January 2010 /$4

Los Angeles lawyers David Waite (right) and C. J. Lafferdiscuss the impact of globalwarming on CEQA procedurespage 22

25th Annual Real Estate Law Issue

EARN MCLE CREDIT PLUS

CMBSLoanWorkoutspage 38

WeatherReport

BrokenCondo Liabilitiespage 29

AppealingProperty TaxAssessmentspage 10

Stop NoticeClaimspage 16

Call 1-800-282-9786 today to speak to a specialist.

22 Weather ReportBY DAVID WAITE AND C. J. LAFFER

The California Natural Resources Agency has issued Proposed CEQA Guidelines for assessing the impact of greenhouse gas emissions in the project approvalprocess

29 Fixer-UppersBY CATHY L. CROSHAW, MARJORIE J. BURCHETT, AND NANCY T. SCULL

When lenders foreclose on a broken condominium project, they expose themselves to liability on many frontsPlus: Earn MCLE credit. MCLE Test No. 188 appears on page 31.

38 Bond BombsBY D. ERIC REMENSPERGER

The collapse of the commercial mortgage-backed securities market has landedanother blow on the real estate industry

F EATU RE S

Los Angeles Lawyer

the magazine of

the Los Angeles County

Bar Association

January 2010

Volume 32, No.10

COVER PHOTO: TOM KELLER

01.10

8 Barristers TipsInternational service of summons andcomplaintBY JEFFREY ANDREW HARTWICK

10 Tax TipsHelping taxpayers contest propertyassessmentsBY TERRY L. POLLEY AND GREGORY R. BROEGE

16 Practice TipsStop notice risks for construction lendersBY ROBERT G. CAMPBELL

45 By the BookLouis D. BrandeisREVIEWED BY STEPHEN F. ROHDE

48 Closing ArgumentIt’s time to fix arbitration discoveryBY KENNETH C. GIBBS AND BARBARA REEVES NEAL

46 Classifieds

46 Index to Advertisers

47 CLE Preview

DE PARTM E NTS

LOS ANGELES LAWYER (ISSN 0162-2900) is published monthly,except for a combined issue in July/August, by the Los AngelesCounty Bar Association, 1055 West 7th Street, Suite 2700,Los Angeles, CA 90017 (213) 896-6503. Periodicals postage paidat Los Angeles, CA and additional mailing offices. Annual sub-scription price of $14 included in the Association membershipdues. Nonmember subscriptions: $28 annually; single copyprice: $4 plus handling. Address changes must be submittedsix weeks in advance of next issue date. POSTMASTER: AddressService Requested. Send address changes to Los AngelesLawyer, P. O. Box 55020, Los Angeles CA 90055.

25th annual real estate law issue

Los Angeles Lawyer January 2010 29

ALL TOO FREQUENTLY in today’s depressed realestate economy, developers attempting tobuild and sell condominiums are finding theirprojects derailed by a lack of buyers. “Brokencondominium projects” are those projects inwhich some units have been sold and thehomeowners have an operating homeownersassociation, but the original developer isunable to complete sales of all the units. Tocomplicate matters, the most recent real estateboom fueled significant speculation in con-dominium construction and conversion, andthe reality of the current condominium mar-ket is that more and more broken condo-minium projects are changing hands. Thesuccessor owners of these projects generally

are lenders, who acquire the property throughforeclosure, or third-party bulk purchasers,who acquire the property under bulk salecontracts.1

Acquiring broken condominium projectsrequires a multifaceted due diligence process.It should include an analysis of a broad rangeof issues involving resales of the property(including statutorily required public reports),owners associations, and developer’s rights.However, the most important of the potentialissues to be analyzed often is the extent of thepotential construction defect liabilities that asuccessor owner may acquire along with thebroken condominium project.

If the construction defect liabilities are

extensive and the acquiring party will be theonly entity responding to those liabilities,and if there is no statutory or other protec-tions to assert against claims of liability, theacquiring party may decide that it is notadvisable to proceed. However, if the liabil-

Cathy L. Croshaw, Marjorie J. Burchett, and NancyT. Scull are partners at Luce, Forward, Hamilton &Scripps. Croshaw practices in the firm’s SanFrancisco office, and Burchett and Scull are in theSan Diego office. They are members of the firm’sReal Estate Practice Group and represent devel-opers, owners, bulk purchasers, and lenders inmajor commercial and residential real estate devel-opments throughout California.

