Hill International, Inc.’s Claims & Consulting Group produces this newsletter to create a forum which addresses key issues related to the construction industry. The information contained herein is for general informational purposes only and should not be relied upon as legal advice. This information cannot be applied to specific facts and circumstances without the advice of legal counsel.

Legal Issues Involving Distressed Properties

In this Issue:

• LegalIssuesInvolvingDistressedProperties

• DistressedAssetsandtheHospitalityIndustryUpdatein2010:We’renotoutofthewoods,yet…

• StopNoticeRisksforConstructionLenders

• RiskManagementandtheDistressedProperty

James J. Sienicki, Partner, Snell & Wilmer L.L.P.

Intoday’srealestateclimate,manycommercialtransactionsinvolvepropertythatissubjecttoforeclosure,loandefault,bankruptcy,litigation,propertyvaluedecline,tenantproblemsorhasexperiencedothersignificantdifficulties.Whendealingwithdistressedproperty,partiesmustbeawareofcertainissuesandpossiblepitfallsthatmaynotariseinnormaltransactions.Thisarticlewilldiscusssomebasicconsiderationsthatpartiesshouldconsiderwhenpurchasingdistressedpropertyorinconnectionwithreceivershipandworkoutsituations.

F I v e I s s u es Fo r Pa rt I es Co n s I D e r I n g t h e aCq u I s I t I o n s o F D I st r es s e D P ro P e rt y

1. normal Due Diligence activities:

Inanyrealestateacquisition,duediligenceplaysavitalrole.Thoroughduediligenceisevenmoreimportantwhenpurchasingdistressedproperty.Acompleteinvestigationofthestatusofthepropertyiscriticaltoprotectthebuyerfromunknownrisks,buttheissuesandproblemsascertainedcanalsobeusedtonegotiatealowerpurchaseprice.Normalactivitiesincludethefollowing:

a. Building Inspection:

Ifthepropertyhasbeenneglectedduetoabandonmentorinabilitytopayfornormalmaintenanceandrepairs,aproperbuildinginspectionwillhelpdisclosetheseitemsandidentifyfutureexpensesnotfactoredintooriginalvaluations.

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b. title review:

Whenconductingtitlereview,thebuyershouldpayspecialattentiontoanydevelopmentagreements,CC&Rsorsimilarencumbrancesthatimposeassessments,developmentrestrictions,timelinesforconstruction,etc.Theowner,duetofinancialinabilityorotherconstraints,mayhavefailedtocomply.Ifso,suchfailurecouldresultinsignificantcosts,potentiallitigationand/orhaveanadverseimpactontheviabilityofthebuyer’splanneddevelopmentoruseoftheproperty.

c. tenants:

Itisimperativetoreviewthetermsofallleases,operatingcontractsandsimilardocuments.Thelengthoftheleasesandviabilityofeachtenantshouldbecloselyscrutinized.Leasedefaultsandleaseexpirations(thatcannotbeimmediatelyrenewed)willhaveadramaticimpactonthevalueoftheproperty.Tenantestoppelcertificatesshouldbeobtainedfromeachtenantwherebythetenantsandtheexistingownercertifythetermsoftheleasesandthattheinstrumentsareinfullforceandeffectwithoutexistingorpotentialdefaults.Theleasesshouldbescouredthoroughlyforanytermsandconditionsthatwouldgivethetenantsanexitrightorabilitytoreducerent.Forinstance,aco-tenancyclausemayallowaretailtenanttoreducerentorterminatealeasewhenananchortenantleavestheproperty.

d. other standard Due Dilligence:

Ofcourse,anALTAsurvey,PhaseIenvironmentalsiteassessmentandotherstandardduediligenceactivitiesshouldalsobeconsidered.

2. existing and Potential Claims and Disputes:

Thebuyershouldaskitslawyeroraconsultanttoconductalitigationsearchandhavethesellertodiscloseallexistingandpotentialclaimsanddisputes.Thelawyermaywishtoconsultwithknowledgeableattorneysregardingrealestate,environmentalandbankruptcyissuesthatexistormayarise.Inmanydistressedpropertycases,theownernotonlyhasproblemswithitslender,butpossiblelitigationmaybeloomingbetweentheinvestors,partnersandmemberscomprisingtheownershipitself.Bewareofsituationswheretheowner’sprospectivedevelopmentoroperationswerefundedbypassiveinvestorswhoarenowdisgruntled.

3. Zoning Issues:

Abuyertypicallyshouldconductathoroughinvestigationofthecurrentzoningandlanduseoftheproperty,includinganypendingapprovalsoroutstandingzoningorsiteplanstipulations.

Ownersofdistressedpropertiesoftenhaveobtainedzoningorsiteplanapprovalsbasedonspecificstipulationsthatmustbefulfilled.Someofthesestipulationsmayhavetimerestrictionsandthesetimerestrictionsmaynothavebeenmet.Failuretoconformtothesestipulationswithintherequiredtimecouldcausetheentitlementstolapse.Ifthebuyerfailstoadequatelyinvestigatethelanduseandzoningrequirementsoftheproperty,thebuyermayfinditselfinapositionwheretherecentlyacquiredpropertyisunusableforitsprospectiveuse.

4. valuations:

Thebuyershouldstronglyconsiderobtainingmultipleappraisalsand/orprofessionalopinionswithrespecttothevaluationoftheproperty.Accuratevaluationsareverydifficultinthecurrenteconomicmarketasthereislittleinthewayoftruearm’slengthtransactions.Byobtainingmultipleappraisals,abuyercanobtainabetterunderstandingofthefairmarketvalue.

5. surrounding Development:

Determinewhetheralloff-siteimprovementsandinfrastructureservingthedevelopmenthavebeencompleted.Inmanycases,buyersacquirepropertyonlytolearnthatthemasterdeveloperisunabletocompleteroads,utilitiesorotherimprovementsthatarenecessaryinorderforthepropertyownertoobtainbuildingimprovementsandbuildingpermitsforitsparcel.Ifthereisuncompletedinfrastructureorimprovements,thebuyershouldconsiderdemandingahold-backofthepurchasepriceorothersecuritytoensurethatallimprovementsaremade.

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Whenbuyingaparcelwithinalargerdevelopment,thebuyershoulddeterminewhetherthecenterisviableandwhetherassessmentsfromtheotheroccupantsarecurrent.Ifthecenterisnotbeingmaintained,thiscangreatlyimpacttheviabilityofthecenterandvalueofthepropertybeingpurchased.

Wo r ko u t ag r e e m e n ts

Decreasedpropertyvaluesandthelackofwillingpurchasershavemadeforeclosureaveryunattractiveoptionformanylendersintoday’smarket.Becauseofthecurrenteconomicconditions,manylendersprefertoprovideloanextensionsinhopesofreceivingsomerepaymentandeventuallybenefitingfromafutureeconomicturnaround.Itisforthesereasonsthatworkoutagreementshavebecomeasoughtafteralternativeformanylenders.

Workoutsareagreementsbetweendefaultingpartiesandthepartiestowhomtheyoweobligationsthatprovideforpaymentoftheobligation,whileaffordingthedefaultingpartytheopportunitytobenefitfromthevalueoftheproject.Sincemostrealestateprojectsareownedbysingleassetentities,anysecurityorassurancethelenderorlandlordwoulddemandintheeventofdefaultisusuallynotavailable.Thedemanditselfmayincreasethelikelihoodofbankruptcy,whichisanunpalatableriskformostlendersorlandlords.Therefore,thelandlordandlenderwillsometimesseeksomekindofresolution,knownasaworkout.

