November 18, 2019

November 18, 2019

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2019 Arizona Case Law Affecting Commercial Real Estate and Lending (September 2019)

The following information accompanies a presentation Mike gave to members of the Arizona Commercial Mortgage Lenders Association (ACMLA) on September 10, 2019.

Arizona Case Law – Deficiency Liability

Helvetica Servicing v. Pasquan (AZ Court of Appeals 8-15-2019)

In May 2003, Michael and Kelly Pasquan bought a 4,000 SF home in Paradise Valley with a $600,000 loan from Hamilton Bank and a cash payment. Over the next several years, the Pasquans substantially renovated the property, expanding the home by 7,000 SF. In 2004-05, the Pasquans borrowed $2.1 million from Desert Hills Bank. The Pasquans used part of the Desert Hills loan to refinance the Hamilton Bank loan and applied the remainder of the loan proceeds to the renovation/expansion project. They also borrowed $225,000 from Pasquan’s father and put that money toward the expansion, and charged another $140,000 on credit cards for the project.

In September 2006, the Pasquans borrowed $3.4 million from Helvetica, secured by a DOT on the property. They used the proceeds of the Helvetica loan to pay off the Desert Hills loan, the loan from Pasquan’s father, the credit card debt, loan fees and interest. They were left with about $357,000 in cash from the loan proceeds, which they used for interest payments to Helvetica and landscaping, maintenance, taxes, utilities and marketing. The Pasquans defaulted on the Helvetica loan and Helvetica sued to judicially foreclose. In April 2009, Helvetica obtained judgment against the Pasquans for the amount due on the loan plus legal fees and a foreclosure judgment on the property. After a sheriff’s sale, the trial court entered deficiency judgment against the Pasquans for about $1.9 million.

Pasquan appealed, and the Court of Appeals vacated the judgment and remanded to the trial court for further consideration under A.R.S. § 33-729(A).1 In that decision, the Court of Appeals held that: (a) a construction loan used to build the home that secures the debt is a purchase money loan that qualifies for anti-deficiency protection under A.R.S. § 33-729(A); (b) refinancing a purchase money loan does not destroy the original loan’s purchase money status; and (c) when loan proceeds are used for both purchase money and non-purchase money purposes, a lender may pursue a deficiency judgment for the non-purchase money amounts if they can be traced and segregated.

The Court of Appeals then remanded the case to the trial court to address: (1) the amount of the Hamilton Bank loan payoff, which is entitled to anti-deficiency protection; (2) whether the DOTs at issue covered the newly constructed residence; (3) whether and to what extent loan proceeds, beginning with the first Desert Hills loan, were disbursed for construction of the residence and/or payment of the remaining purchase price of the property; (4) the purposes for which the Helvetica loan proceeds were disbursed; and (5) the amount of a revised default judgment against Pasquan that includes only non-purchase money amounts.

The trial court ruled in response to the foregoing instruction that: (1) the amount of the Hamilton Bank loan payoff was $600,000; (2) all of the Desert Hills loan was secured by DOTs that covered the real property and buildings and improvements then existing or subsequently built on the property, but the loans from Pasquan’s father and the credit card debt were unsecured; (3) all of the money the Pasquans borrowed from Desert Hills, all of the money they borrowed from Pasquan’s father and all the credit card purchases were used for construction of the residence, except for the $600,000 used to pay off the Hamilton Bank loan; (4) the Helvetica proceeds were used to pay loan fees, loan interest, construction costs and cash to the borrowers; (5) Helvetica was entitled to a deficiency judgment of about $340,000. Helvetica appealed.

On appeal, Helvetica did not dispute the trial court’s ruling that the $600,000 that Pasquan used to refinance the Hamilton Bank loan was a purchase money obligation, but it argued that the loan proceeds Pasquan used to pay off the Desert Hills debt financed home improvements, rather than home construction. The Court of Appeals held that a construction loan used to build a residence is significantly different from a loan used to improve an existing home, and that while a construction loan may fall within the anti-deficiency statute, a home improvement loan will not. In that regard, Pasquan had testified that he did not build a new home from scratch and that he lived in the home during the entire time of the renovation. The Court of Appeals concluded that, except for the $600,000 used to pay off the Hamilton Bank loan, the Desert Hills loan financed home improvements, not home construction.

