construction law seminar -...

Construction Law SeminarFor Lenders in Troubled Times

Construction Law Seminar

DLA Piper – Washington, DC

February 19, 2009

BEING PREPARED FOR CONSTRUCTION CLAIMS AND ISSUES:IDENTIFYING AND UNDERSTANDING KEY ISSUES

Brian K. FieldenAnthony L. Meagher

February 19, 2009Construction Law Seminar

Identifying and Understanding Key Issues

Key provisions in design contracts

Key provisions in construction contracts


Standard Industry Forms – Design & Construction Contracts

American Institute of Architects (AIA)

Design Build Institute (DBIA)

Engineers’ Joint Contract Documents Committee (EJCDC)


Key Provisions in Design Contracts


Avoid Waiver of Consequential Damages Provisions

Found in most form documents; e.g., 2007 AIA B101 § 8.1.3

This waiver is broad enough to encompass all damages of the owner except direct costs of correcting defective design

Problem: may preclude owner from recovering damages incurred by contractor due to defective design


Owner

Architect

Design-BuildContractor

Subcontractors

Owner

Architect Contractor

Subcontractors

Negligence Spearin


Traditional Design-Build



Spearin Doctrine: owner held liable to contractor for contractor’s direct costs and damages due to defective design

However, …. contractor’s damages (which are recoverable from owner under spearin doctrine) would be purely “consequential” damages from standpoint of architect

Thus, owner held liable to contractor for damages due to architect’s negligent design, but …..

Owner has no claim back against architect due to “Waiver of Consequential Damages” provision


Avoid Limitation of Liability Provisions

Usually tied to designer’s fee or some low amount (e.g., $25,000)

Danger: do not utilize signed proposals as the agreement or incorporate proposals into final agreement

Do not tie liability limitation to proceeds received from insurance


Delete Non-Joinder Clause

AIA non-joinder clause 1997 AIA B141 § 1.3.5.4 – “No arbitration arising out of this Agreement shall include . . . an additional person or entity not a party to this Agreement.”

1997 AIA A201 § 4.6.4 – “No arbitration arising out of this Agreement shall include . . . the Architect.”

Potential for conflicting results!

2007 AIA Documents have changed this result


Non-Joinder Clauses in 2007 AIADocuments

Now either party may consolidate the arbitration with any other arbitration to which it is a party (e.g. Owner could consolidateOwner/Contractor arbitration w/ Owner/Architect arbitration) if (1) the arbitration agreement governing the other arbitration permits consolidation, (2) the arbitrations involve common questions of law or fact and (3) the arbitrations employ materially similar procedural rules and methods for selecting arbitrator(s). (A201 15.4.4.1; B101 8.3.4.1)

May join other parties on the same grounds as 1997 version, but only with their consent (A201 15.4.4.2; B101 8.3.4.2)

Thus, consistency in dispute resolution clauses in the various contracts and subcontracts is more important than ever


Ownership of Drawings Provision

Ownership of drawings and specifications provisions are heavily negotiated

Key issue for lenders: ownership of drawings upon terminationAIA: “instruments of service” with revocable license; owner looses license when contract is terminated

Incremental transfer upon payment


Ownership of Drawings Provision

Architect acknowledges and agrees that all right, title, and interest under federal and state copyright and intellectual property laws in any design documents, reports, data, or design concepts, CADD materials, models and information produced by Architect or anyone working under Architect in connection with this Agreement, including but not limited to, any Architectural Works of the Project as defined by the federal Architectural Works Copyright Act (including those furnished in electronic form) shall be conveyed, assigned and transferred by the Architect to the Owner upon submittal of such documents to the Owner and payment by the Owner for the Services required to produce those documents. Architect and its Consultants shall not place a copyright notation on such documents. The rights vested in Owner pursuant to this Article shall not be construed so as to preclude Architect from utilizing standard report language or individual standard features on other projects for other clients. Otherwise, the Architect may not use the design documents on other projects. Owner may furnish documents, reports or other data produced by Architect to third parties in connection with completing the projects contemplated by Owner, and such third parties may rely on such documents, reports and data. Reuse or modification of the aforementioned documents by the Owner without the Architect’s written permission shall be at the Owner’s risk, and the Architect shall have no liability with respect to such reuse or modification.


Key Provisions in Construction Contracts


Scope of Work

Coordinating the contract documentsContractor proposals incorporated by reference often conflict with contract terms or contain outdated pricing / scope information

Reference drawings & specifications issued for construction

Exclusions and qualificationsReview business and legal terms


Completion Dates

Specific, enforceable dates

Define the dateWhat work must be completed by when?

Definition will vary by project type

Consequences of not meeting datesLiquidated damages

Opt for actual damages, instead of liquidated damages


Delays and Delay Damages

Time ExtensionsSpecifically define when extensions are allowed

Outside of contractor’s control / “critical path activities of the work”

Delay DamagesSubcontractor costs & jobsite overhead only

Never agree to home office overhead

Waiver of Consequential DamagesMore favorable to contractor than owner

Consider carveouts (delay, insurable claims, damages arising out of defective work, intentional misconduct, etc.)


Limited Delay Damages Clause

In the event of delay, interference, disruption or inefficiency in the work caused by the Owner, the Architect or any of their consultants or employees, or in the event the Contractor claims that its operations were accelerated, resequenced, impacted, or made less efficient or more expensive, the Contractor shall be entitled to an equitable extension of the Contract Time to coverdelays in the critical path activities of the Work, and shall beentitled to recover compensation or damages only for actual increases in cost for project site personnel, project site equipment, project site labor and other miscellaneous expenses at the project site caused by the delay. In no event shall Contractor be entitled to other general conditions costs, home office overhead, lost profits, loss of use of capital or any other type of consequential damages.


Notice Provisions

Notice provisions should be consistent

Contractor should provide written notice of any claim for extra time or extra compensation

2007 AIA A201 provides for up to 21 days’ notice

10-14 days is adequate

Owner must make informed decisions

Early claims resolution

Claim is waived if notice not provided


Notice Provision

If the Contractor believes it is entitled to an increase in the Contract Sum, or an extension of the Contract Time, or believes it has any other claim for monetary compensation, damages or time extensions from the Owner, the Contractor shall give the Owner written notice of such claim within ten (10) days after the occurrence giving rise to such claim. The notice required by this Paragraph is a condition precedent to the assertion of any claim by the Contractor. If the Contractor fails to give the Owner timely written notice of a claim, as required by this paragraph, the contractor will be deemed to have waived the claim, and the Owner shall have no further liability respecting the claim. . .


