A Year When Key Legal Issues Were Cleared Up

Thanks to a steadily improving market and a host of new court decisions, a lot of legal dust that had been kicked up by the hard times of the early 1990s settled during 1997.

That’s the assessment of two Cox, Castle & Nicholson lawyers in the Los Angeles firm’s soon-to-be-released summary of last year’s real estate legal developments.

A variety of courts cleared up some of the cloudiest issues raised during the recession, said Susan Davis and Greg Karns, while the Legislature enacted new laws eliminating some uncertainties in existing law.

Davis and Karns, who edited the legal summary along with Cox, Castle attorney Amy Wells, will discuss the 1997 legal developments at a UCLA Extension seminar Thursday and Friday. The lawyers said the court cases and new laws addressed dozens of issues regarding the rights of lenders, borrowers, developers and others involved in real estate.

These ranged from highly specialized and esoteric questions of real estate finance to such seemingly mundane matters as a new law requiring apartment owners to install deadbolt locks on all units. (The latter may seem mundane, according to Karns, but it’s a significant development for certain real estate investment trusts and other landlords who own thousands of apartment units.)

The legal developments of 1997 are best understood in contrast with the early 1990s. During the recession, lenders, borrowers and other players in the real estate market began to sue each other much more often over matters that had rarely, if ever, gone to the courts.

“In the early 1990s, all of a sudden we were dealing with atypical business trends, so a number of the court decisions came as surprises to legal practitioners and business people alike,” Karns said. Many were issues that even the most experienced real estate lawyers hadn’t encountered since law school.

Some of the types of disputes that proliferated during the recession had been virtually unheard of for years because of what Karns calls “the good deal exemption.” By that he means that parties involved in a transaction aren’t likely to sue when it’s a good deal for everyone involved.

“If everyone’s getting paid and making money, there’s little impetus for a lawsuit,” Karns said. “For years the market was great and borrowers could always sell a property for more than they paid for it, so banks and other lenders always got paid back.”

The recession came, however, and borrowers and lenders were often at each others’ throats. The courts had to decide many difficult, complicated cases, resulting in a mix of decisions that sometimes appeared inconsistent or at odds with each other.

One example cited by Davis and Karns is an esoteric area of real estate financing having to do with letters of credit.

Although letters of credit are best known for their role in international trade, they often play an important role in the financing of large real estate deals. In a typical scenario, a lender will require a borrower to furnish a letter of credit as supplementary collateral, in addition to the property itself, on certain types of real estate loans.

A running dispute in the courts has been the question of whether a lender who recovers collateral under a letter of credit thereby gives up the right to foreclose on the property. Lower courts ruled in the early 1990s that lenders forfeit their property foreclosure rights if they first go after the letter of credit as collateral.

“That upset the lending community tremendously because letters of credit traditionally are supposed to be sacrosanct,” Davis said, “and wholly independent of the main collateral secured by the property itself.”

But the California Supreme Court in April ruled in support of a new state law that says lenders can draw upon letters of credit without losing their rights to foreclose on the property.

The Supreme Court decision should be the final word in the matter, Davis said, and reaffirms letters of credit as a powerful tool in real estate transactions.

According to experts in real estate law, the letters of credit issue is one of many cases in a legal tug-of-war that borrowers and lenders have fought during the past 10 years.

“During the early part of the down cycle, commercial lenders took a real beating in bankruptcy courts,” said George Lefcoe, a professor of real estate law at USC. Real estate borrowers were able to take great advantage of the bankruptcy laws to force lenders into workouts and various compromises that lenders were “wildly unhappy about,” he said. But lenders have made a good legal comeback in recent years, Lefcoe said, thanks to “some changes in the hearts of bankruptcy judges, and some federal and state legislation.”

Disputes between borrowers and lenders constitute just one of many facets of real estate law involving traditional legal combatants, such as lenders versus borrowers, sellers versus buyers, landlords versus tenants and brokers against the clients they represent.

The types of real estate-related claims being filed in the courts “very much mirror the market,” Lefcoe said, but are “probably somewhere between 90 days and six months behind it.”

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In the late 1980s when office leasing rates were rising rapidly, landlords and tenants fought over the profits that tenants gained when the tenants subleased space to other occupants at higher rates. Landlords were eager to get those profits for themselves and even got some help from the Legislature to recapture those dollars.

“We haven’t seen disputes like that for some time,” Lefcoe said, “but we will.”

Another matter cleared up in 1997 was the question of what lenders must do to ensure that they are entitled to the rents generated by a property between the time a loan goes into default and the time a borrower files for bankruptcy.

A new state law that went into effect last year cleans up “a mess created over many years by bankruptcy courts and California and federal appellate courts,” according to a summary of the new law by Cox, Castle & Nicholson.

“There was prior law having to do with this issue, but basically the case law and the statutory law were incredibly confusing,” Davis said. The issue was important because the gap between a loan default and a bankruptcy filing can sometimes be a year or more, meaning substantial sums of rent may be fought over by lenders and borrowers.

Many of the thorniest legal issues arose in bankruptcy and foreclosure proceedings during the darkest days of the recession, Davis said. One of these that was settled by the U.S. Supreme Court in 1997 concerned the value placed on a property when a bankrupt borrower wants to retain the property as part of a bankruptcy court reorganization.

Borrowers argued that the property should be valued as low as possible, at liquidation or ‘fire sale” prices, Davis said, while lenders argued that the property should be valued at its fair market price, typically a substantially higher figure. The property value established by the bankruptcy court is important because it ultimately determines what portion of the original loan a borrower is required to pay back to the lender.

The Supreme Court ruled that the property should be valued according to its “proposed disposition” by the bankrupt borrower, which essentially means the property’s fair market price if the borrower plans to keep it as part of the bankruptcy reorganization.

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Davis said the court ruling was part of “a trend to make it more difficult” for debtors to force unfair or so-called “cram-down” settlements on their creditors. The courts have been especially wary of bankruptcy cases in which real estate is the debtor’s only major asset and the debtor attempts to have the property assessed at a fire sale value as a means of escaping debt, she said.

While some bankruptcy and foreclosure disputes remain as vestiges of the early ‘90s downturn, Davis said real estate lawyers are seeing far fewer of these cases, largely because of improving economic conditions.

“Borrowers are a lot less likely to walk away from properties than they were before, and lenders are a lot more willing to work out deals,” she said. According to Karns, the industry once again enjoys conditions in which the “good deal exemption” reduces the likelihood of lawsuits.