SANTA CLARA UNIVERSITY
SCHOOL OF LAW

MIDTERM EXAMINATION

Secured Debt
Professors Mertens and Neustadter
December 12, 1996

4 Essay questions; 3 hours

Instructions

1. All questions are based on an initial set of basic facts. Each question adds to or varies the basic facts.

2. The total number of points on the exam is 90. (Recall that the quiz was worth 10 points.) The number of points allocated to each question is indicated. Budget your time accordingly.

3. Please answer each question in a separate bluebook if you are writing the exam, or start the answer to each question on a separate page if you are typing the exam or using a computer. Write on one side of the page only. If your handwriting is difficult to read, skip lines.

4. Think through a question and organize your answer before you start to write.

5. If a question is ambiguous in any material way, point out the ambiguity and explain how resolution of the ambiguity would affect your answer.

6. Assume any deed of trust or security agreement contains standard clauses. All transactions take place in California. Where the U.C.C. is applicable, apply the California version. Remember that the version of the U.C.C. in our materials is the California version.

Basic facts

Sam Seller, a 55 year old shop keeper, decided to retire. Seller owned a parcel of real property improved by a two story building. The bottom story of the building was his grocery store. The top story of the building was his residence. He has operated the grocery store for the past thirty years. The zoning ordinance governing the area requires single-family residential use only, but Seller's use of the building, which had pre-dated the adoption of the zoning ordinance, was grandfathered as a non-conforming use. Accordingly, Seller and any subsequent owner of the real property may continue to use the building in the same manner so long as no substantial changes in the structure occur.

When Seller decided to retire, he needed to sell the real property in order to generate some income on which to live. As you can imagine, the market was limited, but he finally found a buyer -- Ben Buyer. Buyer agreed to pay $500,000, although the building had been appraised for $425,000 when it first went on the market six months earlier. Buyer paid $25,000 down and Seller agreed to carry back $475,000 of the purchase price secured by a first deed of trust on the building. The sale was "As Is".

A year after taking over the grocery store and moving into the residence above, Buyer decided to remodel both floors of the building. After obtaining plans and specifications from an architect, he solicited bids and selected a contractor who bid the job for $400,000. Approximately 50% of the cost was allocated to remodeling the second floor residence and approximately 50% to remodeling the first floor grocery store. Buyer approached Seller with these plans and figures and asked if Seller would subordinate to a new loan in the amount of $400,000. Seller knew nothing about construction. He was a nice, albeit naive man, and agreed to subordinate.

Seller arranged the construction loan with Union Bank. After Union Bank obtained Seller's signature on a subordination agreement, Union Bank made Buyer the $400,000 loan secured by a deed of trust on the property. The escrow recorded both the deed of trust and the subordination agreement.

QUESTION ONE (25 points)

The remodeling began. The contractor discovered that there was asbestos in the ceiling and in the heating ducts of the second story residence and also found extensive and previously undetected termite damage in the walls of the second story residence. The only solution was to hire an asbestos-removal company for $25,000 to remove the asbestos, as mandated by the city building code, and to completely gut the interior of the residence to cure the termite problems. These unanticipated costs required Buyer to spend $300,000 of the $400,000 construction loan on the residence and cut back significantly on the remodeling of the grocery store. Buyer thought about sharing this information with Seller but decided not to for fear that Seller would somehow object to the reallocation of construction funds.

Midway through the remodeling process, a city inspector raised the question of whether the remodeling created "substantial" changes to the structure that could result in revocation of the building's non-conforming use status. The city thus issued a notice requiring construction on the first floor grocery store to stop and the grocery store to close pending the filing and processing of a formal request from Buyer for renewal of the non-conforming use status of the building. The City was very slow in considering the request and therefore Buyer, robbed of income from his grocery store, defaulted on both Union Bank's and Seller's notes.

Union Bank has begun a nonjudicial foreclosure and has served Buyer and Seller with a Notice of Default and Notice of Sale. The sale is scheduled for December 20, 1996. Seller, not understanding much of what is going on, has sought your advice. He wants to know what, if anything, he can do and what will happen if Union Bank holds its sale. Advise him fully about all of his options.