Indemnity

Indemnity Related to Insurable Claims (Injuries to Persons / Property)Standard industry forms contain indemnity for personal injury and property damage, “but only to the extent caused by” the contractor (e.g., 2007 AIA A201)

Excludes claims resulting from joint negligence of owner or architectOwner’s insurance must get involved for claims not solely the fault of contractor

Consider obtaining “in whole or in part” indemnity (may be invalid in some states)Indemnity for claims caused by sole negligence are invalid in most states


Standard Indemnity Language (Related to Insurable Claims)

The Contractor shall indemnify, hold harmless, and defend the Owner, its lender the Owner's project manager (if any), Architect and all of their agents, employees, consultants, parent subsidiaries or affiliated companies, successors and assigns from and against claims, damages, losses and expenses (including, but not limited to, attorneys' fees) arising out of or resulting from performance of the Work, but only to the extent such claims involve injuries to persons and/or property and arecaused in whole or in part by negligent acts or omissions of theContractor, a Subcontractor, a Sub-Subcontractor, a material or equipment supplier, or anyone directly or indirectly employed bythem or anyone for whose acts they may be liable, regardless of whether such claim, damage, loss or expense is caused in part by a party indemnified hereunder.


Indemnity

Indemnity Related to Insurable Claims (Injuries to Persons/Property)

Indemnity Related to Performance


Standard Indemnity Language (Related to Performance)

The Contractor hereby agrees to defend, indemnify and hold the Owner and its lender harmless from any and all claims, suits, liens, demands, debts, damages, loss or expense, including, but not limited to, attorney’s fees and litigation expenses, suffered or incurred by the Owner as a result of the Contractor’s failure to perform in accordance with the Contract Documents.


Protection Against Liens

Take advantage of statutory tools to eliminate / minimize lien exposure at the outset

Notice of commencementFiled at beginning of project

Benefit varies from state-to-state

Contract provisions should mandate compliance


Lien and Claims Waivers

Lien waivers on owner’s form – attached as exhibits

Statutory form lien waivers

Lien waiver + claim waiver – “bring the project current”approach


Lien and Claim Waivers

Lien waiver + claim waiver – if permitted by state statute, include additional waivers and representations

All lower tier subcontractors and suppliers have been paid in full and there are no outstanding claims

Payment = payment in full for all work and costs to date

Waive all claims for damages due to delay, hindrance, interference, acceleration, inefficiencies, extra work, or any other claims through the date of the waiver

Eliminate claims through the payment process


Termination Clause - For Convenience

The Owner may terminate the Contract for convenience at any time upon written notice to the Contractor. In the event of a termination for convenience, the Contractor shall take immediate steps to terminate the Work as quickly and effectively as possible and shall terminate all communications to third parties unless otherwise instructed by the Owner. Provided that no damages are due to the Owner for Contractor’s failure to perform in accordance with the Contract, the Owner shall pay the Contractor for all Work performed to the date of termination, including reasonable overhead and profit for that portion of the Work, and for any other expenses incurred by the Contractor in terminating its activity at the Project site, and the Owner shall have no further liability to the Contractor for such termination.


Termination Clause – For Cause

The Owner may terminate the contract for cause if the Contractor breaches any material provision of the Contract Documents. The Owner shall give the Contractor seven (7) days written notice of its intent to terminate the Contract, and, if the Contractor fails to cure the default within that period, the termination shall take place without further notice. In the event of a termination for cause, the Contractor shall not be entitledto further payment until the Work is completed by others. If the cost of completing the Work, combined with previous payments to the Contractor, is less than the Contract Price, theContractor shall be paid the difference. If the cost of completing the Work, combined with previous payments to the Contractor, exceeds the Contract Price, the Contractor shall pay the difference to the Owner.


Termination Clause

If the Owner terminates the Contract for cause, and it is later determined that the Owner did not have grounds to do so, the termination will be treated as a termination for convenience under the terms of this Paragraph.


Owner’s Disclosure of Financial Information

Previously A201 permitted the Contractor significant, seemingly unfettered, rights to require disclosure of the Owner’s confidential financial arrangements relating to the ProjectContractor could refuse to start or continue the Work absent satisfactory informationPotentially led to harassment, distraction and discord between the Owner and Contractor2007 version (§ 2.2.1) is an improvement for Owners, now essentially permitting the Contractor just one look prior to commencing the work Cause required thereafter:

Owner fails to make payments to the Contractor as the Contract Documents requireA change in the Work materially changes the Contract SumContractor identifies in writing a reasonable concern about the Owner’s ability to make a payment when due




February 19, 2009

The Morning After: Handling Borrower and Contractor Default

Robert L. CrewdsonScott Weinberg


II. ASSESSING PROJECT STATUS AND LIABILITIES

Pre-Workout Loan Document ReviewLoan Status1. Payment/Maturity Default2. Status of Covenant Compliance

Critical Date Status (i.e. deadlines for marketing property, maintaining entitlements, or delivering property to tenants or unit purchasers)

1. Review loan balancing tests and make demands on borrower to makecash deposits necessary to bring loan into balance

2. Confirm Borrower and guarantor financial reporting compliance



Pre-Workout Loan Document ReviewOther Documents and Concerns

Review loan guaranties and assess guarantor’s ability to perform guaranteed obligationsConfirm status of property entitlements, including any condominium offering plansCompile all borrower notices and related loan noticesAssess the status of loan participations and/or intercreditoragreements that may effect exercise of remedies; deliver any required copies of notices and obtain needed consents from participants and/or junior lenders



Pre-Workout Loan Document ReviewOther Documents and Concerns

Review any takeout loan commitment, give any required notices and/or obtain needed consents Have Borrower and Guarantors sign a “Pre-Workout” LetterObtain updated title searchConsider obtaining updated environmental report



Pre-Workout Loan Document ReviewAssess Viability of Development Plan

Is the project as structured still legally viable (e.g., should condo project be changed to rental?)Even though it will produce a certain loss, should lender simply walk away? Consider obtaining updated appraisal and market survey



Pre-Workout Loan Document ReviewConsiderations on whether or not to pursue foreclosure

Why did loan go into default? Borrower issue or market issue? Is the Borrower honest and cooperative? Are they exerting maximum effort? Are they stretched too thin on other projects? Costs of foreclosure (e.g., legal fees, transfer taxes)Are there parts of the property which are operational and generating cash? Should a receiver be sought?



