SECURITY PACIFIC NATIONAL BANK, Plaintiff and Appellant, v. ANTON J. WOZAB et al., Defendants and Respondents.
No. S010502
Supreme Court of California
Nov. 29, 1990.
February 14, 1991
991
Lillick & McHose, Robert L. Morrison, Scott W. Carlson and Karen L. Heilman for Plaintiff and Appellant.
Gibson, Dunn & Crutcher and Dennis B. Arnold as Amici Curiae on behalf of Plaintiff and Appellant.
OPINION
EAGLESON, J.—A bank depositor owed a debt of approximately $1 million to his bank. The debt was secured by a deed of trust on the depositor‘s real property. Without first seeking to foreclose the security interest, the bank set off approximately $3,000 in the depositor‘s accounts in partial satisfaction of the debt. The debtor protested to the bank, contending the bank was required first to foreclose its security interest. The bank responded by reconveying the deed of trust to the debtor and then filing suit to collect the remainder of the debt.
The question before us is whether the bank‘s setoff without first foreclosing its real property security interest precludes this action by the bank to recover the balance of the depositor‘s debt. We hold the bank‘s action on the debt is not precluded.
FACTS
Defendant Anton J. Wozab was president and majority shareholder of Anco Fire Protection, Inc. (Anco). His wife, Dorothea Wozab, was an Anco director. Anco had a line of credit with plaintiff Security Pacific National Bank (the bank) in excess of $1 million. Anco also had demand deposit accounts with the bank. The Wozabs had a term savings account and demand deposit accounts with the bank. The Wozabs executed written continuing general guaranties to the bank for its loans or advances to Anco. The bank became concerned with Anco‘s financial condition and, after discussions between Anton Wozab and the bank, the Wozabs executed a deed of trust on their personal residence as security for their continuing guaranties.
The bank became concerned that Anco might file a bankruptcy petition. To reduce Anco‘s debt as much as possible, the bank set off $110,635.19 in Anco‘s demand deposit accounts and $2,804.82 in the Wozabs’ demand deposit and term savings accounts against Anco‘s indebtedness of $1,090,015.96, leaving due the bank a balance of $976,575.95. The bank exercised these setoffs without first foreclosing its real property security
The bank and the Wozabs entered into discussions as to the Wozabs’ liability under their guaranties. The Wozabs contended that, under the then recently decided case of Bank of America v. Daily (1984) 152 Cal.App.3d 767 [199 Cal.Rptr. 557], the bank‘s setoff constituted a waiver of its security interest in the Wozabs’ home. After considering the matter, the bank reconveyed the deed of trust to the Wozabs and filed the present action to enforce their guaranties, which became unsecured as a result of the bank‘s reconveyance. The bank alleged breach of the guaranties and sought to recover the unpaid debt of approximately $976,000.
The bank and the Wozabs filed cross-motions for summary judgment. The Wozabs contended the bank‘s setoff of their deposit accounts constituted not only a waiver of the security interest but also a waiver of the underlying debt (the personal guaranties). The trial court concluded the Wozabs were correct under Bank of America v. Daily, supra, 152 Cal.App.3d 767, and granted their motion for summary judgment. The trial court, however, expressed its strong disagreement with Daily, noting that it allowed the Wozabs to avoid paying a debt of almost $1 million. The court recommended that the bank appeal.
The bank did so, and the Court of Appeal affirmed. We granted the bank‘s petition for review.
