Liability Issues For The Lender Foreclosing On Broken Construction Projects

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1 American College of Mortgage Attorneys 2011 Annual Meeting The Grand Del Mar San Diego, CA Liability Issues For The Lender Foreclosing On Broken Construction Projects Prepared by Edward A. Murphy, Esq.*** Union Bank, N.A. 400 California Street San Francisco, CA 94104

2 Liability Issues For The Lender Foreclosing On Broken Construction Projects 1. Determine what the borrower had prior to foreclosure Subdivision Condominium Partially completed construction Partial sales Vacant land Title, boundaries and easements Building documents: architectural plans, site plan Permits (what is expiration) Entitlements Declarant rights (under CCR's): original vs. successor Offsites done or not I paid or not CC&R's Public Offering Statement I Marketing materials Acknowledged assignment of critical contracts (builder, architect, permits) 2. At and After Lender Takes Title How title is taken: --usually by foreclosure; sometimes by deed in lieu of foreclosure --Makes a difference some times: ---Washington State Condominium Act (RCW (3) and (4) effect of foreclosure on special declarant rights) ---Special Purpose Entity owned by the lender Inspect and define what you have Secure the property, including lighting: public liability as owner Storm Water Management: sometimes a local or state mandate with fines, penalties Insure the property Is the HOA operational Make contact with HOA Lender's officers I employees serving on HOA --may become a source for additional liability --is this within commonly accepted "activities of a lender" --some states require all HOA members to be an "owner" Liability for unpaid HOA dues Liability for ongoing HOA dues Maintenance of improved common areas Management of occupied units 3. Liability is based on Concept: Lender is selling the property, its collateral, to recover on a loan. It wants to limit its loss to the loan loss and not take on any additional liability not related to that. State law governs seller liability(two very different examples)

3 California (some statutory law, some case law; both apply to all types of development) Washington (explicit statutory regime for condominiums differs from subdivisions) Title to the property --Receivership as an alternative: custodial receivership v. general --Deed in lieu is not clean title --Special Purpose Entity may not work ---if not operated as legitimate entity (capitalization, corporate functioning) ---exemptions usually apply only to the "lender" --In some states the type of deed to the buyer includes/implies covenants ---Calif. Civil Code 1113 Grant: implied covenants (use of the word, "grant" in a deed implies that there has been no conveyance of the same estate to another and that the estate is free of encumbrances "done, made or suffered" by the grantor) ---RCW (warranty deed-form and effect), RCW (bargain & Sale deed-form and effect) and RCW (quitclairn deed-form and effect) 4. Liability Related to Non-Disclosure Liability can be based on NON DISCLOSURE of a material fact which was known to the seller and which should have been disclosed Public Offering Statement and marketing materials prepared by the borrower --representations in them can become the basis of a fraud claim against the lender --prior to offering anything for sale or giving an Offering Statement to a purchaser, review and revise any written statements which were prepared by the borrower / developer Other written Disclosures required by statute --California Subdivided Lands Act: any seller offive or more lots in subdivided land must prepare and file with the state a "public report." A lender intending to use an existing report after foreclosure must notify the Department of Real Estate within 30 days of taking title. (Business and Professions Code Section ) --The seller of property in California must provide copies of various documents (Business and Professions Code Section [copy of public report] and [copy of CCR's etc.] --Washington State "Form 17" RCW (Seller's duty -format of disclosure statement-minimum inforrnation) --15 U.S.C the Interstate Land Sales Full Disclosure Act which is discussed at Miller & Starr California Real Estate 3"' Edition, Chapter 25C Section 76 Preemptive Disclosure --if the Lender has performed work or "finished" construction of the project --best, even if not strictly required, to list all things done as a disclosure, give it to the purchaser and have the purchaser sign it ("Scope of Work Done by Lender") --If there are material defects or conditions affecting value and known to the Lender but not known to the purchaser and not so obvious as to stand out in a norrnal inspection, disclose them as explicitly as possible in a writing attached to the buy-sell agreernent. In California, the standard is not what the Lender could have found if it made an investigation, but rather what it actually knew (including what is in its files).

