to a contract that underlies a letter of credit, that the beneficiary will have available the value of the real estate collateral and the benefit of the letter of credit without regard to the order in which the beneficiary may resort to either.”  (See Stats.1994, ch. 611, § 5.)   The legislative history reinforces the intent the bill was to be “declarative of existing law.”  (Bill Analysis, Sen. Bill 1612, Assem.Com. on Banking & Finance (June 28, 1994).)

9.   Post–Gradsky cases have suggested that when a debt is secured both by collateral pledged by a third party and by the realty of the primary obligor, the secured creditor could first liquidate the collateral pledged by the third party and thereafter nonjudicially foreclose on the realty of the primary obligor without offending Gradsky.  (See Krueger v. Bank of America (1983) 145 Cal.App.3d 204, 208–214, 193 Cal.Rptr. 322.)   Here, Lender pursued an analogous course of action:  It collected the third party pledge of funds and then nonjudicially foreclosed on the realty.

FROEHLICH, Associate Justice.* FN* Retired Justice of the Court of Appeal sitting under assignment by the Chairperson of the Judicial Council.

WORK, Acting P.J., and NARES, J.