Why and How Builders and Real Estate Developers Should Protect Themselves
Real estate developers are popular litigation targets. Builders may be sued for a host of claims, including circumstances beyond their control, such as the presence of hidden, unknown environmental contaminants. The latest litigation threat comes via Chinese drywall used in the construction of homes during the building boom that occurred from approximately 2003 through 2008. Chemicals within the drywall have been linked to illness, as well as damage to homes and appliances, necessitating relocation and lowering property values. Builders and real estate developers are targets of litigation, based on their use of such drywall in the homes they built. Builders and developers should be aware that in the event of a judgment against them, they may lose their personal assets, as well as their real estate and business assets. Insurance will offer limited protection. It is critical for builders to protect their assets, including their real estate and their personal property.
The Extent of the Drywall Problem
The current drywall issue is widespread. Thousands of homeowners have already filed complaints against builders, as well as with the government. The Consumer Products Safety Commission (CPSC), a federal agency, is conducting the largest investigation ever in its history, targeting drywall. The problems have been reported mostly in Florida, Louisiana and Virginia; however, homes around the country (and in Canada) may be effected. The building boom earlier this decade resulted in a domestic drywall shortage which led to the importation of Chinese drywall in many states. It is estimated that some 60,000 homes may have been built with Chinese drywall. One report claims that more than 10 million square feet of Chinese drywall was imported into southwest Florida alone during the housing boom. There is currently one class action pending against a drywall manufacturer in China, although American-made drywall is also suspected of causing injury, and American drywall is also being investigated by the CPSC. Domestic drywall manufacturers such as National Gypsum and Georgia-Pacific have also been sued, along with suppliers such as Venture Supply, Inc. which was forced to close its business. The builders and developers who unknowingly built homes using such drywall are now facing numerous lawsuits.
To make matters worse, many insurance companies are now denying homeowners’ claims for damages suffered because of contaminated drywall. Insurers such as Citizens Property Insurance Corp. (the largest home insurance company in Florida) are also dropping coverage of homeowners who file claims based on drywall. Citizens is not paying for damages related to drywall because insurance policies specifically exclude “builder defects”. Nevermind that the builder did not make the drywall, but merely bought it and installed it, unaware that the drywall manufacturer produced and distributed a dangerous product. If homeowners are suffering damages that are not being covered by their insurers, homeowners now have even more cause to sue the builders and developers.
Impending Insurance Crisis
We can look to the medical industry as a guide for what happens when negligence litigation targets a class of defendants. At a time when medical malpractice insurance policies are becoming smaller, plaintiffs’ malpractice awards grow larger and larger. Insurance companies are not writing new policies and are not renewing existing policies. Many jurisdictions have allowed insurers to increase premiums exponentially. As a result, the medical community is facing a drastic, widely-publicized “insurance crisis”. Doctors have staged “walk-outs” to protest the insurance crisis. Some have chosen to close their practices, move to other jurisdictions or even leave medicine altogether, rather than endure a barrage of lawsuits and inadequate, expensive insurance coverage.
The proliferation of lawsuits based on defective drywall will result in increased insurance costs for builders and real estate developers. If the medical industry is any example, insurers will soon balk at assuming these new risks. One example from the litigation wave against builders and developers based on injuries from mold: State Farm, the largest U.S. home insurer, has eliminated coverage for mold in most states, and Allstate, the second largest insurer, has made its coverage for mold more restrictive and limited. Like the medical malpractice situation, declining coverage for mold-based liability has already been termed a “crisis”. Builders and developers will no doubt feel the pinch from both sides, as targets of lawsuits and as they pay more and more for decreasing coverage.
Builders must protect their assets from potential drywall liability. The days of huge insurance policies serving as reliable umbrellas are gone. There are, however, viable alternatives available to those who plan ahead.
Solution: Asset Protection
In light of the litigation and insurance risks facing builders and developers, the need for asset protection has never been greater. Builders’ real estate holdings, as well as their personal assets, are at risk.
The best way to fend off a plaintiff is to discourage the lawsuit in the first place. Typical contingency fee lawyers start out with the expectation that they are bringing an action against a wealthy, deep pocket real estate developer. The sooner they learn that the builder has no attachable assets, the sooner the strategy will change and the lawyers will take whatever they might get from an insurance settlement. After all, “one third of zero is zero”. The process brings insurance back to doing what it is supposed to do – cover the builder, rather than invite the lawsuit. Domestic asset protection (for example, a family limited partnership, or FLP) will, if properly established and maintained, be 100% effective against all future claims. Such asset protection should discourage future lawsuits and give defendants significant leverage to force favorable settlements within the parameters of their insurance coverage. Additionally, proper asset protection allows builders to reduce liability coverage to reasonable levels. One caveat: it is imperative that builders protect themselves before the commencement of a lawsuit.
Separate and Contain Potential Liabilities
The Revised Uniform Limited Partnership Act (RULPA), which has been adopted as statutory law in all fifty states, provides that the assets owned by a limited partnership are not owned by the individual partners. Therefore, those assets cannot be attached by the personal creditors of a partner. If a real estate developer contributes real estate to an FLP, the properties are no longer owned by the developer (although, he may still control those assets as General Partner). Thereafter, creditors of the builder may not attach those assets merely because they have a personal judgment against him.
As part of an asset protection plan tailored specifically to the builder and his holdings, each asset should be individually evaluated for its exposure to liability. In general, each parcel of real estate should be placed into a separate FLP. The reason for treating each real estate asset individually and placing each one in its own FLP is to isolate the litigation exposure of each asset.
“Equity Strip” the Property and Protect the Proceeds
Domestic asset protection via FLP’s is extremely effective against future claimants, but may not be as effective with respect to pre-existing claimants. In such cases, a property developer may not be completely protected by domestic asset protection and may have to utilize international asset protection strategies. International asset protection strategies are effective primarily because they involve the physical transfer of an asset to a safe and secure foreign locale where the asset is beyond the jurisdiction of U.S. courts. Money, for example, may be wired offshore in order to be completely protected from U.S. creditors. Real estate, however, cannot be moved offshore.
Although it is physically impossible to transfer real estate to a foreign jurisdiction, a builder may protect the real estate by turning it into cash and then protecting that cash by transferring it offshore. This can be done by either selling or mortgaging the property. The equity is thus separated from the property, i.e., “equity stripping”, and then protected. The proceeds of the sale or mortgage can be protected offshore through a number of effective strategies, such as offshore asset protection trusts or investment in foreign deferred variable annuities.
If the real estate is mortgaged and the proceeds are protected offshore, a claimant will be frustrated because any judgment it may receive would be subordinate to the security interest of the mortgagee. As with other effective asset protection strategies, the claimant will be more inclined to settle upon terms favorable to the builder, rather than receive nothing.
It is clear that the risks facing real estate developers, including new theories of tort liability, in addition to traditional areas of concern, all offer compelling reasons for builders to properly protect the assets they have worked hard to acquire. In addition to their real estate holdings, developers must give thought to protecting their personal assets. Proper asset protection strategies offer builders and developers piece of mind and provide the protection their properties need to withstand the inevitable attacks.