In the case of U.S. v. Real Property at 2659 Roundhill Drive, Alamo, CA (9th Cir. (Cal.), 1999) ___ F.3d ___, 1999 DJDAR 10,713, the Federal Ninth Circuit Court of Appeal ruled that the relation back effect of a California nonjudicial foreclosure is effective against the relation back rules involved when the federal government "arrests" a parcel of real property as part of an anti-drug trafficking proceeding. This case illustrates the myriad pitfalls that are presented to owners, to lenders, and to purchasers at a trustee's sale when the property is part of an anti-drug trafficking proceeding. The case emphasizes the need for extreme care in reacting to notice that a property is part of an anti-drug trafficking proceeding, whether you are a lender or bidder considering whether to invest a large sum of money in purchasing the property at a trustee's sale.

The property was purchased by the Paytons in 1990, for $682,500. The Paytons paid $558,310 as a downpayment and placed a $300,000 first deed of trust on the property, obtained from World Savings & Loan Association. The deed of trust was recorded on January 24, 1993.

The federal government believed that the Paytons were involved in illegal drug trafficking activity, beginning in 1974, and that the proceeds from such illegal activity had been used for the down payment for the property. On October 5, 1994, the federal government filed a complaint for forfeiture of the property, under 21 U.S.C. ß 881(a)(6). On October 19, 1994, the government "arrested" the property, and recorded a notice of lis pendens in the recorder's office.

World filed a claim in the forfeiture action asserting an innocent lienholder interest worth $340,000, consisting of the loan principal plus interest due. The government did not dispute that World had a non-forfeitable $340,000 interest in the property, and in fact offered to pay off World's interest as soon as the government was able to sell the property. World refused this offer. Instead, inasmuch as the Paytons had stopped making payments on the World note, World commenced nonjudicial foreclosure proceedings.

The Paytons petitioned the court in the seizure action to stay the foreclosure. Both World and the U.S. opposed the motion, and the court denied the motion. In February, 1995, the court issued a stay, due to a pending bankruptcy action involving the Paytons. This stay was lifted on April 28, 1995.

World conducted the trustee's sale in May, 1995. The amount due to World at that time was approximately $340,000. The appraised value of the property at that time was between $590,000 and $625,000. The purchase price at the trustee's sale was $354,000. World retained the $340,000 due on the note, and interpleaded the remaining $14,000 in the Paytons' bankruptcy action. World withdrew its claim in the seizure action, and the purchasers at the trustee's sale ("the purchasers") submitted their claim in the seizure action.

The purchasers and the government filed cross-motions for summary judgment. The court ruled tentatively in favor of the government. Before the district court issued its final order, the purchasers obtained a court order allowing them to sell the property, providing that the sale proceeds would be deposited into an interest-bearing escrow account subject to the further jurisdiction and order of the court. The property was sold in 1997 for $423,363.79.

In January, 1998, the trial court granted summary judgment to the government. The court ruled that the government was entitled to the Paytons' interest in the property (the value of the property less the $340,000 World note). Thus, the court ruled that the government was entitled to $423,363.79, less the $340,000, i.e., approximately $92,000. The purchasers were left with $340,000, i.e., $14,000 less than what they had paid for the property. World and the purchasers appealed.

There were a number of significant procedural and substantial issues presented to the appellate court.

The government first argued that the purchasers did not have standing to be involved in the case. Drug trafficking property seizure cases are governed by the federal Admiralty Rules of procedure, which are different than the more traditional federal rules of civil procedure. Under the Admiralty Rules, a party who has a claim against property which is the subject of a drug trafficking property seizure case must file a claim within ten days of service of process, and must file an answer within 20 days of filing the claim. (Supplemental Rule, C(6).) There is an exception to the 10 day claim filing period, i.e., the claim must be filed within 10 days or "within such additional time as may be allowed by the court." (Id.) Thus, the district court has discretion to allow untimely claims or answers.

