By A. BARRY CAPPELLO
Much has been written about lenders desperately trying to shore up their books and become financially viable again. Unfortunately, this process is taking place at the expense of borrowers, especially builders and developers.
During the last banking crisis in the late 1980s and early 1990s, lenders were accused of using heavy-handed tactics against borrowers they no longer wanted to lend money to. Builders, developers, farmers and small businesses were popular targets. Many of these borrowers were bullied, threatened and manipulated by lenders until they were forced to default or produce personal collateral in an often-futile attempt to save their business. An area of legal practice, “lender liability,” came into its own at the time. Lenders were sued over breach of contract and fraud and were forced to pay hundreds of millions of dollars in damages to their borrowers.
Fast forward to today. Banks are more frantic and desperate than in the last credit crunch. As they watch their capital base erode and their stock values drop, many lenders are willing to do anything to survive, including tactics that got them into hot water in the past. Not surprisingly, lender liability claims are surging again.
Lenders are cutting off funding to development projects despite contracts signed with their builder/borrower that promise funding. Construction sites sit idle while builders run from lender to lender trying to obtain new financing. These builders believe they can ultimately sell their building projects when the market turns around, but in many cases their lenders think otherwise.
To squirm out of their lending obligations, some lenders delay payments by arguing over invoices, request repeated appraisals and demand builders make management decisions that undermine the builder’s viability but shore up the position of the lender. Some lenders make it so difficult that it is impossible for the builder to continue with a project. When the builder not surprisingly fails to meet its financial obligations, the lender then has an excuse to stop funding.
Why would a lender let a builder fail? Lenders are making the calculated decision to seize properties and force foreclosures to avoid having to front more money for a project that they believe, if completed, cannot be sold. Eventually, lenders hope to sell the land or uncompleted construction at a deep discount to another builder. The lender can then write off the loss on its books and ask for more money from the federal government’s Troubled Asset Relief Program.
But wait, you say, isn’t there a covenant of good faith and fair dealing in every contract, including loan documents? Yes, the Uniform Commercial Code says that no person who is party to a contract can do anything to hinder the other party of the contract from performing. Using the code as a guideline, banks do not have the right to use administrative sleight of hand to force the borrower into default. There is a catch, however. In our judicial system, every party to a contract also has a right to break a contract. The party that breaks the contract just has to be prepared to face the consequences and pay the damages that might arise.
Lenders are evaluating their lender liability exposure and playing the odds. If they fight each lender liability case filed against them, they will win most. Lenders have learned how to stretch out lender liability legal proceedings until a borrower ultimately runs out of money or the will to fight.
How does a builder know if it is a victim of lender liability? Telltale signs are when a lender:
- requires increased accounts receivables or collateral without sufficient justification;
- refuses to advance the full amount available under a loan;
- suddenly requests the builder to sign a waiver for past misconduct by the bank;
- reduces credit lines or changing loan terms without warning; and
- demands performance that is not required in the loan documents.
If builders see some of these signs, they must first educate themselves on what is included in their loan documents. Ideally, they should hire a lawyer well versed in the legal rights of borrowers to help decipher the legalese. Second, builders should send letters and e-mails to their lender demanding that it stop activities that make it impossible for the builder to complete its project. Everything should be documented. A paper trail is critical should legal action become necessary. Three, listen to any lender offers, but be careful. If the lender offers a payment time extension but requires a signed release absolving it of wrongdoing, the builder should not sign. Once signed, the borrower may be waiving any legal claim against the lender. Attempts should be made to obtain the extension without signing a waiver of rights.
A paper trail also helps when negotiating new loan terms. If a lender knows the borrower understands its rights and has the appropriate documentation to help prove a strong case, it may be enough to convince the lender to negotiate new favorable loan terms.
If a case does go to court over the breach of a loan agreement, the most common remedy pursued by borrowers under lender liability law is the recovery of damages. This can include both the difference between the loan amount and the costs for obtaining a replacement loan, and any lost opportunity or lost profit damages.
Lenders can also get into trouble by inappropriately selling collateral after a loan defaults. The Uniform Commercial Code requires that the method, manner, time, place and terms of the sale be “commercially reasonable.” Courts have found sales to be commercially unreasonable where the lender relied on an appraisal that it knew or should have known was too low, or provided insufficient publicity for the sale to generate a sufficient number of bids.
When collateral has been wrongfully repossessed or disposed of, the lender may lose the right to collect a deficiency, forfeit its security interest or be liable for damages. The provisions on commercial reasonableness protect guarantors as well in many jurisdictions.
As bad as the lending climate for builders was in 2008, 2009 is expected to hit even harder, especially in the commercial real estate sector. Gone are the days when a lender coveted a builder’s business. It’s now dog eat dog. Only the most legally savvy builders will survive to see 2010.
A. Barry Cappello is managing partner in the Santa Barbara law firm of Cappello & Noël LLP.
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