Opinion ID: 2612486
Heading Depth: 1
Heading Rank: 5

Heading: Effect of improper setoff

Text: (7a) The more important question in this case is the effect of an improper setoff under section 726 on the underlying debt and security interest. The Wozabs contend the bank lost both its security interest and its right to recover the debt. The bank contends this drastic result is unwarranted and proposes three less severe remedies for an improper setoff: (1) In the bank's view, the fairest remedy would be to restore the parties to their respective positions before the setoff by requiring the bank to return the offset funds with interest thereon to the depositor's account. (2) In addition to return of its funds with interest, the depositor would be entitled to compensatory damages actually incurred as a result of the setoff. (3) At most, the bank should lose its security interest in the real property collateral but retain its right to collect the underlying debt. The California Bankers Association, appearing as amicus curiae in support of the bank, also argues against the double sanction of loss of the security and debt and contends loss of the security is by itself sufficiently drastic to deter improper setoffs. Before addressing the merits of these various approaches, we emphasize the narrowness of the issue before us. The improper setoff was brought to the bank's attention by the debtors' counsel, who contended it resulted in waiver of the security. The bank implicitly agreed (or at least conceded the point) and reconveyed the deed of trust to the debtors. A key fact for the present case that limits the scope of our decision is that the bank did not promptly return the amount of the setoff. We do not have before us a situation in which a bank has set off funds, perhaps inadvertently but in technical violation of section 726(a), and promptly thereafter returned them to the debtor's account. We therefore need not, and do not, decide whether the bank in that situation could subsequently proceed against the security interest over the debtor's objection. In this case the bank set off and retained the funds. [8] We do not have before us either an inadvertent setoff or one of negligible duration. Furthermore, the bank's voluntary reconveyance of the trust deed to the debtors eliminates as a practical matter the issue of whether the improper setoff in this case should be sanctioned with an involuntary loss of the security interest. This question was effectively mooted by the reconveyance. In light of the importance of the issue for future transactions, however, we think it important to note that the bank's voluntary reconveyance was an accurate reflection (and perhaps implicit acknowledgement by the bank) of the long-established rule as to the effect of an improper setoff. When a secured creditor violates section 726(a) by obtaining judgment on the debt before foreclosing upon the security, he is deemed to have waived the security. (pp. 997-998, ante ; Walker v. Community Bank, supra, 10 Cal.3d 729, 733-734.) By parity of reasoning, a creditor bank that violates section 726(a) by taking an improper extrajudicial setoff must be held to have waived the bank's security interest in its depositor's real property. ( Bank of America v. Daily, supra, 152 Cal. App.3d 767, 772.) As noted above, the bank contends this result is unduly severe. The bank argues that a fairer remedy for an improper setoff would be for a court to require the bank to restore the setoff funds to its depositor's account with interest and to award compensatory damages actually incurred by the depositor. We disagree because this alternative would deprive the depositor of the full measure of protection contemplated under section 726(a). One of the primary purposes of the one-action rule is to protect the debtor from having to defend against a multiplicity of actions. Under the bank's view, the debtor subjected to an improper setoff would be saddled with the burden of having to commence a court action to recover the setoff and his other damages. After the debtor prevailed in that action, however, the bank could then judicially foreclose on the security and obtain a deficiency judgment if the security were insufficient to pay the debt. The obvious problem with this result is that the debtor would have been subjected to a multiplicity of actions: bringing one to recover the setoff and defending another by the creditor. The bank's suggested remedy also ignores commercial reality. Unless the amount of setoff is quite substantial, the economics of modern litigation are such that the depositor will be unable to find counsel willing to commence and maintain a lawsuit to recover the setoff. This is especially egregious in the case of a bank setoff because the debtor's bank deposits  presumably his most liquid asset that he could use to obtain legal counsel  will have been placed beyond his reach by the bank itself. The debtor will also have suffered the dual burdens of having incurred substantial, and likely unrecoverable, legal fees and of having been required to suffer the often protracted delays of litigation just to recover funds that never should have been taken from him in the first instance. In short, requiring a depositor to seek affirmative relief (return of the setoff and compensatory damages) would provide little, if any, practical incentive for a bank to comply with section 726(a). The remaining issue before us is whether the bank's improper setoff requires a forfeiture of the underlying debt. As we shall explain, the law does not require that draconian sanction. Until the present