Commontypesofworkoutsinclude:(i)loanorleaserenegotiation;(ii)redesignprojectstoamoremanageablesize;(iii)forloans,alloraportionofthepropertycouldbesoldorrefinancedwhilethelenderforebearsallorpartoftheregularpayments;(iv)borrowerortenantcouldberecapitalizedwithanewpartnercontributingadditionalequityandpossiblyexpertisewhichreducesrisktothelender;(v)deedinlieuofforeclosureinreturnforreleasingborrowerorguarantor;and(vi)terminationofleaseinexchangeforapaymentbythetenant.

Whatevertypeofworkoutisperformed,itisimportantthatthelenderrequirethedistressedpartytofullydiscloseitsfinancialcondition,bothatthetimetheagreementisexecutedandonacontinuingbasisduringthetermoftheworkout.Alendershouldtypicallyhavetheborrowerortenantwaiveanyclaimsagainstthelenderorlandlord,andtheconsiderationfortheaccommodationsmadetothedistressedpartyshouldbeclearlyexplained.Partiesshouldaffirmthetermsoftheoriginalagreement.Unlikenormaltransactions,ifthenegotiationsconcerningtheworkoutfail,thepartiesusuallycannotsimplywalkawayfromeachother;litigationwillbeaprobableoutcome.Therefore,lendersareincreasinglywearyofworkoutsbecause,iftheattemptedworkoutfails,thelenderfacestheprospectofclaimsbeingbroughtbytheborrower.Onemethodoflimitingalender’sriskofpotentialliabilityisthroughapre-workoutagreement.

P r e-Wo r ko u t ag r e e m e n ts

Apre-workoutagreementcanincreasethelikelihoodofsuccessfulnegotiationsandlimittheparties’liabilitiesasitsetstheparametersofthenegotiationsandhelpspreventmisunderstandings.

Theagreementshouldspecifytheintentionsofthepartiesintheirattempttoagreeontermsforrestructuringtheloan.Itisimportantthattheagreementprovideastatementallowinganypartytoterminatenegotiationswithoutriskofliability.Alendershouldinsistthatthepre-workoutagreementmandatethattheborrowercontinuetopursueotherprospectsduringthenegotiation,asthenegotiationsmaynotendinanagreement.

Apoorlydraftedpre-workoutagreement,orevenworsenoagreementatall,putsthelenderatriskthatitsstatementswillbeunderstood(oratleastarguedbytheborrowertobe)defaultwaiversoracceptanceoftherestructuringterms.Therefore,fromthelender’sperspective,thepre-workoutagreementshouldexplicitlyrequirethatanyagreementresultingfromthenegotiationsbeinwritingandsignedbybothparties.Thisshouldhelppreventtheborrowerfromclaimingthatduringthenegotiationsthelenderorallyagreedtocertaintermsorwaivedvariousremedies.

Althoughapre-workoutagreementisnotalwaysnecessary,itisimportanttoconsidertheoverallnegotiationsandwhatleverageapre-workoutagreementmayprovide.Inmanysituations,apre-workoutagreementcanserveasameanstolimitlenderliabilityduringattemptstoworkoutaloan.

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r eC e I v e rs h I P s

Lendersneedtobeawarethattakingtitletodistressedpropertythroughadeedinlieuofforeclosurewillcausethelendertotakethepropertysubjecttootherexistingliens,includingmechanics’liens.Lendersalsoneedtobeawarethattakingtitletodistressedpropertythroughforeclosuremaycausethelendertotakeonunknownliabilitiesthatareassociatedwiththeproperty.Theliabilitiesgreatlyincreaseifthedistressedpropertyisinaconstructionphaseasthelenderwillneedtodecidewhetherornottocompleteconstruction.Alenderwillwanttoconsidertheappointmentofareceivertoreduceexposureandpreservethecollateral.Whenapartyininterestinanassetdemonstratesthatthepropertyisinneedofprotectionorpreservation,acourtmayappointareceivertotakecontrolofthepropertyandadministertheproperty,regardlessofwhetherornotthedebtorispresentinthejurisdictionorgivesconsenttothereceivership.Thereceiver(whoisappointedbythecourtandthereforehasquasi-judicialimmunity)willinsulatethelenderfromliabilityasitwillallowthelendertodelaytakingtitletotheproperty.Additionally,thereceiverwillassumedailymanagementandoperationactivitiessuchasthecollectionofrentsandpropertymanagement.

Theappointmentofareceiverwillnotinvalidateamechanic’slien.Rather,thereceivertakesthepropertysubjecttoallvalidliens,properties,andencumbrances.1ClarkonReceivers§272(1959).However,itisimportanttonotethatalthoughtheappointmentofareceiverdoesnotinvalidateamechanic’slien,shouldthereceivergetauthoritytoborrowmoneyduringitscontrol,thatnewloanmaybeconsideredahigherprioritythananypreviouslyacquiredmechanic’slien.

Askingacourttoappointareceiverwilllikelysavethelendertimeandmoneyasitwillallowthelendertofocusprimarilyontheirareaofexpertise.Further,areceivermayincreasethevalueofthepropertyasthereceiverwillcollectrents,payformaintenanceandimprovementsandpreventdecayoftheproperty.Mostimportantly,thereceiverwilllikelyprotectthelenderfromliabilitiesandobligationsassociatedwithtakingtitletotheproperty.

Thisarticleonlyprovidesabriefoverviewoftheissuestoconsiderwhenacquiringdistressedpropertyandthebasicelementsofreceiverships,workoutandpre-workoutagreements.Intoday’smarkettherearemanyopportunitiesinvolvingundervaluedland,butpartiesmustbeawarethatdistressedpropertycarriesmanypotentialproblemsthatarenotfoundinnormaltransactions.Therefore,anyoneinterestedinadealinvolvingdistressedpropertyshouldconsultanexperiencedrealestateattorneythatdealswithdistressedproperty,alongwithexperiencedenvironmentalandbankruptcyattorneysifappropriate.

James J. Sienicki 602.382.6351 jsienicki@swlaw.com

Jim Sienicki is a partner with Snell & Wilmer in Phoenix, Arizona, where he is the head of the firm’s construction practice group. His practice has been concentrated on a wide variety of construction matters since 1983. Jim is a member of many construction trade associations.

Contributing writers in this article include Jonathan E. Frank, Partner Snell & Wilmer and Byron Sarhangian, Associate Snell & Wilmer

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Dr. Donald W. Wise Global Hospitality Industry, Managing Partner Johnson Capital Hospitality and Leisure Real Estate Investment Banking

Thesentimentsgoingthrougheachofourmindsaswebid2009a“goodriddance”andtrekcautiouslyandmorehopefullyinto2010,emulateFranklinRoosevelt’sfamousquote:“Wehavenothingtofearbutfearitself.”

Inresponsetothedepressedstateoftherealestateandcapitalmarkets,largeamountsofcapitalarenowchasingopportunitiestopurchasedefaultedhotels,aswellashotelrealestateloansatadiscount.Notsincethesavingsandloancrisisinthelate1980’shasthemarketexpectedacomparablevolumeofdistressedhotelstobesold.Forsavvybuyers,thisisachancetoearnenviablereturns.

