Summer 2009 • Issue 33, page 14

Impact of California's Subdivided Lands Act and Right to Repair Law on Foreclosing Lenders

By Riasanovsky, Leslie & Moore, Frederick*

(This is Part II of the article that began in our Spring Issue. It examines whether and under what circumstances a lender who takes title to a builder’s interest in a residential real estate project through foreclosure, or a receiver appointed at the request of a lender, may be deemed a “builder” within the meaning of the Right to Repair law.)

It is also questionable whether Civil Code Section 3434 protects a lender who causes construction activities to be conducted at the property from liability as a “builder” under the Right to Repair Law. The California Supreme Court case which led to the enactment of Civil Code Section 3434, Connor v. Great Western Sav. & Loan Ass’n¹, concluded that a lender could be held liable to homebuyers for construction defects because the lender exceeded its traditional role as lender by actively participating in the construction and sale of homes.

Although Civil Code Section 3434 limits the effect of the Connor case, the statute does not establish a bright line test for determining when a lender has acted “outside the scope of the activities of a lender of money.” Moreover, court cases decided under the laws of other states have recognized that, in some circumstances, lenders who perform construction activities on new homes acquired through foreclosure may be liable as “developers” for defects in the homes.²

Accordingly, any lender whose security includes partially constructed residential homes should strongly consider using a court-appointed receiver to complete the construction of the homes prior to taking title to the homes through foreclosure.³

Due to the uncertain meaning of the term lender in Civil Code Section 3434 noted above, it is also unclear whether that statute insulates a lender from liability as a “builder” under the Right to Repair Law even where the lender does not perform any construction activities on the homes after taking title. It seems unlikely that a court would classify the lender as a “builder,” “developer,” “general contractor,” or “contractor” within the meaning of the Right to Repair Law if the lender does not perform any construction activity on the homes.⁴ But it is more difficult to predict whether the courts would construe a lender as an “original seller, who, at the time of sale, was also in the business of selling residential units for public purchase.”⁵

Foreclosing Lender Liability?
A lender would argue, among other things, that it is not an “original seller” within the meaning of the Right to Repair Law because it did not develop and manage the construction of the homes, is not the first entity to sell the homes (i.e., the first sale of the homes occurred when the homes were sold to the lender at the foreclosure sale), and is engaged in the business of lending (which includes liquidating collateral for loans upon which borrowers have defaulted), rather than in the business of selling residential units for public purchase.

The suing homeowner in a construction defect case may argue that the lender is an “original seller” within the meaning of the Right to Repair Law because the lender is the first seller of the homes to members of the general public, putting it in the business of selling residential units for public purchase.

Which arguments will prevail is not evident from the statute or the legislative history of the statute⁶. To date there do not appear to be any reported court cases on point.

California case law existing at the time of the enactment of the Right to Repair Law does appear to provide guidance on what the legislature intended. Under prior cases an original seller of a newly constructed home (as well as the builder) was deemed to warrant impliedly to the original purchaser that the builder of the home “used reasonable skill and judgment in constructing” the home⁷. An original seller of mass-produced homes was deemed to warrant impliedly to its initial and subsequent purchasers that the homes were “reasonably fit for their intended purpose” and was found to be strictly liable for defects in products which failed to meet this standard⁸.

The primary rationale for imposing liability on the original seller given by the courts was that the original seller has greater knowledge than the buyer about the construction of the home and the buyer relies on that knowledge:

“In the setting of the marketplace, the builder or seller of new construction – not unlike the manufacturer or merchandiser of personalty – makes implied representations, ordinarily indispensable to the sale, that the builder has used reasonable skill and judgment in constructing the building. On the other hand, the purchaser does not usually possess the knowledge of the builder and is unable to fully examine a completed house and its components without disturbing the finished product. Further, unlike the purchaser of an older building, he has no opportunity to observe how the building has withstood the passage of time. Thus, he generally relies on those in a position to know the quality of the work to be sold, and his reliance is surely evident to the construction industry.⁹”

Where the original seller was not in a position to know the quality of the builder’s work, some courts refused to impose liability on the seller. For example, in Siders v. Schloo¹⁰, the court concluded that the implied warranty doctrine did not apply to an individual who retained a contractor to construct a home because the individual was not in the business of commercial development and, the court suggested, did not have the expertise to examine and evaluate the contractor’s work during construction. Similarly, in East Hilton Drive Homeowners’ Assn. v. Western Real Estate Exchange, Inc.¹¹, the court concluded that a company which had purchased newly constructed condominiums at a foreclosure sale and then rehabilitated and sold them to their first occupants four years later was not subject to the implied warranty doctrine because it did not have the ability to examine the homes during construction:

“The Pollard case extended implied warranty liability to sellers of new construction only. The homes here, although not occupied before the sale to respondents, were built some four years before appellant acquired them. If they could be considered new construction when appellant acquired them, then the Pollard case would impose an implied warranty on that sale. But appellant who had no part in building or financing the building of these homes, cannot be considered a seller of new construction whether it occupied the homes or not. The Pollard case did not say a warranty would be implied for first occupants of buildings. It said the warranty would be implied for sellers and builders of new construction. Appellant Western had no better way of knowing of any defects in construction than did respondents. Appellant is not a builder ... Pollard extended the warranty because builders and sellers of new construction are in a better position than buyers of new construction to know of defects. There is no reason to extend this warranty to appellant simply because the homes had lain vacant for a number of years.”

