A Chapter 11 debtor sued the holder of his deed of trust note on various grounds, including fraud, breach of an implied covenant of good faith and violation of housing regulation requiring a face-to-face meeting purportedly incorporated in the deed of trust.
After the debtor filed bankruptcy, he listed a home in his schedules, although he noted that he held legal title as a fiduciary under a family trust. On several occasions the bankruptcy court declined to deal with issues relating to the home on the basis that it was not property of the bankruptcy estate.
The court did confirm a plan of reorganization that contemplated sale of the property with payment of the secured claim in full. The court also approved employment of a broker for the sale. However, it declined to enter an order approving the sale free and clear of liens – again on the grounds that the property was not property of the bankruptcy estate.
The secured lender received ~$695,000 from the sale proceeds (which was less than the total amount owed), and the court approved payment of the broker’s commission. Subsequently the secured lender filed a proof of claim. When it did not respond to the debtor’s objection, the court entered an order disallowing the outstanding balance of the claim.
The debtor also sued the secured lender. Among other things the debtor attacked the secured lender’s status as holder of the deed of trust note – including whether it had a right to collect on the note and whether it was a creditor – as grounds for a fraud claim. However, he eventually abandoned these claims.
Another complaint was that the debtor sought a short sale of the property and was damaged by the secured lender’s delay of more than a year and half in approving the sale. This led to claims for breach of an implied covenant of good faith and fair dealing and for failure to comply with federal law as required by the deed of trust.
With respect to the implied covenant claim, the court noted that (1) applicable state law recognized an implied covenant of good faith in contracts, and (2) breach of the good faith covenant gave rise to a contract breach claim as opposed to a separate cause of action. (The court also commented in a footnote that one case held that the duty of good faith and fair dealing applied only in connection with UCC-related contracts, but then identified several other cases that dealt with the covenant in connection with non-UCC contracts.)
The court went on to stress that under applicable state law the covenant of good faith did not affect express contractual terms. If the parties create valid, binding rights, the covenant is not applicable to those rights. If an activity is governed by express contractual terms, no implied duty arises with respect to that activity.
Turning to the facts of the case, there was nothing in the deed of trust documents that obligated the secured lender to provide relief in the form of a short sale. Since the debtor did not have any reasonable expectation that it was entitled to this assistance, there was nothing that could have been frustrated by the lender’s alleged bad faith. Requiring the lender to accept a short sale would rewrite the terms of the note to require the lender to accept less than what it was owed.
The debtor’s right to receive the benefits of the contract – namely the financing that was already received – was not affected by the lender’s evaluation of the short sale. Rather the lender was entitled to refuse to release its lien until it was paid in full. The implied covenant of good faith could not overrule the express terms of the loan. Consequently, the court dismissed the bad faith claim.
Taking a different approach, the debtor also alleged that the lender violated a HUD regulation requiring it to conduct a face-to-face meeting with the debtor before three monthly mortgage payments became past due. In particular, the debtor argued that a general requirement in the deed of trust that the mortgage lender must comply with applicable federal law caused the HUD regulation to be incorporated in the deed of trust.
Although the debtor cited two state Supreme Court cases to support its position, the bankruptcy court read these cases as supporting the opposite conclusion. In its view, the cases required a specific reference to a regulation as a condition of incorporating the regulation into the mortgage. In this case there was no express reference to any regulation.
Further, the court noted that the documents indicated that the loan was insured by Fannie Mae or Freddie Mac, not HUD or FHA. Consequently the court concluded that the HUD regulation was not applicable federal law in any event.
Accordingly, the court dismissed the debtor’s lender liability counts claiming breach of the implied covenant of good faith and fair dealing and failure to comply with federal housing regulations as required by the deed of trust.
Although the lender won on these issues in the end, this result clearly was not a foregone conclusion. Just because a lender has discretion does not mean that it has absolute discretion – regardless of what the documents say.
Vicki R. Harding, Esq.