“this is like deja vu all over again.” – yogi Berra

Between1989andmid-1995,theResolutionTrustCorporation(RTC)closedorotherwiseresolved747thriftswithtotalassetsof$394billion.Whenaskedaboutwhatisthemostexcitingcomponentof2010-AndrewSegal,presidentofBoxerPropertyinHoustonsaiditwell:“Unprecedentedlowpricedbuyingopportunities.”Whenaskedaboutwhatarethebiggestworriesof2010:“Unprecedentedlowpricedsellingopportunities.”

t h e stat e o F t h e m a r k e t

Bloomberg:“LuxuryHotelSalesMayIncreasein2010asPropertyValuesDrop”.LuxuryhotelswillbeamongU.S.lodgingindustry’smosttradedrealestatenextyearasbuyersgoafterhigh-endpropertiesthathaveslumpedinvalue,”saidArthurAdler,chiefexecutiveofficerfortheAmericasatJonesLangLaSalleHotels.“Theluxuryhotelsectorisamongthetopactivesectorsbecausetherearemorechallenges…Luxuryhotelshavesufferedthemost.Thepossiblediscounts,ifpropertiescometomarketandtrade,willbegreaterinthissectorthaninothers.”

Reuters:“Globalhoteldealstorise40percentin2010”.Globalhoteltransactionsareforecasttoreboundbyupto40percentin2010,boostedbyAsianandMiddleEasterninvestors,aftersalesvolumesplungedtoadecadelowthisyear.Between$11billionand$13billionworthofhotelsareexpectedtochangehandsnextyear,recoveringfromthemarket’s64percentyear-on-yeardeclineof$9billionin2009,investmentservicesfirmJonesLangLaSalleHotelssaid.”

“you’ve got to be very careful if you don’t know where you’re going, because you might not get there.” – yogi Berra

Previously,duringtheRTCdebacleinthe‘90’s,atleasttherewassomecapitalavailable.Thistimelackofcapitalistheproblem.Weareseeinglenderscautiouslygettingbackintothemarket,butatdebtcoverageratiosatmorehistoriclevels.InterestratesarepeggedtoPrimeversusLIBORthatbetterreflecttheriskoftheseinvestments.Overtheyears,thebenchmarkDCRorDebtCoverageRatio(thedebtcoverageratioiscalculatedbydividingtheNetOperatingIncome(NOI)byaproperty’sannualdebtservice.Annualdebtserviceequalstheannualtotalofallinterestandprincipalpaidforallloansonaproperty.Adebtcoverageratiooflessthan1.0indicatesthattheincomegeneratedbyapropertyisinsufficienttocoverthemortgagepaymentsandoperatingexpenses.)Forhospitalityproperties,DCRhashistoricallybeenapproximately1.40.Whenwelookatupcomingcommercialmortgage-backedsecurities(CMBS)andotherloansrollingover,thereisa“highwatermark”basedonrealtimestressedoccupanciesandADR’s(averagedailyrate)–inotherwords,howmanypropertiestodayareachievingthatDCR?

PertheUrbanLandInstitute’sDecember2009newsletter,hoteloccupancyrates(amoving12-monthaverage)stoodat58.7percentinthird-quarter2009,downfrom60percentinthefirstquarterof2009,and680basispoints

Distressed assets and the hospitality Industry update in 2010: We’re not out of the woods, yet…

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belowthesamequarterayearago.Completionswereupslightlyasapercentageofrooms,from2.6percentinthird-quarter2008to3.2percent.Revenueperavailableroom(RevPAR)fellinthethirdquarterof2009comparedtothesamequarterayearago,offby23.1percent.

AccordingtoPKFHospitalityResearch’s(PKF-HR)December2009report:“Theyear2010willcontinuetobeatoughoneforU.S.hotelownersandoperators.PKF-HRisforecastingthat,onaverage,propertieswillcontinuetosufferyear-over-yeardeclinesinrevenueandprofitsfromanalreadydismal2009.However,giventhedecelerationofroomratediscountingobservedduringthethirdquarterof2009,theseverityofthelossesincurredin2009and2010willbelessthanpreviouslyforecast.Inaddition,year-over-yeargrowthinimportantmeasurements,suchasoccupancy,RevPAR,anddemand,willberealizedafullquarterearlierthanthoughtthreemonthsago.

“Accordingly,thisyear’sannualADRforecasthasbeenreducedtoadeclineof8.8percent,andthe2010ADRforecastisnowaminus1.5percent.Thesecomparetodeclinesof10.4percentand3.1percentthatweforecastlastquarter.

“ThesteepdeclinesinRevPARandtheresultinghistoriccontractioninNetOperatingIncomeatthepropertylevelhaveseverelyunderminedtheabilityofmanyownerstomeettheirdebtserviceobligations.Thisdifficultyhasbeencompoundedbytheeconomicrealitythatmanyhotelsthatareservingasthesolesourceofcollateralforthemortgageholdersoftheseassetsarenolongerworththefaceamountofthedebt.DatafromTreppLLCillustrateshowrapidlythissituationhasdeteriorated.AtthebeginningofthefinancialpanicinSeptember2008,only0.55percentoftheroughly3,700CMBShotelloanswereinsomeformofdelinquencyordefault.ByJuneof2009,thisnumberhadincreasedto4.31percent.AsofDecember10,2009,thevolumeofnon-performingCMBShotelloanshadsky-rocketedto13.47percent.”

AccordingtoMoody’sInvestorsService:“Althoughthepaceofdeclinehascontinuedtoslowinrecentmonths,commercialpropertypriceshavefallennearly44%sincetheirpeaktwoyearsago,andnowlookmorelikewhattheindustrysawin2002.”

“ThepaceofdeclineshastaperedoffsincethelargedropsmeasuredinAprilandMay;however,furtherdeclinesareanticipated,”thereportstates.Withthe43.7%dropintheMoody’s/REALNationalAll-PropertyAggregatesincetheOctober2007peak,“itisnownecessarytolooktopropertiespurchasedin2002tofindpositivepriceappreciation.”

Inparticular,thereportnotestheeffectsofpricedropsonloantovaluesareespeciallypronouncedwithmorerecentacquisitions.“Onaverage,loansoriginatedata75%LTVin2005orlaterarenowunderwater”withanaverageLTVtodayof108%,saysthereport.Althoughmostoftheloanswillnotmatureforseveralyears,thusgivingvaluesachancetorecover,“latervintageloansareinadeephole”andfaceincreasingriskofshorttermdefaultaspropertyfundamentalscontinuetoerode.

“Whenitcomestotherateofrecoveryforcommercialrealestate,federalpolicymakersaresettingthepacemoresothanmarketfundamentals,”sayexpertsinareportbasedonPricewaterhousecoopers’quarterlyKorpaczRealEstateInvestorSurvey.

Dr.DavidKellyofJ.P.MorganAssetManagementrecentlyreported:“Unemploymentalwaysgoesupmorequicklythanitcomesdown.Wemaynotreachthatlevel(full-employmentisdefinedbymosteconomistsatanunemploymentrateofabout5%)untilsometimein2014.”TheUnitedStateswasat10.0percentunemploymentinDecember,thehighestunemploymentratesince1983.

AccordingtoBloomberg,“Thedelinquencyrate(incommercialrealestate)willnotimproveuntiltheunemploymentratedropsandconsumerspendingrevives.”

