The Trustee Cometh: How to Protect Construction Loan Funds from Being Grabbed by a Bankruptcy Trustee or Creditor of the Borrower

By Patric J. Kelly1
Adleson, Hess & Kelly, a P.C.
Fall, 2013

The Scenario
You are so happy! You recently closed a nice construction loan for your investors and for your borrower. You have safely tucked away the construction loan proceeds in an account opened up in the name of the borrower just for this purpose, but you feel comfortable because you have an agreement with the borrower that the borrower will not be disbursed any funds for construction costs except upon demand and approval from you. Unfortunately, the borrower did not really disclose to you the depth of his financial problems. You open your mail to find a Notice of Bankruptcy filing by your borrower. Shortly thereafter, you receive a demand from the bankruptcy trustee for all of the construction proceeds you are holding, or you will be sued for those funds. Or, even though the borrower does not file a bankruptcy, you discover that the account has been seized by the sheriff pursuant to a writ of attachment or a writ of execution by another creditor of the borrower.

The Possibilities
There are two (other than panic): (1) you properly documented your construction loan with a construction loan agreement, a security agreement and a "control agreement" (among other documents) so that you can tell the trustee or creditor that their remedies are subordinate to your superior security interest; or, (2) you did not properly document the construction loan, you have to give the trustee or creditor the construction money, and you have to tell your investors that they have a piece of dirt for security with no money to build the proposed improvements.2

Which possibility do you prefer?

Why is the bankruptcy trustee or other creditor of the borrower a risk?
The bankruptcy trustee is entitled to eliminate or ignore any security interests in assets that are not properly "perfected" under state law and to take the assets for the benefit of all unsecured creditors. A creditor may be entitled to attach or seize borrower funds subject to an unperfected security interest. What that means in a construction loan arena is that the loan proceeds are subject to being seized by the trustee or a creditor if the investors have not properly "perfected" their interests in the retained loan proceeds. Perfection in this context is similar to recording a deed of trust. An unrecorded deed of trust can be attacked by a trustee or superseded by a judgment creditor. The reason for the exposure to bankruptcy trustees and creditors is that, once the loan closes and fully funds, the funds belong to the borrower, not the investors. If the investor does not have a security interest in the borrower's funds (like having a deed of trust on the property), then those funds are subject to being seized.

What Need Be Done to Protect You and Your Investors
Documentation is critical under these circumstances. While a smaller deal may be less documented (not recommended), it is best practice to have the following documents to support your construction loan:

  1. Declaration of loan purpose (attempting to eliminate claims of personal or family use rather than business purpose);
  2. A solid construction loan agreement, not just a regular deed of trust with no agreement;
  3. A Construction Loan Deed of Trust, not just your standard deed of trust;
  4. A Construction Promissory Note that melds well with your Construction Deed of Trust;
  5. A Deposit Account and Security Agreement (critical);
  6. An Environmental Indemnity Agreement;
  7. And, most critically, a good Deposit Account Control Agreement (the only practical method for perfection for mortgage brokers).

There could be other documents depending upon the nature of the transaction, but here we are just focusing on what is required to perfect a security interest in the construction loan proceeds.

It is the Security Agreement that "grants" to the investors the security interest in the construction funds being held in the account much like a deed of trust creates a security interest in real property. It is the Deposit Account Control Agreement that "perfects" the security interest (like recording the deed of trust) in the funds being held in the Deposit Account. It is the best practice to open a brand new bank account in a bank separate from one where the debtor is already a customer or has business relations. This can avoid conflicting claims from any bank interests in the account. And, be certain to obtain written assurance from the bank that no other secured creditor has a control agreement regarding, or interest in, that particular account.

Following the guidelines above will remove some of the terror from receiving a demand letter from your borrower's bankruptcy trustee or your borrower's attaching or judgment creditor. Maybe not all of it, but you will sleep better at night knowing that your investors' interests are well protected.

______________________

1 Mr. Kelly is Senior Counsel at Adleson, Hess & Kelly, a P.C. He has thirty-seven years' experience in representing real estate clients and has been a licensed real estate broker since 1980. His practice emphasizes real estate litigation, lender representation, creditor bankruptcy work, receiverships and transactional matters, such as complex real estate loans, collateral security documentation, and mixed collateral documentation, creation and foreclosure. He has lectured extensively to lending-related industry groups since 1982.

2 If the broker used an "as built" value as the "fair market value" in making the loan, the broker may risk having the investors or borrower claim that the broker violated the construction loan provisions of Business & Professions Codes §§ 10232.3(a)(4) [Added by SB 978 as of 1-1-13 for Article V loans] or 10238(h)(4) for multi-lender (Article 6) loans. Arguably, this may impact the multi-lender exemption.