Legal Risks In-Depth Series (Part 1): Turning on Attorneys and Realtors
BY JOEL BERG, a freelance journalist and college professor who resides in York, Pa.
Real estate investing used to be a search for the best deal: the house or condo that could be flipped for a quick profit, the vacant lot that could be transformed into a shopping mall or office building.
But as deals fell apart and foreclosures mounted, real estate investors started searching for the deepest pockets.
Increasingly, that search is ending in malpractice claims against the lawyers who sat at closing tables, drafted lease agreements or worked with developers. Frustrated investors are looking at those attorneys--and their professional liability insurance policies--as a possible avenue to recover their losses.
Indeed, law firms may be the only parties still in business after the deal collapses. In one case involving a failed bid to purchase a Utah ski resort, investors are turning on the attorneys because the people who put the deal together have no assets to speak of, said Kevin Flynn, a partner in the New York office of law firm Mendes & Mount LLP.
"The claims activity that we've seen has been up about 20 percent," said Flynn, who specializes in the defense of professional liability cases.
The American Bar Association's Profile of Legal Malpractice Claims, a report issued every four years, bears out the trend. Real estate practice generated an estimated 2,420 malpractice claims against attorneys in 2007, the report said. That was up from 2,167 in 2006 and 1,801 in 2005.
Real estate has routinely ranked as the No. 2 source of legal malpractice claims, according to the bar association. But the gap has narrowed between real estate and the No. 1 source, personal injury. In the association's 2007 report, personal injury accounted for 21.56 percent of claims, versus 20.05 for real estate. In the 2003 study, the two fields were farther apart, at 19.96 percent and 16.46 percent.
The spike in claims is following the pattern of real estate downturns going back to the 1980s, according to Stephen Tuuk, president of Hanover Professionals, a division of Worcester, Mass.-based The Hanover Insurance Group that is responsible for lawyers' professional liability.
When deals go bad, people return to the original documents, Tuuk said. "Sometimes it's a missed lien that reveals itself; sometimes it's a security interest that was not properly filed; sometimes it is failure to complete one or another part of a transaction," he said. "When times are really good, then the likelihood of uncovering those is not as high as when things are tough."
There has been plenty of incentive to pore over real estate documents. Hundreds of thousands of homeowners have slipped into foreclosure over the last few years and analysts expect a wave of defaults in commercial real estate as well.
Claims against attorneys run the gamut from conducting poor title searches to giving bad advice on 1031 exchanges, which had been a popular tax deferral vehicle for flipping real estate.
Some of the most severe claims are coming out of syndications, deals in which investors pooled money to buy real estate, said Jim Rhyner, worldwide lawyers products manager and law firm industry business manager for Chubb Specialty Insurance, a unit of Chubb Group of Insurance Companies in Warren, N.J.
Investors don't stop their finger-pointing at the people who managed money-losing deals, Rhyner said. "The lawyers get dragged into it, as well as do the accountants."
Lenders, which are facing an uptick in bad loans, are joining investors in pressing malpractice claims. For example, a lender might allege that a developer's law firm rendered representations, warranties or opinions that were false or misleading, Rhyner said. "There's a lot of litigation that gets wrapped up in that."
Banks also are suing over previously undiscovered liens that hamper their ability to foreclose on a property, said Mike W. Smith,president of Axis Insurance Services LLC, a professional liability brokerage in Franklin Lakes, N.J.
Smith said one title agency was sued after a bank found one property had a lien dating back to 1897, outside the standard 60-year search. In another claim, a lien had been filed in the morning of the same day that a transaction closed in the afternoon. "Title agency claims are way up and that's a real difficult class nowadays," Smith said.
Vacant commercial properties are another source of claims and not just against lawyers. Realtors might face lawsuits for failing to fill commercial properties, for finding tenants that end up going out of business or for not being able to sell a property. "A lot of these are groundless cases but they're looking for ways to pay these mortgages," Smith said.
Claims with greater liability potential are being brought under a federal law called the Interstate Land Sales Act, or ILSA. Enacted in 1968, the law was designed to prevent fraud by requiring developers to register subdivisions of 100 or more lots with the U.S. Department of Housing and Urban Development. The law also calls on developers to provide buyers with property reports before any contracts are signed.
ILSA's original goal was to ensure con artists weren't selling worthless land sight unseen. The law is now being invoked in numerous cases involving condo developments in places like New York and Florida, attorneys said.
Buyers had planned to sell their condos for a profit shortly after the developments were completed. But the real estate downturn wrecked those hopes. Some developers, for instance, took deposits but were never able to line up financing and begin construction. Buyers in search of refunds are alleging that developers failed to register the condos as required by ILSA, said Philip Touitou, a partner in the New York office of law firm Hinshaw & Culbertson LLP.
Some developers have settled their ILSA cases, said Touitou, whose work includes defending professional liability claims. "But those settlements may be more related to convenience than actual liability," he said. "Frankly, I think in many cases the liability of lawyers is tenuous."
It's not just actions taken during the real estate boom that are producing claims. The crash that followed is creating new work for real estate lawyers--and exposing them to new liabilities.
The mortgage rescue arena is one of the potential minefields, according to Touitou. Attorneys involved in plans to help homeowners stave off foreclosure could become the targets of malpractice suits, especially in situations where homeowners end up going bankrupt.
Bankruptcy trustees are increasingly aggressive about pursuing lawyers who were present during mortgage rescues in which a homeowner lost equity, Touitou said. Trustees know the lawyer has a recoverable asset in the form of a malpractice insurance policy.
"The theory is that the lawyer should have counseled the homeowner not to enter into the mortgage rescue transaction," Touitou said.
Whatever its source, the rise in claims is leading to higher premiums and tighter underwriting standards for attorneys who practice real estate law, said John Torvi, marketing and sales director at Herbert H. Landy Insurance Agency in Needham, Mass.
"Some companies, we've seen bumps in the real estate rates of 30 percent to 50 percent," Torvi said.
But new carriers are still pouring into the market, bringing with them new capacity and allowing law firms to shop around, brokers said.
"The law firm might not like the price," said Mark Dion, a professional liability broker with Peachtree Special Risk Brokers LLC in St. Petersburg, Fla. "But typically there's always a market for a risk. It's very rare that you have a law firm that's so bad no one will insure them."
May 1, 2010
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