“Baseball is 90% mental -- the other half is physical.” – yogi Berra

Thegravityoftherealtimeproblemisstaggering.Approximately1,341commercialpropertiesinCaliforniaand8,393commercialpropertiesacrosstheUnitedStates,thathavematuringCMBSdebtinthecoming18-months,almost$7billiondollarsofhoteldebtalone,maturesinthenext18-months.Byexample:

California hotel loans:$6.959B

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NumberofCMBSloansmaturingbypropertytypeinnext18-months:

hotel and resort, California: 195

hotel and resort, united states:1,484

ButthenconsiderthatCMBSdebtisonlyapproximately25%ofallcommercialrealestatedebtwhichisbasedon$3.47trillionincommercialrealestateandmultifamilymortgagedebtoutstanding.

Thevastmajorityofthishoteldebtcomingduewas:

� Underwrittenbetween1999and2003;

� Beforepeakvaluationsin2007;and

� Today’svaluationsareprobablyhigherthantheywereattimeoftheoriginationoftheloans.

Thequestionbecomes,“Howmuchofthisdebtwillpresentwithaminimumofa1.20to1.4debtcoveragerationatroll-overtime?”

Moody’sInvestorsServicereportedduringtheChristmasweekthatmultifamilydelinquenciesrosebynearlyafullpercentagepointbetweenOctoberandNovember2009.Infact,multifamilyrankedsecondonlytohotelsintermsofthemonth-to-monthincreaseintheamountofdelinquentloans.

DatafromTreppLLCillustratesthehighestdelinquencyratesinCMBSloanssofarhavebeen:

� hospitality: 13.47%

� multifamily:13.0%

� retail:9.7%

� other:7.2%

� office: 4.9%TwoofthelargerCMBSportfoliosthatexhibitedstressin2009were:

� A$967.2millionmortgageonahotelportfoliocontrolledbyCNLHotels&Resorts

� A$344.6millionloanonahotelportfolioownedbyBeanieBabyinvestorTyWarner

“you can observe a lot just by watching.” – yogi Berra

ComingoutoftheHolidayseason,aCharlesDickensstoryseemsappropriate:ATaleofTwoCities.Thesearetworealtimecasestudiesevolvingatthistimewithbrandedhotelsinestablishedmarkets:

hotel Default of Week one - Baird/Baird real estate

HyattColumbusCapitolSquare.The400-roomHyattCapitolSquareinColumbus,Ohiowaspurchasedfor$38.7million($96,750/key)in2007andfundedwitha$32million($80,000/key),10-yearCMBSloanoriginatedbyLaSalleBank.TodaytheloanisinspecialservicingwithLNRPartnersafterthehotelgeneratedonly$3.2millionofNOIin2008.Atlastreportthehotelwascoveringdebtservice,butbelowthe1.15xcovenantwhichtriggeredspecialservicingfortheloan.Thehotelwasbuiltin1984andisreportedlyingoodcondition,butsufferingfromoverallweakdemandintheColumbusmarket.Bloombergreportsthattheborrowerisseekingarestructuringoftheloanterms.

hotel Default of Week two - Baird/Baird real estate

SpringhillSuitesSeattle.The234-roomhotel’s$32.7million($139,743/key)CMBSmortgagehasbeentransferredtoCWCapital’sspecialservicinggroup.Themortgageis60daysdelinquentasitsdebtserviceshortfallhasn’tbeenfundedbythecurrentownerssinceOctober.The6.4%fixedratemortgagewasoriginatedinNovember2006byCGM.Debtservicehasdroppedunder1.0x,despitehoteloccupancyof71%YTD.Builtin2001,thehotelonYaleAvenueinSeattlewaspurchasedin2006for$50.7million($217,000/key).

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Bothoftheseexamplesgotothecoreofourpreviouslystatedconcerns:welllocatedhotels,havejustbeenhammeredbylocalmarketconditionswithdebtcoverageratioissuestomatch.Thegoodnewsisthatwearequotingnon-recoursedebtforhospitalitywithapreferredloansizeof$10M-$30M(howeverthelenderwillconsiderlargeronacase-by-casebasis);LTV’sof60%-70%;withinterestratesbetween7.5%-9.5%,subjecttotheperceivedriskoftheborrowerandthesite;andtermsof5–7years.Thisincludesnew-buildconstructiononacase-by-casebasis.Wearequotingfull-recourseprogramsinhospitalityranginginpreferredloansizeof$15Mup,withvirtuallynoceiling;LTV’sto70%;pricingatPrime+2.5%,so5.75%today;interestonly;andtermsof2–6years.Wealsohaveentitledlandloanprogramsranginginpreferredloansizeof$3Mto$50M.

Wehaveactivelenderswhowilllookatnew-buildhotelsandresortsaswellasreviewbrokenprojectsbutonacase-by-casebasis.

“a nickel isn’t worth a dime today.” – yogi Berra

In closing:

� 1,484hotelandresortCMBSloanscomedueinthecoming18-months

� CMBSdebtisonlyapproximately25%ofallcommercialrealestatedebt

� ThedelinquencyratesinCMBSloanssofarhavebeen13.47%forhospitality,thehighestofall

� Unemploymentwillnotgetbacktonormallevelsuntil2014

� Nobodyknowswhatdebtwilllooklikewhenitreturnsinabundanceotherthanitwillbefarmoreconservativeanditwillbefarmoreexpensive.

� Finally,oneAnonymousbanker‘soutlookwasthat“Probablytheworstdealsaredoneduringgoodtimes,soIsupposedsomeofthebestdealswillbedoneduringthesetimes.”

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Robert G. Campbell, Esq. Cox, Castle & Nicholson

Constructionlendersfacemyriadchallengesintheplungingeconomyandrealestatemarket.Thedifficultiesincludehandlingaheightenednumberofborrowerdefaults,decidingwhethertocontinuedisbursingconstructionloanfundsinadecliningmarket,anddetermininghowtoweightherisksofforeclosingandcompletingconstructiononanincompleteproject.Whilenavigatingtheseobstacles,lendersshouldalwaysevaluatetheirpotentialliabilitytocontractorsandsuppliersforbondedstopnotices.Meanwhile,claimantsshouldrecognizethefullextentofthestopnoticeremedy.WhilethisarticleispredicateduponCalifornialaw,totheextentthestopnoticelawsofotherjurisdictionsfollowormirrorCalifornialaw,thefollowingdiscussionmaybepertinentandistheseissuesshouldconsidered.

Byservingabondedstopnoticeclaimonthelender,contractorsandsupplierscaneffectivelylienanyundisbursedconstructionloanfunds.Thefailureofaconstructionlendertohonora

properstopnoticecanresultinsubstantialexposure.Constructionlendersthatignoreabondedstopnoticeclaimonaprivateworkofimprovementdosoattheirperil.(1)

Astopnoticeisawrittenandverifiedstatementservedbyaclaimantowedmoneyonaworkofimprovement.Thestatementmustidentifytheclaimantanddescribethenatureofthelabor,materials,orservicesprovided;thenameofthepartytowhomthesewerefurnished;thedollarvalueofwhatwasfurnished;andtheamountclaimedasdue.(2)Byservingavalidstopnoticeonaconstructionlender,astopnoticeclaimantcreatesaclaimorlienonundisbursedconstructionfundsinthehandsofanownerorlenderforthebenefitoftheclaimant.Thisremedyallowscontractors,subcontractors,andmaterialmentoreachundisbursedconstructionloanproceedsassecurityagainstnonpayment.(3)Onceabondedstopnoticeisserved,thelendermustwithholdfromavailableconstructionfundsanamountsufficienttopaythestopnoticeclaimandmaynotusethatwithheldamounttopaydowntheprincipalamountoftheloanortopayinterest,fees,orothercosts.(4)

“Abondedstopnotice”isdefinedasastopnoticegiventoaconstructionlenderthatisaccompaniedbyabondinapenalsumequalto1.25timestheamountoftheclaim.(5)Aconstructionlenderisonlyobligatedtowithholdfundsfromanowner/borrowerifproperlyservedwithabondedstopnotice.Indeed,aconstructionlenderisnotobligatedtohonorastopnoticethatisnotbonded.(6)Theconstructionlendermustwithholdfundspursuanttoabondedstopnoticeservedbyanoriginalcontractor,subcontractor,orfirst-tiersupplier.

