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Our courtroom experiences during the last several quarters have confirmed several important trends in real estate litigation, and they suggest that certain increasingly creative theories are receiving respect in California courts.  Here are some quick highlights on such topics as loan guaranties, receiverships, tax refunds for dishonest fiduciary losses, and bankruptcy work out tactics.

  1. Loan Guaranty Exonerations

    Guarantors can be automatically released from their obligations if the lender materially alters the terms of the debt without the guarantor’s approval, and so a real battleground has become what constitutes a material alteration and whether any pre-dispute loan instrument waivers are enforceable.  Courts can be very receptive to arguments that a material alteration may include inappropriate releases of construction draw funds by the lender, such as when the releases are without appropriate documentation or render the loan funding “out of balance” (i.e., the percentage of funds released exceeds the percentage of work done).  Many expert witnesses say that most lenders have internal standards of loan administration which disapprove of “out of balance” ratios, and if a jury concludes that a bank has violated its own standards (or even just general industry standards), the likely result is an exoneration.  Courts have also suggested that some loan instrument waivers of a guarantor’s right to object to material alterations may be voided as against public policy. 

    Other promising exoneration scenarios have included (1) a bank foreclosure upon other property owned by a guarantor contiguous to the property secured by the guaranteed loan, when such a foreclosure adversely affects the borrower’s ability to develop his property as part of an overall economic community; and (2) a fraudulently-tainted purchase transaction funded with a bank acquisition loan.

  2. The Importance of Confirming Letters

    We have several broker clients who use standard letters to confirm to their clients that they are not providing financial or investment advice, and we have found in trials that those are very helpful.  Indeed, absence of such letters creates vulnerability to arguments that the clients thought they were receiving financial or investment advice.
     
    What has proven most successful in trial, however, is encouragement by the broker for the client to consult his or her personal CPA or attorney, and then confirmation by letter that such a professional has become involved. 
    As to material fact disclosures, we have seen experts forcefully contend that a failure to confirm a disclosure in writing to a buyer falls below the standard of care, and we have seen numerous instances where brokers are exposed to liability because there is no written evidence of key conversations (calendar entries can help but emails are much better).
  3. Lender Use of Receiverships

    For many years we have counseled our lender clients that, at least in some of the more moderate California counties as well as in California Federal Court, they were on equal footing with a borrower before a jury.  But our recent jury selection interviews have suggested that this has probably changed, and in the present economic climate financial institutions seem vulnerable to a general bias against them when litigation claims go before a jury.  Recently, some lenders have attempted to soften the impact of this scale-tipping negative with the use of a Receiver (which under law can usually be appointed when a loan defaults) to create the appearance of a neutral party being involved.  A claim on a guaranty, for example, can be assigned to the Receiver who then sues in his/her own name with the somewhat “whiter hat” of an independent custodian just trying to create order in an otherwise chaotic asset.
  4. Alleged Lender Conspiracy With Dishonest General Partners

    The number of cases involving dishonest general partners or managing members who self-deal with partnership funds is on the increase, yet by the time a complaint is filed the money is usually gone (as may be the offending fiduciary himself).  Plaintiffs are consequently developing theories which accuse the lender of being a co-conspirator with the manager and, under California conspiracy law, all that need be shown is some evidence of knowledge of the dishonest propensity and just a single act that enables it.  Along these lines, lenders have become ensnared during the construction draw process when a dishonest general partner applies for and receives construction draws to pay his company for engineering work when the engineer of record was someone else.  So, when the bank funded the fraudulent draw request, with the true identity of the engineering professional in its construction budget file, significant exposure arose.
  5. Credit Bid Tactics in Foreclosure Sales

    In the foreclosure process, the lender typically credit bids a portion of the face value of its secured note, but if the credit bid is at full value then there should be no damages left for any action on any guaranty.  Lenders are thus temped to submit bids much lower than the face value of the note, relying in part on the presumption under California law that an arms-length bid for the public foreclosure sale is fair market value.  But any such presumption can be overcome in a subsequent guaranty case with convincing evidence that fair market value was indeed higher, and in that process guarantors commonly argue that lender manipulation of value has occurred.  When an apparent taint of such alleged manipulation is added to jury distrust of financial institutions in general, the result can be quite promising for guarantors seeking exoneration. 