Pre-Workout Loan Document ReviewConsiderations on whether or not to pursue foreclosure

Effect of delay in project caused by foreclosure (will work continue during pendency of action) Is Borrower willing to give a deed in lieu of foreclosure?Assess whether foreclosure filing will precipitate Borrower or Guarantor bankruptcy filing Does property have any environmental issues? Are there any PR or reputational constraints on foreclosure?



Project Cost and Construction Contract Exposure Sworn Statements/Bring Project Current

Analysis of Pending Construction Claims

a. Technical Analysis

b. Legal Analysis

Analysis of Potential Construction Claims

a. Technical Analysis

b. Legal Analysis



Assessing Quality of the Work/Defect Issues Technical AnalysisSpecial Attention to “Killer Issues”


III. ASSUMPTION OF CONTRACTS

Contracts Available By Assignment

Assumption/Assignment LimitationsPayment of Existing Liabilities/Amounts Due

Other Restrictions/Limitations

Documenting Takeover/Ongoing Contractual Relationship with Project Parties

Notice Letter

Acknowledgment of Assignment


III. ASSUMPTION OF CONTRACTS

Guaranties and Surety BondsNamed or Additional Obligee

Possible Defenses to Continuing Obligation of Surety or Guarantor

Limitations of Liability/Coverage


IV. MANAGING THE PROJECTAS OWNER

Project ManagementFirmsScope of Authority Issues

Quality Control Issues/Special RisksImmediate ReviewOngoing Verification

Claim Analysis/ManagementInsurance Coverage Analysis

Transition IssuesCoverage in Place


V. CONTRACTOR DEFAULT

Termination Remedies/Completion Options

GuarantiesDischarge Issues

Limitations on Remedies

Surety BondsDischarge Issues

Limitation on Remedies

Managing Lien/Payment Issues


V. CONTRACTOR DEFAULT

Managing Subcontractor Assignments

Managing Defective Work Issues

Contractual Defenses and Limitations of Liability




February 19, 2009

Understanding The Essential Elements of Performance and Payment Bonds

Robert L. Crewdson


Performance Bonds

Surety Obligation to PerformNOW, THEREFORE, the conditions of this obligation are as follows, that if the Principal shall fully and completely perform all the undertakings, covenants, terms, conditions, warranties, and guarantees contained in the Construction Contract, including all modifications, amendments, changes, deletions, additions, and alterations thereto that may hereafter be made, then this obligation shall be void; otherwise it shall remain in full force and effect.


Performance Bonds

Completion OptionsComplete the Construction Contract in accordance with its terms and conditions; or

Obtain a bid or bids for completing the Construction Contract inaccordance with its terms and conditions, and …, arrange for a contract between [the low] bidder and Owner …; or

If the Surety does not promptly perform under (1) or (2) above, allow the Owner to complete …


Performance Bonds

Notice to the SuretyComplete commence performance of its obligations and undertakings under this Bond promptly and without delay, after written notice from the Owner to the Surety.


Performance Bonds

Waiver of Notice ClauseThe Surety hereby waives notice of any and all modifications, omissions, additions, changes, alterations, extensions of time, changes in payment terms, and any other amendments in or about the Construction Contract, and agrees that the obligations undertaken by this Bond shall not be impaired in any manner by reason of any such modifications, omissions, additions, changes, alterations, extensions of time, change in payment terms, and amendments.


Performance Bonds

Indemnification ClauseIn addition to performing as required in the above paragraphs, the Surety shall indemnify and hold harmless the Owner from any and all losses, liability and damages, claims, judgments, liens, costs and fees of every description, including reasonable attorney’s fees, litigation costs and expert witness fees, which the Owner may incur, sustain or suffer by reason of the failure or default on the part of the Principal …


Performance Bonds

No Statute of Limitations


What is a Payment Bond?


Payment Bonds

Obligation to Bond Off LiensIn the event a Claimant files a lien against the property of theOwner, and the Principal fails or refuses to satisfy or remove it promptly, the Surety shall satisfy or remove the lien promptly upon written notice from the Owner, either by bond or as otherwise provided in the Construction Contract.


Payment Bonds

Definition of ClaimantsA “Claimant” shall be defined herein as any subcontractor, person, party, partnership, corporation or other entity furnishing labor, services or materials used, or reasonably required for use, in the performance of the Construction Contract, without regard to whether such labor, services or materials were sold, leased or rented, and without regard to whether such Claimant is or is not in privity of contract with the Principal or any subcontractor . . .


Payment Bonds

Notice Periods for Claimants


General Considerations

1. Dual Obligee Riders

2. Single Payment and Performance Bond v. Separate Bonds

3. Subcontractor Bonds as Substitute for Contractor Bonds


Surety Discharge Issues

Changes in Contract

Steven W. SachsSenior Vice President and Director

National Real Estate and Hotel Practice

Before Disaster Strikes –Construction Insurance in Troubled Times


Objectives

Provide practical information that allows you to place insurance“terminology” within a business context

Establish framework for a better understanding of insurance sections of construction documents


Objectives

Identify critical due diligence issues for REO and/or DistressedDevelopment/Construction loans.

Provide a basis for the formation of relationships between owner’s project managers, attorneys, risk managers, insurance consultants, or knowledgeable insurance brokers


How do I determine what insurance to require or purchase?