Thestopnoticeclaimantalsomaydemandinitsstopnoticethatthelenderprovideacopyofanypaymentbond.(7)Ifthereisapaymentbondrecordedfortheproject,differentrulesapply.Whenapaymentbondhasbeenrecorded,thelenderisnotrequiredtowithholdfundsbutmaydosoatitsoption.(8)Thisappliestoallproperclaimantsotherthantheoriginalcontractor.Similarly,anownerservedwithastopnoticeisnotrequiredtowithholdfundswhenapaymentbondhasbeenrecordedbutmaydosoatitsoption.(9)Ifanownerdeclinestowithholdfundsinresponsetoastopnoticebecauseapaymentbondhasbeenrecorded,thentheownermustfurnishtheclaimantwithacopyofthepaymentbond.

Avalidstopnoticecanbeahighlyeffectiveremedyforaclaimantseekingtoobtainpaymentforitswork.Alenderthatimproperlydisbursesfundssubjecttoastopnoticeispersonallyliablefortheamountduetothelienclaimantunderthecontractwiththeowner(butnotexceedingthemaximumamountofunexpendedconstructionfunds).(10)Further,thestopnoticeremedyisindependentandcumulativeofaclaimant’srightstoamechanic’slien,toenforceanypaymentbond,andtopursueawritofattachment.(11)Thus,aclaimantmayavailitselfofallprejudgmentremediessimultaneously.

Likemechanic’sliens,stopnoticesarenonconsensualanddonotrequirepriorjudicialapproval.Moreover,lienandstopnoticerightsmaynotbewaivedbycontract,reflectingastrongpublicpolicyfavoringpaymentforthosewhoimproveproperty.Similarly,noassignmentbytheownerorcontractorofconstructionloanfunds—whethermadebeforeorafterserviceofastopnoticeonaconstructionlender—haspriorityoverthestopnoticeclaimant.Assignmentscannotdefeattherightsofstopnoticeclaimants.(12)

stop notice risks for Construction Lenders

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Stopnoticesdifferfrommechanic’sliensinthattheyattachtothefundsoftheowneroftheproperty,ortheconstructionloanproceedsfromalender,ratherthantotherealpropertybeingimproved.(13)Asaresult,astopnoticesurvivesaforeclosureoftheproperty.Thus,stopnoticesdonotgiverisetothepriorityissuesregardingtheconstructionlender’sdeedoftrustthatemergewithmechanic’sliens.(14)Ifseveralstopnoticeshavebeenfiledandnotenoughmoneyexiststopaythemall,stopnoticeclaimantsshareprorataintheavailablefunds.15

L I m I tat I o n s a n D r eq u I r e m e n ts

Statuteslimitwhocanassertastopnotice.Ingeneral,Californialawprovidesthatallpersonsandentitiesqualifiedtorecordamechanics’lien,withtheexceptionofthegeneralcontractor,mayserveastopnoticeontheowner.Thisincludesmaterialmen,subcontractors,first-tiersuppliers,equipmentlessors,licenseddesignprofessionals,uniontrustfunds,andthosewhomakeimprovementstothesite.(16)Thesesameclassesofclaimants,plusthegeneralcontractor,mayserveastopnoticeontheconstructionlender.Onlywhenthestopnoticeisbondedisthelenderrequiredtowithholdfunds.

Stopnoticeclaimantsneednotwaituntiltheirworkiscompletetoserveastopnotice.Thisisincontrasttomechanic’slienclaimants,whomustwaituntiltheirworkortheoverallworkofimprovementiscomplete.Nevertheless,stopnoticeclaimantsmusttakenumeroustechnicalstepstoensurethattheirstopnoticesarevalid.Theymustserveaproper20-daypreliminarynoticeinatimelymanner.Servicemusttakeplace“priortotheexpirationoftheperiodwithinwhich[theclaimant’s]claimoflienmustberecordedunder[CivilCode]Section3115,3116,or3117.”17Thesesectionscalculatetheexpirationoftheserviceperiodasaspecifiednumberofdaysafterthecompletionoftheworkofimprovementortherecordationofanoticeofcompletion.

Inmostcases,ownersorlendersdonotrecordorservevalidnoticesofcompletionforcompletedprojects.Intheabsenceofavalidlyrecordedandservednoticeofcompletion,claimantshave90daysfromcompletionoftheprojecttoserveastopnotice.Thatperiodisshorterwhenavalidnoticeofcompletionhasbeenrecordedandserved,orwhenavalidnoticeofcessationhasbeenrecorded.(18)Claimantsmustpaycarefulattentiontotheseprerequisitestoperfecttheirstopnoticerights.

Ifownersorlendersdisputethevalidityofthestopnotice,theymustpostastopnoticereleasebondinanamount1.25timestheamountofthestopnotice.Onlyuponthefilingofthebond,whichhastheeffectofprovidingsubstitutesecurityfortheclaimofthestopnoticeclaimant,canthewithheldfundsbereleased.(19)

Similartoamechanic’slienclaimant,astopnoticeclaimantmusttakepromptlegalactiontoenforcethestopnotice.Anactiontoenforcethestopnoticemaybecommencedatanytimeafter10daysfollowingserviceofthestopnoticebutnolaterthan90daysfollowingtheperiodinwhichamechanic’sliencouldberecorded.Ifnoactioniscommencedwithintheprescribedperiod,thestopnoticeceasestobeeffective,andwithheldfundsmaybepaidtothepersontowhomthefundsareowed.Ifanactioniscommenced,noticemustbegivenwithinfivedays.(20)Whenmultipleactionstoenforceastopnoticearefiled,amotiontoconsolidatemaybefiledsothattheactionswillbeadjudicatedtogetherinoneproceeding.(21)

Asignificantdistinctionbetweenamechanic’slienforeclosureactionandastopnoticeenforcementactionistherightofbondedstopnoticeclaimantstorecovertheirattorney’sfeesiftheyaredeterminedtobetheprevailingparty.(22)Bystatute,prevailingpartyclaimantsalsowillbeawardedinterestatthelegalrate.Interestaccruesfromthedateofserviceofthestopnotice.(23)

Constructionlendersfacingastopnoticeclaimshouldunderstandthatthestatutesgoverningstopnoticesareremedialandareliberallyconstruedtoeffecttheirobjectivesandtopromotejustice.Therefore,whilecertaindeadlinesarestrictlyenforced(suchasthedeadlineforaclaimanttocommencelegalactiontoenforceastopnotice),otherrequirementsareliberallyconstruedinfavoroftheclaimant.(24)Stopnoticesaredesignedtoprotectmaterialmenwhofurnishlaborandmaterialsthatenhancethevalueofthepropertyandaresupposedtobepaidoutoftheconstructionfund.(25)

Asonecourtreasoned,alender’sseniordeedoftrustusuallyprotectsthelenderfromtheriskofdefault.(26)Meanwhile,alendermayprotectagainsttheriskofnonpaymentofclaimantsbyrequiringtheownerordevelopertopostapaymentbond.Alsothelendercaninspecttheprogressoftheconstruction,issuejointchecks,orinstituteotherfundingcontrols.Thecourtfurthernotedthatpermittingaclaimanttorecoveragainstthelenderformaterialsandlaborcontributedtothepropertyisappropriatebecausethosecontributionsincreasethevalueof

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thepropertyandthereforeenhancethelender’ssecurity.Inaddition,thecourtdeclaredthatstrongpolicyreasonssupportrequiringcommerciallenderstopolicethebuildingindustry—andthestopnoticeremedyencouragesthisaswell.