QUESTION TWO (15 points)

Assume that the City did not intervene to close the grocery store and that Buyer therefore did not default on the notes.

A customer of the grocery store, Ms. Clutz, injured herself severely when she tripped on some of the scaffolding put up by the contractor.  Buyer had no insurance coverage for the injury because, stretched financially by the loan payments on the construction loan, he had let his liability insurance lapse. While the contractor may be liable, Buyer's attorney has recommended that Buyer enter into a settlement agreement with Ms. Clutz to avoid long and expensive litigation.

Your client, Ms. Clutz, is interested in accepting Buyer's settlement offer of a $125,000 note, payable, with interest, over five years, but you recommended that she seek some security for the note. Buyer's wealthy grown daughter has offered her household goods, including a grand piano and some extremely valuable antiques and works of art, as collateral.

What will you advise Ms. Clutz about both the legal and practical considerations she needs to weigh in deciding whether to accept this improved offer?

QUESTION THREE (25 points)

Assume Ms. Clutz accepts Buyer's offer described in Question Two and assume that the security interest in the household goods of Buyer's daughter is lawful and enforceable. Buyer defaulted on his first payment under the settlement agreement. Pursuant to an acceleration clause in the note, Ms. Clutz declared the entire sum immediately due and payable and hired a repossession firm to repossess the household goods. Buyer's daughter was not home at the time the repossessors arrived but her husband gladly went around the house pointing out some antiques and one of three works of art which he was glad to unload. The repossessors took only the items which the husband voluntarily gave them.

Following the repossession, Ms. Clutz called the one local antique dealer within 25 miles of her home to see if the dealer would be interested in acquiring the repossesed goods. That dealer was interested and offered to pay $25,000. Because of her busy schedule, Ms. Clutz decided that she wanted to accept that offer without calling anyone else. She told the dealer that she would consummate the sale in one week, subject to exercise of the debtors' right to redeem following the giving of notice.

Ms. Clutz placed a proper notice of the intended sale in Buyer's mailbox 6 days before the sale was to be consummated. On the next day she placed the same notice in a stamped envelope, properly addressed to Buyer's daughter. Because her mail carrier regularly picked up mail from her residential mailbox, she attached the envelope containing the notice to that mailbox. However, the mail carrier had already visited her house that day and did not pick up the envelope until the following day.

Ms. Clutz sold the goods to the antique dealer for $25,000 as planned even though, earlier on the same day, Buyer's daughter called to complain vociferously about the repossession and to warn Ms. Clutz never to have anyone come to the daughter's house again. She used $1,000 of the $25,000 proceeds of the sale to pay the repossessors for the repossession, for their storage of the goods pending sale, and for their transportation of the goods to the antique dealer.

Ms Clutz has consulted you for advice. She wants the rest of her money. What is your assessment of her possible courses of action. If part of your analysis leads to the conclusion that she may recover a money judgment, we do not want you to spend any time discussing the tools or procedures for enforcing a money judgment.

QUESTION FOUR (25 points)

Re-read the Basic Facts and the facts in Question One. Assume that Union Bank's loan went into default as stated, and that the building was now basically a shell, obviously not worth anywhere near the $400,000 Union Bank lent to Buyer. However, Union Bank began to suspect that Buyer was hiding substantial assets and began diligently searching for these before commencing the foreclosure. It found, much to its delight, that Buyer had deposited the sum of $50,000 in one of Union Bank's branches in Venezuela. Union Bank immediately set off the amount in that account and then began its nonjudicial foreclosure in California.

Buyer has retained you to represent him, as he feels that this whole fiasco will be his financial undoing. He has told you that he will do whatever it takes (including going all the way to the California Supreme Court) to remedy the wrongs which have been inflicted upon him by Union Bank. How will you proceed? What arguments will you make? Evaluate your chances of success.

End of examination