According to recent market data, loan default and foreclosure rates are hovering at levels similar to those after the bursting of the real estate bubble in 2008. On many commercial projects, lenders have been left with collateral now valued well below its originally appraised value; often with mechanics liens, partially completed construction, and other challenges. In this environment, how can parties dealing with a distressed commercial property successfully navigate the cycle of foreclosure, receivership and, oftentimes, a borrower's bankruptcy?
When a loan goes into default, foreclosure is the process by which the lender acquires title to real-property collateral that is free and clear of junior liens. This includes mechanics' liens, but only if they are in a junior position. In most cases, priority is determined by a "first in time first in right" principle — namely, the first lien to attach has priority, which is perfected by a public filing, such as the recording of a deed of trust. However, with respect to mechanics' liens, Colorado recognizes a relation-back doctrine, by which a mechanic's lien filed against a property after the recording of the deed of trust may have priority because it relates back to the date of "first work," which may include architectural, engineering, or other site-plan work on the property. If the date of a first work precedes the recording of the deed of trust, a subsequently filed mechanics' lien can "prime" the deed of trust and leap into senior position. To avoid this scenario, lenders in Colorado should take additional steps, such as requiring appropriate lien waivers and affidavits upon disbursing loan funds or obtaining mechanics' lien coverage as part of a lender's title policy.
Besides anticipating and dealing with priority issues appropriately, one of the keys to navigating foreclosure successfully is to understand the procedures involved. Colorado is unique among the fifty states in that it has a public trustee system. Instead of having a private trustee, such as a title insurance company, hold real property in trust for the benefit of a lender, each Colorado county has a public official act as a "public trustee" for real property in that county, and each county has its own procedures and methods of doing business. Parties dealing with distressed loans in Colorado also should be aware that there is no longer a redemption period for the owner/borrower following a foreclosure sale. Instead, the owner/borrower has a longer cure period before the sale. Existing junior lienors, on the other hand, still have redemption rights after the sale, but only if they have timely filed a proof of claim prior to the sale. For this reason, junior lienors generally should consider filing a proof of claim, because this puts them in a position to exercise or transfer their redemption rights after the foreclosure sale.
What if construction has not been completed and the asset is generating operating income, or the property otherwise requires ongoing management while a foreclosure is pending? Such situations probably call for the appointment of a receiver. When the court appoints a receiver, a separate receivership estate is created. This has a number of implications and potential advantages. First, the receivership, by operation of law, acquires legal possession of the property. For income-producing properties, the receivership can collect rents and other operating income and use them to repair and maintain the property. Similarly, the receivership can oversee the completion of unfinished construction, which may include the issuance of "receiver certificates," which are permitted under Colorado law, to obtain additional funding. Finally, for practical reasons, it is often desirable to have the receiver as a buffer between a debtor in default and a lender that is exercising its rights in the collateral.
Regardless of the circumstances, in order for a receivership to be an effective tool, its scope and powers must be properly defined. Because these are determined by the terms of the court order that appointed the receiver, proper drafting of the motion and the order to appoint the receiver are of great importance. While the Colorado statute sets forth the conditions under which a receiver can be appointed, one of the key questions is how and when a receiver can be appointed and to what degree that can be contested by the debtor. In this regard, it is important that the loan documentation include an express right and consent to have a receiver appointed ex parte, without the opposing party present. While most lenders believe their loan documentation sufficiently addresses this issue, unfortunately, that often is not the case.
If a debtor cannot cure all defaults prior to a foreclosure sale, it may, as a last resort, file a petition in bankruptcy court. By operation of law, the filing of the petition generally transfers legal possession of the subject assets from the debtor, or from the receivership if one is in place, to the bankruptcy estate. In addition, the automatic stay under the bankruptcy code goes into effect, which halts all proceedings against the assets of the bankruptcy estate, including the foreclosure sale. None of those proceedings can go forward until the lender either obtains relief from the stay or the bankruptcy is dismissed. If the debtor's petition is one for reorganization under Chapter 11 of the bankruptcy code, the lender may have additional leverage in getting relief from a stay if it can show that the debtor is a single-asset real estate entity (SARE), which may be the case when, for example, the only significant asset of a bankruptcy estate is the lender's collateral, in which case there is no significant operating income or there are other factors that indicate reorganization is not appropriate.
Avoiding Common Pitfalls
While much of the pain in the current cycle is due to falling collateral values, poor execution can exacerbate an already difficult situation. To avoid unnecessary pitfalls, going forward, it is important that loan documentation adequately cover the key collateral and that proper due diligence has been done, not only in obtaining sound appraisals but also regarding title matters and other ancillary collateral, such as water and contract rights. In the current environment, in which mechanics' lien title coverage is increasingly difficult to obtain, sound disbursement procedures are essential. Finally, given much reduced collateral values, lenders will need to consider a variety of other sources, including title insurance, payment and performance bonds, and other claims, to cover loan deficiencies.
Without question, the cycle of foreclosure, receivership, and bankruptcy can be an arduous one to navigate. Parties dealing with distressed real property need to understand not only the purposes and procedures of each phase of this process, but also how they fit together in practice. Especially in the current environment, such a unified approach is key to a successful outcome.