MCLE ARTICLE AND SELF-ASSESSMENT TEST

By reading this article and answering the accompanying test questions, you can earn one MCLE credit.

To apply for credit, please follow the instructions on the test answer sheet on page 31.

Fixer-

Getting a broken condominium project back on track requires a multifaceted approach

UPPERS

25th annual real estate law issue

by Cathy L. Croshaw, Marjorie J. Burchett, and Nancy T. Scull

ities can be limited or managed or are not thesole responsibility of the acquiring party, theacquisition may be feasible. Identifying the lia-bilities and developing a strategy to addressthem may overcome any barriers to acquisi-tion and will be an essential part of the duediligence process.

The most significant factors affecting con-struction defect liability are 1) the construc-tion, if any, to be completed by a successorowner, 2) whether a successor owner plans toengage in retail sales, and 3) the amount oftime that a successor owner plans to hold theproperty. This last factor must be assessedalong with any actions that a successor ownerdoes or does not take during that periodregarding maintenance, management, or gov-ernance of the project. A successor ownerneeds to discern 1) the likelihood of con-struction defect liability, 2) whether the ownerwill need to make payments to cover anyshortfall in assessments or association funds,3) prospective liability for maintenance, man-agement, or operation of the property, 4)what funds may be available to address poten-tial liabilities, and 5) what additional optionsmay be available to protect against liabilitiesgoing forward. Even after the acquisitiontakes place, actions may still be required tomitigate the risks inherent in a broken con-dominium project.

In some cases, a foreclosing lender willhave some protection from these potential lia-bilities under statutory and case law. Underother circumstances, the exposure will be thesame whether a successor owner is a fore-closing lender or a bulk purchaser. The extentof liability exposure for successor ownersultimately will depend on the nature of theirinvolvement with the property as well aswhether they are a foreclosing lender or a bulkpurchaser.

Homeowners associations have standingto sue on behalf of multiple owners. As aresult, attached residential condominiumstructures are frequently the target of con-struction defect claims, whether spurious orlegitimate.2 A broken condominium projectmay be even more vulnerable to such claims,since it may have suffered from neglect in avariety of ways. Once a project is in trouble,construction funds may be reduced, home-owners associations may be underfunded(which may lead to improper or nonexistentmaintenance), assessments may become delin-quent, existing construction defects may notbe addressed, and reserves may be under-funded. All of this could lead to the acceler-ated deterioration of the project and a con-current increase in liabilities.

Civil Code Section 3434 and SB 800

Many construction lenders assume that, afterforeclosure, they are protected from liability

for construction defects caused by the devel-oper. They claim the protection of Civil CodeSection 3434, which provides that a con-struction lender is not liable for construc-tion defects under certain circumstances.However, this protection is limited, so lendersneed to be alert to circumstances that may falloutside its reach.

Section 3434 provides protection to alender “unless the loss or damage is a resultof an act of the lender outside the scope of theactivities of a lender of money.”3 The sectiondoes not specify whether the lender is actingoutside the scope of the activities of a lenderonce it has foreclosed and is in possession ofthe property. It also does not address what,if any, postforeclosure actions constitute act-ing outside the scope of the activities of alender.4

Typically, a lender who forecloses maybe required to assume additional obligationsand responsibilities as soon as the foreclosureoccurs. For example, it may need to serve onthe board of an owners association, engagein the operation of the project, or marketand sell the units to the public.5 In conduct-ing any of these activities, whether the lenderacts outside the scope of the activities of alender is likely to be analyzed as a continuumrather than according to a bright-line test. Thelonger the lender holds the property, and themore involved the lender becomes in con-struction, development, management, oper-ation, and maintenance of the property, themore likely that the lender will lose the pro-tection of the statute. While these activities donot automatically exclude a lender from theliability protections of the statute, the lenderis advised to conduct these activities in waysthat are consistent with protecting its securityinterest and disposing of collateral.

