Lender Beware: Part II — Lender as Joint Venturer / Partner
There are some circumstances in which a lender may be directly liable to third parties for construction defects as a principal or alter ego of the developer. Most jurisdictions hold that for this liability to exist more than just the holding and protection of a security interest and the monitoring of the developer’s operations must exist. A form of this liability may be found when the developer and the lender are partners or joint venturers. Banks and financing institutions may be held liable to home and condominium buyers if the lender has participated in the management of the project to a degree that the court finds that the lender-borrower relationship was a joint venture. Also, when the lender assumes control of the contractor it will usually be bound by the construction contract. If the developer notes construction deficiencies and the lender refuses to withhold disbursements without investigation, the lender may also be liable.
Lender as De Facto Developer
Closely related to the theory of direct or joint venture partnership liability is the theory that the lender is liable to third parties for construction defects because of the control it exercises over the developer’s day-to-day operations. A lender is considered a developer when it is also involved in the development of the homes sold to the purchasers. Similarly, a lender is presumably a joint venturer when the lender has an equity ownership in the project with another entity. Likewise, a lender is deemed to be amalgamated if it merges with a developer or builder so as to appear to be a united entity. The issue is one of “control.” By controlling the developer the lender in effect becomes the developer of the construction project.
Banks and financial institutions that limit their involvement in construction projects to financing will not be found liable under a lender liability theory. However, when the bank takes over the project and constructs or finishes construction as if it were its own, or has some direct involvement, the lender can be held liable for construction defects.
The issue of de facto developer is further complicated when dealing with Community Associations because lenders can become a “Successor Declarant.” In cases involving lenders as Successor Declarants, the courts are faced with evaluating the extent to which the lender should be required to fulfill the obligations of the original developer. When making loans on condominiums or planned unit developments, lenders should consider including “Successor Declarant” language in the documents that more clearly define the rights and obligations of the parties if the original developer conveys the remaining portion of the project to the lender or to another successor. Successor provisions are beneficial when the facts of the law result in the successor being deemed responsible for fulfilling the obligations of the original developer. Whether such a provision would limit a successor’s liability for construction defects will depend on the facts and circumstances and the laws of the jurisdiction where the project is located.
A special situation arises when the lender is forced to foreclose or takes the deed in lieu of foreclosure on a construction project. In our current economically distressed real estate market, an increasing number of lenders are forced to acquire new homes and condominiums from defunct builders and developers and lenders should be aware of potential liability if they become the vendor of these homes. The seller of a new home (whether it’s a developer or a lender who has acquired a property through foreclosure) impliedly warrants the habitability of the home or condominium.
Stay tuned for more on this issue.