Thepurposeofastopnoticeistoprovidematerialmenwithprotectionswhentheyextendtheirresourcesinreturnforafuturepaymentfromaconstructionfund.Mostoftensmallercompaniesaretheoneswhofilestopnotices—companiesthathaveprovidedlaborormaterialstoaprojectwithouttheresourcestolitigate.Whenbalancingtheprotectionofclaimantsexpendingtheirlaborandmaterialsagainstownersorlendersreceivingthebenefitofthosegoodsandservices,theequityscaleusuallytipsinfavorofclaimants.

Becausethestopnoticeremedyissohighlyeffectiveforstopnoticeclaimants,constructionlendershavemadeseveralattemptsovertheyearstostructureaconstructionloanthateffectivelycircumventsit.Inlightofthepoliciesinsupportoftheremedy,lendershavenotmetwithmuchsuccessintryingtodefendagainststopnotices.Forexample,inacaseinvolvingaborrower/ownerthatassignedtothelendertheloanfundunderanagreementtomakespecifiedprogresspaymentstothecontractor,thelendercouldnotdefeatastopnoticeclaimbyassertingarighttoretaintheassignedfundassecurityforrepaymentoftheloan.(27)

Furthermore,ifalendercouldevisceratethepurposeofthestopnoticestatutesbysimplynotcreatingaseparateconstructionfund,theneverysetofconstructionloandocumentsinCaliforniawoulddothesame,andbondedstopnoticeswouldbecomeineffective.ThisresultwouldbecontrarytothepurposeofstopnoticesasdefinedbyCaliforniacourts.Topermitlenderstodootherwisewouldallowthem,uponforeclosureofaproperty,tohavethebenefitsoftheprovidedmaterialsandlaborwithoutpayment—anddeprivelienclaimantsofanyeffectiveremedy.

Courtshavealsoheldthatastopnoticewillreachanundisbursedloanfundevenfollowingadefaultbytheborrowerterminatingtheborrower’srighttoobtainfurtherdisbursementsfromtheloanfund.(28)Stopnoticepriorityextendstoallloanfundsthatremainsubjecttodisbursement—eventhosethatmaynotbedueunderthelender/borrowerconstructionagreementbecausedisbursementconditionshavenotbeensatisfied.Thispriorityisunchangedeveniftheborrowerisindefault.(29)Asaconsequence,alendermaynotproperlydefeatastopnoticebyinsistingthatnoundisbursedfundsexistbecausetheborrowerisindefaultandthelenderisthereforenotobligatedtodisbursethosefunds.Privateagreementsbetweenlendersandborrowersmaynotserveasadefensetoastopnoticeclaim.

Inaseminaldecision,FamilianCorporationv.ImperialBank,(30)thecourtrefusedtoallowalendertopre-allocateconstructionloanfundstoaninterestreserveandtherebyeffectivelysubordinateperfectedstopnoticeclaimstotheinterestreserve.Thecourtheldthatthelendermaynotpayitselffees,points,andinterestinpreferencetostopnoticeclaimantsattheinceptionoftheloan,thusreducingtheloanfundandachievingpriorityoverliensorstopnoticeclaimants.Thispracticeviolatestheanti-assignmentedictofthestopnoticestatutes.(31)Lendersalsoarejudiciallyprohibitedfromattemptingtoachievepriorityby1)applyingtheloanbalancetoreducetheamountdueundertheconstructionnote,and2)depositingunexpendedconstructionloanfundsintoageneralfundorseparateescrowaccount.(32)

Co n st r u C t I o n F u n D s a n D L e n D e r L I a B I L It y

Conflictssometimesariseoverwhatconstitutesaconstructionfund.InpartthiscontroversystemsfromthefactthattheCaliforniaCivilCodedoesnotcurrentlycontainaprovisionspecificallydefininga“constructionfund”forpurposesofstopnoticeclaimants.However,formerCodeofCivilProcedureSection1190.1(h)—thepredecessortoCivilCodeSection3166—defines“constructionfund”astheamounteither“furnishedortobefurnishedbytheownerorlender…asafundfromwhichtopayconstructioncosts”or“arisingoutofaconstructionorbuildingloan.”(33)CivilCodeSection3087definesa“constructionlender”asanymortgageelendingfundstopayforthecostoftheworkofimprovementsonapropertyora“partyholdingfundsfurnishedortobefurnishedbytheownerorlenderoranyotherpersonasafundfromwhichtopayconstructioncosts.”

TheplainlanguageoftheCivilCodeanditspredecessorintheCodeofCivilProcedurebroadlytreataconstructionfundasanyamountofmoneydesignatedtobeusedtopayconstructioncosts.InbothCivilCodeSection3087andformerCodeofCivilProcedureSection1190.1(h),theonlyrequirementforestablishingaconstructionfundisthatanamountmustbedesignatedas“afundfromwhichtopayconstructioncosts.”Therefore,aconstructionloanagreementthatspecifiestheloanproceedsasthemoneyforpayingconstructioncostswouldqualifyasaconstructionfundforthepurposesofstopnotices.

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Theamountretainedbythelenderinresponsetoabondedstopnoticeshouldnotbeusedtopaydowntheprincipalamountoftheloanortopayinterest,fees,orothercostsowedtothelender.Alenderthatfailstoproperlywithholdundisbursedloanproceedsfollowingabondedstopnoticeispersonallyliablefortheamountduetothelienclaimant.Nevertheless,thelenderwillnotbeliableformorethantheamountoftheundisbursedloanproceedsatthetimethebondedstopnoticewasserved.

Fo L LoW I n g Fa m I L I a n

TheFamiliandecisionshouldguidelendersintheirresponsetobondedstopnotices.(34)InFamilian,aconstructionlenderreceivedbondedstopnoticesthatfarexceededtheundisbursedloanbalance.Meanwhile,thelenderhadpaiditselfinterestandfeesfromareserveaccountspecificallysetuptopayinterestontheloanandotherfeesowedtothelenderasthoseamountsaccrued.Theclaimantcontestedtherightofthelendertopayitselffromthereserveaccountbeforethestopnoticewasserved,andthecourtagreedwiththeclaimant.

AccordingtotheFamiliancourt,thepracticeofmakingpaymentfromaninterestreserveconstitutesastatutorilyprohibitedassignmentunderCivilCodeSection3166.Thecourtheldthatthelendermaynotpayitselffeesandinterestinpreferencetostopnoticeclaimants.Todootherwisewouldpermitthelenderadoublerecoverybyallowingittocapturefeesandinterestaswellastheenhancedvalueofitsproperty.Thatenhancedvalueiscreatedbytheconstructionworkperformedbytheclaimants.

TheeffectoftheFamiliandecisionishuge,becauseitcanleadtolendersbeingrequiredtodisgorgeamountstheyhavepaidtothemselvesinearnedinterestandexpenses.ItalsofollowsunderFamilianthatconstructionlenderswithfullydisbursedloansremainatrisk.

