1. Chapter 22 Liability, Agency Problems, Fraud, And Ethics in Real Estate Finance © OnCourse Learning

2. Chapter 22 Learning Objectives  Understand how parties to real estate finance transactions can be held liable for their actions  Understand the structure of agency relationships within real estate finance  Understand that there are agency costs associated with preventing parties from acting solely in their own interest and against the interests of others  Understand how insufficient agency costs allow wealth transfers 2 © OnCourse Learning

3. Lenders’ Legal Liability  Lenders may be subject to liability in two areas:  Violation of state or federal laws regulating certain activities  Violation of contractual obligations involving loan arrangements 3 © OnCourse Learning

4. Federal Laws Regulating Hazardous Waste  Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA)  Liability under CERCLA – strict, retroactive, and joint and several  Strict liability – a charged party may not offer as a defense a claim that its actions were not in violation of any law prior to CERCLA  Joint and several liability – each potentially liable party can be made to bear the entire cost of cleanup even if several parties may have been responsible for the contamination  Superfund Amendments and Reauthorization Act of 1986 (SARA) 4 © OnCourse Learning

5. Hazardous Waste  Potentially responsible parties (PRPs) for contaminated properties:  Current owners / operators of a facility  Owners / operators at the time of discharge  Generators of the hazardous substance or parties arranging for disposal  Transporters of the hazardous waste  Secured-Lender exemption – a PRP owner or operator does not include a lender that holds a mortgage or deed-of-trust on a property as security for a note  Lenders may lose this exemption if they foreclose on the contaminated property 5 © OnCourse Learning

6. Lender Defenses  Lender claims to not be a PRP  Contamination resulted solely from an act of God, act of war, or omission by a third party  Claims to be an innocent landowner with no knowledge of contamination 6 © OnCourse Learning

7. Initial Judicial Decision  United States v. Mirable (1985) – involved three lenders with secured interest in a property  United States v. Maryland Bank and Trust Company (1986) – involved a secured lender that foreclosed on a property and took title through a sheriff’s sale  Guidice v. BFG Electroplating Co (1989) – court recognition of option values related to the CERCLA legislation  Fleet Factors Corporation (1990) – lenders liability extended further  Bergsoe Metal Corporation (1990) – addressed the issue of lender control of business activities 7 © OnCourse Learning

8. April 1992 EPA Regulation  Rules allowing lenders to foreclose and not be liable:  Actions prior to security interest  Periodic monitoring and/or inspection  Involvement from inspection results  Requiring borrower compliance  Restructuring the loan arrangement 8 © OnCourse Learning

9. April 1992 EPA Regulation  Rules allowing lenders to foreclose and not be liable:  Requiring additional rent or interest  Exercising any rights the lender may have under the law or any warranties, covenants, conditions, or promises  Providing financial or administrative advice  In 1994 an appeals court invalidated the 1992 EPA regulation 9 © OnCourse Learning

10. Congress Acts  Asset Conservation, Lender Liability and Deposit Insurance Protection Act of 1996 – part of the spending bill for 1997; provision that codified the 1992 EPA rule  Under the act “participating in the management” term included participating in the operations and ability to engage in several other activities and retain the secured lender exemption  Allows a lender to foreclose on a property, sell, wind up operations and undertake a response action under CERCLA without losing its exemption 10 © OnCourse Learning

11. Other Lender Regulations  Comprehensive Drug Abuse Prevention and Control Act of 1970 allows confiscation of property used in illegal drug activity  The danger for the lender is the greatest when it forecloses on a property that has been used to support illegal drug transaction  The lender must use due diligence defense 11 © OnCourse Learning

12. Other Lender Regulations  Uniform Commercial Code (UCC) which specifies rights and obligations of contracting parties  Two primary areas of lender behavior that can give rise to liability  Nonperformance of oral commitments  Failure to extend credit beyond a certain date 12 © OnCourse Learning

13. Liability from Lender/Borrower Relationship  Oral commitments for Extension of Credit  The following contracts must be in writing in order to be enforced: Agreements that cannot be performed with 1 year Promises to answer for the debts of another (surety contracts) Promises made in consideration of marriage Agreements relating to real property Contracts exceeding $500 for sale of goods Contracts by executors  Termination of demand notes without notification 13 © OnCourse Learning

14. Other Theories of Lender Liability  Prima facie tort  Promissory fraud  Nondisclosure fraud and breach of fiduciary duty  Breach of contract  Duress and lender control 14 © OnCourse Learning

15. Liability to Third Parties: Bankruptcy and Agency Costs  Agency law - another area of the law where the lender may become liable to third parties  If lender undertakes sufficient control for the operations of the creditor’s business (assumes the role of principal)  Bankruptcy law and the cramdown process  Cramdown – the ability, under the law, to force restructuring of the debt owned by the developer  Ethics, fraud and agency costs  Agency relationships have legal and ethical implications  Agency costs – costs incurred to make sure that the agent acts only in the principal’s interests 15 © OnCourse Learning