Make it Part of a Business Process that:

Identifies risk of loss to assets and/or revenue stream

Measures and evaluates both probability of loss and financial impact

Reviews Risk Techniques (avoidance, assumption, retention, transfer, risk control and prevention)


We Are All Risk Managers

Identify what can happen and where you want to be after event or situation occurs

Language is drafted to place the company in preferred position

Ability is based on:

Fairness of issue

Economic leverage

Understanding Contractor’s issues/concerns


Types of Construction orDevelopment Insurance Coverage


Builders Risk

Named Perils versus Causes of Loss –

Special Form (aka All Risk)

Earthquake

Flood

Windstorm

Subsidence/Sink Hole

Transit

Off-Site Coverage

Renovation Projects – coverage under existing property policy versus builders risk


Builders Risk (continued)

Soft Costs

Business Interruption

Permission to Occupy

Boiler and Machinery (energy coverage)

Testing Exclusion

Waiver of Subrogation or Recovery

Terrorism Coverage

Purchased by Owner or General Contractor


Commercial General LiabilityCoverage (Contractor’s)

Contractor Operations

Independent Contractors

Contractual Liability (indemnity and hold harmless agreements)

Conform with Local Statutes

Products/Completed Operations (Construction Defects)

Contractor’s Pollution Liability


Additional Insured vs. Insured or Owners and Contractors Protective Liability Coverage

Primary, Non-Contributory and Not Excess

Specify “Additional Insured Form” to be used

Use Form CG 20 26 11 85 or 20 10 11 85

Resist CG 20 10 10 93

Need for Owner to carry its own CGL Coverage even if a contractor adds owner as additional insured or provides Owners and Contractors Protective Policy


Umbrella Liability or Excess Coverage

What Limit is Correct?


Professional Liability Coverage

Architects and Engineers

Limits

Practice Policies versus Project Policies

Indemnity Issues

Claims Made Forms – require that coverage be maintained 2-5 years past completion


Pollution Liability Coverage (Owner)

Clean Up (on and off-site)

Third Part Liability (on and off-site)

Diminution of Value

Business Interruption

Cost Cap Coverage

It can make a transaction happen

Mold Issues


Owner Controlled or Directed InsuranceProgram

If you have a Wrap Up in place, it has its own considerations


Other Issues – Construction Defects

Condominium Risk Management Issues:

Breach of Fiduciary Duty

Nondisclosure

Negligent Conversion

Statute Violation



A Brave New World

Statutes of Limitations

Statutes of Repose



Where’s The Beef?

A lack of uniformity in interpreting the Commercial General Liability (CGL) policy’s scope of coverage for construction defect claims has made the determination of coverage challenging for even the most straight forward claim



Insurance Voodoo

Read the policy and endorsements carefully

Many insurers are adding endorsements that limit coverage for residential contractors and developers

Read the policy, not the “certificate of insurance”



What are the basics?

Think more like a homebuilder than a typical commercial developer

Inspection/Documentation/Communication

Problem Resolution


Critical Review Issues for Troubled Loans

Detailed Review of Existing Insurance Program surrounding the construction/development project:

General Liability (including completed operations)*

Workers Compensation*

Excess Liability (Umbrella)*

* - may be accomplished via a wrap up or traditionally where all contractors provide their own insurance per contractual requirements


Critical Review Issues for Troubled Loans (continued)

Detailed Review of Existing Insurance Program surrounding the construction/development project:Builders Risk – Breadth of coverage (Soft Cost and Business Interruption)Environmental Liability*Professional LiabilityOwner/Developer’s Protective Liability Policy* - may be accomplished via a wrap up or traditionally where all contractors provide their own insurance per contractual requirements



If the General Contractor (GC) procured the insurance and entity remains on the project performing his contractual obligations, the new Owner/Lender should seek to be included on the policies as the First Named Insured.

If the Borrower (owner/developer/general contractor) procured the insurance and is no longer in business or unable to complete this particular project, the Lender should explore the option of continuing the existing insurance program.



Any project specific insurance already in place should be reviewed and determined if insurance coverage/limits are appropriate, and if possible transferable to the new interests.



Liability issues:Review the contractual liability between the borrower/new interests and general contractor

Does insurance meet contractual requirements?

Review financial solvency of the general contractor and sub-contractors – surety or sub-contractor caution

Possible safety cutbacks from on-site contractors



Liability issues:Potential increase in workers compensation and third party over claims due to drop in employmentConstruction defect claims and completed operations coverage gaps

Contractors Pollution Liability

Professional Liability Issues


Conclusion:

Projects are being delayed, cancelled and ownership changes are definitely increasing in today’s financial and legal climate.

Choose Competent Business Partners

Attorneys

Accountants

Construction Consultants

Insurance Advisors/Brokers




February 19, 2009

Bankruptcy and Construction:Practical Tips for Survival

C. Kevin Kobbe

Dennis J. Powers


Introduction

In 2008, 143 homebuilders filed for bankruptcyAs compared to 80 in 2007 (and less in prior years)Some builders reorganized, but most liquidated

According to a recent report issued by a major accounting firm, approximately 30% of homebuilders are in financial distress

This includes some major industry players2009 is expected to bring record numbers of bankruptcy filings in the industryIn addition, many small builders will simply cease operations without the formality of a bankruptcy filing


Brief Overview of Bankruptcy

Provide the debtor with a “fresh start”To provide a framework for orderly liquidation or orderly reorganization of a debtor (as applicable)To facilitate the fresh start, the Bankruptcy Code employs two significant concepts:

Automatic stayDischarge of debts

For lenders, bankruptcy frequently means:DelayExpenseAggravation

Purpose of Bankruptcy Code



Bankruptcy Court is adjunct of U.S. District CourtBankruptcy Judges serve 14-year terms (no lifetime appointments)Bankruptcy Courts have limited jurisdiction

Matters arising under the Bankruptcy CodeMatters related to a bankruptcy case

Venue Location of debtor’s domicile, residence, principal place of business or principal assets for 180 daysAffiliate rule

Bankruptcy Court Jurisdiction and Venue



Chapter 7Available for both individuals and businesses

Appointment of Trustee

Chapter 11Also available for both individuals and businesses, but primarily used for business reorganization

Debtor in Possession

Chapter 13 Available only to individuals

Repayment plan administered by standing Trustee

Availability of Chapters 7, 11 and 13



Bankruptcy Code (11 U.S.C. § 101, et seq.)

