In this time of economic hardship, and with the commercial real estate sector under extraordinary stress, lenders, borrowers and their respective lawyers need to be fully aware of the proper interplay between receivership and foreclosure under Texas law.
Such consideration is especially important so that financial institutions and their legal advisors know their options and encourage courts to appropriately defer to the legitimate rights of creditors under Texas law and as established by the Texas Supreme Court in the First Southern case over three decades ago.
Background: First Southern
In January 1966, Jerry and Jennye Darnell bought real property situated in Harris County. When they did, they delivered a purchase money note to the sellers in the original principal amount of $21,000.
For seven years, the Darnells dutifully paid their obligations under the note. The Darnells eventually filed for divorce. In connection with that proceeding, a receiver was appointed in April 1973 by a domestic relations court in Harris County to manage the Darnells’ assets.
In this time of stress, the Darnells, for the first time, failed to make a payment on the note. By then, they had paid the principal balance of the note down to approximately $7,000.
The holders of the note were, to put it kindly, unforgiving. The holders immediately commenced foreclosure proceedings. No demand for the missed payment was made, and no notice of acceleration was provided.
In the events to follow, one of the holders admitted that she knew that a receiver had been appointed to take possession of and administer the property. Despite this knowledge, no default notice and no foreclosure notice was provided to the receiver. Without the knowledge of the receiver, the property was foreclosed.
From these facts, the case of First Southern Properties, Inc. v. Vallone was born. The receiver sued to set aside the sale. He won.
The case went to the Texas Supreme Court, which noted the general rule that a receiver, once appointed, is an agent of the court that appoints him. “A receiver has been said to be an arm or instrumentality of the court, holding possession of property for the court which appointed him,” the court held. This is a rule that is well-known to creditors’ rights lawyers.
The implications of that rule played themselves out in First Southern, for an obvious question arose: If a court appoints a receiver to administer specific property, and if that receiver is an agent of that court in the course of such administration, can a third party simply, without notice, wrest such property from the possession and administration of such receiver (and, by extension, from the court)?
The Texas Supreme Court answered the question in the negative – a ruling born not just of common sense but which satisfied the interests of justice, given the facts of the case, recited above. The Court noted: “No one has authority, even under a prior deed of trust or execution, to sell property held in custodial legis by a duly appointed receiver, unless the sale is authorized by the court in which the receivership is pending.”
Though well-acquainted with the holding of First Southern, creditors’ rights practitioners in the State of Texas have sometimes failed to notice the wise words of the Texas Supreme Court in the decision’s final paragraph. While it is clear that the ruling in First Southern is one designed to promote a proper respect for the court that had appointed the receiver, the Texas Supreme Court emphasized that the holding was not meant to be unduly harsh to creditors holding legitimate rights as to the property subject to receivership:
“The apparent harshness of the custodial legis rule is tempered somewhat by the fact that a purchaser without actual notice under an execution or deed of trust sale is entitled to recover his money as was ordered in the present case. Furthermore, a receivership destroys no prior vested right, nor does it determine any right as between the parties by reason of an existing contract. The enforcement of a third party’s liens or other rights are merely suspended until their enforcement is approved by the court having custody of the property.” (Emphasis added.)
Thus, three rules emerge from First Southern:
- First, a receivership does not take from a secured lender its right to a nonjudicial sale of its collateral. Thus, absent injunctive relief entered against the lender or a bankruptcy filing which stays enforcement of rights and remedies, the lender, upon making its application to the receivership court for approval of a proposed trustee’s sale, is entitled to an order approving such sale.
- Second, a receivership does not alone determine any right as between a lender and its borrower under their existing contract. Thus, a secured lender is entitled to exercise of its contractual rights and remedies (including the right to a nonjudicial sale); the existence of the receivership does not act to determine the enforceability of any such rights. Again, if the secured lender’s contractual rights are to be impacted, that must occur via traditional legal means, such as an application for injunctive relief, satisfying the elements required for such relief. Absent that or a bankruptcy filing, the lender, upon making its application to the receivership court for approval of foreclosure, is entitled to an order approving such sale.
