Understanding Lender Liability: Avoid California’s 10-Year Liability for Construction Defects in Fix and Flip Properties

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Should you be a lender with a borrower in default on a fix & flip property, it is likely you will be taking the property back after foreclosure. There are potential pitfalls for a lender when a fix & flip borrower walks away from a project and leaves you to clean up the mess. You will have to deal with these unfinished projects, and if there is no equity because the property is in disrepair or mid-construction, you may be considering finishing the project yourself to mitigate the loss. The statute of limitations for construction defect claims in California is 10 years, so the potential for liability follows you for a decade.  Litigation may rear its ugly head many years after you transferred the property and thought this nightmare was behind you. This article explores the risks lenders should beware of when taking back a fix and flip after foreclosure and offers ways you can protect yourself from significant liability.

When a lender becomes the property owner after foreclosure and then sells that property to a third party, the buyer may sue you under various theories including construction defects, negligence, third-party beneficiary, strict liability, indemnity, nuisance, and negligent interference with prospective economic advantage.  This is true even when the lender did not contract for the repairs/construction; whether the lender has made further improvements or not.

This Article does not address residential construction sold new on or after January 1, 2003, which falls under SB 800 or The Right to Repair Act, which is part of the California Civil Code.

What disclosures, if any, must you, as a Lender, make upon selling a property after foreclosure?

Generally, in residential real estate transactions, the seller must provide purchasers with a Transfer Disclosure Statement (“TDS”). Civil Code § 1102. The statutory form requires the seller to provide information concerning the condition of the property.  Civil Code § 1102.6. However, in a transfer by a foreclosure sale or deed in lieu of foreclosure, or any transfer thereafter by a beneficiary or mortgagee who acquired the property by foreclosure or deed in lieu of foreclosure, a TDS is not required. Civil Code § 1102.2.

Notwithstanding the foregoing, a common law duty of disclosure still exists any time real property is transferred. Civil Code § 1102.8.  In California, “where the seller knows of facts materially affecting the value or desirability of the property . . . and also knows that such facts are not known to, or within the diligent attention and observation of the buyer, the seller is under a duty to disclose them to the buyer.” RSB Vineyards, LLC v. Orsi (2017) 15 Cal.App.5th 1089, 1097.  “Where a seller fails to disclose a material fact, he may be subject to liability for mere nondisclosure since his conduct in the transaction amounts to a representation of the nonexistence of the facts which he has failed to disclose. RSB Vineyards, LLC, 15 Cal.App.5th at 1097.  What creates the seller’s statutory duty is actual knowledge of the defect. San Diego Hospice v. County of San Diego (1995) 31 Cal.App.4th 1048, 1055-1056.

A lender’s duty of disclosure even exists in the case of a foreclosure sale.  For example, in Karoutas v. HomeFed Bank (1991) 232 Cal.App.3d 767, a lender secured by a deed of trust on the borrower’s residence commenced foreclosure after the borrower’s default.  Prior to the sale, the lender had received reports from the borrower of physical defects in the property. At the trustee’s sale, the property was purchased by a third party who could not inspect the property in advance of the sale, and the lender did not ask the auctioneer to announce or disclose the defects at the time of the auction.   After the sale, the buyers discovered the defects which substantially affected the value of the property and sued the lender for rescission, declaratory relief, fraud, and negligent nondisclosure. The court found that at common law, there was a duty to disclose material facts that are known only to the defendant where the defendant knows that the plaintiff does not know or cannot reasonably discover the undisclosed facts.  Most importantly, the court determined that the nonjudicial foreclosure statutes do not eliminate the common law duties owed to prospective purchasers at trustee’s sales.

If you are aware of material facts affecting a property which you are selling, transferring, or foreclosing on, that cannot reasonably be discovered by the prospective buyer, you are obligated to disclose such facts.

Do you, as the Lender, face any liability for work performed by your borrower?

What if you foreclose and acquire a property that had been improved, partially or completely, by the borrower?  What potential liability do you face if you sell that property, and the buyer later discovers undisclosed defects in the construction?  The buyer will likely seek to recover from you for any damages caused by those defects. Ultimately, their recovery will depend on whether you knew about the defects.  If the lender did nothing but acquire the property at the trustee’s sale and then turned around and sold the property, its liability will usually be limited to nondisclosure of defects of which the lender had actual knowledge. See Karoutas v. HomeFed Bank (1991) 232 Cal.App.3d 767.

This is because lenders are provided with statutory protections.  Specifically, a lender who makes a loan of money, the proceeds of which are used by the borrower to construct, modify or improve real property for sale, shall not be liable to third persons for any loss or damage caused by any defect in the real property resulting from the failure of the borrower to use due care, unless the damage is a result of the lender acting outside the scope of its role in merely lending money, or was a party to any misrepresentations made with respect to the real property. Civil Code § 3434.

It wouldn’t make sense to hold a lender liable for defects they knew nothing about, did not direct or control, and could not inspect after completion.  As such, so long as a foreclosing lender does not act outside the scope of its role as merely lending money (i.e., does not try to take control of the borrower or control the conduct of the borrower or improve the property), the lender is not liable for any defects in construction.

It is important to note: despite the anti-deficiency limitations, a construction lender after obtaining the property through foreclosure, may maintain a negligent construction action against the borrower/developer for damages caused by negligent construction because the measure of damages does not relate to the collection of the secured debt. Sumitomo Bank v. Taurus Developers, Inc. (1986) 185 Cal.App.3d 211.

Do You, as the Lender, Incur Liability for Work you Authorized or Directed After You Took the Property Back at Foreclosure?

If a lender forecloses on real property and proceeds to finish construction and/or perform improvements after the foreclosure sale, the lender is going outside the scope of activities of a lender of money and is no longer absolved of liability for the defects in the design or construction of the improvements. Civil Code § 3434. That means if you perform improvements after foreclosure, which improvements are completed in a negligent manner, you may become liable for the negligence in defective construction based on the general rule imposing liability upon persons who perform services to third persons within the area of foreseeable risk.

Such liability is akin to the liability of a developer or general contractor because, even though you were not completing the repairs yourself, you were orchestrating, approving, and directing those repairs.  The most sure-fire way to take on post-foreclosure liability, is to complete the construction project or take on the repairs yourself.  Our recommendation—don’t do it.  But, if you are absolutely determined to complete the project before selling the property, make sure you protect yourself with insurance.  One option is to contact your insurance professional and request a commercial general liability policy that will cover any claims made against you as a result of construction – so called “completed operations” coverage.  This may be difficult (or expensive) insurance to obtain, so you may need to contact an insurance broker that sells coverage written by an insurer that is not admitted in California.  Alternatively, if you are not doing the work yourself, you can require your general contractor (and all sub-contractors) to add you to their coverage as an additional insured.

With either option, however, remember that the statute of limitations in California for construction defect claims is up to 10 years.  Accordingly, you need to make sure that insurance coverage remains in place for the full 10 years after completion of the project.

Instead, if you intend to make improvements to the property after foreclosure before selling it, and still maintain the protection of Civil Code § 3434, the lender should be protected if it seeks the appointment of a receiver to operate the project and improvements, so long as the lender does not act outside the scope of merely lending money.  This would require you to seek appointment of the receiver before you complete the trustee’s sale (and we can help with that).

As ever, be careful, and strategic, in your decision-making process.  Call the team at Geraci anytime.  We are glad to help.

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