Federal Rules of Bankruptcy Procedure

Federal Rules of Civil Procedure

Federal Rules of Evidence

Local Rules

Federal Statutes governing bankruptcy-related matters (e.g., jurisdiction, venue, appeals)

www.uscourts.gov/bankruptcycourts

www.abiworld.org

Sources of Bankruptcy Law


How Bankruptcy Changes the Landscape

Immediately triggered by bankruptcy filingProtects both the Debtor and the Debtor’s PropertyGenerally all enforcement activities in which creditors traditionally engage are stayedApplies in both voluntary and involuntary casesEffective Immediately without any court actionEffective against All Creditors regardless of Notice

Dual Purpose:Protection from Creditors (a “breathing spell” for the Debtor)Prevents individual creditors from taking advantage of the Debtor; promotes the bankruptcy goal of equality of distribution

1. The Automatic Stay



The Bankruptcy Code includes numerous exceptions to the automatic stay, including action to perfect, or to continue perfection of, a mechanic’s lien Special Rules for Single Asset Real Estate Debtors

A single asset real estate case generally involves a debtor with no substantial business other than operation of a single real estate project other than residential real property with fewer than 4 unitsIn general, a secured creditor is entitled to relief from stay unless a single asset real estate debtor, within 90 days after commencement of the case, either:(a) Files a plan with a reasonable possibility of confirmation; or(b) Commences monthly payments to the secured creditor

1. The Automatic Stay (cont’d)



Mandatory Disclosures by DebtorSchedules of Assets and LiabilitiesStatement of Financial AffairsMonthly Operating Reports (Chapter 11)Disclosure Statement (Chapter 11)

Meeting of CreditorsTraditional Discovery Devices Available in Adversary Proceedingsand Contested MattersFRBP 2004

Available absent pending Adversary Proceeding or Contested MatterPermits broad examination of “any entity”

2. Disclosure of Financial Information



Debtor retains control over assets and financial affairs

Under limited circumstances, however, management may be ousted

Salaries of officers subject to review

DIP is a fiduciary

3. The Chapter 11 Debtor in Possession Concept



Broad definition of property of the estate

Bankruptcy Court has broad jurisdiction

Single forum for dispute resolution on any issue relating to debtor’s financial affairs

Elimination of collateral litigation

4. Single Forum



Debtor’s ability to use, sell or lease property is restricted to “ordinary course of business” transactions

Debtor may not incur new debt without court approval

Lender under no obligation to extend additional credit

Restrictions on use of “cash collateral”

Settlements must be approved by Bankruptcy Court

5. Restrictions on Debtor’s Activities



Unsecured creditors and beyond

Unsecured creditors should consider pros and cons of committee service

Watchdog function; heightened scrutiny of actions taken by the debtor and the secured creditors

Lenders are frequently the target of committee investigation

Another seat at the table; another hog at the trough

6. Appointment of Committees in Chapter 11 Cases



Bankruptcy Court has authority to approve sale free and clear ofliens, claims, encumbrances and other interests

Some Advantages of Bankruptcy Sales:Bankruptcy Court order provides finality of sale and additional protection for purchaser

Integrity of process; purchasers have confidence

Assets may be sold free and clear, even if purchase price is less than liens (lenders beware)

Tax advantages is sale if conducted under terms of a plan

7. Sale of Assets



Subject to Bankruptcy Court approval, a debtor may assume or reject

Right to reject burdensome leases is a key benefit to many debtors (e.g., retail bankruptcies)

8. Executory Contracts and Unexpired Leases



Bankruptcy Code provides for various causes of action (e.g., preferential transfers and fraudulent transfers)

Potential claims against lenders are typically investigated

Increased scrutiny = increased risk

9. Bankruptcy Causes of Action



Ultimate goal of a Chapter 11 case is plan confirmation

A plan is essentially an agreement between the debtor and its creditors to restructure obligations

Plans are frequently designed to impair the interests of lenders

In general, the debtor has exclusive right to file a plan for 120 days (180 days in a small business case)

10. Chapter 11 Plan of Reorganization


Bankruptcy and Construction:Practical Tips for Survival

When the owner or contractor is on the brink of bankruptcy.

Mechanics lien claims in bankruptcy.

Terminating the contractor in the bankruptcy context.


When the Contractor is on the Brink

Important that lender become proactive.

Ensure change orders up to date (especially deductive).Trustee will pursue owner for monies due contractor.

Be vigilant about sworn statements and subcontractors’waivers.

Unpaid subcontractors may have lien rights that prime the lender’s rights.

If possible, eliminate trailing waivers.

Joint checks to contractor and subcontractors.


When the Contractor is on the Brink

Performance and Payment Bonds.

Ensure bonds are in place.If the lender is a joint obligee, lender will have rights under the bond.

Review and verify bonds are properly issued.


When the Owner is on the Brink

Exercise rights under the loan documents before bankruptcy is filed.

Declare an event of default if cause exists.

Appoint a receiver.Can then request bankruptcy court to keep your receiver in place.

Verify status of project with contractor.Current contract pricePayment status



Payments to contractors may not be vulnerable to a preference action.

The contractor is viewed as a secured creditor.

Even if the lien is not yet perfected.



GuaranteesBad boy guaranty

Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, 477 F. Supp. 2d 366 (D. Mass.).

Completion guarantyMay require guarantors to pay contractors and keep property lien free.Construed by the courts as a security interest. Guarantor often not required to complete improvements if lender fully secured.If lenders forecloses and sells property, it may lose the benefits of completion requirement.


Lien Claims in Bankruptcy

Contractors may perfect their lien rights after an owner files bankruptcy because the lien rights are effective, albeit inchoate, to date of construction contract with owner (pre-bankruptcy).



Stay is lifted after 90 days if no plan or payments to lender.

Can proceed with foreclosure and sale of project.

Property subject to a mechanics lien can be sold, but the lien attaches to the proceeds of the sale.



Priority of mechanics liens versus lender’s mortgage or deed of trust analysis the same as non-bankruptcy setting.

Priority analysis depends on jurisdiction.Often depends on date of contract compared to date mortgage or deed of trust recorded.

Many jurisdictions permit contractors to agree to subordinate lien rights to lender’s mortgage or deed of trust.

To bind subcontractors, they must have notice.



What rights does the contractor’s bankruptcy estate have to retainage?

Typically not the property of the contractor’s estate.

Entitlement to retainage the same as pre-bankruptcy.


Termination of the Contractor

Contractor bankruptcyCan still be terminated for convenience if contract permits.

Should seek bankruptcy court approval for termination for cause.

Will need to evaluate the cost and ease of termination for convenience versus cause.