Many lenders who know that significantinvolvement in the project is necessary beforeletting it go will either 1) acquire the projectas a single purpose (or special purpose) entity(SPE) to limit their liability exposure to thevalue of the property they acquire or 2) seekthe appointment of a receiver to operate theproject while sorting out liabilities and an exitstrategy. Provided that the lender is not con-trolling the activities of the receiver, the lenderwill be protected by Section 3434 during thereceivership, because the lender is not doinganything inconsistent with lending activities.The lender should exercise caution in limit-ing its involvement in the project so that thelender always stays within the scope of theactivities of a lender.

If the property is “original construction,”bulk purchasers—as well as lenders whoengage in retail sales and are not protectedunder Civil Code Section 3434—may beliable for construction defects under theCalifornia Right to Repair Law, commonly

referred to as SB 800.6 They may also beliable under common law if the property is acondominium conversion or if SB 800 isfound not to apply to the successor owner oforiginal construction.7 Common law princi-ples also may come into play if the successorowner has not engaged in direct retail sales.This happens when the homeowners sue allthe entities in the chain of title to the projectprior to retail sales.

For construction defects associated withexisting or previously owned property andunknown to the seller, the seller is generallynot liable under an implied warranty for thedefects. According to case law, “The doc-trine of implied warranty in a sales contractis based on the actual and presumed knowl-edge of the seller, reliance on the seller’s skillor judgment, and the ordinary expectationsof the parties.”8 However, no California casehas directly addressed the application of SB800 or common law to foreclosing lenders orbulk purchasers. In other jurisdictions, whenthe lender or bulk purchaser has no involve-ment in any construction on the property,courts have been reluctant to impose liabil-ity for construction defects under commonlaw.9

To help minimize liability, lenders engag-ing in retail sales of foreclosed propertyshould specifically disclose that the propertyis sold in its “as-is” condition. In addition,lenders should disclose if they did not performany construction on the project. If they didengage in construction, they should list theparticular improvements they made in orderto define the scope of any potential liability.Lenders should also craft a recital as part ofthe sale. It should state that they are sellingthe property to recover the value of loanssecured by the property and they are not inthe business of constructing or selling resi-dential units for retail purposes.

These steps should be taken if the suc-cessor owner has undertaken no work at theproperty or only protective actions (such assecuring the property against vandalism) orminor decorating. If, however, lenders orbulk purchasers are required to do con-struction work to complete or renovate anexisting project before they can market theproperty, they should evaluate their atten-dant liability exposure. Again, Californiacourts have not directly addressed this issue,but decisions from other states have foundforeclosing lenders liable for performance ofexpress representations to buyers, for patentconstruction defects in the entire project, andfor breach of any applicable warrantiesregarding the work performed by thelenders.10 Thus, whenever possible, successorowners should refrain from performing con-struction work to complete a project. Optionsto construction include seeking the appoint-

30 Los Angeles Lawyer January 2010

Los Angeles Lawyer January 2010 31

MCLE Test No. 188The Los Angeles County Bar Association certifies that this activity has been approved for MinimumContinuing Legal Education credit by the State Bar of California in the amount of 1 hour.

MCLE Answer Sheet #188FIXER-UPPERS

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Law Firm/Organization

Address

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E-mail

Phone

State Bar #

INSTRUCTIONS FOR OBTAINING MCLE CREDITS

1. Study the MCLE article in this issue.

2. Answer the test questions opposite by markingthe appropriate boxes below. Each questionhas only one answer. Photocopies of thisanswer sheet may be submitted; however, thisform should not be enlarged or reduced.

3. Mail the answer sheet and the $15 testing fee($20 for non-LACBA members) to:

Los Angeles LawyerMCLE TestP.O. Box 55020Los Angeles, CA 90055

Make checks payable to Los Angeles Lawyer.

4. Within six weeks, Los Angeles Lawyer willreturn your test with the correct answers, arationale for the correct answers, and acertificate verifying the MCLE credit you earnedthrough this self-assessment activity.

5. For future reference, please retain the MCLEtest materials returned to you.

ANSWERS

Mark your answers to the test by checking theappropriate boxes below. Each question has onlyone answer.

1. nn True nn False

2. nn True nn False

3. nn True nn False

4. nn True nn False

5. nn True nn False

6. nn True nn False

7. nn True nn False

8. nn True nn False

9. nn True nn False

10. nn True nn False

11. nn True nn False

12. nn True nn False

13. nn True nn False

14. nn True nn False

15. nn True nn False

16. nn True nn False

17. nn True nn False

18. nn True nn False

19. nn True nn False

20. nn True nn False

1. Lenders who seek the appointment of a receiver tomanage their broken condominium projects while theydevise their exit strategies can limit their liability bydirecting the receiver’s day-to-day activities.

