Daily Development for Thursday, April 10, 2003
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
dirt@umkc.edu

The Reporter for this DD is Harris Ominsky, writing in the Blank
Rome newsletter (the editor has edited the text and added
comments)

MORTGAGES; DISCLOSURE; CONSTRUCTION LENDERS:
Construction lender  must provide information to the permanent
(takeout) lender about the financial condition of the borrower.

Wells Fargo Bank v. Arizona Labors, Teamsters and Cement Masons
Local No. 395 Pension Trust Fund, 38 P. 3d 12 (Ariz.. 2002)

The case has a bit more interest because an important principle of the
fraudulent borrower here was Fife Symington, later Governor of Arizona,
who was indicted and convicted in connection with allegedly fraudulent
real estate dealings, but who's conviction was later set aside.  Symington
thereafter was pardoned by President Clinton.  The story goes that
Symington, as a young man, rescued the young Clinton from possible
drowning during a New England summer.  Symington, reports have it,
has gone to cooking school and now is a successful pastry chef in
Arizona.  What got served to the lenders here, however, was not such a
tasty dish.

A permanent lender ("the Fund") alleged that the construction lender,
("Wells Fargo"), had deliberately delayed foreclosing against the
borrower on an unrelated loan to buy time until the the Fund paid off the
construction loan.  The Fund further alleged that Wells Fargo did not
disclose to the Fund that the borrower had submitted false financial
statements to the Fund, and that Wells Fargo knew that the statements
were false.

The court held that even though the construction lender had no
common-law duty to disclose the borrower's worsening condition, the
construction lender could still be liable for an intentional tort or for
breach of contract when it structured its own activities relative to the
borrower in ways that might divert the take out lender's attention from
the borrower's problems and which might lead the Funds to complete the
take out and thus alleviate Wells Fargo of the burden.
The Supreme Court of Arizona reversed a summary judgment granted to
Wells Fargo and held that the alleged conduct of Wells Fargo was
enough to make it vulnerable to tort claims for aiding and abetting fraud,
fraudulent concealment and tortious interference with contract, as well as
a contract claim for breach of its duty of good faith and fair dealing.  It
upheld the lower court's refusal to find that Wells Fargo engaged in a
fraudulent conspiracy.

The case revolves around a tri-party agreement entered into among the
borrower, the Fund and the predecessor to Wells Fargo on the
construction loan. Based on the permanent lender's commitment to take
out the construction loan upon completion of construction of a project
called "Mercado," Wells Fargo agreed to advance an interim construction
loan of $10,000,000. While tri-party agreements are not frequently used
any more, the form used in the Wells Fargo Bank case was fairly typical
at one time.

The Fund had conditioned its takeout obligation on a personal guaranty
of the borrower's general partner, and production by the borrower and
the guarantor of various financial statements of the borrower, its
principals and its guarantors. Even though the borrowers and guarantors
were required to deliver financial statements to the Funds, Wells Fargo
had no obligation to furnish information to the Fund during construction
of the project, such as existence of the liens, unless  the Funds made a
"reasonable request" for such information.  Wells Fargo also agreed to
inform the Funds of any default under the construction loan, or any
intention by the bank to foreclose on that loan. The tri-party agreement
stated that the bank had no other obligations in connection with the
Fund's loan.

During the construction period the borrower ran into trouble, not only
with the Mercado project but also an unrelated project, Alta Masa
Village, that had also been financed by the bank for $2.3 million. When
the Alta Masa loan matured, the bank extended the loan, and when the
borrower was still unable to pay, the bank entered into a short-term
forbearance agreement with the borrower agreeing to delay any collection
efforts on the Alta Masa project until after the "takeout" date when the
Fund was to pay off the bank's interim construction loan on the Mercado
project.

The court in a long, detailed analysis of the facts, concluded that there
was enough evidence that the bank had acted deliberately to cloak the
borrower with a false appearance of financial vigor and to deprive the
Fund of any reason to refuse to Fund the permanent commitment. In
short, the court found that the Fund had raised enough material factual
issues to require trial on the various theories put forward by the Fund.

In arriving at its conclusion the court rejected various defenses that the
lower court had allowed.

First, Wells Fargo had argued that it had no fiduciary duty of disclosure
to the Fund because the duties of disclosure were patent on the face of
the tri-party agreement.  That agreement only  required information upon
the Fund's "reasonable request;" and there had been no such request; The
bank was not aware of any fraudulent activity by the borrower; The bank
acted lawfully to protect its own interest when it postponed collection
efforts on the Alta Mesa project. Despite the inaccurate financial
statements, no event had occurred to the borrower's financial status that
would have given the Fund the legal right to refuse to honor the tri-party
agreement; and Wells Fargo had a duty not to disclose confidential
customer information.

The court acknowledged that there may have been no direct duty of
disclosure, but felt that was beside the point.  The court stated:

     ". . . If simple nondisclosure were the essence of this case, the
     Bank would not be liable . . .. But, as discussed, simple
     nondisclosure is not the claim the Fund makes. The real questions
     are the propriety of the Bank's affirmative decision not to institute
     foreclosure proceedings against Alta Mesa, the forbearance, the
     failure to report Symington's false statements to federal
     authorities, and whether these intentional actions or omissions
     interfered with the Funds' right to receive from Symington
     information material to their decision to fund the Mercado loan."

