Co-Author: Jeremy S. Durham
At the time of the publication of this article, the seizing of the credit markets seems to have stalled all but the most conservative commercial real estate loans. Many commercial real estate ventures are financed with short term debt. Lenders are not renewing loans that have matured. Other lenders are not providing replacement financing. The inability to get financing handicaps developers from selling projects. While each lender may be acting in its own best short term financial interest, the collective behavior increases the number of defaulted commercial real estate loans.
Developers generally expect that when their loans secured by real estate go into default, the lender will first seek to foreclose on the collateral. The principals of many borrowers are willing to facilitate “deed-in-lieu of foreclosure” or “short pay off” transactions to save the lender the time and expense of foreclosing on the collateral. If the lender is unable to satisfy the debt with the collateral, then most borrowers expect the lender to next pursue the borrowing entity, now typically a limited liability company. The guarantors (if there are any) expect only to pay if the lender has not first satisfied its debt through the sale of collateral or from the pursuit of the borrowing entity. Sureties, who have guaranteed debt secured by real estate that is appraised for more than the debt, do not expect to pay on their guarantees.
Yet neither Colorado law, nor the loan documents signed by most borrowers and guarantors, require the lender to proceed in this order. In most situations, the lender may sue the guarantors without first foreclosing on the debt. In the vast majority of single family financing, the lender first forecloses on the property and only considers pursuing borrowers or guarantors individually after the foreclosure. However, as real estate becomes less liquid, commercial lenders are increasingly suing the individuals who are personally liable on the debt, without first completing the foreclosure on the property. Cash is king. Even in cases where the real estate has an appraised value that exceeds the amount of the debt, lenders are declining deeds-in-lieu of foreclosure. While doing so may be legal, lenders must still comply with the covenant of “good faith and fair dealing” when exercising the lender’s collection remedies. This article explores lender’s duty of good faith and fair dealing.
Promissory notes, deeds of trust, and other credit agreements between lenders and borrowers are contracts. Every contract creates an implied duty of good faith and fair dealing. The obligation requires a “faithfulness to an agreed common purpose and consistency with justified expectations of the other party.” Wells Fargo Realty Advisor Funding Inc. v. Uioli, Inc., 872 P.2d 1359 (Colo. App. 1994) (All subsequent quotations in the article are from this Uioli case. )
The duty of good faith and fair dealing “does not obligate a party to accept a material change in the terms of the contract or to assume obligations that vary or contradict the contract’s express provisions.” When a contract permits one party to use discretion, the other party has an expectation that the party exercising the discretion will do so in a reasonable manner. “When one party uses discretion conferred by the contract to act dishonestly or to act outside of accepted commercial practices to deprive the other party of the benefit of the contract,” the covenant of good faith and fair dealing is breached. While the notion of “good faith” is inherently ambiguous, the Uioli case provides useful breach examples.
The Uioli lender gave a borrower a revolving line of credit for the lesser of a fixed sum or seventy-five percent of the property’s appraised value. The loan agreements provided that a lender selected appraiser could determine the market value. The lender used its own in-house appraisers who devalued the property by31% from an appraisal done six months previously . This reduction in the perceived value of the property required the borrower to pledge additional collateral.
The Uioli lender deliberately delayed the foreclosure process to increase the debt as the value of the collateral substantially exceeded the value of the debt.
The lender pressured its own in-house appraiser to decrease the estimated value of the collateral.
The collateral was multiple parcels of real estate. The lender did not hold a first lien on all of the parcels. When some of the parcels went to foreclosure auction from foreclosures initiated by other senior lenders, the Uioli lender surreptitiously acquired those parcels at the foreclosure sale. Presumably, the lender would not have bought the property at the foreclosure auctions unless there was value in the property above the foreclosed upon debt. The lender did not disclose to the borrower that the lender had acquired the other parcels in an attempt to avoid having to credit the equity against the borrower’s debt.
Might there be other examples where lender’s behavior would be found to violate the implied covenant of good faith and fair dealing? The two cases mentioned in this article were both decided in the early 1990’s based on lawsuits that emanated from Colorado’s last real estate bust at the end of the 1980’s. It is inevitable that this real estate bust will provide fresh new examples.
Jeremy S. Durham was a law clerk at Frascona, Joiner, Goodman and Greenstein, P.C.