True.False.

2. Successor owners of broken condominium projectsthat do not perform construction work on their projectswill not have any liability exposure for constructiondefects.

True.False.

3. If a foreclosing lender did not perform any con-struction work on the project, it may still have liabilityas a “builder” under SB 800.

True.False.

4. If the developer chose to opt in to the provisions ofSB 800, the successor owner will be required to do soas well.

True.False.

5. Successor owners that are uncertain whether SB 800will apply if they engage in retail sales should obtaina waiver of SB 800 claims from buyers to avoid liabil-ity under the statute.

True.False.

6. A wrap insurance program purchased by a developerto cover its construction defect liability will transferautomatically to the successor owner because the insur-ance is intended to cover all construction on the projectuntil the expiration of the statute of limitations.

True.False.

7. The purpose of forming a single purpose entity to fore-close on property in place of the original lender is tolimit postforeclosure liability to the assets of the SPE.

True.False.

8. A receiver’s liabilities are the same as those for asuccessor owner of a broken condominium project.

True.False.

9. Successor owners that hold the common area of aproject for several months may shield themselves fromliability for maintenance and management if they do notparticipate on the board of directors of the homeown-ers association and in the operation of the property.

True.False.

10. Civil Code Section 3434 provides protection forlenders from construction defect claims even after

lenders foreclose and take possession of a property.True.False.

11. Potential construction defect liability is only one ofseveral risks to be evaluated in deciding whether to pur-chase a broken condominium project.

True.False.

12. One of the most significant factors affecting con-struction defect liability for successor owners is whetherthey engage in retail sales.

True.False.

13. A broken condominium project may be uninsuredeven if it is under a wrap insurance program, becausethe program’s limits may be exhausted by other proj-ects covered by the same program.

True.False.

14. Bulk sales of units in a broken condominium proj-ect present the same construction defect risks andliabilities as retail sales.

True.False.

15. SB 800 defines “original construction” as the por-tion of a project that existed prior to the project’s refur-bishment as a condominium conversion.

True.False.

16. Civil Code Section 2782 limits express contractualindemnities provided from subcontractors to the con-tractor.

True.False.

17. A condominium project is designated as “broken”when it lacks a homeowners association.

True.False.

18. “Hold and wait” is often the best investment strat-egy for a broken condominium project.

True.False.

19. The successor owner of a broken condominiumconversion is not liable under SB 800 for construc-tion defects.

True.False.

20. The California Court of Appeal has ruled that SB 800applies to foreclosing lenders and bulk purchasers.

True.False.

ment of a receiver and completing work pre-foreclosure, selling the units as is, or offeringthe purchasers an option to contract with athird party to perform any finish work thatmay be necessary.

SB 800 further complicates the picturefor lenders, since courts have provided noguidance about how to interpret the lawtogether with Civil Code Section 3434. If a

lender acquires property for resale to a bulkpurchaser, without performing any con-struction prior to the resale, the acquiringparty does not appear to fall within the def-inition of a “builder” in SB 800. However,when acquiring new construction with theintent of engaging in retail sales now or in thefuture,11 the lender will need to considerwhether it has builder obligations and lia-bilities under SB 800. The definition of“builder” under the statute includes the “orig-inal seller…in the business of selling resi-dential units to the public.”12 Further, thestatute applies to “original constructionintended to be sold as an individual dwellingunit.”13 SB 800 does not define “originalconstruction,” but lenders may argue that, forthe acquiring entity, the project is not “new”or “original” construction, and the successorentity is not necessarily “in the business of sell-ing residential units to the public.” Until thelaw is settled in this area, the safer approachfor successor owners is to assume that SB800 could be applied to the acquiring entityas the seller of “original construction” andassure compliance with the statute whilespecifying that such compliance is not anadmission of the applicability of the statute.

