Use of Receiverships in Failed Common Interest Ownership Projects
USE OF RECEIVERSHIPS IN FAILED COMMON INTEREST OWNERSHIP PROJECTS
By Philip B. Korb
Ballard Spahr LLP
In many markets, the condominium sector has become the real estate meltdown’s poster child for overbuilding and failed developments. Every distressed sector has its quirks and special characteristics that dictate differing techniques to address the needs of each affected party. Residential condominiums and other common interest ownership communities, such as cooperatives and planned communities, are certainly examples of special needs projects.
A partially sold condominium or planned community is both a retail business that must market its inventory to succeed, and a functioning community comprised of that most delicate and sensitive of occupants - homeowners. It is also subject to the ground rules established by a recorded declaration that functions like a constitution, and to an elaborate statutory framework, both local and federal, that governs every detail of its existence and operation. The demands and potential liabilities faced by the controlling parties in such projects make receiverships particularly attractive. They offer unique opportunities while raising unique issues that affect lenders, developers, property managers, home owners and community associations.
The typical example of today’s failed project would look something like this: A 150-unit high-rise condominium the developer began to promote three years ago during in the midst of a red-hot market. Construction began two and a half years ago after the developer and the lender approved ground breaking based on no more than refundable reservations, or just a term sheet and the perceived certainty of a permanent boom. Construction was completed eight months ago when the first buyers closed on their purchases and moved in. Fifty units have been sold and are occupied, but sales virtually ceased six months ago. Five months ago, the developer stopped paying assessments and making any other payments relating to the property.
Once the velocity of sales slows, it quickly becomes impossible (or if not impossible, at least pointless for a financially strong developer) for a developer to fund its obligations. Even if its loan is not yet literally due, interest will continue to run on its construction loan, quickly eroding any theoretical equity. The additional burden that makes the developer’s predicament untenable in a condominium is the ongoing operational cost associated with unsold units. As owner of those units, the developer is obligated under most condominium declarations and condominium statutes to pay the assessments levied on the condominium units it owns. The Uniform Condominium Act (“UCA”), and the Uniform Common Interest Ownership Act (“UCIOA”), together are in effect in almost half the states. Their progeny, the Uniform Planned Community Act and Uniform Residential Cooperative Act, are virtually copied from UCA. Under these statutes, and the statutes of many non-uniform act states as well, a developer, like every other unit owner, is obligated to pay its share of common expenses from the moment assessments are levied by the association. UCA § 3-115. Under UCA , unpaid assessments are an automatic statutory lien against the delinquent owner’s units. UCA § 3-116.
Especially in a high-rise building, with elevators and other significant mechanical elements, and in a ‘luxury’ project (which has become the typical high-rise project) with services and amenities such as concierge and doorman service, fitness centers, swimming pools and valet parking, monthly assessments often reach the neighborhood of $1.00 per foot. A developer left holding 100 units averaging 1,500 square feet owes $150,000 per month for the assessments on his vacant units. Under UCA, every unit is a separate tax parcel, receiving an individual real estate tax bill for which the developer is also responsible. UCA § 1-105. As a unit owner, the developer will also be responsible, either directly or indirectly, for unit utility costs.
Since it owns a majority of the units in the project, the developer also has control over the condominium association and its executive board during this initial period of declarant control. UCA 3-103. With an evaporated market and declining values, the developer has neither the ability nor any incentive to continue to support and manage the property or the condominium association and its executive board. The unit owners have probably become frustrated, worried and hostile, making it difficult for even the most well-intentioned developer to play any role in operating the condominium.
It is usually the secured construction lender that has the real economic interest in the units owned by the developer. [1] The lender’s goal is to maximize their value, but that is a challenging task. It would prefer a stabilized project, with the lights still on and services still provided, so that the unsold units have as much value as possible. It also will be seeking an exit strategy, which could be foreclosure or sale in bulk to a real operator that may market the units for either sale or lease. Until then, the lender will not blithely assume liability for all the costs of ownership of the empty units, including the costs that have gone unpaid by the developer. Also, it will want to avoid, or at least defer, responding to warranty claims and other construction issues that may have been raised by the unit owners.