case, no court had held that an improper bank set off resulted in loss of the debt. The earliest cases arising from an improper setoff did not even reach the remedy issue. In McKean, supra, 118 Cal. 334, the seminal case, the plaintiff (an assignee of the depositor) sued to recover $400 that had been deposited with the bank. The bank defended on the ground that the deposit had been set off against the depositor's secured debt. The court held that the setoff was invalid and that the bank was obliged under section 726 to bring a foreclosure action against the debtor before seeking to recover on the debt itself. The depositor was not a party to the action, and the court did not hold the bank had lost either its security interest or the underlying debt. To the contrary, McKean, to the extent it provides any guidance for this case, suggests the bank did not lose its right to enforce the debt. The same result obtained in subsequent decisions. In Gnarini v. Swiss American Bank, supra, 162 Cal. 181, and Woodruff v. California Republic Bank, supra, 75 Cal. App.3d 108, the courts held the setoffs were ineffective but did not hold or even suggest the debts were unenforceable. The remedy issue was first squarely addressed in Bank of America v. Daily, supra, 152 Cal. App.3d 767 ( Daily ). In Daily, a bank set off $10,412.50 from a debtor's checking account as partial payment of a promissory note secured by the debtor's real property. The bank then filed an action to foreclose on the secured property to recover the balance of the debt. Applying the rule of McKean, supra, 118 Cal. 334, and its progeny, the court held the setoff was a violation of section 726. The court then considered the question of the appropriate remedy for the violation. As in the present case, the bank in Daily, supra, 152 Cal. App.3d 767, contended the proper remedy would be to return the parties to their respective positions before the setoff. The court rejected this argument and held the bank had waived its right to foreclose the security. That was the necessary and correct result under section 726(a). (P. 1002, ante. ) The bank in Daily, however, was not seeking a judgment on the underlying debt, and the court did not have occasion to decide whether the bank was precluded from doing so. The Wozabs nevertheless rely heavily on Daily for their argument that the setoff waived the underlying debt. In reaching its conclusion as to the loss of security, the Daily court briefly quoted from a treatise: `The classic sanction against the creditor who fails to exhaust all his security for the same debt in a single action is harsh, yet it follows inescapably from the availability of but one action to the creditor  he waives the balance of the security and he waives any claim to the unpaid balance of the debt.' (152 Cal. App.3d at p. 772, italics added, quoting Hetland, Cal. Real Estate Secured Transactions (Cont.Ed.Bar. 1970) Antideficiency Legislation, § 6.18, p. 258.) Daily, supra, 152 Cal. App.3d 767, does not support the Wozabs' position. The cause of action in Daily was for foreclosure of the bank's security interest. Unlike in the present case, the bank was not seeking to recover on the debt. The court's brief quotation regarding the debt was clearly dictum. (8) `It is the general rule that the language of an opinion must be construed with reference to the facts presented by the case, and the positive authority of a decision is coextensive only with such facts.' ( Brown v. Kelly Broadcasting Co. (1989) 48 Cal.3d 711, 734-735 [257 Cal. Rptr. 708, 771 P.2d 406], quoting River Farms Co. v. Superior Court (1933) 131 Cal. App. 365, 369 [21 P.2d 643].) Daily did not decide whether an improper setoff requires forfeiture of the debt as well as the security interest. (7b) We are therefore confronted with an issue of first impression: Does an improper bank setoff result in the forfeiture of the underlying debt? We conclude there is no forfeiture. (9) When a secured creditor sues only on the underlying debt without seeking to foreclose the security, he is precluded by section 726(a) from proceeding against the security in a subsequent action. ( Salter v. Ulrich (1943) 22 Cal.2d 263, 268 [138 P.2d 7, 146 A.L.R. 1344].) The creditor is deemed to have waived his security. [9] The judgment on the debt, however, is unaffected by the creditor's failure to comply with the chronology required by section 726. (22 Cal.2d at p. 268.) Similarly, if a creditor has multiple security interests for a debt and proceeds against less than all of them in a judicial foreclosure action, in which he obtains a deficiency judgment, he cannot thereafter seek to foreclose the excluded security. ( Walker v. Community Bank, supra, 10 Cal.3d 729, 733-734.) In that situation, however, the creditor also has a judgment on the underlying debt. In this case the bank's setoff was not a judicial action, and the bank therefore did not obtain a judgment for the full amount of the debt (as in Salter v. Ulrich, supra, 22 Cal.2d 263) or for any deficiency after sale of the security (as in Walker v. Community Bank, supra, 10 Cal.3d 729). In both Salter and Walker the creditors failed to comply fully with section 726, but in both cases the creditors were allowed a judgment for the full amount of the debt. The only sanction was that the creditors lost their preferred position as secured creditors (in whole or in part) and were reduced to the status of unsecured creditors  a drastic sanction in the marketplace. (Bernhardt, Mortgages and Deeds of Trust (Cont.Ed.Bar 1989) 12 Real Prop. L. Rptr. 184, 186.) (7c) By parity of reasoning, the