In complying with the statute, successorowners should make their own decisionsregarding whether to opt in or opt out of thenonadversarial provisions of SB 800. Theseprovisions establish an optional nonlitiga-tion path for resolution of construction defect

claims.14 Successor owners should make thisdecision carefully since the approach taken bythe original developer may not apply or maymake compliance difficult for any successorowner. For example, the original developermay have opted out of the statutory nonad-versarial provisions in favor of procedures dic-tated by its insurer and, in connection withits insurance requirements, issued a warranty

provided by the insurer that did not alsoinsure the successor owner. In this situation,there is no reason for the successor owner toadopt the same approach. Similarly, if theoriginal developer opted into the statutorynonadversarial provisions, the successorowner needs to independently evaluatewhether it will be able to comply given thatit may not have access to construction doc-uments that it may need to produce to aclaimant on relatively short notice.15 If SB 800is applicable, the successor owner is subjectto strict construction defect liability for theproject’s failure to meet the functionalitystandards16 and may be liable for obliga-tions of the minimum fit and finish warrantyrequired by the statute.17

Although SB 800 liability cannot be waivedif it does apply,18 the successor owner shouldconsider a provision in its sales agreements thatif SB 800 does not apply to the project, theacquiring entity disclaims responsibility for theoriginal construction and acknowledges thatthe property is sold in its as-is condition. Evenif successor owners engage in retail sales butdo not consider themselves to be governed bySB 800, they will need to decide whether toprovide a fit and finish warranty or someother express warranty to buyers to avoidthe warranty being “implied” under thestatute.19 Whether the property is sold as is orsubject to some type of express warranty, thepurchase agreement should contain a waiverof implied warranties.

In the majority of situations, at least apotential for construction defect liability willexist even though actual liabilities have notyet materialized. However, identifying poten-tial or actual liability is not the end of theinquiry. Successor owners also must evaluatethe extent of their exposure, whether they canprotect themselves either by the appointmentof a receiver or by the manner in which they

take title to the property, and whether anyfunds other than the resources of the succes-sor owner may be available to allay the costof any liabilities.

Insurance

Another way to address defect liability riskis through insurance. The first general inquiryfor successor owners is whether they canbenefit from the liability insurance purchasedby the developer. This starts with an inves-tigation of what insurance the developerhad—and by the time foreclosure hasoccurred, this information may be some-what elusive. Policies and premium paymentrecords may be difficult to locate; if thedeveloper, contractor, and subcontractorswere insured by a single insurer under a“wrap” insurance program, then manualscontaining the conditions for continuation ofcoverage may not be available, and auditinformation or other critical documents mayhave disappeared. Moreover, a wrap insur-ance program is typically coordinated andadministered through a third-party admin-istrator paid by the developer. Once a proj-ect is in trouble, the administrator’s con-tract may no longer be current, and theadministrator may no longer be in place.

Wrap insurance covers the acts or omis-sions of owners, general contractors, andsubcontractors for a construction contractin a single policy. It has become the stan-dard for most condominium projects in

32 Los Angeles Lawyer January 2010

To help minimize liability, lenders engaging in retailsales of foreclosed property should specifically disclose

that the property is sold in its “as-is” condition. Inaddition, lenders should disclose if they did not perform

any construction on the project. If they did engage inconstruction, they should list the particular

improvements they made in order to define the scope ofany potential liability.

California in lieu of separate policies for eachparty. This is because wrap insurance canreduce the overwhelming litigation costs asso-ciated with multiple insurers on a single proj-ect. Each wrap insurance program must beevaluated individually as to whether it islikely to provide any meaningful insurancecoverage once the developer is no longer inthe picture.

The fundamental analysis of any liabil-ity insurance involves identifying the policylimits. With wrap insurance, the availablelimits will depend on the scope of the pro-gram. For example, if a wrap insurance pro-gram covers multiple projects, the entirelimits of liability may be eroded by a singleproject, leaving others under the same pro-gram virtually uninsured. The determina-tion of available policy limits does not endwith the total limits of liability per occur-rence and in the aggregate but also encom-passes all out-of-pocket costs to the developeror other insureds. Included in this calculationshould be the amount of the self-insuredretention or deductible and whether the costof defending litigation is in addition to thestated limits of liability or is included withinthe stated limits.20