DISCUSSION
1. Code of Civil Procedure section 726
The threshold question is whether the bank‘s setoff of the Wozabs’ accounts was improper under
A. Definition of “action”
Whether the bank‘s setoff was an “action” is answered by
The bank‘s setoff was not a “proceeding in a court of justice.” No court had anything to do with the setoff. It was therefore not an action within the meaning of
Despite the clear language of
B. Security-first rule
We first addressed the effect of this rule on a bank setoff almost a century ago in McKean v. German-Am. Savings Bank (1897) 118 Cal. 334 [50 P. 656] (McKean), in which a depositor‘s assignee sued a bank to recover the amount of the bank‘s setoff. As a defense, the bank contended the depositor‘s debt was due at the time of the setoff, that the setoff was against this indebtedness, and that the setoff was before the assignment. The plaintiff-assignee contended
Subsequent decisions without exception have followed McKean in construing bank setoffs to be subject to
The bank contends we should overrule McKean, supra, 118 Cal. 334, and its progeny. The bank relies primarily on
We also note the record before us does not indicate that the prohibition of bank setoff against a secured debt has caused significant problems for the banking industry. If the courts’ construction of
We reaffirm the long-standing rule that under
2. Effect of improper setoff
The more important question in this case is the effect of an improper setoff under
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
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
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
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
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
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
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
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. “It is the general rule that the language of an opinion must be
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. When a secured creditor sues only on the underlying debt without seeking to foreclose the security, he is precluded by
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
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
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
Allowing the bank to sue on the debt does not violate the two fundamental purposes of
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
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.
DISPOSITION
The judgment of the Court of Appeal is reversed with directions to remand this action to the trial court for further proceedings in accord with this opinion. The bank is awarded its costs on appeal.
Lucas, C. J., Panelli, J., and Arabian, J., concurred.
BROUSSARD, J., Concurring and Dissenting.—I concur in the majority‘s conclusion that plaintiff bank, as a secured creditor, violated the provisions
I
Although I concur in the majority‘s conclusion that the bank‘s exercise of a setoff against the debtor‘s nonsecured bank account violated
The majority start off on the wrong track by beginning its analysis with a discussion of whether the bank‘s setoff was an “action” within the meaning of
I believe the majority‘s analysis would be on sounder ground if it started from the general principles that govern the conduct of a secured creditor in collecting a secured debt. In Walker v. Community Bank (1974) 10 Cal.3d 729, 733 [111 Cal.Rptr. 897, 518 P.2d 329], Justice Sullivan, writing for a unanimous court, briefly explained the most fundamental restriction that California law places on a secured creditor: “In California, as in most states, a creditor‘s right to enforce a debt secured by a mortgage or deed of trust on real property is restricted by statute. Under California law ‘the creditor must rely upon his security before enforcing the debt. (Code Civ. Proc., §§ 580a, 725a, 726.) If the security is insufficient, his right to a judgment against the debtor for the deficiency may be limited or barred by sections 580a, 580b, 580d or 726 of the Code of Civil Procedure.’ [Citation.]” (Italics added.)
As this passage from Walker v. Community Bank, supra, 10 Cal.3d 729, suggests,
Once it is understood that
Because of the pertinence of the McKean decision, it is worth quoting the relevant analysis of that decision at some length. The McKean opinion explained: “[T]he decisions of this court . . . mean that the mortgagee, whether a banking corporation or a private individual, must first look to the mortgaged premises as constituting the primary fund out of which the debt secured by the mortgage must be paid. . . . [¶] The reason of the rule that gives to banks the right to appropriate a deposit to the payment of the depositer‘s matured indebtedness does not apply where the bank has security for that indebtedness . . . . [¶] . . . [W]hen the legislature declared that there should be but one action to enforce a debt secured by mortgage, it did not mean that payment could be enforced against the consent of the mortgagor by giving a bank the right to enforce payment under a general banker‘s lien upon some other property, and that, too, without any legal proceedings whatever. The lien given on the mortgaged premises . . . was intended to be in lieu and exclusive of all implied liens. . . . [A] bank should [not] be given a right to forcibly, and against the consent of the depositer, appropriate his money, when, if it came into court to do so, the action would not lie. . . . [¶] The difficulty with [the bank‘s] argument is that it ignores the force and effect of
