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In the years between 2003 and 2007, buyers were beating down the doors to buy lots in vacation developments in the mountains and at the beach. Developers could not produce lots fast enough to keep up with demand, and lenders were eager to get in the game, frequently teaming up with developers to offer short term, interest only loans, because everyone thought values were going to continue to climb forever.

In the aftermath of the market collapse in 2008, lenders and developers alike have been swept up in a tidal wave of litigation involving failed developments. The usual scenario is that the developer has gone bust, the development is unfinished, promised amenities do not exist, and borrowers are stuck with undeveloped lots that are worth substantially less than they owe.

In these scenarios, borrowers are looking for ways to get out of their loan obligations and, if possible, recover whatever money they put into the deals. The result has been a spate of lawsuits in which lenders are alleged to have engaged in a vast conspiracy with crooked developers to defraud buyers, all driven by a thirst for short term profits over sound lending practices. As a practical matter, since most of the developers have gone broke, borrowers hope for a scenario in which they can stick the lenders with the property and walk away from their debt.

While the courts have been willing to allow borrowers to proceed against developers on a variety of fraud related theories, lenders have been fairly successful (at least in North Carolina) in having claims of this type dismissed at an early stage. The courts have either relied on implausibility grounds (i.e., a rational lender would not knowingly make millions of dollars of substantially under secured loans), or have refused to impose duties on lenders beyond those contained in the loan documents. In other words, the courts have not been willing to make lenders into guarantors of the soundness of their borrowers’ investment decisions.

There are, however, still potential risks for lenders in these types of cases. In a recent decision from a federal court in the Western District of North Carolina, Synovus Bank v. Coleman, 2012 U.S. Dist LEXIS 114918 (Aug. 15, 2012), the court refused to dismiss a federal Interstate Land Sales Full Disclosure Act (“ILSA”) claim against a lender on a Rule 12 motion, although the court did dismiss a laundry list of state law claims against the lender.

ILSA creates a private right of action against “developers” and “agents of developers” in connection with sales made in violation of its provisions. The act is designed to prevent false and deceptive practices in the sale of unimproved tracts of land by requiring developers to disclose information needed by potential buyers. On its face, this Act would not appear to apply to lenders who had simply financed these transactions.

Although the Court noted that “Lending institutions acting in the ordinary course of their business are generally not considered developers within the meaning of ILSA,” the Court also observed that “where a financial institution acts beyond its ordinary course of dealing as a lending institution and participates in the actual development, marketing or sale of property . . . liability may arise under ILSA.” The Court then held that the following allegations were sufficient to create a plausible basis for the borrower’s claim that the bank’s activities rose to the level of participating in the actual development, marketing or sale of property:

[The borrower] alleges that the Bank co-hosted a series of marketing events which were designed to promote the sale of lots in Seven Falls and to convince potential purchasers of the development’s financial viability. . . . The Defendant further alleges that the Bank provided financing for a series of DVDs produced by the Developer which marketed Seven Falls to consumers. . . These allegations, when taken as true, create a plausible basis for the Defendant’s claim that the Bank’s activities constitute “a level of involvement and participation in the development activities . . . that goes beyond the ordinary course of dealing of commercial banks.”
The Court contrasted these allegations to an earlier case (the Karp case) against the same lender, in which an ILSA claim had been dismissed:

The Karp case, however, is distinguishable from the case at bar. In Karp, the defendants alleged that a Bank employee appeared at off-site sales events, made statements regarding the quality of the lots as investments, and made one statement that the Bank was one of the major funders of the development. The Magistrate Judge concluded that these allegations did not rise to the level of showing that the Bank “was so involved in advertising the lots for sale that it went beyond its function as a commercial bank and could be considered a developer under the ILSA.”

Frankly, it’s a little difficult to see the distinction between the allegations of the bank’s involvement in the two cases, but apparently it was enough for the Court. While this case appears to go against the recent trend of dismissing claims of this type against lenders, there are older cases from prior market collapses that reach similar conclusions. The silver lining in this decision is that the court did say the borrower’s allegations in support of the ILSA claim against the bank “are rather thin” and that they might not survive summary judgment, and the court dismissed all of the state law claims against the lender.

This decision may have given wind to a spate of new lawsuits filed in the Western District the week of August 20 against 3 banks, in which the central claim is the ILSA claim, and the complaints go into great length about alleged participation by the banks with the marketing of the properties in an attempt to fit within the Synovus framework.

The lesson here, however, is plain: when the real estate market finally turns around and development is flourishing, lenders should take care not to align themselves too closely with the marketing efforts of developers. What looks like just good business when the market is hot may turn out to be an ILSA claim if the markets tank again and there are unhappy borrowers who are looking for a way out.

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