The California Court of Appeal recently held that a foreclosure by the beneficiary under a first deed of trust extinguished a junior lien, even though the beneficiary acquired the property by way of a deed in lieu of foreclosure prior to the foreclosure. In reaching its conclusion, the court grappled with the concept of "merger" of lien and title.

The borrower in this case owned real property subject to a first deed of trust and a junior mechanic’s lien. Facing foreclosure on the first deed of trust, the borrower gave the trust deed beneficiary title to the property by way of a deed in lieu of foreclosure. The grantee/beneficiary then foreclosed, purchased the property at the foreclosure sale, and later sold it to a third party. The holder of the junior mechanic’s lien subsequently filed suit to foreclose on its lien.

The mechanic's lienholder argued that its lien was not eliminated by the foreclosure of the trust deed because when the trust deed beneficiary accepted the deed in lieu of foreclosure, the two interests (as beneficiary under the trust deed and as grantee under the deed in lieu) merged, destroying the senior lien. The trial court agreed, finding the mechanic’s lien had priority and was not extinguished by the foreclosure of the trust deed.

On appeal, the California Court of Appeal reversed. The appellate court explained that when a senior lienholder accepts a deed in lieu of foreclosure, it is presumed that the lienholder does not intend for the senior lien and title to merge. Without such merger, the senior lienholder retains the power to foreclose and eliminate the junior liens. Also significant to the court was that the deed in lieu at issue expressly provided that the interest of the grantee under the deed in lieu shall not merge with the interest of the lender under the loan documents. Consequently, the appellate court concluded that there was no merger, the foreclosure was proper, and the foreclosure eliminated the junior mechanic’s lien. Therefore, the third party purchaser took title to the property free from the mechanic’s lien.

Although the same result may occur by operation of law, this decision may prompt lenders to strongly consider including an express provision in deeds in lieu that the interest of the beneficiary under the deed of trust, and the interest of the grantee under the deed in lieu, shall not merge.