Never going to give you up, never let you down, . . . (but I will run around and foreclose on you) – the Purchase Money Deed of Trust

Title note¹

We are seeing a number of “true” purchase money deeds of trust (“PMDT”), over the past few months, where the current owners of the property convey to a new owner in one deed, and simultaneously record a PMDT taking back a lien for the balance of the purchase price.  These kinds of “alternative financing” are risky and lawyers who attempt to use them must be extremely careful with setting them up and explaining the risks to their clients.

These “true” PMDTs are entitled to special protection as being absolutely first in priority; and also entail special risks, as the vendors, who set the purchase price, are not allowed to receive a windfall if the PMDT is foreclosed, and cannot file an action for a deficiency. The vendors must be satisfied with whatever the property brings at foreclosure as their full and final payoff because the N.C. General Statutes prohibit a creditor in a seller-financed purchase money real estate transaction (where the seller of the land and the creditor providing financing for the sale are the same person) from obtaining a judgment against the buyer for any unpaid debt. The theory behind this anti-deficiency statute is that the foreclosure of the real estate by the seller of the land puts the seller back in exactly the position they were in prior to the sale, making any monetary recovery against the buyer after the foreclosure an unfair windfall to the seller. ​While easy to understand in theory, the cumbersome wording of the statute makes understanding the application and scope of the statute difficult to interpret. N.C.G.S. § 45-21.38 reads as follows:

In all sales of real property by mortgagees and/or trustees under powers of sale contained in any mortgage or deed of trust . . . to secure to the seller the payment of the balance of the purchase price of real property, the mortgagee or trustee or holder of the notes secured by such mortgage or deed of trust shall not be entitled to a deficiency judgment on account of such mortgage, deed of trust or obligation secured by the same: Provided, said evidence of indebtedness shows upon the face that it is for balance of purchase money for real estate: Provided, further, that when said note or notes are prepared under the direction and supervision of the seller or sellers, he, it, or they shall cause a provision to be inserted in said note disclosing that it is for purchase money of real estate; in default of which the seller or sellers shall be liable to purchaser for any loss which he might sustain by reason of the failure to insert said provisions as herein set out.

The statute was enacted in the depths of the Great Depression, to provide a rudimentary form of consumer protection, especially for personal residences.  While many states limit application of their anti-deficiency statutes to cover only real estate which consists of a buyer/borrower’s primary residence, this particular statute is not so limited. It applies to any type of seller financed real estate sale including commercial property, primary residences, second homes, or farmland. See Barnaby v. Boardman, 313 N.C. 565, 330 S.E.2d 600 (1985). The anti-deficiency provisions of G.S. § 45-21.38 have been roundly criticized, especially where the purchase is of commercial property.  (See, for example 1 Webster’s North Carolina Real Estate Law (6^th ed. 2011) §13-46[1] at page 13-88, et. seq.)

For real estate lawyers, the risks of a true PMDT are even greater where the PMDT secures secondary financing (a second deed of trust, filed as a subordinate lien to the primary financing).  In Sink v. Edgerton, 76 N.C. App. 526, 333 S.E.2d 520 (1985), the North Carolina Court of Appeals held that the anti-deficiency statute applied to subordinate notes and deeds of trust and prevented suit on the note after the senior lien had been foreclosed.

Perhaps the clearest cautionary tale for extreme care in dealing with PMDTs to secure secondary financing is Cornelius v. Helms, 120 N.C. App. 172, 461 S.E.2d 338 (1995).  Although the case appears to be an attorney malpractice case, the facts arise from a dispute over a secondary PMDT.  Superior Court Judge Preston Cornelius and his wife owned property which they agreed to sell. The terms of the offer to purchase and contract called for Judge and Mrs. Cornelius to hold a first lien purchase money deed of trust on the property until the new buyer began construction on the lot.  After construction was begun, the Cornelius’ PMDT was to be subordinated to a 75% loan-to-value construction loan.  Unbeknownst to the Judge and his wife, the buyer had already agreed to a lot acquisition and construction loan from First Union Mortgage, and the closing attorney ended up closing both transactions simultaneously.  The PMDT securing Judge Cornelius and his wife was drafted by the attorney who represented the buyer.  The PMDT provided that it was subject to the deed of trust to be executed by the buyer to First Union. This requirement was contrary to the sales contract which specified that their contract would be subordinate only to an amount equal to 75% of the value of the construction improvements on the lot. 

Of course, the buyer defaulted, First Union foreclosed, cutting off the secondary PMDT, and Judge and Mrs. Cornelius had no recourse for their losses, except to allege malpractice on the part of the attorney who had drafted the PMDT and did not explain the ramifications of G.S. § 45-21.38 to the Judge and his wife.  The closing attorney contended that no attorney-client relationship existed between the Cornelius’s and himself, but this was rejected by the trial court and upheld by the Court of Appeals.  Since an attorney-client relationship existed between the parties, the closing attorney owed Judge Cornelius and his wife a fiduciary duty to render professional services in a skillful and prudent manner.

I always read this case with a good deal of sympathy for the closing attorney who thought he was only representing the buyer and did not “explain the legal effects” of the law to a sitting Superior Court Judge who was conveying the property. 

Some of the most dangerous transactions for real estate attorneys involve purchase money financing by the seller. Carefully consider the following practice pointers for seller financing transactions:

• Disclose in writing to all parties the nature of non-recourse financing as a result of N.C. Gen. Stat. § 45-21.38. Under this Anti-Deficiency Statute, the seller may foreclose in the event of a default but may not sue the borrower on the note (either in lieu of a foreclosure or in the event there is a deficiency still owed after the foreclosure sale). Accordingly, the seller must assess whether the buyer is an acceptable credit risk before accepting a purchase money deed of trust.
• Disclose in writing to the seller the legal ramifications of subordination requests.
• Clearly inform all parties in writing who you will and will not be representing in the transaction.
• Do not try and represent both the buyer and seller in a PMDT transaction. It is well worth the minimal fee you may lose to have separate counsel advising the other side.
• Do not attempt to use third-party guarantees to avoid the Anti-Deficiency Statute. They will not work.
• Do not incorporate extra land into the deed of trust as additional collateral (beyond what is being sold) and do not add personal property (such as stock) as additional collateral.
• Mark the note and deed of trust as “purchase money” on the face of the instruments. See N.C. Gen. Stat. § 45-21.38.
• Disclose the seller financing to other institutional lenders involved and clarify the lien priorities in writing.
• Do not allow the parties to split your fee as this can lead to an argument that you represented both parties in the closing.

Resist the temptation to represent both the buyer and seller where purchase money financing is involved. Send a non-engagement letter to the party you do not represent and advise that party to seek separate counsel for legal advice.

[1] Troy Crawford, our Managing Counsel at LM Title Agency, grew up in the 1980’s and therefore suffers from a very limited pool of musical references.  This article title is in homage to the great Rick Astley’s magnum opus from 1987, Never Gonna Give You Up.  This classic currently sits at #28 on VH1’s 50 Most Awesomely Bad Songs – Ever list and sparked the Internet Phenonium of Rick Rolling.