June 17, 2015
If a construction lender takes deed in lieu of foreclosure from the developer of a failed construction project, what rights does the lender have to sue the developer's subcontractors for construction defects relating to the project? That was the issue addressed by the Colorado Supreme Court in a recent case called SK Peightal Engineers, Ltd. v. Mid Valley Real Solutions V, LLC. As discussed below, the case holds lessons for the construction industry.
The basic facts were that a developer secured construction financing from a bank to build a residential home. The developer defaulted on the loan, and the bank — through a subsidiary — accepted a deed in lieu of foreclosure from the developer. Before the bank could sell the home, the bank discovered cracks in the foundation caused by settling soil. It sued certain subcontractors, including the structural engineer and geotechnical contractors, for negligence.
In response to the claims, the defendant subcontractors invoked a legal doctrine known as the "economic loss rule." The economic loss rule comes into play when a plaintiff would have a claim for damages against the same defendant under both contract law and tort law. It essentially forces the plaintiff to sue under the contract unless the plaintiff can show that the tort arose independently of the contract. For example, assume that a town hires a contractor to install certain water lines, and the contract imposes a duty on the contractor to perform the work in a good and workmanlike manner. If the lines later leak, the town cannot sue the contractor for negligence (which is a tort claim) but would rather be limited by the economic loss rule to suing for breach of contract. This is because the negligence claim would assert that the contractor did not do the job in a good and workmanlike manner, which is what the contract already requires. Thus, the negligence claim would not arise independently of the contract.
In the construction defect context, the economic loss rule does not prevent a "subsequent purchaser" from suing for construction defects. For example, if a developer builds a home and sells it to a third party who discovers cracks in the foundation, that third party could sue the responsible subcontractors for negligence. The reason is that a subsequent purchaser would not have a contractual relationship with the subcontractors, so a lawsuit for negligence would be the only claim available.
Turning back to the case at hand, the bank argued that it was a subsequent purchaser by virtue of having accepted the deed in lieu of foreclosure and could, therefore, bring its negligence claims against the subcontractors. However, the court found that the bank had acquired the ability to enforce the developer's contracts with the subcontractors. In this circumstance, the court held that the bank would not be considered a subsequent purchaser and would be limited to suing under the contracts because of the economic loss rule.
The case does not discuss why the bank was reluctant to sue under the contracts. It could be that the contracts contained language limiting the subcontractors' liability. It could also be that there were insurance-coverage implications because the subcontractors' liability insurance might not have covered contract claims. Whatever the reasons, the case highlights the importance that rights and remedies be spelled out in construction agreements. Before a lender accepts a deed in lieu of foreclosure (and perhaps earlier in the lending process), it will now have to review the applicable construction agreements to ensure that they provide adequate remedies (because the economic loss rule will prevent separate negligence claims if needed).
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Ultimately, lenders may elect not to accept deeds in lieu of foreclosure at all.
Noah Klug is owner of The Klug Law Firm, LLC, in Summit County, Colorado. He may be reached at 970-468-4953 or Noah@TheKlugLawFirm.com.
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