In this case, the purchasers first objected to the jurisdiction of the court. When the court ruled against them, some, but not all, of the purchasers filed claims within 10 days of the court's order and then filed answers about 6 months later. Despite this clear noncompliance with the requirements of Supplemental Rule C(6), the district court allowed the purchasers to proceed in the action. The 9th Circuit deemed this to be an exercise of the district court's discretion, as allowed by Supplemental Rule C(6), and rejected the government's argument on this point.

The purchasers argued that the district court lacked jurisdiction over the property after the trustee's sale. Their argument was basically that, after the trustee's sale, the district court merely had jurisdiction over the excess proceeds from the sale, and no jurisdiction over the property itself. The 9th Circuit rejected this argument. The steps necessary for release of the property from a seizure proceeding are set forth in Supplemental Rule C(5), which requires either a stipulation from the government to release the property from the court's jurisdiction or an order from the court releasing the real property for foreclosure and declaring the sales proceeds to be the new res, i.e., declaring the sales proceeds to be substituted for the property itself. In this case, no such order was made by the district court. Nor was there a stipulation by the government. Thus, the district court had in fact retained jurisdiction over the property.

The purchasers next argued that the government had "abandoned" the property by its active support of World Savings in opposing the Paytons' motion to stay the foreclosure and by failing to take any affirmative steps to stop the foreclosure. The 9th Circuit noted that, throughout this process, the government continued to assert its intention to pursue forfeiture of the property. The 9th Circuit rejected the purchasers argument.

The purchasers next argument was to the effect that the California relation-back rules provided them with clear title to the property. Under California law, the interest of a purchaser at a trustee's sale "relates back" to the time the original deed of trust was recorded. In this case, the trustee's sale occurred in May, 1995, but the purchasers' title 'related back' to the date the deed of trust was recorded, i.e., January 22, 1993, before the government initiated forfeiture proceedings.

However, the 9th Circuit pointed out that the government had a "relation back" statute of its own on which it could rely. The forfeiture statute provides that all "right, title, and interest in [forfeited] property" shall vest in the government upon commission of the act giving rise to forfeiture. (21 U.S.C. ß 881(h).) In other words, the government's interest in the property would "relate back" to the time that the Paytons started their allegedly criminal behavior. In this case, the government had alleged that the Paytons drug trafficking activity commenced in 1974, long before the Paytons bought the Roundhill property and, therefore, long before the World Savings deed of trust was recorded against the property. The district court had relied upon this provision when it ruled that the government's interest in the property had priority over the purchasers' interest in the property.

The 9th Circuit pointed out, however, that relation back does not take effect until a judgment of forfeiture has been entered. In this case, the trustee's sale took place prior to any judgment of forfeiture had been entered. In this circumstance, the purchasers were considered to be "innocent purchasers". Since no judgment of forfeiture had been entered, the government's claim was based solely on the lis pendens that it had recorded after the deed of trust had been recorded but prior to the commencement of the nonjudicial foreclosure proceedings. The 9th Circuit ruled that, by operation of California law, the purchasers' title related back to the recordation of the deed of trust, which extinguished the government's interest in the property (which interest had been established by the lis pendens).

The court next addressed the concept of "innocent ownership", in the hopes of clarifying the issues related to it. 21 U.S.C. ß881(a)(6) sets forth an exception for property held by "innocent owners", i.e., it provides that no property shall be forfeited "to the extent of the interest of an owner, by reason of any act or omission established by the owner to have been committed or omitted without the knowledge or consent of that owner."

The purchasers had argued that the government had the threshold burden of proving that they had used illegitimate funds in the purchase of the property. The government argued, and the Ninth Circuit agreed, that the statute places the burden of proof on the party with the interest in the property (the purchasers in this case) to establish that they are innocent owners.

The purchasers had also argued that any purchaser who used legitimate funds to purchase the property was necessarily an innocent owner. The Ninth Circuit disagreed with this argument. The court pointed out that the "innocent owner" defense could be used by a purchaser who used illegitimate funds to buy a property; in that circumstance, the purchaser would have to prove that he or she was unaware of the illegal source of the money used to buy the property.