Helvetica also challenged the trial court’s finding that points, interest and reserves paid in connection with the Helvetica loan were entitled to anti-deficiency protection. The Court of Appeals held that, because only $600,000 of the Desert Hills loan should receive anti-deficiency protection, only the portion of loan fees and interest associated with the $600,000 are entitled to anti-deficiency protection.
 

Lender takeaways: A lender financing a substantial remodeling project needs to understand exactly what the borrower plans to do with the existing home and the loan proceeds. Knocking down the existing home will likely make all or part of your loan effectively non-recourse.

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1 A.R.S. § 33-729(A), which applies to mortgage foreclosures and judicial foreclosures of deeds of trust, provided at the time that, if a mortgage [or DOT] is given to secure the payment of the balance of the purchase price, or to secure a loan to pay all or part of the purchase price, of a parcel of real property of 2½ acres or less which is limited to and utilized for either a single one-family or single two-family dwelling, the lien of the judgment in an action to foreclose such a mortgage [or DOT] will not extend to any other property of the judgment debtor and prohibited the judgment creditor from satisfying a deficiency out of other property of the judgment debtor.

Arizona Case Law – Statutes of Limitation

Monroe v. Arizona Acreage LLC (AZ Court of Appeals 5-16-2019)

In September 2006, Sunny Lakes Ranchos LLC signed a $5 million promissory note in favor of over 100 individuals and entities. The note was secured by a DOT encumbering several acres of undeveloped land in Mohave County, and was guaranteed by Mardian.

In August 2007, an affiliated entity, Arizona Acreage LLC, signed a $4 million promissory note in favor of over 80 individuals and entities (many, but not all, of whom were also lenders in the Sunny Lakes loan). The note was secured by a DOT encumbering a different plot of undeveloped land in Mohave County, and was also guaranteed by Mardian.

Both borrowers stopped making payments on their notes in July 2008. In late June 2014, believing the statute of limitations was close to expiring, the lenders filed two class action lawsuits (one of which named Sunny Lakes and Mardian as defendants and the other of which named Arizona Acreage and Mardian as defendants) to judicially foreclose on the parcels securing the loans and to recover any resulting deficiencies. The obligors moved to dismiss the lawsuits, arguing that a four-year statute of limitations applied under A.R.S. § 12-544(3)2 and that the lenders lacked standing because they did not obtain the 51% majority agreement required by the DOTs to declare a default and bring a judicial foreclosure action.

The trial court reserved the issue of Mardian’s liability under his guaranty until after the parcels were sold at the sheriff’s sale and a fair market value hearing could be held. The trial court later determined that Sunny Lakes owed approximately $13.9 million plus interest on its promissory note, and Arizona Acreage owed approximately $10.9 million plus interest on its promissory note. The obligors appealed the trial court’s orders and, while the appeals were pending, both parcels were sold at a sheriff’s sale (the Sunny Lakes parcel sold for $80,000 and the Arizona Acreage parcel sold for $195,000).

The promissory notes, deeds of trust and guarantees were all executed in Nevada and included choice-of-law provisions designating Nevada law as the governing law. The Court of Appeals therefore reviewed substantive issues in the case according to the laws of Nevada, but applied Arizona law to resolve any procedural issues.3 

With regard to the applicable statute of limitations, the obligors argued that the four-year limitations period under A.R.S. §12-544(3) barred the lenders’ claims, while the lenders asserted that a six-year limitations period applied under Article 3 of the Uniform Commercial Code4 [meaning that the actions were timely filed].

The Court of Appeals stated that, where one statute of limitations has general application and another arguably competing statute of limitations is specific, the specific statute should prevail. The Court presumed that (i) the Legislature is aware of existing statutes, and (ii) when the Legislature enacts a new statute that applies to pre-existing statutes, it intends some change in existing law. Therefore, when there is a conflict between two statutes, the more recent, specific statute governs over the older, more general statute. The Court of Appeals further observed that a statute of limitations defense is not favored, and where two constructions are possible, the longer period of limitations is preferred. The Court of Appeals noted that, while Arizona had for decades applied different limitations periods to written instruments depending on whether they were executed in or outside of Arizona, the law has evolved since that time.

The Court of Appeals noted that, in 1993, Arizona adopted UCC Article 3 (which includes A.R.S. §47-3118). That enactment was made long after the general limitations periods in the 1928 Arizona Revised Code and deals solely with negotiable instruments [a specific subset of the “instruments” referenced in A.R.S. §12-544(3)]. Considering the more recent enactment of Article 3 and the clear purpose and policy of the UCC to simplify and make commercial transactions more uniform, the Court of Appeals concluded that A.R.S. §47-3118(A) was the more specific limitations statute and applied that statute to the promissory notes and related DOTs at issue. The Court of Appeals also noted that Nevada had adopted UCC Article 3 and its six-year statute of limitations.

