Making Lemonade from Lemons: Using Receivers for Partially Completed Projects

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Many real estate development projects have stalled in the downturn, leaving lenders with difficult decisions and limited options. A partially completed project is considered one of the most “toxic” assets in a lender’s portfolio. Some lenders simply foreclose on the property or sell the note, frequently incurring substantial losses along the way. However, many banks are bypassing foreclosure or note sales on large, troubled real estate developments by installing court-appointed receivers to take over the property, complete the construction and in the process limit or eliminate losses on the loan.

Risks to Lenders on Partially Completed Projects

A partially completed project presents an extremely difficult challenge for a lender and many lenders elect not to foreclose except as a last resort after other alternatives have failed. The first issue is timing. A lender will generally want to obtain immediate control of the project. In many cases, the lender may feel that the borrower has mismanaged the construction and may not want to have the borrower remain in control of the project. The risks of leaving a partially completed project exposed to the elements for any period of time are substantial. In order to gain control of the project, the lender may either attempt to enforce its rights under the loan documents to require the borrower to satisfactorily manage the project or it can foreclose. Each of these approaches present substantial risks to the lender.

Lenders have broad discretion to protect their collateral in most loan documents, but a lender can incur liability under a variety of theories if it attempts to control the borrower or the project itself without first appointing a receiver. A lender needs to avoid being deemed a “mortgagee in possession,” which can be found if the lender is deemed to control the actions of the borrower. A mortgagee in possession must account to the borrower for management of the property and is liable for failing to act reasonably and in a businesslike manner in handling the real property and the rents collected [1]. A mortgagee in possession is not entitled to compensation for its management efforts [2] and is responsible for any losses caused by its negligence [3]. For these reasons, lenders are extremely cautious about taking any action which could give rise to an allegation that they are a mortgagee in possession. Even an allegation that the lender is a mortgagee in possession can ensnare the lender in litigation. These cases are complex and time-consuming to defend and even a successful defense can take years and cost hundreds of thousands of dollars.

Foreclosure will take months, if not years, before the lender is able to control the project. A nonjudicial foreclosure takes a minimum of four months to complete. A judicial foreclosure requires the lender to first obtain a judgment against the borrower and a borrower has a one-year right of redemption after the foreclosure to repurchase the property, so as a practical matter it is difficult to sell a property in the year after a judicial foreclosure. If the borrower files bankruptcy, these time periods can be extended for months.

Further, if a lender forecloses on a partially completed project to take control of it, the lender becomes exposed to potential liabilities simply by virtue of being in the chain of title. A lender can be subject to claims for environmental issues from the moment it acquires the property. In addition, there are usually pending or threatened mechanic’s liens to be addressed which may or may not have been extinguished by the foreclosure. Civil Code Section 3134 provides that mechanic’s liens have priority over any other lien or encumbrance which is recorded after the commencement of the work of improvement. This raises a factual issue of whether a single claimant commenced its work before the recordation of the lender’s deed of trust, which if proven will mean that all mechanic’s lien claimants will have priority over the deed of trust – not just the single claimant whose work predated the recordation of the deed of trust. Regardless, if the lender wants to proceed with the original contractor, it will often need to compensate the contractor for unpaid amounts even if the contractor’s mechanic’s lien was extinguished by the foreclosure.

Additionally, the lender faces substantial risk if it elects to complete a residential project itself after the foreclosure. Under Civil Code Section 911, a “builder” is strictly liable for construction defects in residential projects. A builder is defined as “any entity or individual, including but not limited to a builder, developer, general contractor, contractor or original seller, who at the time of sale, was also in the business of selling residential units to the public for the property that is the subject of the homeowner’s claim or was in the business of building, developing, or constructing residential units for public purchase for the property that is the subject of the homeowner’s claim.” If a lender meets the requirements of a “builder” under Civil Code Section 911, it will be held strictly liable for construction defects in a residential project. Similarly, a lender can face claims for construction defects in commercial projects under a variety of legal theories.

Receivers – Benefits to Lenders

Lenders seek to appoint a receiver on partially completed projects for three primary reasons. First, the appointment provides the lender with immediate third party control of the project. While a receiver is an officer of the court and is not directed by the lender, the receiver will provide hands-on management and clear reporting to all parties. Second, the appointment of the receiver shields the lender from the risks and liabilities described above. Third, and an issue of central importance to lenders with partially completed projects, the appointment of a receiver can dramatically limit the losses the lender might otherwise incur if it foreclosed and sold the partially completed project to a third party.

The appointment of a receiver does not make the lender a mortgagee in possession [4] and the lender is not generally liable for any misconduct by the receiver [5]. This concept was codified in California Civil Code Section 2938(e), which provides that the appointment of a receiver to enforce an assignment of rents provision and the subsequent collection, distribution, or application of rents, issues, or profits shall not make the lender a mortgagee in possession of the property, does not constitute an action, render the obligation unenforceable, violate Section 726 of the Code of Civil Procedure, or be deemed to create a bar to a deficiency judgment.

Appointment Process

Civil Code Section 564 sets forth the requirements for the appointment of a receiver. Civil Code Section 564(b)(2) is the most common basis for a lender seeking the appointment of a receiver after a borrower’s default on a partially completed project [6] and states that a receiver may be appointed: “In an action by a secured lender for the foreclosure of a deed of trust or mortgage and sale of property upon which there is a lien under a deed of trust or mortgage, where it appears that the property is in danger of being lost, removed, or materially injured, or that the condition of the deed of trust or mortgage has not been performed, and that the property is probably insufficient to discharge the deed of trust or mortgage debt.”

