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What to do with a substantial windfall after the sale of an REO foreclosure property is likely a problem few mortgagees have faced since before 2008. However, as the market continues to improve in some areas, mortgagees will at least be comforted to know that they are not required to use such a windfall as a setoff against deficiency judgments obtained in foreclosure.  A new case out of the Second Appellate District makes clear that when a mortgagee obtains a deficiency judgment against a mortgagor in a foreclosure action, purchases the property a judicial sale, and then resells it to a third party for an amount in excess of the price paid at the judicial sale, the mortgagor is not entitled to a setoff in enforcement proceedings to recover the deficiency. Old Second National Bank v. Jafry, 2016 IL App (2d) 150825.

In Jafry, the bank obtained a judgment of foreclosure and sale showing an outstanding loan balance of $1,362,329. The bank was the only bidder at the judicial sale, obtaining the property with a bid of $900,000.

The court approved the sale and entered a deficiency judgment against the defendants in the amount of $577,876.  The bank then sold the property to a third party for $1,320,000. The bank also initiated collection proceedings against the defendants, seeking the full deficiency judgment amount of $577,876 plus interest.

The defendants sought an equitable setoff, requesting that the deficiency judgment be reduced by the difference between the amount the bank sold the property for and its winning bid at the judicial sale.  They argued that allowing the bank to seek the full deficiency essentially entitled them to a double recovery.  The trial court dismissed the petition, and the defendants appealed.

The appellate court based its decision upon the nature of the relationship between the mortgagee and mortgagor, and how it changes as the foreclosure action progresses. When a mortgagee acquires a certificate of purchase after a judicial sale, a new relationship is created, which is in no way dependent on, or influenced by, the prior contract between the mortgagee and the mortgagor. Id. at ¶11 citing Johnson v. Zahn, 380 Ill.  320 (1942).  Put differently, the foreclosure ends the mortgagor-mortgagee relationship, and transfers the rights, title and interest of both the mortgagor and mortgagee to the purchaser.

The court pointed out that the right to setoff is derived from either a contractual right or equity. Brannen v. Seifert, 2013 IL App (1st) 122067, ¶95. Since the foreclosure terminates the contractual relationship between the parties, there is no contractual right to setoff. The court found no equitable right either since a mortgagee has no right to increase its deficiency judgment if it ultimately sells an REO property for less than its bid. The court essentially reasoned that if the mortgagor is not liable for future losses, it should not be entitled to future gains.

The ruling should be welcome clarification for mortgagees, as it prevents a situation in which lender would have to account for the costs and reasonableness of its improvements to REO properties, as well as fluctuations in the real estate market. It also precludes the need for mortgagees to account for potential future setoffs in determining their bid amounts. Mostly, it is comforting to see the appellate court reach a decision that does not create another opportunity for defendants to extend the foreclosure proceedings and erode the finality of an order approving the sale.

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