Lenders and contractors may want to take additional precautions before they take title to a newly constructed home through foreclosure (or deed in lieu of foreclosure) following a recent decision by the Colorado Supreme Court. The decision highlights the importance in obtaining assignments of indemnities, warranties and other contractual obligations prior to taking title. The party taking title should not assume that it will be able to assert a negligence claim in the event it discovers defective construction, so it should take every effort to secure its right to make other kinds of claims.

In SK Peightal Engineers, Ltd. V. Mid-Valley Real Estate Solutions V, LLC, the Colorado Supreme Court found that a construction lender's Subsidiary (Subsidiary) is barred from asserting construction defect negligence claims against subcontractors on a defunct construction/development project.

Case Background

In SK Peightal, the Subsidiary of a lender, which Subsidiary was wholly owned by lender and formed specifically to own the property, took title to a construction project from a developer by a deed in lieu of foreclosure. Following the closing of the deed in lieu, the Subsidiary sued several subcontractors who had performed construction-related work or services on the development project with claims of negligent construction (which are tort claims).

The subcontractors moved for summary judgment on the Subsidiary's claims under the Economic Loss Rule. This rule states that absent an independent tort duty, a plaintiff is generally barred from suing in tort if the plaintiff seeks redress for breach of a contractual duty that caused only economic losses (as opposed to bodily injury for example.)
The District Court denied and the Court of Appeals upheld the denial of the subcontractors' summary judgment motion but the Colorado Supreme Court reversed the denial and remanded the case. The court determined that Subsidiary's claim of negligence was barred because Subsidiary was not a "subsequent purchaser" of the property and therefore no duty was owed to Subsidiary to use reasonable care during construction.

The Colorado Supreme Court set out to answer "whether th[e] independent duty [to use reasonable care in the construction of a new home] extends to protect commercial entities [like Subsidiary]" in the same manner that the duty protects subsequent homeowners. The Court concluded that the Subsidiary does not qualify as a subsequent purchaser and is not a member of the class of parties to which a special independent duty is owed.

Hence, the Subsidiary could not assert a negligence claim at this time and the case has been remanded for further proceedings. The issue is to determine if the subsidiary has contract claims against the subcontractors or tort claims based on a duty, other than the duty to use reasonable care in the construction of a new home.

Lessons for Construction Lenders

To avoid a similar result, a construction lender would be wise when making a loan to obtain collateral assignments of the general construction contract and major subcontracts, which specifically describe the rights and remedies of the parties in the event of a claim. A lender also should include successors and assign specific beneficiaries.

The construction lender (or a contractor who is considering a deed in lieu to settle a mechanic's lien foreclosure lawsuit) should confirm and assign with the conveyance of the property that any indemnities, warranties, insurance or other protections that would be afforded to the contracting party (borrower/owner) are assigned to both the lender (or contractor), and any of lender's (or contractor's) subsidiaries that takes title to the project. This can provide the lender's/contractor's entity that is taking title to the property direct contractual claims that it can assert to address construction defects.

The lender's/contractor's subsidiary will still need to ensure that the assigned rights were properly assignable, or such subsidiary may need to obtain consents from that various indemnitors or subcontractors. (Note: This is advised to do at the beginning of the project by properly wording the loan/construction documents.)

In the closing of the deed in lieu, it would be wise to affirm that the general contracts and subcontracts are assigned to the buyer/subsidiary so indemnities, warranties and other contract rights (including Correction of Work obligations such as those set forth in AIA201-2007, §12.2.2) accrue in favor of the buyer/subsidiary. Insurance may also be available to cover any gap that the indemnities, warranties or other contract rights assigned do not cover.