February 5, 2001

The California Court of Appeal for the First Appellate District upheld a jury finding that a borrower and its general partners were liable for bad faith waste and punitive damages when the borrower failed to pay property taxes and instead diverted cash flow from the real property collateral to its affiliates. The Nippon Credit Bank, Ltd., Los Angeles Agency v. 1333 North California Boulevard (January 23, 2001).

FACTS
A partnership obtained a million non-recourse loan secured by real property. Anticipating cash flow problems, the borrower requested an interest rate reduction, which the lender denied. On the date that 8,000 in property taxes was due, the borrower instead, paid 3,000 of cash flow from the property to an affiliate. The affiliate received a total amount of ,700,000 of cash flow while the taxes remained delinquent. The lender, foreclosed by a trustee's sale then sued the borrower for "bad faith waste". Even though the loan was non-recourse and even though California law generally prohibits a deficiency judgment following a trustee's sale, a jury awarded the lender approximately 5,000 in compensatory damages for “bad faith waste” and over million in punitive damages. These damages were payable by the borrower and its general partners (although the trial court ordered a new trial to determine the amount of the punitive damages).

COURT OF APPEALS
The appellate court upheld the jury finding that the borrower and its general partners were liable for “bad faith waste”. Failure to pay the property taxes constituted the waste and diversion of the cash flow, which the court characterized as “the 'milking' of the security" or constituted bad faith. The California anti-deficiency laws did not protect the borrower because “bad faith waste” is a long-standing exception to those rules. Also, and certainly most surprising to the borrower and its general partners, the express non-recourse provisions of the loan did not shield these parties from liability because “bad faith waste” is a tort action instead of a breach of contract action. Consequently, the borrower and its general partners were liable for actual tort damages and could be subject to punitive damages.

SIGNIFICANCE
California borrowers may be liable to their lenders - even under non-recourse loans - for both compensatory and punitive damages if there is “bad faith waste”. “Waste” is a broad concept that may include such items as failure to repair or failure to pay property taxes. Although the presence of delinquent taxes on foreclosed properties is typical, the borrower’s behavior (i.e., diversion of cash flow to an affiliate) in this case may have been more egregious than other cases. Whether this decision would extend to less egregious cases, for instance where the borrower simply failed to establish adequate reserves, is unclear.

Ironically, the single purpose entity (“SPE”) requirements imposed by many lenders may make the threat of punitive damages less of a concern to borrowers because other assets are not at risk in an SPE. (However, other assets may be at risk if the owners of the SPE are found liable under contractual recourse carve-outs). Similarly, jury trial waivers (which will still be strongly preferred by lenders), may have the surprising consequence of limiting the exposure under comparable cases. A judge may be less likely than a jury to impose a large punitive damage award or find that nonpayment of 8,000 of taxes constitutes a “substantial” impairment of the security for a million loan (a factual finding of the jury in this case).

Founded in 1983, Pircher, Nichols & Meeks is a national real estate law firm with a diversified real estate practice that includes litigation, bankruptcy, corporate, tax and public finance matters. Based in Los Angeles, the 45-attorney firm also maintains a full-service office in Chicago. The Los Angeles office is located at 1999 Avenue of the Stars, Los Angeles, CA 90067; phone: (310) 201-8900.

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