Receivers are neutral third parties that are appointed by the court to take control and manage the property for the purpose of preserving the collateral. Receivers are not the owners of the assets, but rather, earn fees for their work – protecting the value of the asset that serves as collateral for the defaulted loan. Income generated by the property goes into a receivership estate that the borrower cannot access.

Receivers are not required to be licensed and may be individuals such as real estate developers, property managers, attorneys or others with hands-on property experience. They are often recommended to the court by the lender. A receiver can be viewed as a caretaker for the property to maintain it and protect the asset until the property is foreclosed by the bank or sold to a third party.

Receivers can also play an important role in helping move a stalled development project forward. Complex ownership and lending structures can also lead to the use of receivers with more diverse experience in real estate finance.

This trend in receivership as an interim step to solving complex, troubled property loans has opened up opportunity for highly experience real estate professionals, and offers a peek into how properties may be ‘unwound’ from underwater loans.

Receivership Costs

Most people in the real estate industry are familiar with the typical “rents and profits” receivership, where a receiver takes over a completed project and uses the rents generated by the property to pay the costs of managing the property and the receiver’s fees. A partially completed project presents more challenges, as there is usually no income to pay for the management of the property. In addition, the project almost always has significant unpaid bills, mechanic’s liens and other claims.

In these cases, the funds for the management of the property generally come from the foreclosing lender. While this can be expensive for the lender, the lender must balance the projected costs for the receivership against the substantial discount it will generally be forced to accept if it elects to sell the loan or foreclose and sell the project in a partially completed state.

Receivership Essentials

Receivers take on the role of the owner/operator but do not hold title, and a bond of insurance is put in place to protect the receiver and the property during this period of interim administration. Receivers collect rent and any other amounts owing to the owners such as CAM charges, maintain the property, secure the grounds where needed, and generally operate the property in the best interest of maintaining its value.

Receivers often take steps beyond the caretaker role, such as in hiring brokers to lease available space in the property, or reviewing leases and local tax requirements to make sure the asset maintains, if not enhances, its value.

Challenging Projects Increase the Need for Receiverships

The appointment of a receiver for challenging and complex projects, and particularly for a partially completed project, can bring substantial benefits to a lender. A receiver can help more effectively deal with many of the problems and opportunities presented in these cases:

Insurance. The order appointing receiver should specifically authorize the receiver to enter into new insurance contracts and to renew existing contracts, whose lapse could endanger the project or raise its ongoing cost basis.

Entitlements. In a partially completed project, there are many factors which can jeopardize the existing entitlements and approvals, including the fact that the borrower has defaulted on the loan, the existence of mechanic’s liens, the failure to meet construction timelines and the possible change in ownership by the foreclosure. A receiver can be empowered to negotiate with cities, counties and governmental agencies to preserve entitlements. Frequently, cities and other government agencies are receptive to reasonable modifications to entitlements, as they have no more interest in a stalled project in their jurisdiction than any of the other parties. From the lender’s perspective, it can be extremely difficult to find a buyer for a project where the entitlements are no longer valid.

Weatherization. Stalled construction projects are exposed to the elements, and receivers can enter into contracts to weatherize the project during the winter to preserve the value of the work completed to date. Mechanic’s Liens. Most partially completed projects have pending or threatened mechanic’s liens claims. A receiver can be authorized to negotiate with the contractors and suppliers to resolve these claims.

Construction Defect Claims. A good example of the value of a receiver arises in the case of construction defect litigation and the decisions concerning the scope of repair. Such decisions can involve huge sums and have long term implications for the property. A receiver can preserve the value of the collateral by working to resolve these claims and working with the claimants, the borrower’s insurer and the lender to prevent these problems from escalating.

Sale of Property. In certain circumstances, a receiver can sell the project before the lender forecloses. This benefits the lender as it never enters the chain of title. A receiver can make many important operational decisions and obtain court approval for substantive decisions, protecting the property’s value while maintaining the lender’s insulation from liability. With a highly experienced but ‘disinterested’ 3rd-party receiver in place, and the court overseeing the receiver’s recommendation, these operational decisions keep the property from losing value and, in many cases, help move it forward. Beyond the legal and procedural requirements, a receiver’s appointment can also provide a “fresh start” for all of the parties, from contractors with mechanic’s lien claims to buyers seeking to acquire the asset. Often third parties will be more cooperative with a receiver under court appointment versus a lender that may have legacy issues in dealing with the property, or may not have necessary expertise or staffing levels for such matters.

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[1] Davis v. Stewart (1944) 67 Cal.App. 2d 415.
[2] Earp v. Earp (1991) 231 Cal. App. 3d 1008.
[3] Murdock v. Clarke (1891) 90 Cal. 427.
[4] Bank of America v. Bank of Amador County (1933) 135 Cal.App. 714
[5] Tourney v. Bryan (1924) 66 Cal.App.426.
[6] Receivers can also be appointed pursuant to Civil Code Section 564(b)(11) to specifically enforce an assignment of rents provision. However, most partially completed projects do not have tenants and cash flow.


- L. Gerald “Jerry” Hunt is a Managing Principal of Quattro Realty Group, a Danville, CA-based asset advisor and is the Court-Appointed Receiver for the Sunnyvale Town Center project in Sunnyvale, California.

 

- Attorney Chris Hunter is the Chairman of Morgan Miller Blair in Walnut Creek, CA and heads its Distressed Asset Group. He was appointed by the Court as Counsel to the Receiver for the Sunnyvale Town Center project.

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