Second, the tri-party agreement had given the Fund the right to terminate
if, among other things, the borrower was "generally not paying its debts
as such debts become due," or "became insolvent," as that term is defined
in . . . the "Bankruptcy Code".  Wells Fargo maintained that no event had
occurred to the borrower which would qualify under the relevant
bankruptcy statutes as failing to pay its debts "as such debts become
due."  Consequently, any non disclosure to the Fund was not material.
The Fund retained its responsibility to take out the loan.

The court disagreed with this and held that despite the loan extensions
and the forbearance agreement, the Alta Mesa loan was absolutely in
default and amounted to a clear failure to pay a debt when due.

Reporter's Comment 1:  The decision for the Fund was made easier
because of the conduct of the bank in connection with the Alta Mesa loan
and because Arizona law implies a covenant of good faith and fair
dealing in every contract. However, many other disputes under tri-party
agreements arise under circumstances where the construction lender does
not have another loan with the same borrower, and many arise in states
that do not apply that somewhat mysterious and vague standard of "good
faith" to all contracts.

Reporter's Comment 2:  One of the lessons the case can provide to
construction lenders is to negotiate carefully the conditions in a tri-party
agreement that relate to the change of a borrower's financial condition. A
construction lender expects to rely on the permanent commitment to pay
it off once the project is completed. It would like to know that all of the
conditions of the takeout commitment are under its control. Therefore, if
the construction lender has properly budgeted construction funds and
supervised the job, it can have reasonable confidence that the project is
completed to specifications within the designated deadline of the tri-party
agreement. From the construction lender's perspective, completion of the
project in accordance with plans and specifications within a specified
period of time is an appropriate condition to the takeout.

One of the issues frequently negotiated in these agreements is whether
the risk of a borrower's change of financial circumstances should fall on
the construction or the permanent lender. That is a factor that is out of
the control of the construction lender; and a cautious approach by the
construction lender would be to resist any condition that relates to
changed financial circumstances of the borrower. Despite that, the
construction lender may have to concede that the takeout lender can walk
away when the borrower goes bankrupt before the takeout closing.
However, the bank should resist any other conditions that would permit
the takeout lender to wriggle off the hook if the borrower falls into
default on other loans or if the borrower's financial condition
deteriorates.

In this world of volatile stock markets, it is not unlikely that during a
prolonged construction period, a borrower's net worth could rise, or fall
by substantial percentages. A construction lender would not want that
change of fortune to trigger a loss of its takeout loan. That is particularly
true where permanent lenders are making the loan commitment and the
credit decision based largely on the appraised value of the completed
project, or on the credit of specified tenants who have accepted the
completed construction project.

Although these details are not discussed in the Wells Fargo Bank case, it
appears that the decision would have gone the other way if the bank had
not permitted the takeout loan to be conditioned on contract provisions
related to the borrower's changed financial condition.

Editor's Comment 1: Arizona is that same wonderful place that gave us
Lombardo v. Albu, 14 P.3d 288 (Ariz. 2000) (the DIRT DD for
12/14/2000) (Buyer's broker has duty to disclose adverse financial
information concerning buyer because buyer also has such a duty under
concept of good faith and fair dealing.  This is not what you'd call a
caveat emptor state.  The editor has the same problem with this result
that he did with Lombardo  - it's hard enough to understand your own
economic position when dealing with a difficult borrower.  It's virtually
impossible to make determinations as to what information might be
material to third parties who are making evaluations of their own risk.
Absent evidence of a deliberate intent to deceive, can we be sure that the
Wells Fargo personnel in the field were completely certain that they had
all the facts both about the buyer and about the take out lender's
knowledge and objectives?

Note that here, perhaps in response to Lombardo, Wells Fargo put
language in the agreement delimiting its disclosure obligations.  Didn't
help.

Editor's Comment 2: It is difficult to know just how much of the
decision was based solely on the fact that there was fraud on the part of
the borrower.  The bulk of the opinion does seem directed at the notion
that Wells Fargo had direct information that fraud was occurring and did
not warn the Funds of this fraud in order to further its own interest in
implementing the Mercado take out.  That strikes the editor as a
reasonably solid holding.

But when the court starts discussing good faith and fair dealing, the
contours and limits of the lender's duties in such cases fuzz up.

Where a party has some awareness that certain activities *may*  be
fraudulent and acts in its own financial interest without any intent to
mislead others, the editor is less comfortable with the party becoming
liable for what is, at bottom, the failure of the third party to look after its
own affairs.    For instance, absent the fraud, the simple extension of the
due date on another loan so that the borrower could meet its financial
goals regarding the take out strikes the editor as quite consistent with the
contract provision stating that Wells Fargo had no duty to discuss the
financial condition of the borrower with the Funds unless asked.

Readers are encouraged to respond to or criticize this posting.

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