Pub. 6 2016-2017 Issue 4

8 O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S Lenders’ Rights To Assert Claims For Defectively Constructed Collateral SCOTT C. SANDBERG, SNELL & WILMER L.L.P. A fter a borrower’s default on a loan secured by improved real property, lenders frequently acquire the property and the improvements through foreclosure or a deed- in-lieu of foreclosure. Unfortunately, the lender also acquires any defects in construction, which can severely diminish the collateral’s value. The lender’s ability to recapture some of that value by pursuing claims against the contractors, architects, engineers, and other construction professionals who caused the defects is less than clear in Colorado. A recent case before the Colorado Supreme Court addressing this issue provided little clarification. At this time it appears that lenders can only definitively rely on contractual provisions directly or indirectly granting them the right to pursue construction defect claims. But such rights are infrequently provided in typical loan documents. In S K Peightal Engineers v. Mid Valley Real Estate Solu- tions, a lender acquired a newly constructed home from a defaulting borrower through a deed-in-lieu of foreclosure. The home was deeded to a single asset entity (Mid Valley) created and owned by the lender. Serious cracks later appeared in the foundation and Mid Valley sued the geotechnical engineers who provided the soils reports for the property, claiming their negligence caused the defects. The lender and Mid Valley had no contracts with the engineers, so Mid Valley sued them for negligence in performing their duties. In ruling on Mid Val - ley’s ability to maintain such claims, the Colorado Supreme Court held that: 1. A deed-in-lieu of foreclosure and loan doc- uments can be deemed to be “interrelated” contracts with construction contracts. Lenders are usually not parties to contracts between bor- rowers and construction professionals. However, depending on how they are structured, loan documents and contracts can be deemed to be “interrelated” such that lenders are sub - ject to the rights and obligations provided by construction agreements. 2. Single asset entities used by lenders to take title to collateral can be the beneficiary of such interrelated contracts, even if the entity did not exist when the construction contracts were entered. For a variety of reasons, lenders frequently create single asset entities to take title to real property collateral obtained from defaulting borrowers. Such entities are usually not created until after the borrower’s default, meaning the entity had no role in negotiating or devising interrelated construc- tion contracts. Despite this lack of existence or involvement, single asset entities may still be subject to the interrelated construction contracts. 3. When lenders and their entities have such interrelated contracts, construction profes- sionals do not owe lenders or their entities any duties outside of the contracts. A typical homeowner faced with defective construction may sue both under their contract with construction profes- sionals, and for independent duties owed by the professionals to the homeowner and to subsequent purchasers of the home. No such independent duties are owed to single asset entities with interrelated contracts, leaving them solely with whatever rights the contracts provide. The S K Peightal Engineers case necessitates more lender vigilance inmaking and enforcing construction loans and oth- er loans secured by newly-constructed improvements. Lend- ers may require any level of involvement in their borrowers’ construction process, including inspection rights, assignments of borrowers’ claims against construction professionals, and direct contracts between the lender and construction profes- sionals. While excessive lender involvement in the construc- tion process is impractical, lenders should scrutinize both loan documents and construction contracts for the rights provided by both. There is no cause to abandon the use of single asset entities, but the terms of a deed-in-lieu of foreclosure should be closely scrutinized as well. Among the approaches to address concerns with limits on construction defect claim are taking measures to ensure ad- equate protection in the construction contracts. Lenders can scrutinize the contracts between borrowers and construction professionals, ensure the contracts provide adequate remedies for defects, and also ensure that those remedies are assigned or readily assignable to the lender. Alternatively, lenders may also require borrowers and construction professionals to waive any claim that loan documents are interrelated with construction contracts. Either approach should be carefully documented in loan documents, construction disbursement approvals, and deed-in-lieu agreements. n