Part of the policy review will involvedetermining who is insured under the policyeither as a named insured or as an additionalinsured. Typically, lenders will require thatthey be named as an additional insured underthe contractor’s liability policies. The term“additional insured” describes a party addedto the coverage of the policy by endorse-ment. However, the endorsement creatingthis status also may contain coverage limita-tions. As an additional insured, a lender maynot have coverage for completed operations,which typically is the coverage that applies toconstruction defect claims. At a minimum, theadditional insured endorsement for a lenderwill typically exclude any alterations, con-struction, or demolition by the lender.Therefore, lenders generally will require sep-arate insurance if they perform any work atthe project.21

However, even if the insurance includes thelender, wrap insurance policies carry a num-ber of ongoing obligations that the devel-oper may or may not have met, particularlywith a distressed asset. If the lender is namedin the developer’s liability insurance policy, thelender will have to explore whether coveragewas properly maintained by the developerand whether the developer’s insurer contendsthat the insurance was compromised either bythe developer’s conduct prior to the foreclo-sure or as a result of the foreclosure. If thelender is not directly covered under the devel-oper’s policy, the lender should explorewhether it can be added to the policy and con-tinue with it after the foreclosure.

Another likely obligation of wrap insur-ance is that each subcontractor meet certainqualifications and complete an applicationform. Subcontractors that did not qualify forthe wrap insurance program may have pro-vided evidence of insurance and performedwork on the project with independent cov-erage—despite the fact that the bulk of theproject was covered by a wrap program. If so,the acquiring entity should also explore theadditional policies that may exist apart fromthe wrap program.

Additionally, the norm for the pastdecade for any construction insurer inCalifornia is to require the developer toimplement quality control measures in orderto monitor the project as it progresses andmake recommendations to minimize liabil-ity. In those projects that have encounteredfinancial trouble, the developers may nothave followed the quality control measuresrequired by the insurer. This failure may begrounds for a denial of coverage when claimsmaterialize.

Any investigation regarding potentialinsurance coverage must include a review ofthe specific policy language applicable to theproject in question. Most often, wrap insur-ance programs are built upon the same basicgeneral liability policy forms as traditional lia-bility insurance. Endorsements added to theprogram can change—or even obliterate—thiscoverage.22 Any assumptions about whatmay be covered are unreliable without areview of the entire policy. Successor ownersshould engage an attorney, agent, and/or bro-ker experienced in construction liability insur-ance coverage to make this analysis. Insurancecoverage issues may be obvious in some casesbut more often they are esoteric, counterin-tuitive, or obscure.23

Many wrap insurance programs do notinclude design professionals, who most likelyhave separate errors and omissions cover-age. Depending on the anticipated liabilitiesthat the successor owner has identified for theproject, these policies may be significant.However, unlike insurance issued directly tothe developer, design professionals shouldnot be expected to name the lender as anadditional insured. For that reason, thesepolicies cannot be considered as a source offunds directly available to the successor ownerbut rather as an additional pool of money thatmay be available to cover claims.

Insurance maintained by the existinghomeowners association may provide anothersource of funds to cover potential liabilities.The association’s property insurance policymay cover claims arising from a problemcaused or exacerbated by the association’s fail-ure to maintain a component. Similarly, if thestatute of limitations has run for a claimagainst the developer, the association may

Los Angeles Lawyer January 2010 33

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become the primary entity responsible fordamages within the project. The acquiringentity should obtain and review copies ofthe association’s liability insurance, propertyinsurance, and directors and officers insurancepolicies.

A single homeowner in an attached con-dominium project has the potential to causedamage to multiple units. Thus many projectsnow contain requirements in their governingdocuments that individual homeowners main-tain liability insurance in specified minimumamounts. Even in the absence of a require-ment, an individual homeowner may obtainliability insurance, which will only become afactor when the damage for which the suc-cessor owner is sued was either caused orexacerbated by the homeowner’s conduct.Reviewing the governing documents to ascer-tain the insurance requirements imposed uponthe project’s homeowners will at least allowthe successor owner to assess the likelihoodthat an individual homeowner (or the home-owner’s insurer) will be in a position to beara share of any damage to the project.

