Avoiding Marshalling

Private lenders with cross-collateralized assets typically have extra security but face a unique challenge: junior lienholders who have no other source of assets from the same creditor can sue to force the lender into focusing on a different collateral or even get a court order on the sequence of collateral. This is known as marshalling of assets or the “two-funds rule.”

Although the junior lienholder may litigate this issue at any time, this typically occurs when a borrower is facing multiple separate defaults and a private lender who has not yet start foreclosure proceedings (or perhaps has) is now forced into court arguing over which foreclosures can be done.

What is Marshalling of Assets?

Civil Code section 3433 says “Where a creditor is entitled to resort to each of several funds for the satisfaction of his claim, and another person has an interest in, or is entitled as a creditor to resort to some, but not all of them, the latter may require the former to seek satisfaction from those funds to which the latter has no such claim, so far as it can be done without impairing the right of the former to complete satisfaction, and without doing injustice to third persons.”

In this context, a private lender who is cross-collateralized is therefore entitled to several funds but when there is a junior lienholder only tied to a single collateral, the junior lienholder can file suit.  Whether or not the private lender is foreclosing is irrelevant.

This is based upon a broad principle that the junior lienholder should not be dependent upon the private lender not strategically wiping out their claim when the private lender could go elsewhere (akin to preventing a blackmail situation).  All that is required are: (1) the two contesting parties are creditors of the same debtor; (2) there are two funds belonging to that debtor; and (3) one of them alone has the right to resort to both funds.  (Shedoudy v. Beverly Surgical Supply Co. (1980) 100 Cal.App.3d 730, 734.)  The Shedoudy case involved a bank account for a second judgment creditor but the principle is the same.

This is entirely an equitable principle and is only implied when it would not be unjust.  The main disputable issue is whether it is equitable, which is entirely an argument about the property values of the other collateral.  If there is no equity in the other collateral, it would be inequitable to force the private lender to go elsewhere.  If there is ample equity, a court may order it to prevent the junior lienholder from being wiped out.

Strategies to Avoid Litigation

To avoid this kind of unwarranted litigation, private lenders can consider several provisions in their loan documents:

• The most extreme advice would be to include a complete bar on junior liens on any collateral or notice and specific approval by the lender for any junior liens. Both options are not likely to be workable and may be unproductive on a practical level. 
  • First, the amount of additional irrelevant paperwork is not likely to be productive. Each junior lienholder would need to be checked against all the other properties to ensure that the junior lienholder has other funds which is not important to the private lender.
  • Second, a lender would always appreciate a borrower seeking a junior lien for repayment if they are default to the current lender and forcing a new loan agreement in this situation is more problematic than helpful.
  • Third, the lender would need to continually monitor all the collateral that is cross-collateralized and may repeatedly need to provide notice and threaten to foreclose on a good paying loan that is otherwise not problematic.
  • Fourth, a lender that ignores this provision may face problems if there is a need (or desire) to foreclose. This material non-curable breach is perfect for a foreclosure but the borrower may move to seek a temporary restraining order on the grounds of estoppel. Estoppel is an argument that the lender let the actions go unopposed for too long and could be used by a borrower as part of a temporary restraining order to jam up the foreclosure attempt.
  • Fifth, from a marketing and business perspective, this is likely to ensure that less borrowers seek out the lender just because of the additional unique and unnecessary chaos.
• Instead, consider a provision waiving marshalling in the loan agreement and ensure that this provision is recorded with a statement that it constitutes actual or constructive notice. A junior lienholder is therefore put on notice about suing.  This contractual provision would not override the statute but it would create a default by the borrower from which the lender (with the superior position already) can use to proceed ahead of the junior lienholder’s marshalling litigation.

Litigation Strategies if Sued for Marshalling

The most significant and complex issue is the values of the various collateral.  When the lender does not have a significant equity cushion in other collateral, then the lender will spend time and money arguing about property values to avoid being marshalled.  More often, the lender does have significant equity in other assets but seeks to maximize their leverage to voluntarily reconvey their lien (rather than by court order). 

Under Code of Civil Procedure Section 430.10(d), a party can demurrer to a complaint based on a defect or what is called a misjoinder of parties.  There are necessary parties and indispensable parties.

A necessary party is one that “claims an interest relating to the subject of the action and is so situated that the disposition of the action in his absence may (i) as a practical matter impair or impede his ability to protect that interest or (ii) leave any of the persons already parties subject to a substantial risk of incurring double, multiple, or otherwise inconsistent obligations by reason of his claimed interest. If he has not been so joined, the court shall order that he be made a party.”  (Code Civ. Proc., § 389(a)(2).) 

A party is indispensable based on a series of factors including “(1) to what extent a judgment rendered in the person’s absence might be prejudicial to him or those already parties; (2) the extent to which, by protective provisions in the judgment, by the shaping of relief, or other measures, the prejudice can be lessened or avoided; (3) whether a judgment rendered in the person’s absence will be adequate; (4) whether the plaintiff or cross-complainant will have an adequate remedy if the action is dismissed for nonjoinder.”  (Code Civ. Proc., § 389(b).)

The other junior lienholders have an interest related to the subject of the action (namely, the private lender’s order of cross-collateralization as that would add risk to their junior liens) and since the private lender is sufficiently cross-collateralized, the private lender has no interests in protecting the other junior lienholders.

Further, the junior lienholder(s) are not just necessary but indispensable parties to the case.  The plaintiff is then forced to include them into the case or face a court order dismissing the entire marshalling litigation.  While additional parties add costs to any litigation, this creates nuisance and delays for the plaintiff.  From there, the lender can then sit back and let the other junior lienholders (with a greater interest in becoming a priority on any foreclosure) spend the time and resources litigating which ensure that the plaintiff will want to remove the lender (and the other juniors) to proceed with any judicial foreclosure.

Closing Thoughts

Being forced to spend money in litigation to dispute the order of any cross-collateralization is the opposite purpose of being cross-collateralized but private lenders should be aware of this extremely nuanced risk.  Protective measure in the loan agreements can be done but if not, the best strategy is to make it more difficult for the plaintiff to proceed and force a settlement which can include a release of one lien in exchange for payment.