Mardian (the guarantor) argued that UCC provisions do not apply to a guaranty agreement, as a guaranty is a separate contract. Mardian therefore contended that the shorter four-year limitations period under A.R.S. §12-544(3) should apply to the guaranty, irrespective of whether the six-year limitations period of A.R.S. §47-3118(A) applies to the judicial foreclosure claims against the borrowers. The Court of Appeals agreed that Arizona law treats guaranty agreements as separate from their related instruments, but held that the UCC could apply to a guaranty agreement in situations where the borrower under a negotiable instrument is an entity owned by the guarantor. The Court of Appeals noted that Mardian was the owner and managing member of both borrowers and signed each guaranty agreement at approximately the same time as the corresponding promissory note. The Court therefore concluded that it would be illogical to apply one limitations period to the guaranties and another to the notes. Absent any prior agreements to the contrary by the parties, the Court held that the applicable statute of limitations for bringing a claim on the guaranties should not expire before the statute of limitations on the underlying promissory notes.

Finally, the obligors argued that the lender’s claims were barred because they lacked standing to sue for failure to comply with the clause in each DOT requiring beneficiaries holding a minimum 51% of the beneficial interest in the deed of trust (which mimicked a Nevada statutory requirement in N.R.S. § 645B.340) to declare the default and to commence foreclosure proceedings. The trial court found that, by providing notice to the other lenders and an opportunity to opt out of the foreclosure actions, the lenders declaring the defaults and commencing the judicial foreclosure action complied with the 51% majority requirement under the default clause.

Lender takeaways: This decision (if it is not appealed to and overturned by the Arizona Supreme Court) provides clarity and uniformity as to the limitations periods that apply to the various claims (i.e., suit on the note, suit on the guaranty and foreclosure of the DOT) that are a part of the typical judicial foreclosure. This case also reflects a desirable (from the lender’s standpoint) trend in eliminating the application of different limitations periods depending on whether a document was signed inside or outside of Arizona (particularly given that many Arizona transactions include documents signed out of state and overnighted or emailed to Arizona on or very shortly before the closing date). Lenders should look for applicable statutes of limitations in places other than A.R.S. Title 12; doing so may have saved the day for the lenders in the present case. The lenders in a multi-lender facility should have some agreement among themselves as to the manner in which decisions will be made in loan default and enforcement scenarios. Finally, this case impresses the need to pay attention to, and appropriately customize, the choice of law provisions in a transaction that involves multiple parties and multiple states.

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2 A.R.S. §12-544(3), which was part of the 1928 Revised Arizona Code, requires an action to be commenced within four years after the cause of action accrues upon an instrument in writing executed outside the state of Arizona.

3 Under the typical conflict of laws analysis, the court will, if certain requirements are met regarding connections between the parties or the transaction at issue and the state whose law is designated to govern the document, apply the law of the selected state to substantive issues, but will apply the law of the so-called forum state (the state where the action is pending) to procedural issues, including the applicable statutes of limitations.  A judicial foreclosure action typically needs to be brought in the state where the land is located so that the court has the authority to direct the sheriff of the county in which the land is located to sell the land under execution.

4 A.R.S. §47-3118(A) requires an action to pay a note payable at a definite time to be commenced within six years after the due date or dates stated in the note, or, if a due date is accelerated, within six years after the accelerated due date.
 

Arizona Case Law – Privity of Contract

JTF Aviation Holdings, Inc. v. CliftonLarsonAllen LLP (AZ Court of Appeals 7-02-2019)

Freer was the founder, president and sole shareholder of JTF. CLA, a national accounting firm, agreed to provide JTF with a billing, collection and revenue-cycle analysis, and memorialized the scope of the work in an engagement letter dated 8-15-13. On 12 30-13, JTF and CLA entered into a second engagement letter, which provided that CLA would audit JTF’s 2013 consolidated financial statements and perform other non-audit services. The 12-30-13 engagement letter provided that, notwithstanding any statute or law of limitations that might otherwise apply to a dispute between the parties, any action or legal proceeding must be commenced within 24 months after CLA delivers its final audit report to JTF, regardless of whether CLA performed other services relating to the audit report. On 2-03-14, CLA delivered its 2013 audit report, addressed to “Shareholder” (i.e., Freer), pursuant to the 12 30-13 engagement letter.