4 5. Liability relating to the construction of improvements at the property Construction Defects California is a trend setter --started with Connor v. Great Western (1968) 69 Cal2d 850, 447 P.2d Civil Code Section 3434 intended to protect lenders is open to interpretation "A lender who makes a loan of money, the proceeds of which are used... by the borrower to finance the design, manufacture, construction, repair, modification or improvement of real or personal property for sale or lease to others, shall not be held liable to third persons for any loss or damage occasioned by any defect... resulting from the failure of the borrower to use due care... unless such loss or damage is a result of an act of the lender outside the scope of the activities of a lender... or unless the lender has been a party to misrepresentations with respect to such real or personal property" ---imperfect re,sponse to Connor case ---"activities of a lender" important concept which is not defined in Section 3434 or elsewhere What is included in "Activities of a Lender" --Foreclosure on collateral - clearly an activity of the lender --Biggest Problem is repair or completion of construction: both are a matter of degree --factors: if the lender makes no further improvements or subdivision and has had no active participation with the actual developer, retail sale of the units is arguably an activity of a lender. --CA Civil Code 3434 does not exempt a foreclosing lender as some other laws do --Special Purpose Entity not as well protected as "lender" --When the lender becomes a "developer" it acquires liability What is a "Builder" or Developer --California Civil Code Section 911 (a) definition of "builder" could include the lender "in the business of selling residential units to the public" or" in the business of building, developing or constructing residential units for public purchase... " --Ohio Case, McKnight v. Board of Directors (1987) 512 N.E. 2d 316 not decided on issue of construction defects but the case discusses factors to consider when deciding whether a foreclosing lender is a "developer" -- When the lender completes construction and sells the units, it risks creating exposure to liability as a developer for construction defects How long does exposure last --10 year window in CA (Civil Code Section 941 (a) provides, "Except as set forth in this title, no action may be brought to recover under this title more than 10 years after substantial completion of the improvement but not later than the date of recordation of a valid notice of completion.") --"Wrap" insurance: expensive, but usually covers the owner and the contractor --There is a growing business of defect law suits: condo defect trial lawyers ---awards not limited to repair: can include relocation costs, attorneys fees ---right to attorneys fees may come from purchase/sale contracts

5 Other types of liability based on the Condition of the Property --Fitness for use as residential --Implied Warranty of Habitability --Physical condition --Soil condition --Structural --Extraordinary circumstances (Mold, crime, vandalism) --Hazardous waste cleanup (but see below concerning CERCLA) --Debris cleanup --Attractive nuisance Construction Warranties (Express and Implied) --California Civil Code Sections 895 through concerning contractor liability ---the warranty liability of a property owner in California is based on an analysis which concludes that the owner is a "developer" if it purchases the property, hires a contractor, improves the property and sells it ---the warranty liability of a developer is implied and based on privity of contract. The developer as seller warrants that the improvements have been made in a reasonably workmanlike manner, are free of material defects and fit for use. --RSW : Express warranties of quality --RSW : Implied warranties of quality - Breach 6. Reducing Liability by Performing "Repair Work" California "Right to Repair Act" Civil Code Section 895 et seq. has detailed specific standards, timelines and procedures which enable a contractor to inspect claimed defects and make repairs of work considered defective or mediate the dispute before being sued (See Civil Code Sections 917 and 919). Originally intended as a framework for the resolution of construction defect claims in which homeowners and contractors could resolve defect claims short of litigation. Contains a section entitled, "Pre-litigation Procedures," which is designed to facilitate litigation by the homeowner. Although put in terms of contractor liability, it covers a "builder" using the definition described above from Civil Code Section 911 No specific exemption for lenders Includes an "original seller" and anyone "... in the business of selling residential units for public purchase CERCLA: special exclusion for foreclosed property held by a lender 42 U.S.C. Section 9601 (20) (E) "(ii) Foreclosure. The term 'owner or operator' does not include a person that is a lender that did not participate in management of a vessel or facility prior to foreclosure, notwithstanding that the person - (I) forecloses on the vessel or facility; and (II) after foreclosure, sells, re-ieases..., or liquidates the vessel or facility...

6 8. How the Property is Sold may Add to Liability In bulk or to individual end users Statutory requirements must be followed for sales of "never-occupied" units --Statutory requirements of "public report" or "public offering statement" --California Business and Professions Code Section (subdivisions) --Washington RCW Section (Public Offering Statement - Requirements - Liability)(part of the Condominium Act which begins at RCW ) --Seek an amendment to the California Public Report to add disclosures (Business & Professions Code Section ) ---that sales are "As Is" ---that the lender is not the builder or developer ---that the information in the lender's possession is limited When is the lender the "first" or "original" seller? --Argument that foreclosure is the first sale. Problem: it is not to an end user --Sale of several multiple units one at a time may make the lender a "dealer" 9. Disclaimer of Warranties and Representations Sale "As-Is" and "With All Faults" --Does not do away with duty to disclose --seller should state that it took title by foreclosure and has limited knowledge --buyer due diligence should be specific section of purchase and sale agreement Limited effect: seller cannot disclaim everything --specific written disclaimer should take the form of a list within the Purchase and Sale Agreement which is initialed by the buyer --public policy sometimes imposes liability which cannot be disclaimed completely Special Warranty Deed or other deed without implied warranties Addendum to Listing Agreement should, among other things, state that seller makes no warranties or representations to the Broker other than that seller has the right to sell the property. The lender should carefully read and if necessary modify the Final Owner's Affidavit which it gives to a title company to be sure that there are no untrue representations or warranties. *** References to the Revised Code of Washington State are for information only and are offered as a contrast to the scheme of laws in California. I am only admitted to practice in California. For interpretation or explanation of RCW Sections cited in this outline or any other Washington law, consult Washington State counsel.