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Obscure Loan Provision Can
Have a Big Effect on Liability

Lenders often cross state boundaries when making real estate loans. For example, a California lender may make a loan secured by New Hampshire real estate or a New Hampshire lender may make a loan secured by New York real estate. Institutional lenders nearly always have a set of standard forms. These forms usually provide that the law of the lender's home state governs the transaction. For example, a New York lender loaning money in New Hampshire will normally provide that New York law governs the transaction. In most cases, no one pays much attention to these provisions. However, a recent case has shown how important they can be.

The Law
The laws governing any given transaction can be divided into two categories: (1) procedural law, and (2) substantive law. If the particular issue of law is procedural, the law of the state where the case is heard (the forum state) will always apply. On the other hand, if the issue is substantive, the parties are free to choose the state whose law will govern so long as (a) that the state has some relationship to the transaction, and (b) the chosen law does not violate the public policy of the forum state.

Now that we know the ground rules, we need to see how they can actually affect a transaction.

The Case
In a recent case, an Arizona resident borrowed money from a California lender. The loan documents provided that California law would govern the transaction. When the loan went into default, the lender conducted a trustee's sale in Arizona and then sued for a deficiency judgment in an Arizona court. A suit for a deficiency is permissible under Arizona law, but is not permissible under California law following a trustee's sale (although it is acceptable following a judicial foreclosure). The Arizona court held that because the right to a deficiency judgment was substantive, rather than procedural, the parties' agreement that California law governed the transaction would be enforced. This meant that California law would apply to the Arizona lawsuit, and the lender had no right to a deficiency judgment! This is a case where a sophisticated lender, by insisting on the law of its home state, actually cost itself a deficiency judgment of millions of dollars.

The Lesson
The lesson of this case is clear. If you are a borrower or a lender engaged in an interstate loan transaction, pay close attention to the choice of law provision. The law governing enforcement of real estate loans varies greatly from state to state. This disparity in the laws means that a borrower or lender may be waiving valuable rights when he agrees to a choice of law provision without even knowing that he is doing so.

Therefore, when borrowing or lending money across state lines, it is always a good policy to check with counsel in the other state before agreeing on the choice of law provision so you know exactly what you are getting or giving up by doing so. If you do not, you may be in for a very expensive surprise.

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