- And third, even though the receivership alone destroys none of a secured lender’s rights, and even though the existence of a receivership alone does not act to determine any of the rights between secured lender and borrower, the secured lender is required to notify the receivership court of the lender’s determination to proceed with a trustee’s sale, and to obtain the receivership court’s order to so proceed.
Judicial Developments Post-First Southern
Since First Southern, a number of borrowers have been eager to cast far too great a significance on the case, arguing that, if a receiver is appointed to administer property, a lender’s proposed foreclosure of that property effectively becomes “judicial,” requiring the lender to provide actual justification to the receivership court for its proposed foreclosure. The argument reverses the natural order of things, because it is a defaulted borrower’s burden to seek injunctive relief (and to provide evidence that the elements of injunctive relief are satisfied) in order to stop a proposed nonjudicial trustee’s sale of its property. Moreover, the argument ignores the critical final paragraph of the holding of First Southern, where the Texas Supreme Court emphasized that receivership, in and of itself, (1) divests a lender of none of its rights and (2) does not act to actually determine any contractual rights between lender and borrower.
One court citing to First Southern fell into this exact trap. In Texas Am. Bank / West Side v. G.O. Haven, a receiver was appointed to administer property that was subject to the bank’s lien. At the time of the appointment, the bank had already commenced foreclosure. The validity of the lien of the bank was not in dispute. The receiver nonetheless requested injunctive relief, so that the receiver might attempt to sell the property. The receivership court granted the injunction, and the bank appealed.
The decision on appeal did not address whether the receiver had carried its burden in obtaining injunctive relief; in fact, none of the elements were discussed at all in the decision. Instead, the Texas Court of Appeals in Fort Worth framed the issue as follows: “… whether a family law court has the authority to deny a secured party’s request for foreclosure when no dispute exists regarding the validity of the lien of the debt.”
The bank, of course, contended that the receivership court had no authority to simply deny the bank’s right to foreclose, which was correct, given that its right to foreclose validly existed under both the lender’s and borrower’s private contractual arrangement and Texas law. The bank also contended that any type of blanket denial of its foreclosure right (which could be effectuated by the court not entering an order approving the bank’s proposed trustee’s sale) effectively elevated the powers of the receivership court to the equivalent of a bankruptcy court.
To support its arguments, the bank cited Mussina v. Morton, a Houston Court of Appeals decision which had held that, even if a receiver had been appointed, there was no valid dispute over the bank’s lien or the note secured thereby. This meant that the party objecting to foreclosure had no likelihood of success on the merits – and thus was not entitled to any injunctive relief stopping the sale. Mussina in turn held that, if there were no valid basis to leave in effect injunctive relief, the receivership court had no authority to prevent the bank’s right to foreclose. Texas Am. Bank distinguished Mussina – unconvincingly – noting that the receiver in Mussina had not requested the injunctive relief in that case. Of course, the rationale of the Mussina court was correct – irrespective of who the actual applicant for injunctive relief was.
Having cast aside Mussina, the court in Texas Am. Bank then issued the following sweeping statement: “[T]he appointing court may then enjoin any interference with the property in the receiver’s hands.” By this, the Texas Am. Bank ruled that a receivership court could enjoin a secured creditor’s right to foreclosure until the receivership court was good and ready to authorize such a sale, unfettered by the restrictions of law applicable to the granting of injunctive relief. Texas Am. Bank thus cast aside the bank’s legal right to proceed to a nonjudicial trustee’s sale, concluding as follows:
… appellant argues that although the Vallone court (First Southern) held that a creditors’ rights are suspended, these rights remain suspended only until a request is made to the court for foreclosure. Appellant contends upon the making of such a request, the trial court may not enjoin enforcement of a creditor’s rights. Appellant offers no authority for this position, and we find none. Adoption of appellant’s argument would mean that a receiver appointed by a trial court would serve at the pleasure of a secured creditor.