Inaddition,whenaconstructionloanissold,apreexistingbondedstopnoticeclaimisnotdefeatedbythetransfer.Theoriginalconstructionlenderservedwithaneffectivebondedstopnoticeremainsobligatedtocomplywithstopnoticewithholdingrequirements.Therefore,constructionlendersshouldprocureappropriateindemnitiesortakeotheractionstosafeguardagainstthisriskwhensellingaloansubjecttoabondedstopnotice.

ManyquestiontherationaleoftheFamiliandecisionandconsideritpoorlyreasoned.Forexample,inSteinyv.CiticorpRealEstate,Inc.,anotherappellatecourtdisagreedwithFamilian(35)andruledthatalenderwasentitledtokeeppaymentsmadetoitselffromtheloanfundtotheextentthoseamountswereearnedpriortoserviceofthestopnotice.However,theSteinycasewasdecertifiedfrompublicationand,asaconsequence,maynotbecitedasauthority.Familian,wartsandall,remainsexistinglaw.Whilelendersmustheedthisdecision,bondedstopnoticeclaimantshavebeenhandedapowerfulsword.

Lendersseekingtodefendagainstastopnoticeclaimshouldfirstevaluatewhethertheprerequisitesforastopnoticehavebeenmet,suchasverifyingthattheclaimantobtainedtheappropriatebond,gaveaproperandtimely20-daypreliminarynotice,andtimelyservedthestopnotice.Theyshouldfurtherascertainthattheclaimantisamongthecategoriesofclaimantsthatpossessstopnoticerights.Moreover,intheappropriatecircumstances,lendersshoulddiscerniftheclaimantwasproperlylicensed.Also,alendershouldworkwiththeborrowertodeterminethemeritsoftheamountclaimedtobedueandattempttocompeltheborrowertoresolvethedisputewiththeclaimant.Alendershouldconsiderdemandingthatthepropertyownersecureastopnoticereleasebondifalegitimatedisputeexists.

Lenderswhoselldistressedconstructionloansretainanyexistingstopnoticeliability.Merelytransferringanotedoesnotridalenderoftheobligationtohonoranexistingbondedstopnotice.Provisionstoprotectagainstthisrisk,includingindemnities,shouldbemadepartoftheloansaleagreement.

Ultimately,owner/borrowersandlendersshareastrongincentivetokeepstopnoticesfrominterferingwithtimelyprojectcompletion.Anincompleteanddelayedprojectincreasesconstructioncostsandunderminesthevalueofalender’ssecurity.Inaddition,ifalawsuitisfiledtoenforcethestopnoticeandisaccompaniedbyamechanic’slienforeclosureaction,thelendershouldconsiderwhethertotenderthelawsuittothetitleinsurer.Finally,lendersmayneedtoconsiderwhethertofileaninterpleaderaction,inwhichtheymaybeentitledtorecovertheirattorney’sfees.

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r e F e r e n C es

1. stop notices on public works projects are governed by different rules.

2. Civ. Code §3103.

3. Civ. Code §3083 (defining “bonded stop notice”)and §3103 (defining “stop notice”); Black’s Law Dictionary 1432 (7th ed. 1999).

4. a-1 Door & materials Co. v. Fresno guarantee sav. & Loan ass’n, 61 Cal. 2d 728 (1964).

5. Civ. Code §3083.

6. Civ. Code §§3159, 3162.

7. Civ. Code §3159(a)(3).

8. Civ. Code §3159(a)(2).

9. Civ. Code §3161.

10. Calhoun v. huntington Park First sav. & Loan ass’n, 186 Cal. app. 2d 451 (1960).

11. Civ. Code §§3158 et seq.

12. Civ. Code §3166.

13. Connolly Dev., Inc. v. superior Court, 17 Cal. 3d 803 (1976).

14. mechanical Wholesale Corp. v. Fuji Bank, Ltd., 42 Cal. app. 4th 1647 (1996).

15. Civ. Code §3167.

16. Civ. Code §3158.

17. Civ. Code §3160.

18. Civ. Code §§3115, 3117.

19. Civ. Code §3171.

20. Civ. Code §3172.

21. Civ. Code §3175.

22. Civ. Code §3176.

23. Id.

24. hendrickson v. Bertelson, 1 Cal. 2d 430 (1934); Familian Corp. v. Imperial Bank, 213 Cal. app. 3d 681 (1989).

25. rossman mill & Lumber Co. v. Fullerton sav. & Loan ass’n, 221 Cal. app. 2d 705, 709 (1963).

26. miller v. mountain view sav. & Loan ass’n, 238 Cal. app. 2d 644 (1965).

27. a-1 Door & materials Co. v. Fresno guarantee sav. & Loan ass’n, 61 Cal. 2d 728 (1964).

28. Id.

29. Id. at 734.

30. Familian Corp. v. Imperial Bank, 213 Cal. app. 3d 681 (1989).

31. Civ. Code §3166.

32. Familian, 213 Cal. app. 3d at 686.

33. see, e.g., a-1 Door, 61 Cal. 2d at 734 (quoting former Code of Civil Procedure §1190.1).

34. Familian, 213 Cal. app. 3d 681.

35. steiny v. Citicorp real estate, Inc., 85 Cal. rptr. 2d 38 (1999) (unpublished).

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by Dennis L. Allen, CPA, CFE, CCIFP, Senior Vice President for Hill International

TheconceptofRiskManagementiswellestablished,thoughnotalwayswellfollowedinmanagementplans,especiallyonconstructionprojects.TheProjectManagementInstitute’saGuidetotheProjectManagementBodyofKnowledgedefinesRiskManagementasthe“systematicprocessofidentifying,analyzing,andresponsingtoprojectrisk.Itincludesmaximizingtheprobabilityandconsequencesofpositiveeventsandminimizingtheprobabilityandconsequencesofadverseeventstoprojectobjectives.”Potentialcashflowproblemsofowners,contractors,andsubcontractorshasalwaysbeenoneoftherisksconsideredintheseplansbutinthecurrenteconomy,theriskisfargreaterandtheeffectsmuchmoresignificant.Thesefinancialriskscanstrikefromanumberofdirectionsastheowner,thelender,thedesigner,thegeneralcontractor,subcontractors,andevenmaterial

supplierscancallanddeclaretheyaredone,“sorry”.

P r e v e n t I o n

Likemostrisks,financialriskmanagementstartsearlywiththedevelopmentofcontract(s).Somequestionstoconsideratthisstagewouldinclude:

� Whointhechainisresponsibleforthefailureofanotherparty?

� Arepaymentandperformancebonds,largelyavoidedincommercialprojects,arequirementtoreconsiderintoday’sclimate?

� Whatcontractsareassignableupondefault?

� Whoownsstoredmaterialsandoffsitework-in-progress?

� Whatisasufficientretainagepercentageoramounttorestartworkwithareplacementcontractor/subcontractor?

� Whatreportingrequirementsorotherproceduralactivitiescanbeusedtodemonstratecurrentandongoingfinancialhealth?

Theabilityoftheownertopayhaslongbeenacommonquestion,andhistorically,evidenceofaconstructionloanhasbeenthenecessaryproof.Butitisimportanttorememberthathavingaconstructionloaninplacedoesn’tguaranteepaymentifthedeveloperdefaults.Butit’snotjustownerstothinkabout.Whataboutthefinancialhealthoftheotherentities,contractors,designers,manufacturers?Intoday’schallengingeconomy,manyaresofocusedonwinningworkthattheyfailtoconsidertheprecariousnatureoftoday’sprojectteams.Partiesshouldconsidermakingproofofthefinancialhealthofallpartiesaperiodicrequirementjustlikeonewouldverifyproofofinsurance.Lookatfinancialstatementsandcreditreportswithanadvisorthatcaninterprettherisksinvolvedasevenasubcontractors’cashcrisiscanhobbletheforwardprogressofajob.Makethereportingrequirementsandthefinancialhealthrequirementsspecifictoavoiddisagreementslaterintheprojectastohowhealthyishealthy.