The McKean court‘s holding in this regard is no aberration and has been repeatedly and uniformly followed in subsequent decisions in the more than 90 years since the McKean decision. In Gnarini v. Swiss American Bank (1912) 162 Cal. 181 [121 P. 726], for example, the issue before the court was whether the defendant bank had acted improperly in closing a firm‘s account and applying the balance of the account to the amount due on a separate note. In posing the issue, the Gnarini court stated: “The plaintiff contends that the indebtedness represented by the note was secured by [a] mortgage, and that therefore the bank had no right to charge this note to the deposit account. It seems to be conceded—as indeed it must be—that if the mortgage . . . still subsists, and is security for the indebtedness represented by the second note, the bank had no right to apply the deposit to its payment. This was squarely decided in the case of McKean . . . , where it
In view of this long and unbroken line of decisions interpreting
While the majority properly recognize that the bank‘s exercise of a setoff violated
In view of the unwarranted advantages a bank may obtain if it improperly exercises such a setoff, it is important that there be adequate remedies both to compensate those who are injured by such conduct and to deter the bank from attempting to obtain such unjustified benefits in the first place. As noted at the outset, it is on the question of the appropriate remedies for the bank‘s misconduct that I part company with the majority.
II
Before reaching the specific aspect of the remedy issue on which I disagree with the majority—the question whether a secured creditor that has improperly exercised a setoff retains the right to pursue the balance of the
As discussed above, it is clear under the majority opinion that a bank that holds a secured debt has no right to collect that debt by setting off a nonsecured bank account of the debtor. If a bank improperly exercises such a setoff, it has unlawfully converted the debtor‘s funds. In such a case, the debtor always retains the option of bringing a tort action against the bank for (1) the return of the setoff funds, (2) interest, and (3) any consequential damages that the debtor has suffered as a result of being improperly deprived of the use of its funds. Although in the present case the debtor may not have suffered significant consequential damages, in other instances a debtor may suffer substantial damages as a result of being deprived of the proceeds of a personal bank account. There should be no question but that in a such case the debtor retains the right to pursue a tort action against the bank.
I emphasize this point simply to avoid any possible misunderstanding with regard to the majority‘s discussion of the debtor‘s tort remedy. In this case the bank has conceded that a debtor whose funds have been improperly set off in violation of
III
The question before us is whether the bank‘s violation of
I cannot agree that the appropriate alternative sanction for the bank‘s misconduct in this case is simply the loss of the bank‘s security interest, leaving the bank free to collect the remainder of its debt from all of the nonsecured assets of the debtor. In my view, restricting the remedy in this fashion is fundamentally inconsistent with the basic rationale of the security-first principle embodied in
As we have seen, in Walker v. Community Bank, supra, 10 Cal.3d 729, 733, this court set forth the basic principle that “a creditor‘s right to enforce a debt secured by a . . . deed of trust on real property is restricted by statute. Under California law ‘the creditor must rely upon his security before enforcing the debt. . . .’ [Citation.]” In Pacific Valley Bank v. Schwenke, supra, 189 Cal.App.3d 134, 140, Justice Brauer pointed out that the corollary to the rule requiring a secured creditor to exhaust the security before proceeding against the debtor personally is that “the debtor, by signing a note secured by a deed of trust, does not make an absolute promise to pay the entire obligation, but rather makes only a conditional promise to pay any deficiency that remains if a judicial sale of the encumbered property does not satisfy the debt. [Citation.]” (Italics added.) (See also Biddell v. Brizzolara (1883) 64 Cal. 354, 362 [30 P. 609].) In light of the conditional nature of the debtor‘s obligation to pay a secured debt from nonsecured assets, California cases have long made clear that a secured creditor enjoys no unilateral right to release or waive its security interest and thereby assume the status of an unsecured creditor with the right to proceed immediately against the debtor‘s nonsecured assets. (See, e.g., Barbieri v. Ramelli (1890) 84 Cal. 154, 156-157 [23 P. 1086].) Absent the consent of the debtor, a secured creditor cannot escape the statutory limitations on its right to pursue nonsecured assets of the debtor.
