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Broken Condos: Lenders Beware

TAKING CONTROL OF BROKEN CONDOS:  LENDERS BEWARE

By Kerry S. Bucklin of Bucklin Evens PLLC

With every swing of the real estate cycle, Lenders are faced with troubled projects.  The latest cycle introduced unprecedented development of residential and mixed-use condominium communities. There are unique pitfalls awaiting lenders who take control of "broken" condominium communities (i.e., partially constructed, phased, or sold). 

WORST OPTION: FORECLOSURE FOLLOWED BY INDIVIDUAL UNIT SALES.

When a lender takes title to unsold condominium units, it typically becomes a "Dealer[1]."  Typically, the lender will acquire the "Special Declarant Rights[2]" and thereby become a successor "Declarant[3]."  As a successor Declarant, the lender is usually subject to all liabilities and obligations imposed by the Washington Condominium Act or the Declaration including unpaid assessments for the foreclosed units.  As a successor Declarant and Dealer, the lender is responsible for delivering a public offering statement (POS) to purchasers and is liable for any "omission of material fact there from if the [lender] had actual knowledge or the misrepresentation or omission or, in the exercise of reasonable care, should have known of the misrepresentation or omission.[4]"  Any "agent, attorney, or other person" assisting the lender may be liable for any material misrepresentation in or omissions of material facts from the POS if that person had actual knowledge at the time the POS was prepared.[5]  Finally, as a successor Declarant and Dealer, the lender will be liable for breach of the implied warranties of quality[6] with regard to those units sold by the lender and the undivided interest in the common elements attributable to those units.  These warranty claims typically involve defective building envelopes and can cost millions of dollars and take years to resolve.

The lender can avoid liability as a successor Declarant if the lender limits those Special Declarant Rights it receives to the right to operate sales facilities.[7]  However, the lender will need additional Special Declarant Rights if the lender completes any construction, adds any units designated for subsequent phases, or assigns parking and storage.  Before acquiring title, the lender should investigate whether it can work with the Declarant borrower to complete the project and assign parking and storage to allow the lender this option.  To exercise this option, the lender must record an instrument which specifically limits the Special Declarant Rights being acquired at the foreclosure.  However, even under this option, the lender is exposed to those obligations and liabilities relating to delivery of a proper POS and, as a Dealer, is exposed to implied warranties of quality claims.

BETTER ALTERNATIVE: FORECLOSURE FOLLOWED BY BULK SALE

The lender can avoid substantially all of the liability and obligations under the first foreclosure option by recording an instrument declaring its intention to hold the Special Declarant Rights solely for transfer to another person as part of a bulk sale of the remaining units to that person.[8]  This option does not allow the lender to recover the higher revenues that may be available by individually selling the units. The lender should carefully evaluate the exposure attributable to the liabilities and obligations of a successor Declarant and Dealer before rejecting this option.

POTENTIALLY THE BEST OPTION: WORKING WITH THE DEVELOPER

From a liability perspective, the best option available to a lender is to retain the lender's first-priority lien position and work with the Declarant borrower to complete construction and sellout.  The Declarant borrower has knowledge of the condition of improvements and the defects and deficiencies that must be corrected or disclaimed to avoid liability under the implied warranties of quality.  The Declarant borrower may also have the best relationship with vendors necessary to complete the project.  The proceeds received by the lender in payment of the lender's construction loan are not exposed to the liabilities and obligations discussed above because the lender has not become a successor Declarant or Dealer. 

Of course, the Declarant borrower may not be willing to cooperate or may lack the integrity, skills, relationships, or resources necessary to complete the project.  In those cases, the lender can still avoid the liabilities and obligations attributable to becoming a successor Declarant or Dealer by commencing a receivership to control the project.

FINAL OPTION: RECEIVERSHIP

The lender has the right by statute and typically in the loan documents to institute a receivership proceeding following a material default.  Receivership is a court supervised proceeding which involves hiring a receiver to take control of the properties of the Declarant borrower.  Under this option, the lender incurs additional costs resulting from the court's supervision, receiver's charges, and engaging new vendors to complete the project and sell the units.  The lender, however, never becomes a successor Declarant or Dealer and therefore avoids liability as such.  When a receiver is appointed, the receiver must engage experienced condominium counsel to update the disclosures in the POS.  The receiver may also be able to obtain a court order authorizing the sale of the remaining units free of all implied warranties of quality pursuant to a specific exception in the Washington Condominium Act for sales pursuant to a court order.[9]

CONCLUSION

The options available to a lender faced with taking control of a broken condo involve a significant disparity in terms of the lender's control, costs, and exposure to liability and obligations as a successor Declarant and Dealer.  A lender must timely elect the desired course of action.  Too often, a lender will take title by foreclosure to unsold units in a condominium community and unknowingly expose itself to liability and obligations that could have been avoided.  In-house and outside counsel are typically not knowledgeable of the unique obligations and liabilities involved with condominium communities.  Lenders will be well served by engaging experienced condominium counsel to work with their in-house and outside counsel.

Kerry Bucklin of Bucklin Evens PLLC has focused his practice on condominium law for over 20 years and is available to assist lenders and their in-house or outside counsel.



[1] RCW 64.34.020(13) defines a "Dealer" as a person who owns six or more units.

 

[2] RCW 64.34.020(36) defines "Special Declarant Rights" as the right to complete improvements, the right to exercise development rights such as the right to add additional units in subsequent phases and assign parking and storage to the unsold units, the right to use sales facilities including a sales office, model unit, and signage, and the right to control the owners association.

 

[3] RCW 64.34.020(14) defines a "Declarant" as any person including a lender to whom Special Declarant Rights are transferred.  RCW 64.34.316(3) provides that the lender will automatically acquire Special Declarant Rights if the lender acquires all units being foreclosed unless the lender requests that all or any of those rights not be transferred.

 

[4] RCW 64.34.405(3).

 

[5] RCW 64.34.405(3).

 

[6] RCW 64.34.445 provides that a Declarant and Dealer (owner of six or more units) of condominium communities warrant that the unit and common elements are "suitable for the ordinary uses of real estate of its type" and that improvements made by such Declarant or Dealer "will be: free from defective materials; constructed in accordance with sound engineering and construction standards; constructed in a workmanlike manner; and constructed in compliance with all laws then applicable to such improvements."

 

[7] RCW 64.34.316(c).

 

[8] RCW 64.34.316(d).

 

[9] RCW 64.34.400(2)(b).