Atthetimeoflettingthecontracts,lookcarefullyattheScheduleofValues(“SOV”).FrontloadedSOV’s,or“unbalanced”bidscanleadtoproblems.Ifthecontractororsubcontractorneedsamobilizationpaymentbeyonditsimmediatecashcostsoftheproject,consideraloanthatisrecoupedoverthecourseoftheproject.Atatimewhentheeconomicpressureoncontractorsistogetcashearlyintheproject,goodbusinesspractices,aswellaseconomicpressuresonowners/developersistopayforonlythepro-rataportionoftheprojectineachpaymentapplication.TheproposedScheduleofValuesorMilestonePaymentsneedsscrutinytoavoidunintentionallypayingformoreworkthanactuallyhasbeencompleted.

risk management and the Distressed Property

15

m o n I to r I n g

ThemonitoringpartofaRiskManagementplanislargelyself-perpetuatingifthepaymentproceduresaresetupappropriately.Theobjectiveistomaintaintheproperbalancebetweenwhathasbeenpaidforandwhathasbeendeliveredorperformed.Assuch,theongoinginvoicingandpaymentprocessiscriticalinthesedifficulttimes.Whereasbefore,onecouldrelaxsomewhatintheknowledgethatbeing“paidahead”wasonlyamoderatetimingissueonalumpsumcontract,theprospectsoffinancialfailureofacontractororsubcontractortoday,havemadeitcriticaltonotonlylimitprogresspaymentstorealprogress,buttomakesureyouownwhatyoujustpaidfor.Somespecificprocedurestoconsider:

� MakeProgressPaymentcheckstoboththeprimecontractorandthesubcontractors(i.e.dualpayees),paymentsmadedirecttosubcontractors,aswellasenforceablelienreleasesareawaytobesurethatthechainofcashflowdoesnotbreakdown.

� Lackingdualchecks,havearequiredscheduleforthepaymentofinvoicesdownthechainofsuppliersandthereceiptoflienreleasesandaggressivelyenforcethatschedule.Iftheschedulestartstosliptakeactionimmediatelytodeterminethecauseoftheproblemandensureit’snotthebeginningofadownhillslide.Thecontractor/subcontractorwhoisslowingpaymentstosubcontractorsnotonlyisnotmakingyoufriendsontheproject,butputsthepayeratriskifthecontractorweretoquitunexpectedly.

� Considermakingcontractorpaymentstiedtocompletionmilestonesorspecificactivitiesintheprojectschedule.Thisisacommonprocedurethatencouragespropermonitoringoftheprojectscheduleandincentivizestheteamtowatchtheactualprojectprogressandmanagethescheduleappropriately.

� Considertheuseofindependentwarehousesandbillofsalesforstoredmaterials.Thematerialsupplierwhohaspossessionofpaid-for,butundeliveredprojectmaterialscanbeasignificantrisktoboththecostandscheduleoftheproject

� Havetheownerkeepatleast60daysofconstructioncostinanescrowaccountandcheckthatthebalanceismaintainedproperly.Stopworkifthebalancedipsbelowthecostsincurredtodate,theretainagebalance,andthecosttodemobilize.

� Watchtheprogressofthearchitectsdesignworktoensurethattheusablecompletedworkisatleastroughlyequaltotheamountpaidtothearchitectanditssub-consultants.

� Getpendingchangeordersresolved,onthescheduleofvalues,andpaidinatimelymanner.Ifsomeonegoesunder,alonglistofunresolvedchangeordersisalwaysaproblem.

m I t I g at I o n

Despitealltheplanningandmonitoring,thereisstillariskofsomeonegoingunder.Thefinalstepofariskmanagementstrategyistohaveaplanincasetheworstcasescenariooccurs.Whenthishappens,theprojectteamoftenreactsinaverysymptomaticmanner,i.e.fixthecurrentissueandmoveon.Unlessoneaddressesthecausationalissue(s),aquickfix,suchasacashadvanceorreleaseofretainage,islikelytojustpushbackthetimewhentheentitywillgetintroubleagain.Beverysuspiciousofvagueexplanationssuchas“bankerror”or“administrativeglitches”thatmighttemptyoutoproceedonhopingforthebest.Likethefrogthatgetsusedtothehotwaterafewdegreesatatime,it’stemptingtoletlatepaymentsslidealittleratherthansteppinginquickly.Rarelyhasanyonesaidtheywishtheyhadtakenactionlaterthantheydid.Ifformalbankruptcyisinvolved,thereareprocedurestobefollowedandtheadviceofanattorneyisinvaluable.Butuntilthen,considerthefollowingtoprotectyourself:

Ifyouaretheownerwhereacontractor,subcontractor,orsupplierbelowyouhasstoppedworking:

� Readthecontractandfollowallspecificandrequiredprocedures.

� Contactthesuretyifthereisone.

� Takecontrolofthesiteandanyoff-siteassetsyouhavepaidfor.Protectyourselffromthecreditorswhowillalsobetryingtograbwhattheycan.

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� Inventorythesiteandtheactualcompletionstageoftheproject.Alsolookalsoforcompleted,butdeficientworktolimitwhatyoumayfindyourselfpayingfortwice.Createarecordbytakingpictures,includingavideoofthesiteandmaterials.

� Looktoyourabilitytoassumelowertierentitiestocutouttheproblemandkeeptheprojectmoving.

� Totheextentpossible,communicatewitheveryonetokeeptheteamtogetherandtheprojectmovingforwardifatallpossible.Stoppingandrestartingisanexpensiveproposition.

� Takeafewextradaysthoughandseeifyoucangetareplacementcontractor/supplierforafixedpricetocompletion.Commonly,thereplacementcompaniesdon’twanttheriskofalumpsumwhendoingatakeover,buteventhemulesknowwhentheworkisT&M.

� Ifyouareacontractorandoneofthepartiesaboveyouhasquit:

� Readthecontractandfollowanyspecificprocedures.

� Contactthesuretyifthereisone.

� Takecontrolofanythingyouhavecompletedandnotbeenpaidfor.

� Inventorythesiteandtheactualcompletionstageoftheproject.Takepicturestodocumenttheworkandmaterialsinplace.

� Takecontrolofyourequipmentanduninstalledmaterials.

� Communicatewithanyentitiesbelowyou.

� Sendaninvoiceforanyworkyouhavecompleted,buthavenotbeenpaidforto-date.

� Don’tcompleteanymoreworkuntilyouknowhowyouaretobepaid.

� Don’thesitatetofilealienwhereappropriate.

Co n C Lu s I o n

Unexpectedeventshavealwaysoccurredonconstructionprojects.Theindustryasawholeisgoodatreacting,correcting,andcompletingaprojectdespiteitschallenges.Thedistressedproject,thoughstillrare,hasauniqueabilitytosurprisetheunawareandleaveaffectedpartieswithnoviablecorrectiveactionstotake.ARiskManagementPlan,includingconsiderationsforfinancialrisk,isthebestwaytominimizetheimpactoftheseunfortunatecircumstances.