Termination of the Contractor

Owner bankruptcyOwner will have right to assume or reject the contract.Lender will have input.Factors to consider.

Conventional wisdom is not to change horses mid-stream.Permit issues.Demobilization and mobilization costs.Whose warranty governs what.New contractor premium.If EPC contract, who owns the engineering.Is the existing contractor making unreasonable demands.Easier to change if at easy breaking point.

Track completion costs versus warranty and punchlist costs.




February 19, 2009

ENFORCING LENDERS’ RIGHTSAND MINIMIZING RISKS AND LIABILITIES

Fred Klein Kevin Kobbe


Overview

Introduction

Enforceability of Commitments to Fund

A Binding Oral Commitment to Fund

Practice Tips

Withdrawal from CommitmentsMaterial Adverse Change

Force Majeure

Conditions Precedent

Renegotiating Commitments and Loan Agreements

Pitfalls

Practice Tips

Discretion to Make Advances

Borrower ClaimsCauses of Action

Damages/Remedies


Introduction


Introduction

The unprecedented turbulence in the credit markets, and the lack of liquidity have caused lenders to re-evaluate their lending practices

Often these evaluations include a comprehensive review of their current commitments and loan agreements, particularly those that may be “out of the money”

These difficult times also require more disciplined approaches to loans in default

Even the most proactive and effective precautions may not insulate lenders from litigation in the current environment

There are, however, things that can be done now to minimize the threat of litigation and mitigate any resulting exposure



An oral commitment to fund is binding if: Material terms are sufficiently definitive:

Duration or maturity date of loan/leaseInterest rate or formulaMode of repayment (installment v. lump sum)Collateral

Mutual assent

No express reservation not to be bound without a written contract

Partial performance (fee/advance)

BUT, in many states, Credit Agreement Acts or Statute of Frauds will bar oral commitment claims

Credit Agreement Act can bar tort claims too in some states


Oral Commitments & The Parol Evidence Rule

Courts often consider parol evidence to decide whether there was an oral commitment

Examples:Witness testimony

Emails and other correspondence

Notes

Compensation and self-evaluation memoranda

Industry custom and practice

Course of dealing

Partial performance

He said/she said can preclude summary judgment


Practice Tips for the Loan Team

A savvy loan team can be the first (and best) line of defense against unintended oral agreementsIt is important to educate the loan team on what creates a binding oral agreementWhat can you do?

Confirm all agreements in writingEmphasize that oral communications do not constitute an agreement and that any agreement is subject to the approval of senior management and a signed written agreementIf the loan officer keeps notes, the notes should reflect that the borrower was advised that any agreement is subject to the approval of senior management and a signed written agreementAvoid conjecture: “If you can get your cash flow in shape, we can do a deal”All terms and conditions are important, especially financial covenants


When Must a Commitment Letter Lead to a Full Commitment?

A commitment letter “does not guarantee that the final contract will be concluded if both parties comport with their obligation,as good faith differences in the negotiation of open issues may prevent a reaching of final contact.” (Teachers Ins. & Annuity Ass’n of Am. v. Tribune Co., 670 F. Supp. 491, 498 (S.D.N.Y. 1987)).But a lender cannot justify a withdrawal of its commitment simply by proving that the deal did not close. Rather, the lender must use “reasonable efforts to advance [the] primary goals of [the] contract.” (See, e.g., Dalton v. Educ. Testing Service, 87 N.Y.2d 384, 389 (N.Y. 1995)).A lender may not act “arbitrarily or irrationally” in exercising its discretion to enforce its contractual rights. (GECC v. D’Agostino, 2005 WL 1683531, at *2 (S.D.N.Y. July 18, 2005)).


Withdrawal from Commitment Good Protection

Sample protective language:“This proposal constitutes only a general, non-binding expression of interest on the part of Lender. THIS PROPOSAL IS SUBJECT TO LENDER’S CREDIT, LEGAL AND INVESTMENT APPROVAL PROCESS AND IS NOT INTENDED TO, AND DOES NOT, CREATE A LEGALLY BINDING COMMITMENT OR OBLIGATION ON THE PART OF LENDER. The creation of such a legally binding commitment or obligation is subject to, among other things, the completion by Lender of an in-depth investigation of the proposed investment, the results of which are deemed satisfactory by Lender and the negotiation, execution and delivery of definitive documents which shall be mutually agreed upon by all parties. IT IS UNDERSTOOD THAT NO PARTY HERETO SHALL BE LEGALLY BOUND TO THE OTHER BY REASON OF THIS LETTER, NOR SHALL RIGHTS, LIABILITIES OR OBLIGATIONS ARISE AS A RESULT OF THIS LETTER”


Withdrawal from CommitmentBetter Protection

Even proposals should include integration clausesSimilar language regarding non-binding nature of proposal

Includes the following integration clause: “BY ACCEPTING THIS PROPOSAL, BORROWER ACKNOWLEDGES THAT THIS LETTER CONTAINS THE ENTIRE PROPOSAL FOR THE LOAN AND SUPERSEDES ANY (IF ANY) ORAL OR WRITTEN PROMISES, AGREEMENTS OR UNDERSTANDINGS REGARDING THE LOAN THAT ARE OUTSIDE OF THIS LETTER, NONE OF WHICH MAY BE LEGALLY ENFORCED. THE TERMS OF THIS PROPOSAL MAY BE CHANGED ONLY BY A SUBSEQUENT WRITTEN AGREEMENT MUTUALLY EXECUTED.”

BUT BEWARE, integration clauses can be overcome by course of conduct


Withdrawal from Loan Agreements –Material Adverse Change



Material Adverse Change (MAC) means a “significantly disadvantageous situation” in the life of the borrower, the market sector, the capital markets, or the financial markets generally

Wording of the MAC can be criticalIs it directed specifically at the borrower’s business or financial condition? (e.g., Business MAC)

OR is it more broadly worded:Borrower’s prospectsBorrower’s industry sectorCapital marketsFinancial markets more generally (Market MACs)



Kena Properties LLC v. Merchants Bank & Trust, 2007 WL 627382 (6th Cir. 2007) (Ohio law)

Two commitment letters for refinancing of investment properties in Ohio and a revolving line of creditMAC Clause: “This commitment may be deemed null and void if there are any material adverse conditions with respect to the Borrower that occur before the closing”Borrower was sued for mortgage fraud prior to funding dateLender invokes MAC Clause to avoid fundingCourt held MAC occurred because of “the virtual certainty that it would affect the financial position of the borrower”Contrast: “Many commentators have noted that Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement.” Hexion Spec. Chem. v. Huntsman Corp., 2008 Del. Ch. LEXIS 134, *52 (Sept. 29, 2008 Del. Ch.).