The foregoing cases suggest that, under California case law existing at the time of enactment of the Right to Repair Law, a lender selling completed homes acquired through foreclosure would not have been subject to the implied warranty doctrine because, unlike the original builder and seller of the homes, the lender was not in a better position than the buyers of the homes to know of any construction defects¹². Moreover, under the East Hilton Drive Homeowners’ Assn. case, even a lender who performed repair work on the homes before selling them might have been exempt from implied warranty liability, although that conclusion is less certain¹³.

In light of such cases, as well as the lack of any evidence of legislative intent to the contrary, it seems plausible that the legislature did not intend for the phrase “original seller, who, at the time of sale, was also in the business of selling residential units for public purchase” to encompass a lender who acquires fully completed newly constructed homes through foreclosure and does not perform any construction activities on the homes. Moreover, that interpretation is certainly consistent with Civil Code Section 3434, which, even if it is not strictly applicable to lenders who have taken title to real property through foreclosure, clearly evinces a public policy not to hold lenders liable for construction defects as long as they do not overstep their traditional role of financiers and have not made any misrepresentations to buyers.

Nevertheless, any lender contemplating taking title to newly constructed homes needs to realize that there is uncertainty concerning whether the lender may have potential liability for construction defects in the homes (even if the lender did not perform any construction) and should take appropriate steps to preserve its arguments under Civil Code Section 3434 and the Right to Repair Law in the event of litigation. It is important to remember that, even if Civil Code Section 3434 applies, it does not shield a lender from liability “if the lender has been a party to misrepresentations with respect to such real or personal property.”¹⁴ Therefore, among other things, the lender should make sure that it is giving appropriate disclosures concerning the homes to prospective purchasers.

In addition, that portion of the definition of “builder” in the Right to Repair Law referring to an “original seller” requires that the original seller be “in the business of selling residential units for public purchase.”¹⁵ Accordingly, the lender should take appropriate measures to make clear to prospective purchasers that the lender is not the builder or developer of the homes and has acquired, and is selling the homes, as part of the process of collecting on the collateral for loans.

Lenders should evaluate each situation on a case-by-case basis. However, among other things, a lender may want to consider some of the following issues:

• Whether the public report and governing documents (if applicable), lender’s disclosures, and advertising media adequately disclose that the lender is not the builder or developer of the homes, that the lender has no information or only limited information about the construction of the homes and the financial condition and insurance of the builder or developer, and that the prospective purchaser will not be able to look to the lender in the event any construction defects in the homes are subsequently discovered;

• Whether the broker retained by the lender to sell the homes is experienced and knowledgeable about the documents used by the lender and properly supervises its sales staff to disclose to prospective purchasers that the lender is not the builder or developer of the homes (as well as the other items referenced herein);

• Whether the lender will sell the homes on an “as-is” basis and require a release from prospective purchasers (as note
  above, if so, the governing documents approved by the DRE may need to be modified to reflect this condition) and whether the sales documents make clear that the buyer has the responsibility to investigate the property and the purchase price has been negotiated and reflects the “as-is” nature of the sale;

• Whether the lender will offer prospective purchasers the opportunity to have any optional items installed at the homes and, if so, how that should be structured to minimize any potential liability to the lender;

• Whether the lender will offer any form of third party warranty in connection with the sale of the homes¹⁶;

• Whether the lender has made all disclosures required by law and, assuming the lender is providing prospective purchasers with disclosures prepared by the builder and/or developer, whether the lender has made appropriate disclaimers regarding the information contained in the builder’s and/or developer’s disclosures; and

• Whether the lender’s purchase and sale documents should address the notice, pre-litigation options, and other requirements imposed on builders at the time of sale by the Right to Repair Law, subject to the caveat that they shall apply only if the Right to Repair Law is ultimately determined to apply to the lender.

Receiver Liability?
Many, if not all, of the foregoing issues should also be considered by a receiver who has been appointed by a court at the request of a secured lender and is contemplating selling newly constructed homes in residential real estate developments. The definition of “builder” in the Right to Repair Law does not expressly exclude court-appointed receivers¹⁷. Thus, like a lender who forecloses on newly constructed homes, a court-appointed receiver also runs a risk of being characterized as an “original seller, who, at the time of sale, was also in the business of selling residential units for public purchase.”

This risk would appear to be minimal, however, as long as the receiver does not exceed his authority under the court’s orders in selling the homes, since the receiver is the agent of the court and, as such, is clearly not in the “business” of selling homes¹⁸.