bank in this case also must be allowed to seek a judgment for the full balance of the debt. The particular facts of this case also demonstrate that allowing the bank to recover the Wozabs' debt is consistent with the purpose and operation of section 726. As we explained in Walker v. Community Bank, supra, 10 Cal.3d 729, the operation of section 726 is in large part within the control of the debtor. If a secured creditor brings an action on the debt before foreclosing the security, the debtor can interpose section 726 as an affirmative defense, thereby requiring the creditor to exhaust the security before he may obtain a money judgment against the debtor. If the debtor does not raise the statute as an affirmative defense, the creditor's action on the debt is allowed to proceed to judgment. The creditor, however, is precluded from thereafter foreclosing on the security. He is deemed to have elected his remedy. ( Id., at pp. 733-734; Roseleaf Corp. v. Chierighino, supra, 59 Cal.2d 35, 38-39.) When the bank set off the Wozabs' account, they were in the same functional position as a debtor defending a judicial action on the debt. They could have demanded that the bank proceed against the security before resorting to their personal assets, i.e., their bank deposits. Instead, they notified the bank that in their view the setoff had waived the security interest. The Wozabs then accepted the bank's reconveyance to them of the deed of trust. (The record does not reflect that the Wozabs ever requested a refund of the setoff.) By doing so, they voluntarily relinquished the protection of the security-first rule. Put plainly, the bank erred in taking the setoff. For reasons unknown to us  personal, economic, or otherwise  the Wozabs seized the opportunity to reclaim their deed of trust, preventing the bank from first proceeding against the security as required by section 726. We find no merit in the Wozabs' belated claim that the bank should have foreclosed before seeking a personal judgment. The Wozabs acquiesced in (indeed, demanded) the bank's decision not to foreclose. This is consistent with the rule that a debtor can waive the protection of section 726 by failing to insist that the creditor first proceed against the security. ( Salter v. Ulrich, supra, 22 Cal.2d at p. 268.) Acquiescence in error takes away the right of objecting to it. (Civ. Code, § 3516.) To allow the Wozabs now to claim they were deprived of the benefits of the rule would be to encourage gamesmanship  demanding reconveyance of the security and then demanding that the creditor resort to the security. The two demands are mutually inconsistent. (10) Allowing the bank to sue on the debt does not violate the two fundamental purposes of section 726: (1) preventing a multiplicity of law-suits against the debtor, and (2) requiring exhaustion of the security before a resort to the debtor's unencumbered assets. The present action is the only lawsuit against the Wozabs, and they freely chose not to have the bank foreclose upon the security interest. (7d) Finally, the result advocated by the Wozabs  allowing them to evade their debt almost in its entirety  would be a gross injustice to the bank and a corresponding windfall to the Wozabs. (Mertens, California's Foreclosure Statutes: Some Proposals For Reform (1986) 26 Santa Clara L.Rev. 533, 555 [noting unfairness of this result].) They voluntarily executed their personal guaranties and the trust deed to further their substantial business interests. They promised to pay, if necessary, the money loaned to their business for their benefit. They induced the bank to rely on this promise by executing the deed of trust. The Wozabs got what they wanted, money for their business. They now want to deprive the bank, however, of its benefit of the bargain. They have their property free and clear of the security interest and thus far they have avoided the debt almost entirely  having paid only $2,804.82 and leaving unpaid a balance of $976,575.95. Such result would violate the notion of simple morality that He who takes the benefit must take the burden. (Civ. Code, § 3521.) Moreover, the result advocated by the Wozabs is so harsh as to be punitive. It would constitute a penalty against the bank 300 times greater than the amount of the setoff. One commentator observed of this result, To force a bank to forfeit nearly $1,000,000 because it mistakenly attempted to apply $3,000 in a deposit account to a secured debt is unreasonable. In fact it is downright silly. (Munoz & Rabin, The Sequel to Bank of America v Daily: Security Pac. Nat'l Bank v Wozab (Cont.Ed.Bar 1989) 12 Real Prop. L. Rptr. 204, 210.) We agree. The result we reach is also fair and workable in future cases. Because a debtor can object to an improper setoff and require the bank to return it and proceed first against the security interest, a bank cannot unilaterally waive its security interest by taking an improper setoff and then proceeding directly on the underlying debt. The debtor retains the right to require the bank to return the improper setoff and proceed against the security interest before the bank attempts to recover on the underlying debt. Of course, if the bank refused the debtor's demand and retained the setoff funds, the security-first rule (pp. 1001-1002, ante ) would preclude the bank from foreclosing the security interest or proceeding on the underlying debt. Conversely, if the bank complied with the debtor's demand to return the funds and to proceed first against the security, the debtor could not thereafter assert that the bank had waived its security interest.