Sinclair Broadcast Group Inc. v. Bank of Montreal, 1995 U.S. Dist. LEXIS 1969 (S.D.N.Y. Feb. 21, 1995)

Commitment letter to loan $25M and serve as arrangement agent for syndication of another $70M

MAC Clause: “No material adverse change in the business condition (financial or otherwise), performance, operations, properties or prospect of the Borrower or its Subsidiaries sinceDecember 31, 1990”

Borrower asks what is meant by MAC, and Lender allegedly advised “that the clause was not significant, and declined to define any particular level of performance required by [Borrower] in order for the financing to occur”



Sinclair Broadcast Group Inc. v. Bank of Montreal (Cont’d)Borrower then signs Commitment Letter and pays non-refundable arrangement fee

Borrower provides lower projections to Lender

Lender invokes MAC Clause and Borrower sues Lender

Court refuses to dismiss claims without discovery because it is plausible that Lender “was motivated by the … non-refundable fee payment to withdraw from the deal at the first colorable sign offinancial instability. If this instability fell short of a [MAC] in [Borrower’s] financial position, then [Lender’s] withdrawal would be pretextual, and therefore in bad faith”



The Market MACProtects against adverse changes in the markets generally

Date back to the 1970s and were not uncommon until recently

Given strong credit markets of last five years, Market MACs wererarely included in financing agreements

Following the disruption of credit markets in summer 2007 and more recent events, Market MACs are making a comeback



Langley v. Prudential Mortgage Capital Co., 2007 WL 4365423 (E.D. Ky. Dec. 12, 2007)

Lender committed to loan $43.3M and offered rate lock

Market MAC in loan agreement: “[Lender] shall be under no obligation to make the Loan and [Lender’s] determination to close and fund the Loan shall be subject to [Lender’s] sole determination that there have been no material adverse change to (or disruption in): (a) financial, banking, loan syndication, securitization, or capital markets”

Borrower locked rate, but Lender refused to honor rate lock because, among other reasons, it claimed disruption in credit markets in summer 2007 was a material adverse change

Court rejected MAC argument and agreed with Borrower that rate lock was intended to “remove any risk [to the Borrower] that adverse changes in the capital markets could affect the interest rates on the loans”


Withdrawal from CommitmentForce Majeure

Force majeure means extraordinary events beyond the control of the parties

Subject matter of contract is destroyed OR

Means of performance is destroyed so as to make performance objectively impossible

Must be written into the agreement; there is no oral force majeure

Can the dramatic change in the capital and financial markets constitute a force majeure?

Trump v. Deutsche Bank Trust Co. (N.Y. Sup. Ct. 2008)TRO deniedCase pending


Withdrawal from Commitment Force Majeure (Cont’d)

U.S. Bancorp. Equip. Fin., Inc. v Ameriquest Holdings, LLC, 2004 WL 2801601 (D. Minn. 2004) (applying New York law)

Borrower defaults under airplane lease agreement following 9/11Lender foreclosed and sold airplanes and sued Borrower for deficiencyBorrower invoked force majeure clause, claiming collapse of the aircraft market following 9/11 rendered performance impossibleCourt held that force majeure clause as written did not protect Borrowers, only Lenders, AND“The crash of the airline and airplane industry does not rise to the level of impossibility demanded by New York law. Certainly 9/11 radically depressed the market for airplanes. However, decreased value ofcollateral is not contemplated by New York law as an excuse for lack of performance based on impossibility. As New York courts have made plain, the fact that a contract proves to be unprofitable or onerous for one party does not excuse performance.” (Emphasis added.)


Withdrawal from Commitment Other Conditions Precedent

Lenders should emphasize conditions precedent to any commitment to loan

Lender due diligence/underwriting approval

Execution of final loan documents

Closing by date certain

Cross default on material obligation

But, lender must always act in good faith and not arbitrarily and capriciously

It is important to clearly and consistently document the basis for the withdrawal in writingCourts will look to contemporaneous documentary evidence to determining whether decision to withdraw was in good faith or pretext

Also, lender cannot be the cause of the failure of the condition precedent


Renegotiation of Commitments and Loan Agreements – Pitfalls


Renegotiating Commitments and Loan Agreements – Pitfalls

Borrowers may misinterpret attempts to renegotiate as repudiation

Examples:“We can never fund that deal at that rate”

“We are never going to be able to make the deal on those terms”

“Given the market conditions, we can’t continue in this loan”

“If you don’t renegotiate, we will default you and terminate”


Economic DuressMarket Condition or Bad Act?

Borrowers sometimes assert that the lender exercised “economic duress” in the renegotiation of commitments or loan terms

Economic DuressGenerally, a claim for economic duress is very difficult to establish because “when two commercial parties enter into an agreement, one of them [often] has a decided economic advantage over the other. The weaker party must enter into the bargain because of his economiccircumstances, a disparity in bargaining power to his disadvantage of some combination of the two.”(VKK Corp. v. NFL, 244 F. 3d 114, 123-24 (2d Cir. 2001)).

In short, the party must establish that it was denied its right to exercise its own free will and was unable to seek relief in Court at the time. For example, an economic duress claim may be sustained where the lendor insisted on raising the previously agreed upon interest rate without providing the counter-party with any additional benefit.


Economic Duress Market Condition or Bad Act? (Cont’d)

The party asserting the claim must act quickly to seek relief from a Court – waiting a matter of months has resulted in dismissal of the claim. (Broadway LLC v. Credit Suisse First Boston Mortgage Capital LLC, 2001 WL 410074, at *2 (S.D.N.Y. Apr. 23, 2001)).

The party must not enjoy the benefit of the bargain before repudiating the deal. (Barrier Sys., Inc. v. A.F.C. Enters., Inc., 264 A.D.2d 432, 433 (2d Dep’t 1999)).


