As lenders, borrowers, and guarantors attempt to work towards solutions to the multi-pronged problems associated with troubled real estate construction projects in our credit crisis environment, several issues seem to arise repeatedly. The parties should consider including the following seven items on their respective checklists for the negotiations.
- Has There Been a Thorough Analysis of Potential Lender Liability Claims? 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 and thoroughly considered before any releases are executed.
- Have All Guarantor Issues Been Addressed?
Lenders need to evaluate whether to proceed with non-judicial foreclosure remedies (which can eliminate rights against guarantors if there is not an adequate waiver) as opposed to a judicial foreclosure action, and indeed whether a principal’s guarantee is even enforceable (for example, where the borrower is a general partnership). 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 upon being provided with information on the guarantor’s weakened financial condition.
- In Any Plans for a Chapter 11 Bankruptcy, Has There Been a Full Consideration of the 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, which generally entitles the lender to an early dismissal of a Chapter 11 proceeding if a readily confirmable plan has not been presented to the Court. But borrowers are becoming increasingly creative in their arguments as to other assets, such as third party guarantees or income streams generated from affiliated businesses operating on the site, and 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, particularly with declining real estate values, can provide a real impetus to work out negotiations and it can lead to increased flexibility from lenders.
- Have All Construction Defect Issues Been Covered? 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. Sometimes this can include dry rot damage that may occur with the rainy season at hand, and that kind of physical damage to unfinished work might strengthen claims for coverage.
- 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. Whether they can be eliminated through foreclosure actions before or in conjunction with a third party sale are critical tactical issues as well.
- Has the Enforceability of Exculpatory Clauses Been Examined? Many Construction Loan Agreements 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.
- Has Full Attention Been Paid to Alternative Dispute Clauses? The parties will need to determine whether arbitration is required, which service provider is best, which arbitrator is suitable, 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 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 be on anyone’s short list. For more information or details, please contact Bill Norman or one of the other members of Cooper’s Subprime/Credit Crisis Group.