Even when liability insurance is ostensiblyavailable to the project either through thedeveloper or some other source, whether thatinsurance will actually cover a particularclaim cannot be tested until the claim isasserted. Successor owners who have donetheir investigatory homework and uncoveredthe existence of insurance may find that thepolicies offer false hope. For this reason, suc-cessor owners should consider the option ofobtaining their own insurance, which willapply retroactively to the construction that isalready in place.24

In a wrap insurance program, the con-tractor and subcontractors generally willhave waived any claims against each otherto the extent that they are covered under the program. However, if there is a large deductible or self-insured retention, the con-tractor and subcontractors may have re-served the right to seek indemnity againsteach other for those amounts. Also, succes-sor owners may have indemnity and/or sub-rogation rights if a project is insured by tra-ditional insurance—with each party insuredunder its own general liability policy—or ifsome of the subcontractors are ineligiblefor the program and are insured indepen-dently. To determine whether the contractor,subcontractors, or their insurers may be asource of contribution to any constructiondefect liabilities, successor owners shouldreview the construction contracts and sub-contracts. If the contract review reveals thepotential for indemnity from these parties,any indemnity agreements must be furtheranalyzed to confirm that they are enforceablein light of recent California legislationrestricting the circumstances under which a

34 Los Angeles Lawyer January 2010

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subcontractor may be required to indemnifythe contractor.25

Completing Construction

Acquisition of an incomplete project pre-sents additional challenges. Successor ownersmay choose to enhance the value of theirprojects and take on any possible risks bycompleting construction themselves for abulk resale or for retail sales. Alternatively,they may choose the safe route of not com-pleting construction and simply conductinga bulk resale. Another option is to look atpotential exit strategies as part of a contin-uum. By doing so, successor owners can seekmechanisms for limiting liability at variouslevels of construction.

The purpose of forming an SPE to forecloseon property in place of the original lender isto limit postforeclosure liability to the assetsof the SPE. Ideally, the SPE should succeed tothe rights and obligations of the original lenderand thus have whatever statutory protectionmay be available to the lender under CivilCode Section 3434. To do so, the lendershould transfer the loan and all related doc-umentation, rights, and obligations to theSPE prior to the foreclosure, so that the SPEis effectively the lender at the time of fore-closure. With regard to both common lawand SB 800 liability for construction defects,the analysis should be same for the SPE as itis for an original lender. The SPE also musttake appropriate precautions to maintain itsseparateness from the original lender to pro-tect against ultra vires claims or claims alleg-ing that the corporate veil has been pierced.

Risk assessment and risk managementcan minimize the element of surprise in theacquisition of a broken condominium project.This is particularly true regarding construc-tion defects. While not all issues regardingpotential liability have been settled, any lenderor bulk purchaser considering whether topick up the pieces of a broken condominiumproject should identify any potential problemsthat could lead to exposure and the extent towhich they can be mitigated or eliminated. n

1 Some broken condominium projects will involvecourt-appointed receivers, whose liabilities are differ-ent from those of successor owners because receiversact at the direction of the court. See Andrea C. Chang,Giving and Receiving, LOS ANGELES LAWYER, Dec.2009, at 22.2 CIV. CODE §1375.3 CIV. CODE §3434.4 However, there is some precedent in other areas of thelaw for the idea that merely foreclosing and becomingan owner does not by itself cause the loss of lender pro-tections—so long as the lender’s postforeclosure actionscontinue to be consistent with the protection of itssecurity interest. See, e.g., 42 U.S.C. §9601(20)(A)(creating the so-called security interest exemption forlenders from the otherwise automatic liability under theComprehensive Environmental Response, Compen-sation and Liability Act). Of course, this still raises the

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question of when a lender crosses the line of no longeracting in a manner consistent with the protection of itssecurity interest.5 A bulk sale of units does not present the same risksand liabilities as retail sales, because the risks in bulksales may be contractually allocated, and bulk sales donot have the same regulatory and disclosure require-ments as retail sales. In addition, SB 800, the con-struction defect law in California (see nn.6-21, infra,and accompanying text) applies to the builder or theoriginal seller to the public. If the lender is neither thebuilder nor the original seller, it would not incur strictliability under SB 800 for construction defects. SeeCIV. CODE §911. However, to the extent that the fore-closing lender engages in some construction activity toresell the project, it could risk construction defectexposure under common law. See text, infra.6 CIV. CODE §§895-945.5.7 CIV. CODE §896.