Tips for Reducing the Risk of an Economic Duress Claim

Pre-negotiation letters should be used if there is an existing loan in defaultIdentify ground rules for negotiation, including that senior management must approve any agreement and that any agreement must be set forth in a signed writingGood faith motives should be documented contemporaneouslyBe aware when there is more than the traditional borrower/lender relationship; for example:

Placement of managementFinancial/strategic advice providedAdditional fees have been charged/receivedSeparate loans are present or are being discussed in other matters


Renegotiating Commitments and Loan Agreements – Practice Tips

“You Tube” rule – your sales team should assume that their conversations with customers will show up on You TubeDo not suggest in any way that the lender will not honor its commitments/contractsConfirm intent to perform current commitment/agreement in writing (email, letter, notes)Ensure that consideration is given for renegotiated termsObtain release from the borrower and guarantors as part of renegotiationOther contract protections

Jury trial waiverChoice of lawForum selectionIntegration clause


The Clear Channel Opinion

BT Triple Crown Merger Co., Inc. v. Citigroup Global Markets, Inc., 2008 WL 1970900 (May 7, 2008 N.Y. Sup.)

Borrowers, Bain Capital and Thomas H. Lee, contemplated a leveraged buyout of most of Clear Channel’s stock Lenders armed Borrowers with a $22 billion Commitment Letter just before the summer of 2007As the credit market tightened and the buyout negotiations progressed, the Lenders allegedly recognized that the loan was “out of the money” and attempted to either withdraw from the commitment or renegotiate the terms of the financingBorrowers alleged that the Lenders sought to do so improperly by:

(a) threatening to back out of an unrelated loan to the Borrowers; (b) insisting that the Borrowers accept certain terms in the closing documents that were antithetical to the terms of the Commitment Letter;(c) taking steps to delay the leveraged buyout; and(d) failing to negotiate the final terms in bad faith (i.e., making unreasonable demands)


Clear Channel Opinion (cont’d)

BT Triple Crown Merger Co., Inc. (Cont’d)Borrowers filed suit against the Lenders in New York state courtfor breach of contract, fraud, unfair trade practices and civil conspiracy

The same day, Clear Channel (buyout target) obtained an ex parteTRO from a Texas state court enjoining Lenders from interfering with the merger agreement, including “refusing to fund the [Acquisition] as agreed in the Commitment Letter.”

Discovery unearthed damaging internal Lender e-mails:“Let’s draft the nuclear version” of the closing documentsDescribing plan to send “draconian docs” to the Borrowers“Time to take the gloves off”

Coupled with the non-performance of the loan, these e-mails raised an issue of fact as to Borrower’s anticipatory breach claim



Depends on the terms of the agreement

Loan Agreement: “Debtor acknowledges and agrees that any Advance made pursuant hereto shall be at Secured Party’s sole discretion and that no Advance will obligate Secured Party to make any Additional Advance.” (emphasis added)

Still requires good faith


Discretion to Make Advances (Cont’d)

Yankton Production Credit Ass’n v. Larsen, 365 N.W.2d 430 (Neb. 1985)

Credit agreement provided sole discretion and that “nothing shall be construed to obligate [Lender] to make advances”Lender advanced only one-half of the funds requested by BorrowerBorrower defaulted, and Lender sued Borrower; Borrower counterclaimed that refusal to advance caused default and other damagesLender policy, not in loan agreement, was to advance unless loancommittee decided not to advance based on loan performanceSummary judgment for Lender reversed and trial court ordered to examine whether Lender acted in good faith under UCC

Lesson: Cannot rely solely on loan documents; must examine discoverable facts and lender practices and policies



K.M.C. Co. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985) (applying New York law)

Lender extended $3.5M line of credit to Borrower

Lender decided that it would not lend the remaining $800,000 left on the line

Borrower sued claiming Lender's refusal to extend remaining credit without prior notice was bad faith that caused "death of the company"

Evidence sufficient to support jury verdict that Lender should have given Borrower prior notice before refusing to extend additionalcredit



K.M.C. Co. (Cont’d)"[Lender's] abrupt refusal to advance funds to [Borrower] . . . amounted to a unilateral decision to . . . wind up the company. If [Lender] had agreed to advance the $800,000 but no more, and checks still had bounced, we would have a different case. But, given that [Lender] knew or should have known that the bank was adequately secured, and that if adequately secured it was [Lender's] policy that some period of notice would be due before financing was denied, [Lender's] action could only be justified if in some way [it] reasonably believed that it was necessary to protect the bank's interests."

Court noted that, had Lender given at least 48 hours notice to allow Borrower to find new financing, "we would be facing a different case”

See also Carrico v. Delp, 490 N.E.2d 972 (Ill. App. Ct. 1986) (implying reasonable notice before terminating line required even where loan agreement allows lender to terminate in sole discretion)



Compare Kham & Nate’s Shoes No. 2 v. First Bank of Whiting, 908 F.2d 1351 (7th Cir. 1990) – Rejects KMC’s “duty of kindness”

Bankruptcy court held that bank acted “inequitably” by terminating advances that would have been secure even though the Bank had express right not to make additional advances.

Seventh Circuit reversed equitable subordination, holding that Bank need not do more than loan agreement required

“Knowledge that literal enforcement means some mismatch between the parties’ expectations and the outcome does not imply a general duty of ‘kindness’ in performance, or of judicial oversight into whether a party had ‘good cause’ to act as it did. Parties to a contract are not each others’fiduciaries; they are not bound to treat customers with the sameconsideration as their families. Any attempt to add an overlay of ‘just cause – as the bankruptcy court effectively did – to the exercise of contractual privileges would reduce commercial certainty and breed costly litigation.”


Summary of Borrower’s Claims --Causes of Action

Breach of contract/Anticipatory breach

Bad faith/Breach of the covenant of good faith and fair dealing

Negligence or Negligent misrepresentation

Breach of fiduciary duty

Promissory estoppel/Detrimental reliance

Fraud


Summary of Borrower’s Claims –Damages & Remedies

Direct damages (out-of-pocket)

Consequential damages

Lost Profits

Death of the Company

Punitive Damages

Practice Note: Check loan agreements for limitations on damages

Specific performance

Declaratory judgment

Reformation




February 19, 2009