On June 30, 2014, in Decon Group, Inc. v. Prudential Mortgage Capital Co., LLC, the California Court of Appeal for the Second District held that a senior lienholder's lien does not merge into title when the senior lienholder acquires title to property through a deed in lieu of foreclosure (174 Cal. Rptr. 3d 305 (Cal. Ct. App. 2014)). As a result, the senior lienholder retains the right to foreclose and extinguish any junior liens on the property.

AZ Wellesley Plaza, LLC purchased real property in Los Angeles and financed the transaction with a loan secured by a deed of trust from Prudential Mortgage Capital Company, LLC. The deed of trust was then assigned to PMCF Properties, LLC. Wellesley later contracted with Decon Group, Inc. to perform renovations on the property. The following year, Decon recorded a mechanic's lien against the property for $436,651.

Wellesley defaulted on the loan and opted to deliver a deed in lieu of foreclosure to PMCF. The deed in lieu included a non-merger clause that expressly provided that the parties intended for PMCF's lien under the deed of trust to not merge with the fee estate it obtained through the deed in lieu, thus preserving PMCF's ability to foreclose on the property and extinguish any junior liens.

After accepting the deed in lieu, PMCF foreclosed on the property and purchased it through a credit bid at the foreclosure sale. PMCF subsequently sold the property to a third-party buyer.

Decon, the holder of the mechanic's lien, filed suit to foreclose its mechanic's lien on the basis that its lien was not extinguished by PMCF's foreclosure. Decon argued that when a deed of trust beneficiary accepts a deed in lieu of foreclosure, its interests as a beneficiary under the deed of trust and as a grantee under the deed in lieu merge. As a result, the senior lien is extinguished and any purported foreclosure on that lien was a sham. The Superior Court agreed and PMCF appealed.

The Appellate Court explained that a deed in lieu of foreclosure can be advantageous to both parties as:

However, the Appellate Court also noted that one potential risk associated with a deed in lieu of foreclosure is that, unlike in traditional foreclosure sales, the title passes to the lender subject to all existing liens. For example, if the title is encumbered by two deeds of trust, a third party grantee takes the fee title to the property subject to both. If the grantee is the senior lienholder, its lien would normally merge into its fee title and be destroyed, leaving the senior lienholder holding fee title subject to the junior deed of trust, rather than free and clear as intended.

In order to avoid that unintended result, California law presumes that in a deed in lieu of foreclosure:

The Appellate Court affirmed Davis v. Randall, which held that merger is a question of intent and equity will keep the legal title and the mortgagee's interest separate (48 P. 906 (Cal. 1897)).

As a result, the Appellate Court reversed the lower court's decision and found that because PMCF was the senior lienholder and the parties clearly intended that PMCF's interests would not merge (by virtue of the non-merger clause in the deed), PMCF retained the power to foreclose on the property and extinguish Decon's mechanic's lien.

The Court also pointed out that the presumption against mergers in this situation does not prejudice the rights of a junior lienholder, since the junior lienholder's interest is always at risk of elimination through foreclosure on a senior lien.

This decision underlines the need to state clearly in a security instrument the parties' intent that the interests of the secured party will not merge when a secured party accepts a deed in lieu of foreclosure. Senior lienholders should be prudent and include a non-merger clause in the deed if they want to ensure that their liens will not merge with the fee estate granted by a deed in lieu and that they will retain the ability to foreclose and extinguish junior liens.