Nevertheless, to avoid potential disputes with disgruntled homeowners over the scope of the receiver’s agency, a receiver should take appropriate measures to ensure that prospective purchasers clearly understand the receiver’s role. At a minimum, the receiver's purchase and sale documents should emphasize that the receiver is an agent of the court and is selling the homes pursuant to the directives and orders of the court. Other issues, such as those discussed above with respect to foreclosing lenders should also be considered (e.g., disclosures and advertising, training of sales staff, use of “as-is” provisions, availability of optional items, third-party warranties, disclaimers relating to builder’s and developer’s documents, notice, pre-litigation, options, and other requirements imposed by the Right to Repair Law on builders).

Final Thoughts
Any lender (or receiver appointed at the request of the lender) who is contemplating selling newly constructed homes in a California residential development should give considerable thought to the potential applicability of the Subdivided Lands Act and the Right to Repair Law before commencing the selling process. The failure to do so could result in unexpected consequences, including potential civil and criminal liability under the Subdivided Lands Act and potential liability for construction defects under the Right to Repair Law. However, with advance planning and assistance from the proper real estate consultants, a lender (or receiver) may be able to reduce one or more of those risks.

*Leslie T. Riasanovsky is an attorney practicing real estate and business law, who frequently works with Frederick C. Moore in Irvine, California.

*Frederick C. Moore is a partner in the Irvine, California law firm of Gallagher & Moore whose practice focuses on residential and commercial real estate development and general real estate law.
 

¹ Connor v. Great Western Sav. & Loan Ass’n. (1968) 69 Cal.2d 850.
² Chotka v. Fidelco Growth Investors, 383 So.2d 1169 (Fla.App. 2 Dist. 1980); Port Sewall Harbor and Tennis Club Owners Association, Inc., 463 So.2d 530 (Fla.App. 4 Dist. 1985) (Lender may be held liable for performance of express representations made to the buyer, for patent construction defects in the entire project, and for breach of any applicable warranties due to defects in the portions of the project completed by the lender); Roundtree Villas Ass’n. v. 4701 Kings Corp., 321 S.E.2d 46 (S.C. 1984)(Lender may be held liable for damages proximately caused by allegedly negligent repairs made at the lender’s request and funded by the lender after the builder deeded title to the property to a corporation created by the lender, but not for any original damages proximately caused by the negligence of the builder); see also McKnight v. Board of Directors, 512 N.E.2d 316 (Ohio 1987)(A case which does not involve construction defects, but discusses various factors the courts should consider in determining whether a lender who takes title to property through foreclosure or a deed in lieu of foreclosure should be considered a developer).
³ McFarland and Crispin, “A Primer for Lenders: Legal Aspects of Practical Solutions for Defaulted Residential Development Projects and Loans” published in Issue 29 of Receivership News (Summer 2008).
⁴ Cal. Civ. Code §§ 911, 3434.
⁵ Cal. Civ. Code § 911.
⁶ Cal. Civ. Code §895 et seq.; Senate Judiciary Committee Analysis of SB 800, Martha M. Escutia, Chair 2001-2002, Regular Session; Senate Judiciary Committee Analysis of AB 903, Martha M. Escutia, Chair 2003-2004, Regular Session; Assembly Committee on Judiciary Analysis of AB 903, Ellen M. Corbitt, Chair, 2003.
⁷ Pollard v. Saxe & Yolles Dev. Co. (1974) 12 Cal.3d 374.
⁸ Kriegler v. Eichler Homes, Inc. (1969) 269 Cal.App.2d 224; see also Avner v. Longridge Estates (1969) 272 Cal.App.2d 607.
⁹ Pollard v. Saxe, supra at 379; see also Becker v. IRM Corp. (1985) 38 Cal.3d 454; Kriegler v. Eichler Homes, Inc (1969) 269 Cal.App.2d 224 (recognizing that the original seller’s ability to obtain insurance coverage was another public policy reason for imposing liability on the original seller).
¹⁰ Siders v. Schloo (1987) 188 Cal.App.3d 1217.
¹¹ East Hilton Drive Homeowners’ Assn. v. Western Real Estate Exchange, Inc. (1982) 136 Cal.App.3d 630, 632-33.
¹² The court’s language in the East Hilton Drive Homeowners’ Assn. case suggesting that a lender who plays “a part in …financing the building” of the homes may be subject to implied warranty liability appears to be no more than an acknowledgment of the established rule that a lender who oversteps its traditional role of financier may be liable for construction defects under Civil Code Section 3434 and associated case law.
¹³ East Hilton Drive Homeowners’ Assn., supra.
¹⁴ Cal. Civ. Code §3434.
¹⁵ Cal. Civ. Code §911.
¹⁶ A third party limited warranty may bolster the enforceability of the “as-is” provision and lender’s disclaimer of warranties. See Hicks v. Superior Court (Kaufman and Broad Home Corp.) (2004) 115 Cal.App.4th 77. Ideally, the third party limited warranty should satisfy the “fit and finish” warranty requirements set forth in Civil Code Section 900 just in case the lender is ultimately determined to be a “builder” under the Right to Repair Law.
¹⁷ Cal. Civ. Code §911.
¹⁸ Id.