In June 2014, Vistria Group, through its subsidiary Aviation West Charters, as purchaser, entered an agreement with JTF, as seller, and Freer, as JTF’s shareholder, to buy substantially all of JTF’s assets for $80 million plus assumed liabilities. In the purchase agreement, JTF warranted to Vistria that JTF’s financial statements had been prepared in accordance with GAAP and fairly presented JTF’s financial position and results of operations. In September 2014, Vistria filed a complaint in Delaware state court against Freer, JTF and others, alleging that the defendants fraudulently induced Vistria to purchase JTF at an inflated price because the company financial statements on which Vistria relied did not conform to GAAP, which had the effect of inflating JTF’s EBITDA from $11 million to $41 million.

In September 2016, Vistria settled its claims against Freer and the other defendants in the Delaware lawsuit in exchange for a payment of $4.85 million, and in April 2017, Freer and JTF sued CLA in Arizona state court, alleging that CLA’s professional negligence gave rise to the claims against them in the Delaware lawsuit. CLA contended that the applicable statutes of limitations and contractual limitations in the 12-30-13 engagement letter barred the claims. The trial court ruled that Freer was bound by the 24-month contractual limitations period in the engagement letter, which barred JTF’s and Freer’s claims.

The Court of Appeals noted the longstanding general rule in Arizona that only the parties to a contract are subject to or may enforce its terms. Freer was the sole shareholder, president and founder of JTF and the beneficiary of the planned sale of JTF’s assets in connection with which CLA was hired to perform an audit. Freer not only knew of the engagement letter, but signed the management representation verifying the financial information JTF provided to CLA, and CLA relied on the accuracy of those financials in performing its audit. The trial court had ruled that Freer was bound by the limitations provisions in the 12-30-13 engagement letter in light of his relationship to JTF and because his claims could not be adjudicated without analyzing whether CLA complied with that contract.

The Court of Appeals noted that the Arizona courts had not previously adopted the closely related party doctrine. However, the Court held that, under appropriate circumstances, non-signatory transaction participants may benefit from and be bound by contract terms when the non-signatories are closely related to a signatory or the dispute. The Court noted that several other states had adopted the closely related party doctrine to promote efficient resolution of contract disputes, and determined that the doctrine should apply to the present case.

The Court of Appeals stated that, in determining whether a non-signatory is closely related to a contract, courts consider the non-signatory’s ownership of the signatory, its involvement in the negotiations, the relationship between the two parties and whether the non-signatory received a direct benefit from the agreement. The Court of Appeals also stated that, in considering whether to apply the closely related party doctrine, a court must decide whether enforcement of the clause by or against the non-signatory party was foreseeable.

The Court of Appeals held that Freer was so closely related to the contract or its signatories (because of his close relationship to JTF and his involvement in the conduct of the contract) that enforcement of the contract terms was foreseeable. Therefore, the Court held that Freer was bound by the terms of the 12-30-13 engagement letter, including the limitations period.
 

Lender takeaways: This case is evidence of the continuing erosion of the “privity of contract” rules that once strictly applied to a third party’s ability to enforce a contract to which it was not a party. While the Court of Appeals allowed the defendant to use the closely related party doctrine as a shield in the present case, a lender should not automatically assume that it will be permitted to use the doctrine as a sword in pursuing an affiliate having a close relationship to an obligor that has signed a contract. Nonetheless, it is worth keeping this new Arizona doctrine in mind for an appropriate situation.

Arizona Case Law – Fiduciary Duty

In re Sky Harbor Hotel Properties, LLC (AZ Supreme Court 6-25-2019)

The U.S. Bankruptcy Court for the District of Arizona, in adjudicating certain bankruptcy cases before it involving alleged breaches of fiduciary duties, certified the following questions to the Arizona Supreme Court:5 

  1. Does a manager of an Arizona LLC owe common law fiduciary duties to the LLC?
     
  2. Does a member of an Arizona LLC owe common law fiduciary duties to the LLC?
     
  3. Can an Arizona LLC’s operating agreement lawfully limit or eliminate those fiduciary duties?
     

The Supreme Court first noted that the Arizona Legislature had adopted a new LLC statute in 2018 to apply to LLCs formed on or after 9-01-19, and to all LLCs starting on 9-01-20; the new LLC statute expressly provides that LLC managers and members owe fiduciary duties to the LLC. The Court therefore noted that its decision in the present case was limited to the LLC act that pre-dated the 2018 legislation (referred to herein as the “original LLC act”), which did not expressly impose fiduciary duties on LLC members or managers; this limitation obviously restricts the impact of the Supreme Court’s decision going forward. The Court noted that by statute, the law of agency applies to the entire original LLC act, and the Court therefore applied common law agency principles to resolve the certified questions.