A court-appointed receiver is a natural interim solution for the lender, and often for the developer as well. So long as it avoids taking title to the declarant’s units, the lender has no liability for the expenses of ownership or claims relating to the building and construction issues. It also will prefer to avoid the burden of directly running the association and the property. The developer’s units still give it majority control over the association and the executive board, and in any case the project is still probably operating within the initial declarant control period of most condominium statutes. UCA, 3-103. Neither the developer nor the lender want these duties, but the executive board and the association must nevertheless be operated properly, which is in the lender’s interest.
The appointment of a receiver to take control over the declarant’s units, and to control the executive board and thereby the property, addresses all of these problems. The receiver can shield the lender from liability for assessments and building costs, while the lender can decide how much it wishes to spend to maintain the project. It may also be in the interest of the developer to cooperate with the appointment, so as to free itself from ongoing responsibility for the project, if not ultimate financial responsibility during this period, while it still has legal title to the project. The developer may also be able to use the crafting of a consensual receivership order as an opportunity to negotiate the terms of the resolution of its loan.
In many states, a lender does not have an automatic unilateral right to the appointment of a receiver even if the loan documents purport to give the lender that right. As a rule, waste, wrongdoing or other appropriate circumstances must be proven. Metropolitan Life Ins. Co. v. Liberty Ctr. Venture, 437 Pa. Super. 544, 650 A.2d 887 (1994); Leighton v. One William St. Fund, Inc., 343 F.2d 565, 568 (2d Cir. 1965). Receivership orders therefore are often consensual, which obviously makes them much easier to obtain in jurisdictions in which the right to the appointment of a receiver is not automatic. Further, in a consensual order, the parties can more easily negotiate the terms of the receivership. The receiver is the creature of the court. The court-approved Order appointing the receiver will govern the receiver’s role, obligations and powers. The Order may state expressly that the receiver has no powers beyond those established by the Order.
Certain issues require particular attention in fashioning the Order. The receiver should be given express power to exercise the special declarant rights of the developer. The receiver’s power to market, sell and lease units should be made explicit, including specifically and clearly stated power to execute deeds and leases. The receiver should be given express rights to control the Executive Board during the period of declarant control, as if the receiver were the developer, along with the concomitant right to vote on behalf of the owner of the declarant’s units. Those matters requiring the approval of the lender should be identified, including the maximum amount the receiver may spend without lender approval, and decisions about selling or leasing specific units. The parties should decide whether to permit the receiver to act as property manager, or to keep those functions separate, giving the receiver the power to hire and fire the manager. The limits of its power should be stated expressly and clearly.
The parties will expect the receiver’s tenure to be limited. It may have that role only as long as it takes to complete a foreclosure proceeding. More generally, the lender envisions the receiver’s role as preserving the asset until it has devised and effected its exit strategy, often, as noted above, until a bulk buyer for the units or the loan is found and the transaction completed. However long the receiver’s engagement, a unique issue to be faced by receivers in common interest ownership projects is the implicit and unavoidable conflicts of interest that accompany dealing with the lender and running the association and executive board.
As to lender conflicts, the problem is not simply a technical legal conflict, but the practical risk of biting the hand that feeds you. The receiver was probably selected by the lender, and is in its debt for that reason in and of itself. There will usually be little or no income flowing from the declarant’s units during this period. No one but the lender has the capacity to pay the receiver’s fees. The Order will establish the procedure for paying the receiver, and may provide that the costs will be initially paid by the lender but will be charged to the declarant. As noted below, the receiver will often find itself seeking funds from the lender needed to operate the property, a negotiation that can be awkward.
The more explicit conflict arises when the receiver takes de facto control over the executive board and the association. Most condominium statutes provide that during the initial sales period, before most of the units have been sold, the declarant controls the executive board, and therefore the condominium. Moreover, a declarant that owns a majority of the units will necessarily control the yea/ nay voting by the association itself.
The court order imposes on the receiver a fiduciary duty to preserve and protect the value of the property entrusted to it, that property being the individual condominium units owned by the declarant. It therefore also requires the receiver to protect the interests of the declarant in the units, if there is any equity, and, more likely, the lender and other creditors. However, under most condominium statutes, every member of the executive board bears a duty to the condominium association, including every non-declarant unit owner. This creates a perhaps inevitable conflict of interest. The receiver must make decisions regarding the property to protect it and unit owners, while protecting the value of the unsold units that are his court ordered responsibility. Those interests will often coincide, but occasionally they may clash.
