How Developers and Lenders Can Mitigate Legal Risk in a Downturn Economy

Having been through a few recessions and noticing significant trends, it’s safe to say we can answer the question of “Does history repeat itself?” with a resounding “yes.” However, we can gain valuable insight from the past to better prepare for the future to mitigate risk.

It is apparent from today’s headlines that we are heading into, or already in, a recession. Regardless, any downturn in the market has historically impacted the commercial real estate market, and this time is no different.

The business implications of these recessions – from tightening of credit to changes in sales volume – have been both positive and negative, but the legal problems that ensue are likely the most long-lasting and costly. Identifying the risks that emerged during prior recessions and understanding how they may have been resolved can help protect lenders and developers during these turbulent times. In addition, knowing this history can equip both parties to take the necessary precautions to ensure that history does not, in fact, repeat itself. 

A Look Back on Past Recessions

Statistically, there are more construction-related litigation matters than any other loan litigation claims in any given year, and during a recession, these numbers increase even more. For construction loans, recessions have and will likely continue to trigger a myriad of legal issues. These loans are risky enough without market fluctuations, but in a recession, contractors who are strapped for cash, or those who have underbid a project, may end up cutting corners. This can result in an increase in defects due to rushed workmanship, supply chain delays, difficulty finding workers, cost cutting, and/or manufacturing problems. 

In addition to an increase in problems related to the construction itself, construction delay claims can become more prevalent and more costly to resolve during a recession. While the more common weather delays, workmanship issues, and supply chain delays may still be factors, during a recession and as we experienced during the pandemic, government shutdowns can impact the timing of permits and even require project work stoppage. Delays can trigger events of default under loan documents, penalties, or extension fees. They can also impact permanent funding sources and present additional carrying costs. Delays may also implicate guarantor liability on certain loans and thus make it more challenging for the project to ultimately stabilize.

Of course, a volatile market typically indicates unstable interest rates. However, locking in an interest rate early can have advantages and disadvantages. For those rare construction-to-permanent loans, changing interest rates can greatly impact the costs of completion. During past recessions, many lenders were left with difficult decisions about the viability of loan commitments facing claims from borrowers, resulting in many borrowers with forward commitments having loan approvals pulled because of changing interest rates. 

Broken commitments can result in significant litigation and, in rare instances, punitive damages. In addition, the resulting impact and delays can essentially destroy a project’s viability. If there are guarantors on the loan and the borrower breaks the commitment, personal liability may also ensue. Prior recessions saw dozens of lawsuits surrounding loan commitment breakage, with many courts scrutinizing whether the reasons for the termination were justified.

Finally, recessions can lead to a less stable tenant pool. When tenants are incapable of maintaining their rental obligations, borrowers are more likely to default on their mortgage obligations. Not surprisingly, there are more foreclosures, deeds in lieu, and collection efforts during a recession than when times are good. This financial instability lends itself to a higher rate of bankruptcy.

Mitigating Risk in a Downturn Economy

Despite the cloud of doom that may be looming amongst many commercial lenders and developers, a recession can actually bring opportunity; some of the risks can even be mitigated with careful planning. Hindsight and decades of ensuing risk management and litigation have led me to firmly believe it boils down to these ten tips:

1. Get a fresh set of eyes on loan documents, construction contracts, and land purchase agreements to fully understand all your contract terms. Check your force majeure clauses and notice provisions thoroughly and be sure to comply with them. Regularly review your documents throughout the life of the project, particularly if construction loans are involved.
2. Make sure your deadlines are consistent between documents. Provide ample time for potential delays that may be out of your control.
3. Ensure that you keep accurate, exhaustive records and notes from the outset. Monitor contract compliance recording deviations and delays as you go.
4. Conduct regular, on-site inspections. Owners and developers should be watching their contractors and overseeing the project’s progress, and lenders should observe firsthand whether deadlines are being met.
5. Communication is key. It may seem cliché, but strong communication can salvage a relationship and increase the potential for a loan or contract modification when necessary. 
6. Review and maintain insurance. 
7. Don’t overpromise. It seems simple, but a project’s success can, at times, depend on managed expectations.
8. Stay in your lane. As one court recently noted: “[i]f a lender exercises excessive control over a borrower . . ., a lender can assume the role of fiduciary rather than creditor.” However, even absent a fiduciary duty, “if a lender takes a particularly active role in the business decisions of the borrower” it “may become liable for tortious interference.” 
9. Utilize consultants – construction managers, inspectors, supervisory architects, lawyers, and/or accountants – who have the experience and know-how to tackle any issue that could arise.
10. Seek modifications to documents where necessary, obtain appropriate consents, and document any changes to agreements. 

Even in the midst of a recession, following these ten steps will minimize legal risk, if not alleviate it fully.

Bonnie Rothell is partner at Morris, Manning & Martin, LLP