The decision was overbroad. No one would argue that a receivership court “may not enjoin enforcement of a creditor’s rights” when that creditor requests approval to proceed to a trustee’s sale. Of course, a receivership court may do exactly that – so long as the elements of injunctive relief are presented and proven by the borrower or another party in interest with standing. What a receivership court may not do, however – and here First Southern is instructive – is destroy a lender’s right to proceed to a nonjudicial trustee’s sale only on account the receivership itself. This is because the receivership, in and of itself, does not destroy the lender’s right of nonjudicial foreclosure, and does not serve in any manner to determine the rights and obligations between lender and borrower as set forth in their private contractual arrangements. Texas Am. Bank professed to find no authority to support the bank’s contention that the bank was entitled to an order allowing it to proceed with foreclosure. But if the Texas Am. Bank court had heeded the findings set out in the final paragraph of First Southern, it would have found that exact authority.
One last observation: Texas Am. Bank need not have taken such offense to the notion of a receiver “serv[ing] at the pleasure of a secured creditor.” Absent validly entered injunctive relief, there is no reason for a receiver’s existence to preclude a secured lender from taking actions to which said lender is entitled to take under Texas law. This is true even when the receiver was appointed at the request of the lender. The right to the appointment of a receiver is routinely one that is bargained for by lenders who advance monies as part of commercial loan transactions. Receivership is a remedy of the lender – a means of protecting its collateral and the income it derives. Under Texas law, a lender is expressly authorized to pursue all of its remedies, either concurrently or consecutively. As stated in Vista Dev. Joint Venture II v. Pacific Mut. Life Ins. Co., “A secured party is never bound to a specific remedy against a defaulting debtor, but may select any action or combination of actions provided by agreement or law.”
Lessons for Lenders: The Proper Interplay Between Receivership and Foreclosure
Thus, a lender is entitled – and no offense need be taken by Texas courts – to first seek the appointment of a receiver and to thereafter proceed to a trustee’s sale (again, absent a validly entered injunction or a bankruptcy filing). And the same holds true irrespective of whether or not there is equity in the property to be foreclosed. Texas law contemplates the possibility of foreclosure even when there is equity in the property to be foreclosed, and expressly provides for a process of distribution of sale proceeds, in excess of the debt owed to the foreclosing lender, to junior lienholders and to the owner of the property. Under Texas law, the presence of equity in property to be foreclosed does not, alone, serve as grounds for injunction of a trustee’s sale.
(Ginther-Davis Center, Ltd. v. Houston National Bank states that “Appellants contend that unless the foreclosure sale is enjoined they will lose their substantial equity and investment in the property. … [E]ven if proven, such allegations would not in themselves be grounds requiring the issuance of an injunction.”)
Contrary to the protests of borrowers and their lawyers, First Southern does nothing to eliminate a lender’s right to proceed to a nonjudicial trustee’s sale, as authorized under Texas law, upon default by a borrower. Instead, First Southern commands a certain respect for Texas courts, by requiring that a lender provide notice to any court that has appointed a receiver of the lender’s intention to foreclose receivership property. Any other result would be to sanction a lender turning a blind eye to the authority of the court that has asserted jurisdiction over the lender’s collateral.
Further, the request for authorization provides notice to the constituents of the receivership estate of the lender’s intention to foreclose. From there, an offended party with standing may seek to enjoin the lender’s proposed sale. But, absent any such party carrying its burden of proof with respect to its motion for injunctive relief, the receivership court is to approve the lender’s request to proceed.
The existence of the receivership alone does not divest the lender of its rights, and the existence of the receivership alone provides no basis for the court to alter the existing contractual rights and obligations between lender and borrower. The extraordinary authority to do this without the need for an injunction lies elsewhere – in the bankruptcy courts.
Brett Anders is a shareholder and serves as chair of Polsinelli’s Financial Services Litigation practice group. He enforces the rights and remedies of both securitized lenders and traditional lending institutions in state, federal and bankruptcy courts across the nation, having worked out commercial real estate loans and appeared in courts in more than 40 states. He can be reached at banders@polsinelli.com or 816-360-4267.
James Billingsley is a Dallas-based shareholder in Polsinelli’s Financial Services Litigation practice group. In nearly 20 years of practice, he has navigated plenty of mazes in both courtrooms and boardrooms and has handled matters ranging from complex business and bankruptcy to commercial disputes, asset acquisitions and financial services matters. He can be reached at jbillingsley@polsinelli.com or 214-661-5541.