A Receiver’s Fiduciary Duty to the Court and Protections from Liability
A receiver is, in essence, an officer of the court that appoints it. Its duty is to “protect and preserve, for the benefit of the persons ultimately entitled to it, the estate over which the court has found it necessary to extend its care.” Warner v. Conn, 347 Pa. 617, 619 (Pa. 1943).
As an officer of the court with responsibility for protecting and preserving the assets of the estate, a receiver owes a fiduciary duty to those parties that have an interest in the property under its care. Warner, 347 Pa. at 619; Sovereign Bank v. Schwab, 414 F.3d 450 (3rd Cir. 2005). “A receiver represents not only the corporation but all its creditors, and, as to the latter, it is his duty to secure all the assets available for their payment.” Seidler v. Gayville Co., 19 Pa. D & C. 200, 201 (1927). The receiver is a fiduciary “with respect to all persons interested in the receivership estate.” Phelan v. Middle States Oil Corp., 154 F.2d 978, 991 (2d Cir. 1946). Generally, the receiver will not violate this duty so long as it acts in good faith in carrying out its duty and does not exceed the authority conferred by the court. Witt v. Commonwealth, Dep't of Banking, 493 Pa. 77 (Pa. Commw. 1981).
An Executive Board Member’s Duty to All Unit Owners
Depending on its scope, the court-approved receivership order often permits the receiver to exercise all rights held by the developer/declarant. As suggested above, it is usually desirable for the receivership order to grant the receiver expressly the same right to control the executive board that the declarant itself would have. However, most condominium statutes impose a duty on executive board members, that may approach or expressly reach a fiduciary duty, to the association and all unit owners.[2] Similarly, every undertaking or duty imposed under the Uniform Condominium Act carries with it an obligation of good faith in its performance. Lyman v. Boonin, 535 Pa. 397 (Pa. 1993).
What happens when the unit owners demand that action be taken against the declarant (and the declarant’s units) for unpaid assessments? What should the receiver do when the unit owners request changes in the level of services and monthly assessments? What decisions can the receiver make regarding renting the units, or discounting their sale price, if these actions may impair the value of the sold units? In short, what decisions can the receiver make if the receiver believes that protecting the value of the declarant’s units may be inconsistent with the best interests of the overall condominium and the existing unit owners?
Because the receiver needs protection when it is carrying out its duties, a suit cannot be brought against a receiver without the permission of the court that appointed it unless authorized by statute. This rule is based on the theory that the court first obtaining jurisdiction and appointing a receiver retains jurisdiction over all issues relating to the conflicting interests between the parties that grow out of or relate to the subject matter in controversy. Warner, 347 Pa. at 620.
Additionally, a receiver is entitled, and in some cases required, to seek instructions and approval of the court. The receivership order should prepare for the right of the receiver to apply to the Court at any time during the action for further directions and guidance to assist the Receiver in its managerial role. Some cases even suggest that in certain situations, a receiver must seek such advice from the court or assume the risk of liability for its costs and expenses. Interlake Co. v. Von Hake, 697 P.2d 238 (Utah 1985). In Interlake Co., the Supreme Court of Utah suggested that a receiver assumes the risk of liability for costs and expenses incurred when it acts without court authority. Id. at 240. Accordingly, the prudent receiver faced with a decision that may present a conflict should ask the court for direction and supervision.
Where an action against a receiver stems from the performance of its duty within the scope of its power under a valid court order, the receiver is protected from personal liability. Any action challenging such action is treated as if brought against the receivership generally, and any recovery is payable from funds in the receiver’s hands. FDIC v. Bernstein, 786 F. Supp. 170 (E.D.N.Y. 1992). An action brought directly against the receiver must be based on a claim that the receiver has failed to exercise good faith or that its actions constitute gross negligence or willful misconduct. The receiver must be sensitive to the scrutiny it will receive from unit owners who may be predisposed to view the receiver as the servant of the lender. Accordingly, the careful receiver should not only act in good faith, but also preserve the appearance of good faith.
1
[1]In the example given, it is unlikely that a mezzanine lender or other junior creditor will have a realistic expectation of any meaningful return on its investment or recovery of its debt.
[2]3-103(a) of UCA provides:
(a) Except as provided in the declaration, the bylaws, in subsection (b), or other provisions of this Act, the executive board may act in all instances on behalf of the association. In the performance of their duties, the officers and members of the executive board are required to exercise (i) if appointed by the declarant, the care required of fiduciaries of the unit owners and (ii) if elected by the unit owners, ordinary and reasonable care.