Court Ruling Puts Second Trust Deeds in Doubt

For many years investing in second trust deeds has been a popular means for individual investors to increase their return over that obtainable in alternative investment opportunities.

For smaller investors to participate in the second trust deed market, typically the trust deed has been divided and sold in fractional shares, often with the seller of the trust deed enhancing the investment by issuing its own guarantee to the investor to further collateralize the trust deed.

Unknown to most real estate professionals, and small investors, is the existence of bankruptcy case law that may render such practices fatal to their real estate secured investment, leaving them with nothing more than a general unsecured claim should their trust deed seller and guarantor file bankruptcy.

This may be true even if the investors have properly recorded trust deed assignments and title insurance naming them as the legal holder of the fractional interest in the trust deed.

Many hundreds of second trust deed holders are learning this financially devastating lesson in the $100 million Property Mortgage Co. bankruptcy currently pending in Los Angeles. Instead of being able to remove their trust deed investments from the tangled web of the bankruptcy proceedings, these investors, who believed for many years they were the legal owners of their trust deeds, are now facing challenges to their investments, and possibly even direct litigation, by the very debtors who sold them and guaranteed these investments, as well as the unsecured creditors of Property Mortgage, seeking to claim a share of these investments for themselves.

The root of these legal troubles is an obscure bankruptcy case called In re Lendvest Mortgage Inc. decided by the U.S. 9th Circuit Court of Appeals Bankruptcy Appellate Panel in 1990. In essence, the court held that where the trust deed investor did not have physical possession of the note, and the note was guaranteed by the seller of the trust deed, the investor never had the “risk of loss,” and accordingly, even though the documents reflected the transaction as a “sale” of the loan to the investor, the court re-characterized the transaction as a “loan” by the investor to its seller which, being “unperfected,” rendered the hapless investor as a mere general unsecured creditor of the bankrupt mortgage company.

In view of these serious legal dangers to their investments in the context of bankruptcy law, holders of second trust deeds should give serious thought to the following steps:

--Cancel any guarantee of repayment that was issued by the trust deed seller or its affiliate.

--Try to take physical possession of the original note. Should that not be feasible due to the number of co-owners of the note, then try to designate one of the co-owners to hold the original note as agent on behalf of the others and prepare an agency agreement setting forth the fact that the note is being held by this co-owner as agent for the others.

Under no circumstances should the seller of the note, or its affiliate, be permitted to retain physical possession of the original note.

--Be sure an assignment of the trust deed is properly recorded in favor of the new owner(s).

--Obtain from the title insurance company an appropriate endorsement (CLTA Form 104 or one of its variations) insuring that there has been a valid assignment of the trust deed to the new co-owners.

--Carefully review with their attorney the effects of Lendvest and certain other related bankruptcy cases on their respective trust deed investments.

Taking these steps in light of the Lendvest decision can save one’s entire trust deed investment should it become embroiled in bankruptcy litigation.