Spring 2009 • Issue 32, page 21

Long Term Construction Defect Liability Claims May Await Lenders Who Foreclose on New Condominium and Tract Housing Projects in California

By Smylie, Robert*

A lender that has carefully assessed the risks associated with long term construction defect claims on new condominiums and tract housing projects in California, has taken the first step to minimize its exposure before deciding to foreclose on non-performing construction loans.

What is SB 800 and why should lenders and receivers be knowledgeable about it? Senate Bill 800 is complex legislation which was enacted in an attempt to reduce construction defect litigation. SB800 is a significant pitfall for lenders who foreclose on new non-performing for-sale housing projects, particularly those which construction to complete and/or to repair. Many lenders have been advised that they are protected from construction defect claims by California Civil Code Section 3434. As discussed below, §3434 may not provide the perceived lender protections.

California has led the nation in construction defect litigation resulting in multi-million dollar judgments against builders. These judgments are often a result of run-away juries in civil actions. Even where claims are meritless, builders and insurance companies will incur significant fees and costs to defend such actions. This problem is compounded by the fact that homeowner and homeowners associations have up to 10 years (in most cases) to file construction defect claims, with most claims made more than eight years after the completion of a project.

In the near future, it is highly likely that plaintiffs’ attorneys will name, in construction defect claims, construction lenders who: foreclose on unfinished housing projects and undertake completion of the improvements, make significant post-completion repairs (often the case when new housing developments get in trouble), and/or sell the balance of the units/lots the general public. It will be argued in actions that lenders fit within the broad definition of “Builder” for purposes of SB 800.

In defense of such claims, lenders’ counsel will likely assert the protections of California Civil Code § 3434, which provided lenders with protection from the acts of the builder/borrower. Section 3434 reads:

“A lender who makes a loan of money, the proceeds of which are used or may be used by the borrower to finance the design, manufacture, construction, repair, modification or improvement of real or personal property for sale or lease to others, shall not beheld liable to third persons for any loss or damage occasioned by any defect in the real or personal property so designed, manufactured, constructed, repaired, modified or improved or for any loss or damage resulting from the failure of the borrower to use due care in the design, manufacture, construction, repair, modification or improvement of such real or personal property, unless such loss or damage is a result of an act of the lender outside the scope of the activities of a lender of money or unless the lender has been a party to misrepresentations with respect to such real or personal property.“

The bolded and highlighted portion above is fertile ground for allegations by plaintiffs’ lawyers, as supported by the broad definition of “builder” in SB800. Although California courts have traditionally provided lenders with significant protections when acting within the scope of their duties as a lender, existing case law does not provide “on point” direction, comfort, or guidance on the new factual situations we are confronting. Lenders must be aware of the risks and not take for granted the historical benefits that have emanated from §3434. Failure to adequately prepare for such risks is likely to result in the expenditure of substantial resources by lenders to defend SB800 claims and significant liability exposure in a court system that has demonstrated a strong bias towards consumer protection rights.

It is often challenging for lenders to obtain necessary construction documents to comply with the stringent timelines prescribed by SB800. Under this scenario, lenders may lose the opportunity to inspect and repair, but more importantly they may be exposed to litigation and not benefit from the alternative dispute resolution of claims.

Rather than foreclosing and taking title to projects, lenders can create a layer of protection for themselves by the appointment of a receiver to complete and sell projects. This allows the borrower/developer entity to remain in place in the event of a construction defect claim. However, even when a receiver has been appointed, lenders should be careful to limit the scope of involvement in the construction and/or disposition of units/lots to activities that would be typical of a lender/borrower relationship. The appearance of direct involvement in the activities of the receivership may expose lenders to additional liability.

SB800 was also enacted to allow builders to receive notice of potential claims from a homeowner or association, a right to inspect the purported claims and the opportunity to repair or replace the defective improvement before civil actions could be filed. Builders can make an election to create their own process of addressing construction defect claims or to comply with SB800, which includes satisfaction of onerous procedural requirements, including delivery of numerous construction documents. Failure to comply with each obligation within the time restrictions under SB 800, results in forfeiture of builder’s right to repairs, and the homeowner is free to litigate against the builder. This election may have a significant effect on successors.

A partial checklist of issues that lenders should consider prior to making the decisions regarding foreclosures and receiverships of non-performing assets include the following:

  • Are dispute resolution provisions relating to construction defect claims in the CC&R’s, Purchase and Sales Agreement and construction agreements strong enough to avoid protracted and expensive litigation?

  • Is “wrap insurance” in place? If not, there will probably be no long term construction defect insurance. Is it possible to secure new or additional insurance?

  • Has the borrower/developer or contractor done anything that might affect coverage or given rise for the insurer to deny coverage?

  • Can coverage be extended to the lender and/or receiver as an additional insured?

  • Is the coverage adequate for the lender’s protection?

  • How much are the deductibles and are they reasonable for the coverage?

  • What happens to the existing liabilities of the original contractor and subcontractors when the foreclosing lender brings in a new contractor and subcontractors to rework or finish the unfinished or defective construction?

*Robert O. Smylie is the principal of Robert O. Smylie & Associates, a Century City law firm that specializes in all aspects of real estate law, with an emphasis on development, entitlement and construction issues. He was formerly a deputy Real Estate Commissioner for the State of California.