The Arizona Supreme Court had previously observed that, unlike corporations and partnerships, LLC members do not owe each other fiduciary duties unless such duties are expressly included in the LLC’s operating agreement. However, the Arizona Supreme Court had never previously determined whether, based on the common law of agency, LLC managers or members owe fiduciary duties to the LLC.

The Supreme Court noted that, absent controlling authority to the contrary, it generally follows the Restatement6 when it sets forth sound legal policy. The Restatement of Agency provides that an agent is a fiduciary with respect to matters within the scope of its agency. The Court noted that partnerships, joint ventures and corporations are all owed fiduciary duties (including a duty of loyalty, a duty of good faith and duty of care) by agents empowered to act on their behalf.

The Court noted, with respect to an LLC, that the members, by default, are agents of the LLC for the purpose of carrying on its business in the usual way. However, if an LLC’s management is vested in one or more managers, then the members are not automatically agents by reason of being members, except to the extent the operating agreement or the manager delegates that authority to them. Therefore, whether a member owes fiduciary duties to an LLC depends on whether management is vested in one or more managers. If not, then all members are deemed agents to the LLC and owe common law fiduciary duties to the LLC. However, if the LLC is managed by one or more managers, members are considered agents only to the extent they have been delegated authority by the managers or the operating agreement, and owe common law fiduciary duties to the LLC only if the members act as agents of the LLC.

The Supreme Court further held that the fiduciary duties of a manager or member, when acting as an agent of the LLC, may lawfully be limited by a valid operating agreement. The original LLC act allows the operating agreement to contain any provision that is not contrary to law and that relates to the rights, duties or powers of its members, managers, officers, employees or agents. Neither the original LLC act nor any other applicable law broadly prohibits an operating agreement from altering or limiting fiduciary duties that managers or members would otherwise owe to the LLC. The defendants in the present cases had conceded that, regardless of their arguments relating to common law fiduciary duties, they could not eliminate the implied covenant of good faith and fair dealing by an operating agreement, and the Court confirmed that that conclusion was supported by public policy and case law. The Court therefore held that, while an operating agreement under the LLC act may lawfully limit or eliminate common law fiduciary duties owed by the members or managers, it may not eliminate the covenant of good faith and fair dealing implied in every contract.

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5 A certified question is a formal request by one court to another court for an opinion on a question of law.  The Arizona Supreme Court is considered to be the ultimate authority on questions of Arizona law.  In the present case, the federal Bankruptcy Court asked the Arizona Supreme Court to decide certain questions of Arizona law to assist the Bankruptcy Court in making decisions in pending cases that were to be impacted by the answers to those questions.

6 The Restatement is a legal treatise that seeks to set forth and clarify generally accepted principles of contract common law (case law) and occasionally suggests new rules that contradict existing law.
 

Arizona Case Law – Merger of Interests and Private Easements

Dabrowski v. Bartlett (AZ Court of Appeals 5-07-2019)

This case had a somewhat complicated factual and procedural background that doesn’t lend itself to a meaningful discussion in a limited space. However, it contains a good discussion of the elements of merger of title (of an easement into fee title), implied easements or ways of necessity, express easements and private condemnation.

Copyright © 2019 Ryley Carlock & Applewhite. A Professional Association. All Rights Reserved.

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About this Author

Michael Ripp Real Estate Attorney Ryley Carlock Law Firm
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Mike has been with Ryley Carlock & Applewhite since 1986 and heads up the Phoenix office's banking and finance practice, which continues to be recognized in U.S. News & World Report's "Best Law Firms" rankings as a "Tier 1" (top tier) practice in the Phoenix market.  He represents banks and life insurance companies--and occasionally borrowers--in real estate, commercial and agricultural loan transactions, loan workouts, loan enforcement, including trustee's sales, judicial foreclosures and receiverships, deeds in lieu of foreclosure and resales of collateral...

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