LOS ANGELES - Two home owners have asked a California appellate court to reconsider its recent decision on the enforceability of a mortgage-forgiveness rider that is similar to those appearing in other bond transactions.

The home owners, Michael and Bonnie Benov, have filed for a rehearing, arguing that the decision reinstating their mortgage obligation relied on various misstated facts tied to the handling of their mortgage. In particular, they argue the court erred by assuming the trustee sold the mortgage notes prior to the bond redemption.

"It seems real clear to us that this ruling is contrary" to the market's expectation that these riders would be enforceable, said Mark Mosley of O'Melveny & Myers, who represents the Benovs.

In November, the First Appellate District of the California Court of Appeal overturned a lower court decision and found that mortgages funded by tax-exempt bonds need not be forgiven if they are sold by the trustee before the bonds are redeemed.

Market participants are following the case because they developed mortgage-forgiveness riders so issuers could cope with federal limitations expected mortgage yields relative to yields on accompanying tax-exempt bonds.

"It's troublesome because there could be some implications" for other mortgage revenue bond deals, said Perry Israel, a partner at Orrick, Herrington & Sutcliffe. The appellate ruling "raises some shadows," Israel said, though it is still unclear if it would actually affect the enforceability of many forgiveness clauses.

For example, Israel said the decision might have limited application if it can be confined to the specific facts of the Benovs' case.

Enforcement of the forgiveness clauses, which cancels a home owner's note obligation, permits an agency to avoid exceeding the 1 1/8 spread it is allowed to earn between the mortgage yield and the bond yield.

Such deals, which include determination of a so-called arbitrage date, generally anticipate that the mortgages would be forgiven late in the life of a bond issue, when outstanding balances are quite small.

The Benov case arose out of a $20.6 million tax-exempt mortgage revenue bond issue sold in 1985 by the Foster City Community Development Agency. The bonds were redeemed quickly, in 1988, because commercial interest rates dropped suddenly and made the tax-exempt deal unattractive.

Only a few loans were originated out of the bond proceeds, and those were eventually sold to Coast Funding Corp., which had a contract to originate loans for the agency's program.

The Benovs subsequently learned about the forgiveness rider and sued Coast Funding, arguing that the rider should have applied when all the bonds were redeemed and the Foster City agency had received all expenses owed it under the indenture.

A superior court in San Mateo County ruled in favor of the Benovs in 1991.

In its reversal, the appellate court said "the mortgage forgiveness rider can be construed as applying only when the [trustee] holds the note at the time it redeems the bonds and pays off the issuing agency's obligations."

The appellate decision relied heavily on the fact that the Benovs' loan had been sold before the bond redemption, but the Benovs' rehearing filing argues that this is a mistaken assumption. The filing claims the note was conveyed after the bonds were redeemed. The Benov's filing said the appellate court's confusion "is apparently based on a clearly erroneous statement" in the lower court's decision regarding the timing of the loan sale.

The filing also argues that any sale of the note to Coast Funding could not extinguish the forgiveness obligation because Coast officials knew the provision existed. Coast essentially "stepped into the shoes" of the issuer, the filing says, and "lost any right it might have had to raise any defenses" that would not have been available to the Foster City agency.

Mosley, the Benovs' lawyer, said in an interview he also was troubled by the court's reliance on a concept that a contract will, if possible, be interpreted to avoid a forfeiture of an obligation.

"Nobody will ever try to enforce one of these again" if the forfeiture provision applies in such cases, Mosley said.

Forgiving the Benovs' loan "does not entail a ~forfeiture' [that harms any party] because it still only serves to transfer a pure arbitrage profit windfall from the agency to the home buyers - a result consistent with both the forgiveness rider itself and the federal tax law and policy it was designed to enforce," the rehearing filing says.

If the petition for a rehearing is denied, Mosley said the Benovs likely will ask the California Supreme Court to review the case. Mosley said the high court's options would include letting the appellate ruling stand, but de-publishing it so it could not be cited as precedence.

Mosley also hopes that some issuers or major investors would consider intervening through friends-of-the-court filings. Mosley said these parties should be interested because forgiveness riders were designed to avoid potential problems with having mortgage revenue bonds declared arbitrage bonds, thereby endangering their tax-exempt status.

Lawyers at Brown & Wood who represent Coast Funding in the case did not file a reply to the Benovs' request for an appellate rehearing. Michael Danko, a Brown & Wood lawyer, said he viewed the rehearing request "as utterly without merit."

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