    In one case, the lender made matters even worse by contacting the appraiser with a suggestion that he consider some additional information from the bank on an alternate cap rates, and we successfully obtained a dismissal of the guaranty action.

  6. Tax Refunds for Losses Caused by Dishonest Partners

    When a limited partner or an LLC member loses his or her investment by reason of a foreclosure, occasioned in turn by the managing member’s defalcations, opportunities to write off the business losses on the investors’ tax return are often misunderstood.

    Recent changes in IRS Regulations now extend the number of years for which income can be offset by current losses, and this can result in huge savings for defrauded taxpayers who enjoyed high earnings in earlier years.  Further, our experience is that many accountants do not fully understand the interplay between writing off a loss and the filing of a civil action against the dishonest fiduciary and/or against the recipients of improperly diverted funds.  Happily, the IRS does not consider the latter to be inconsistent with suing a fiduciary for the loss since any future recovery would then be subject to ordinary income tax.

  7. Effective Tailoring of Arbitration Clauses to Limit Legal Expenses

    A surprising number of real estate professionals and lenders are suspicious of arbitration because they fear the general rule that arbitrators are not necessarily bound by the law and arbitration decisions cannot be overturned by a court even if their decision is erroneous.  Current California law is moving away from the absolute infallibility of arbitration decisions, and, our experience teaches that most if not all of these concerns can be addressed with a careful drafting of the arbitration clauses in the purchase agreements.  This includes, for example, a provision for a “judicial reference” proceeding in which a retired judge is indeed bound by the rules of evidence, the law, and is subject to appeal, or even specific provisions for appellate court review of the merits of arbitration awards.

    Further, parties can choose an arbitrator in a manner that will assure that the selected arbitrator will have the integrity to follow the law carefully as opposed to merely “splitting the baby.”  This can be done by carefully identifying who the arbitration service provider is, and by requiring that both parties agree in advance to the identity of a specific arbitrator (whose background can be investigated beforehand).

    Parties who fear the expense of lengthy discovery, including multiple and costly depositions, can also contractually limit (but probably not eliminate altogether) the scope of such expensive procedures, and even the length of the arbitration hearing itself.

    Finally, courts will routinely enforce requirements in arbitration clauses that the parties mediate in good faith first on pain of foregoing their right to collect attorneys’ fees even if they prevail.

  8. Bankruptcy Workout Negotiations

    After a Notice of Default is recorded by a lender, and as the foreclosure sale date approaches, the threat of borrower bankruptcy has always been in play.  But in today’s environment, the level of detail in pre-petition workout discussions as to possible bankruptcy scenarios has increased dramatically.  For example, although a lender’s claim on a guaranty is not part of a direct claim on the promissory note being pursued against the borrower’s estate, there can be an effective bar if it is proven that the guarantor has such a unity of interest with the borrower that they are legally inseparable alter egos of each other.   While most loan agreements contain assurances that there is separateness, interestingly enough many guaranties do not contain such a purported waiver.  If the finances of the two were impermissibly commingled, and the lender was on notice of that, then the risk of a jury disregarding the contractual assurance is not insubstantial. 

    Similarly, lenders normally contend that a single purpose limited liability company (LLC) holding title to the securing real property, under well-established Single Asset Real Estate (or “SARE”) bankruptcy rules, cannot remain in bankruptcy for very long, but such rules may not apply if the LLC’s financial affairs are commingled with other entities controlled by the same principals.

Conclusion

These “Lessons Learned” confirm earlier trends and suggest a new waive of aggressiveness.  If you have any questions with regard to how any of these issues are unfolding in today’s current financial crisis, please contact Bill Norman, Chair of Cooper, White & Cooper LLP’s Financial Crisis Group, at wnorman@cwclaw.com; 415-765-6236.

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