But it does not necessarily follow that a purchaser who uses legitimate funds to purchase property is automatically an "innocent purchaser." The Ninth Circuit stated that the focus of the inquiry would be on whether the purchasers know or consented to the Paytons' drug trafficking when they bought the property. In such an inquiry, most courts apply a standard of actual, rather than constructive, knowledge; and an owner cannot deliberately avoid actual knowledge through 'willful blindness'. However, the Ninth Circuit applies a standard more similar to constructive knowledge: "innocence is incompatible with knowledge that puts the owner on notice that he should inquire further." (U.S. v. Real Property Located at 10936 Oak Run Circle (9th Cir. 1993) 9 F.3d 74.)

In this case, the district court had held that the lis pendens recorded by the government at the outset of the seizure proceedings imparted sufficient knowledge to the purchasers to defeat their "innocent owner" defense as a matter of law. The Ninth Circuit rejected the district court's analysis, and stated that the lis pendens by itself did not preclude an "innocent owner" defense. The lis pendens (Calif. Code of Civ. Proc. ß 405.24) merely puts a person on notice that the property is the subject of a lawsuit, it does not necessarily impart knowledge of the previous owner's illegal activities. [Knowledge of the previous owner's illegal activities is the type of knowledge that will preclude reliance on the "innocent owner" defense. (21 U.S.C. ß 881(a)(6).)] The 9th Circuit ruled that the lis pendens creates a question of fact as to whether the purchasers were put on notice, but was not determinative as a matter of law all by itself.

In conclusion, the Ninth Circuit reiterated that its ruling was that the purchase of the property at the trustee's sale 'related back' to the recording of the deed of trust, which occurred prior to the recording of the lis pendens as part of the seizure action. At the time of the trustee's sale, the government's sole claim to the property was a lawsuit (the seizure action), and this by itself was insufficient to defeat the relation back provisions of California law. However, this case stands as a clear illustration of the hurdles and pitfalls that are associated with owning or purchasing an interest in property that is subject to drug trafficking seizure proceedings initiated by the federal government.

Comments:

The first lesson to be taken from this case is that there are serious procedural pitfalls for those that are unwary or unfamiliar with the special rules that pertain to drug trafficking seizure cases. You must be prepared to act quickly if you are notified that a property you have an interest in is subject to one of these proceedings. Claims must be filed within 10 days of service of process, and answers must be filed within 20 days of the filing of the claim. Failure to do so leaves you without standing to protect your interests in court. In this case, the district court overlooked the purchasers procedural errors, but one cannot always rely upon the discretion of the district court to grant relief from lack of compliance with the procedural requirements.

The second lesson of this case also highlights the necessity of being familiar with the Admiralty Rules when dealing with drug trafficking seizure cases. In order to remove the property from the jurisdiction of the drug trafficking seizure case, you must either obtain a stipulation to that effect from the government or obtain a court order. Otherwise, a party can purchase the property at a trustee's sale, and find that they are now involved in a seizure case where the government is attempting to take over the property, despite the foreclosure.

The third lesson to be obtained from this case is the importance of concluding the nonjudicial foreclosure prior to the entry of judgment of forfeiture, particularly if the acts which form the basis for the forfeiture pre-date the recordation of the deed of trust. Otherwise, the government's relation back statute (21 U.S.C. ß 881(h)) could prevail over the California relation-back provisions.

The fourth lesson to be learned from this case is that the "innocent owner" defense is not automatically available if legitimate funds are the source of the investment in the property. The Ninth Circuit does not apply the stricter actual knowledge standard; rather, it instead uses a broader standard similar to a constructive knowledge standard. A person who holds an interest in or is contemplating purchasing an interest in property subject to drug trafficking seizure proceedings must proceed with caution, with full knowledge of the risks and of the strict procedural requirements associated with such proceedings.