As lenders borrowers, and guarantors attempt to work towards solutions to the multi-pronged problems associated with troubled real estate construction projects in our current credit crisis environment, several damage-related issues seem to arise repeatedly. Prudent parties should probably consider including the following seven items on their respective checklists to be sure they are fully prepared for the negotiations.
Has There Been a Thorough Analysis of Potential Lender Liability Claims?
Have damages been caused by third parties under circumstances which might fully exonerate a guaranty or reduce the amount due on a loan? There seems to be an increasing trend by LLC borrowers to contend that their project’s lender has aided and abetted the dishonest acts of a managing member of the LLC, legally exposing the lender to potential claims for commingling, excessive, and/or unauthorized payments to insiders, or even straight defalcations. Since under many scenarios the managing member may have been terminated and/or proven to be judgment-proof, borrowers are increasingly invoking California legal principles applicable to co-conspirator liability in formulating claims against lenders. These obviously need to be addressed in the work-out negotiations before any releases are executed.

Have All Guarantor Issues Been Addressed?
Lenders need to evaluate how proceeding with non-judicial foreclosure remedies might affect rights against guarantors (and even the borrower) if a credit bid at the sale is below fair value.  Indeed, they should even consider whether a principal’s guaranty is even enforceable (for example, where the borrower is a general partnership or there is an alter ego relationship between the borrower and the guarantor). Further, since the balance sheet of many a guarantor will likely include other real estate projects, the overall state of the current market may well decrease net worth substantially to the point where a lender might have to write the loan down immediately either upon initial default or upon being provided with information on the guarantor’s weakened financial condition. The size of such a write-down can significantly affect settlement negotiations.

In Any Plans for a Chapter 11 Bankruptcy, Has There Been a Full Consideration of Exceptions to Single Asset Rule?
Borrowers routinely threaten bankruptcy to forestall foreclosure efforts and lenders traditionally discount this risk because of the Single Real Estate Asset Rule. The latter generally entitles the lender to an early dismissal of a Chapter 11 proceeding if a readily confirmable plan has not presented to the Court But borrowers are becoming increasingly creative in their arguments as to other assets; such as third party guaranties or income streams generated from affiliated businesses operating on the site, and consequently the procedural protections available to lenders in the Single Asset Rule may be less reliable. The prospect of keeping the project in bankruptcy for an extended period of time can provide a real impetus to work out negotiations and it can lead to increased flexibility from lenders.

Have All Damages Caused by Defects Been Considered?
Any partially completed real estate project is, of course, vulnerable to the existence of construction defects, whether due to unpaid subs stopping work or otherwise.  With construction funds having been cut off by a foreclosing lender, significant strategic decisions have to be made for completion of the project in order to obtain a maximum sale price.  Tactical issues also arise in connection with what kind of insurance coverage might be available for claims against subcontractors. Some kinds of physical damage to unfinished work caused by the passage of time or weather can strengthen claims for coverage. Further, construction defect claims can provide an offset against liens. Finally, just how the foreclosure process (which can wipe out all subcontractor liens) is managed becomes critical.

Have All Subcontractor Lien Issues Been Resolved?
Troubled projects are very often the subject of subcontractor liens and close scrutiny is required to determine whether the very specific requirements for serving Preliminary Notices or recording Mechanic’s Liens have been timely met. It is surprising how often deadlines are missed and that can prove fatal to lien claimants.

Has the Enforceability of Exculpatory Clauses Been Examined?
Many Construction Loan Agreements and guaranties have exculpatory clauses which attempt to immunize lenders from claims or limit their responsibility in the construction draw process. But there are limits to how far courts will go to enforce these clauses, and each fact situation must be closely analyzed on its own.  Courts can be very reluctant to enforce exculpatory clauses for forward-looking lender misconduct.

Has Full Attention Been Paid to Alternative Dispute Clauses?
Many clients and attorneys believe that arbitrators often “split the baby” and so, in their eyes, liability is a given and damn ages are regrettably the only remaining issue, Others disagree and argue that a party can control this risk by selecting the arbitrator carefully, Whether it is a desired resolution approach or not, the parties need to determine whether arbitration is required, which service provider is best (there are many cheap but substandard ones), which particular arbitrator is suitable for a given set of facts, and whether mediation is required first. Further, a borrower’s need for injunctive relief against a lender can be impacted by the wording of an arbitration clause, particularly when the need for speedy legal resolution is important.

There are certainly many other damage-related items which should be included on any comprehensive checklist for work out negotiations, but the very recent trends we have observed in credit crisis litigation suggest that these seven items should probably be on anyone’s short list.

***This article was originally published in the Winter 2010 issue of Dunn on Damages: The Economic Damages Report for Litigators and Experts.

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