Given these well-established principles, the majority‘s conclusion, that when a bank violates
In fact, the majority go out of their way to qualify even their limited holding regarding the loss of the bank‘s security interest in a manner that substantially increases the risk that banks will exercise improper setoffs in the future. Although the majority hold that the debtor has the right to treat the bank as having waived its security interest when, as here, a bank not only improperly sets off a debtor‘s funds but retains those funds after the matter is brought to its attention, the majority, while purporting not to decide the issue, go on to suggest that if a bank that has improperly offset funds promptly returns the funds when the propriety of the setoff is challenged, it might be “excessive” to impose on the bank the limited sanction of the loss of its security, even when that sanction—rather than the return of the offset funds—is the sanction that the debtor seeks to invoke. (See, ante, p. 1001 & fn. 8.)
In light of this significant qualification of the majority‘s holding, a bank could rationally conclude that it faces little risk in improperly exercising a setoff against a debtor‘s nonsecured bank account. If the debtor is not aware of his rights and fails to object to the bank‘s conduct, the bank would be able to retain the improperly setoff funds with impunity. If the debtor is aware of his rights and brings the matter to the bank‘s attention, the bank can promptly return the funds to the debtor‘s account and potentially avoid any sanction. Thus, the qualification in the majority opinion largely eliminates any incentive a bank might have to ensure that its employees do not exercise a setoff in violation of the security-first rule.
These untoward consequences would be avoided if the majority, instead of attempting to fashion a truncated sanction for the bank‘s violation of
Contrary to the majority‘s suggestion, nothing in this court‘s decision in Walker v. Community Bank, supra, 10 Cal.3d 729, is inconsistent with this conclusion. In Walker, the debt in question was secured by both real and personal property of the debtor. When the debtor defaulted, the creditor brought a judicial foreclosure action against the secured personal property and in the same action also obtained a deficiency judgment; neither the debtor nor the creditor mentioned the real property security in that action. Thereafter, the debtor sold the real property to a third party, Walker. The creditor then commenced foreclosure proceedings against the real property, but the new owner of the property filed an action to enjoin those proceedings and to quiet title, contending that the creditor, by failing to exhaust the real property security before obtaining a deficiency judgment against the debtor, had waived its right to foreclose on the realty. In Walker, supra, 10 Cal.3d 729, we sustained the new owner‘s contention, holding that “where . . . there is a single debt secured by both real and personal property and the creditor elects to judicially foreclose only on the personal property, he thereby loses his security interest in the real property as against all parties even though the debtor does not raise the one form of action rule (§ 726) as affirmative defense in the judicial foreclosure proceedings.” (10 Cal.3d at p. 741.)
In contending that Walker v. Community Bank, supra, 10 Cal.3d 729, suggests that the bank in this case should lose only its security interest and not its ability to collect the balance of its debt, the majority apparently rely on the fact that while Walker prohibited the creditor from judicially foreclosing on the property, the decision at the same time expressly noted that “[t]he Bank may, of course, levy execution upon any of [the debtor‘s] property in order to satisfy the deficiency judgment.” (10 Cal.3d at p. 741, fn. 6.) The majority suggest that because the Walker court did not find that the creditor‘s violation of
In the present case, by contrast, the bank, by unilaterally setting off the debtor‘s nonsecured bank account, collected a portion of its secured debt from nonsecured assets without giving the debtor any opportunity to forestall the taking of such assets by the interposition of a
It is true that, on the facts of this case, the traditional sanction for a
I would affirm the judgment of the Court of Appeal.
Mosk, J., and Kennard, J., concurred.
Respondent‘s petition for a rehearing was denied February 14, 1991. Mosk, J., Broussard, J., and Kennard, J., were of the opinion that the petition should be granted.