Chapter 22

Liability, Agency Problems, Fraud, And Ethics in Real

Estate Finance

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Chapter 22 Learning Objectives

Understand how parties to real estate finance transactions can be held liable for their actions

Understand the structure of agency relationships within real estate finance

Understand that there are agency costs associated with preventing parties from acting solely in their own interest and against the interests of others

Understand how insufficient agency costs allow wealth transfers

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Lenders’ Legal Liability

Lenders may be subject to liability in two areas: Violation of state or federal laws regulating certain activities

Violation of contractual obligations involving loan arrangements

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Federal Laws Regulating Hazardous Waste

Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) Liability under CERCLA – strict, retroactive, and joint and several

Strict liability – a charged party may not offer as a defense a claim that its actions were not in violation of any law prior to CERCLA

Joint and several liability – each potentially liable party can be made to bear the entire cost of cleanup even if several parties may have been responsible for the contamination

Superfund Amendments and Reauthorization Act of 1986 (SARA)

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Hazardous Waste

Potentially responsible parties (PRPs) for contaminated properties: Current owners / operators of a facility

Owners / operators at the time of discharge

Generators of the hazardous substance or parties arranging for disposal

Transporters of the hazardous waste

Secured-Lender exemption – a PRP owner or operator does not include a lender that holds a mortgage or deed-of-trust on a property as security for a note Lenders may lose this exemption if they foreclose on the contaminated property

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Lender Defenses

Lender claims to not be a PRP

Contamination resulted solely from an act of God, act of war, or omission by a third party

Claims to be an innocent landowner with no knowledge of contamination

Initial Judicial Decision United States v. Mirable (1985) – involved three lenders with

secured interest in a property United States v. Maryland Bank and Trust Company (1986) –

involved a secured lender that foreclosed on a property and took title through a sheriff’s sale

Guidice v. BFG Electroplating Co (1989) – court recognition of option values related to the CERCLA legislation

Fleet Factors Corporation (1990) – lenders liability extended further

Bergsoe Metal Corporation (1990) – addressed the issue of lender control of business activities

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April 1992 EPA Regulation

Rules allowing lenders to foreclose and not be liable: Actions prior to security interest

Periodic monitoring and/or inspection

Involvement from inspection results

Requiring borrower compliance

Restructuring the loan arrangement

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April 1992 EPA Regulation

Rules allowing lenders to foreclose and not be liable: Requiring additional rent or interest

Exercising any rights the lender may have under the law or any warranties, covenants, conditions, or promises

Providing financial or administrative advice

In 1994 an appeals court invalidated the 1992 EPA regulation

Congress Acts Asset Conservation, Lender Liability and Deposit

Insurance Protection Act of 1996 – part of the spending bill for 1997; provision that codified the 1992 EPA rule

Under the act “participating in the management” term included participating in the operations and ability to engage in several other activities and retain the secured lender exemption

Allows a lender to foreclose on a property, sell, wind up operations and undertake a response action under CERCLA without losing its exemption

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Other Lender Regulations

Comprehensive Drug Abuse Prevention and Control Act of 1970 allows confiscation of property used in illegal drug activity The danger for the lender is the greatest when it forecloses on a property that has been

used to support illegal drug transaction

The lender must use due diligence defense

Other Lender Regulations Uniform Commercial Code (UCC) which specifies rights

and obligations of contracting parties Two primary areas of lender behavior that can give

rise to liability Nonperformance of oral commitments Failure to extend credit beyond a certain date

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Liability from Lender/Borrower Relationship Oral commitments for Extension of Credit

The following contracts must be in writing in order to be enforced:Agreements that cannot be performed with 1 year

Promises to answer for the debts of another (surety contracts)

Promises made in consideration of marriage

Agreements relating to real property

Contracts exceeding $500 for sale of goods

Contracts by executors

Termination of demand notes without notification

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Other Theories of Lender Liability

Prima facie tort

Promissory fraud

Nondisclosure fraud and breach of fiduciary duty Breach of contract

Duress and lender control

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Liability to Third Parties: Bankruptcy and Agency Costs Agency law - another area of the law where the lender may become liable

to third parties If lender undertakes sufficient control for the operations of the creditor’s business

(assumes the role of principal)

Bankruptcy law and the cramdown process Cramdown – the ability, under the law, to force restructuring of the debt owned by the

developer

Ethics, fraud and agency costs Agency relationships have legal and ethical implications

Agency costs – costs incurred to make sure that the agent acts only in the principal’s interests