Using receiverships to maximize the value of distressed assets.

• Author: Dervishi, Brian S.

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The decline in the real estate market has hit not only consumers hard, but also businesses and lenders throughout the nation. While much is made of the surging tide of foreclosures clogging the nation's courts and dispossessing Americans from their homes, the burst of the real estate bubble and its effect on developers and financial institutions is no less pernicious. Recognized homebuilders such as TOUSA, (1) Levitt & Sons, (2) and WCI Communities (3) have declared bankruptcy, and many smaller developers are facing financial crises created by excess supply and marginal demand.

The effect on lenders is equally dramatic. Lenders are faced with the unappealing choices of keeping bad loans on the books, financing a developer through a Ch. 11 bankruptcy, or foreclosing and selling the real estate for pennies on the dollar. Consequently, the financial woes for lenders have increased, resulting in heavy losses and, in some cases, financial collapse or the need for government aid in order to stay afloat.

Desperate times call for creative measures, and one potential solution for lenders mired in heavy real estate lending is rooted deep in American law: a state court receiver. In the real estate context, receivers are often viewed as passive custodians of real property, maintaining the value of an otherwise depreciating asset while another primary action, such as a foreclosure, is being prosecuted. But a receiver can also be an active manager of the property, selling units and paying back the debt owed to the lender either in concert with a foreclosure or independent of any other action. This article discusses the application of active receiverships in the real estate context of home and condominium builders to create value for lenders above and beyond what a foreclosure action can bring. This article also discusses the limitations of this concept, as well as venue, due process, and other considerations for a lender facing nonperforming real estate loans.

Passive Versus Active Receiverships

A state court receivership is an amalgamation of certain principles inherent in both bankruptcy and agency law. The receiver is an officer of the court (4) whose powers flow from statute,5 common law, applicable rules of civil procedure, the order appointing the receiver, and those acts expressly authorized by the appointing court. (6) Receivers also share traits with bankruptcy trustees, overseeing an estate composed of the property of the entity in receivership and inheriting certain rights from the debtor, such as pursuing causes of action. (7)

There are two types of receiverships, one of which will be called "passive" and the other "active." (8) Passive receiverships are crafted to simply conserve the property, while active receiverships employ broader powers, such as the power to sell and to contract. (9) It follows that passive receiverships need minimal cash flow to maintain necessary utility services and insurance on the property, whereas active receiverships require a more significant "start-up" cash flow from the lender and the employment of professionals and consultants.

Although active receiverships have higher costs, the upside reward can be significantly greater. Whereas passive receiverships are limited by design to ensure that the asset in receivership does not depreciate during the pendency of the primary action, active receiverships are meant to enhance the value of the assets and generate income for distribution to creditors of the receivership estate in accordance with their priority, which usually means that all or most of the proceeds will be applied against operational expenses of the estate and toward repayment of the first priority mortgage.

Active Receiverships in Practice

To illustrate the concept of an active receivership, consider the case of Builder with a single development under construction in South Florida. Builder owes $15 million to Lender and is currently in default, and it owes another $2 million to a variety of contractors and subcontractors, some of whom have filed liens against unsold homes due to nonpayment. Lender extended a loan to Builder during the peak of the real estate market. Builder has constructed approximately 100 of the 200 homes intended to be built in the project, and these homes sell for an average of $225,000. Another 20 homes are substantially complete, but still require some work before a certificate of occupancy can issue. An additional $5 million is required to complete the amenities and infrastructure-related construction (usually referred to as "horizontal" construction in developer parlance) on the remainder of the development. Overall, Builder has sold and conveyed 65 homes, but many of its larger competitors are underselling it, and it has no sales currently pending. Out of the remaining 35 completed homes, 10 are fully furnished models for showing to prospective purchasers.

For a variety of reasons, Lender is unenthusiastic about the prospects of Builder. Lender does not feel that Builder will be able to reorganize successfully either inside or outside of bankruptcy and does not wish to restructure the loan given Builder's outlook. However, Lender is also skittish about filing a foreclosure action against Builder, because the market for a successor developer to come in and complete the development is minimal. Lender expects it could sell the development for about $6 million under prevailing market conditions, most likely to an investor that will hold the property while the market recovers before reselling it at an appreciated value.

If Lender foreclosed and appointed a passive receiver to simply maintain the properties, there would be minimal costs associated with utilities for the completed homes as well as day-to-day maintenance of the community. Lender could possibly complete the foreclosure process in six months to one year, depending on the number of parties involved in the action. Lender would spend approximately $200,000 in fees and costs in preserving the property, in addition to its own attorneys' fees in prosecuting the foreclosure.

However, a case such as this would be a prime candidate for an active receivership. Given the inventory of homes, and based on an average price of $200,000 per home (factoring in a discount due to the distressed nature of the property), there is approximately $7 million in homes that can be sold to existing and new purchasers. Even if $200,000 proved to be an unattainable price because of the market, the receiver can undersell competitors because the receiver will not profit from the sales--whatever profit the developer would make in an ordinary course sale would simply go to the creditors. As discussed above, because of the requirement that proceeds are applied in order of priority, the court would order the proceeds be applied to satisfy existing receivership debt and the bank's mortgage prior to claims made by construction lienors and unsecured creditors; the lienors' claims would not be reached unless proceeds exceeded the $15 million first mortgage debt in addition to administrative expenses incurred by the receiver. Moreover, there are other steps an active receiver can take to generate a profit margin that a similarly situated developer could not attain. For example, a certain percentage of profits from a sale by a developer would need to be reinvested in the project to complete amenities and other horizontal development. Because a property in receivership necessarily contemplates the existence of a future successor developer, these major costs can be apportioned between the receiver and a successor developer, or simply put off by the receiver and later taken into account in the receiver or Lender's sale of the development to a successor developer. If the receiver's sales program is successful, Lender may consider authorizing the receiver to complete the...