8 Pollard v. Saxe & Yolles Dev. Co., 12 Cal. 3d 374,379 (1974). See also Shapiro v. Hu, 188 Cal. App. 3d 324, 379 (1986); East Hilton Drive Homeowners’Ass’n v. Western Real Estate Exch., Inc., 136 Cal.App. 3d 630, 633 (1982); Larosa v. Superior Court,122 Cal. App. 3d 741, 753 (1981); Allison v. HomeSav. Ass’n of Kansas, 643 S.W. 2d 847, 851 (1982)(citing Pollard, limiting implied warranty to builder-vendors, and refusing to extend the warranty tolender-sellers: “[T]he abandonment of caveat emptorcan be applied only to those who have the opportu-nity to observe and correct construction defects.”). Seealso Brejcha v. Wilson Mach., Inc., 160 Cal. App. 3d630, 641 (1984) and Tauber-Arons Auctioneers Co. v. Superior Court, 101 Cal. App. 3d 268, 284(1980) (Auctioneers who sell personal property are notliable for defects in the property that are unknown to them.).9 20 A.L.R. 5th 499, at 1.

10 Chotka v. Fidelco Growth Investors, 383 So. 2d1169, 1170 (1980); see also Port Sewall Harbor &Tennis Club Owners Ass’n, Inc. v. First Fed. Sav. &Loan Ass’n of Martin County, 463 So. 2d 530, 532(1985) (reaffirmed limit to foreclosing lender’s liabil-ity). Similarly, the Supreme Court of South Carolinadecided in 1984 that a lender who marketed newly con-structed units following its purchase of the units fromthe builder but did not participate in the original con-struction was only liable to purchasers for negligencerelated to the repairs it performed. Roundtree VillasAss’n, Inc. v. 4701 Kings Corp., 282 S.C. 415 (1984).However, more recently, the Supreme Court of SouthCarolina extended a foreclosing lender’s potential lia-bility to include defects resulting from the originaldeveloper’s construction through a theory of impliedwarranty. The ruling was premised on the fact that thelender became substantially involved in completion ofthe home, beyond the normal practices of a lender.Kirkman v. Parex, 369 S.C. 477 (2006).11 SB 800 applies only to residential sales to the pub-lic, not to a foreclosing lender who engages in a bulksale to a third party. CIV. CODE §911.12 Id.13 CIV. CODE §896.14 CIV. CODE §§914 et seq.15 CIV. CODE §912. Successor owners should makeevery effort to obtain complete construction docu-ments and insurance files from the developer at the ear-liest time possible in the transaction rather than wait-ing until a claim arises.16 CIV. CODE §896. The minimum standards requiredfor new construction apply to potential water intrusion,structural integrity, soils, fire protection, plumbingand sewer, and electrical matters, among others.17 CIV. CODE §900.18 CIV. CODE §926.19 CIV. CODE §900.20 If the insurance program provides for defense costsin addition to the liability limits of a $3 million generalliability policy, the insurer could spend $1.5 million indefending construction defect litigation, but $3 mil-lion in coverage would still remain to satisfy claims. If,under the same scenario, defense costs are “within lim-its,” only $1.5 million would remain for claims. Becauseof the high cost of construction defect litigation, if thedefense costs are within limits, the full amount of cov-erage may be exhausted by the payment of those costs,leaving nothing for repair or replacement of the defec-tive building component.21 A typical precautionary step is to include the devel-oper’s rights in any existing insurance coverage as partof the assets upon which the lender is foreclosing.Similarly, the bulk purchaser should seek an assignmentof those rights as part of its acquisition of the project.These actions are particularly helpful when any party’spolicies cannot be located or if the successor ownersquestion whether the policies they have obtained arecomplete.22 Some developers have had the unpleasant surprise ofdiscovering that a wrap insurance program purchasedfor a condominium project does not cover multifam-ily construction.23 With the use of standardized policy forms so preva-lent, courts in various jurisdictions have interpreted thesame policy language in different contexts. Thus,dozens of courts in many states have analyzed themeaning of a commonly used term such as “sudden.”24 If existing insurance can be confirmed and if the suc-cessor owner is either covered or can obtain coverageunder the insurance, there are advantages to doing so.For instance, having a single insurer covering all con-struction defect claims at the project eliminates theconflict between multiple insurers regarding whosecoverage applies in the event of a loss.25 See CIV. CODE §2782.

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