It is typical in the home building industry that home builders provide their buyers with warranties for replacing or repairing defects or other components in the new residential units. However, with a rising number of home builders going into bankruptcy, a pressing issue is: what happens to these warranties if the builder subsequently files for bankruptcy?
General Unsecured Claims Generally, claims by home buyers under these warranties are treated as pre-petition general unsecured claims in bankruptcy proceedings. Simply put, they are at the bottom of the “cash waterfall”, since post-petition proceeds from assets sales and liquidation would go first to senior secured lenders and then vendors holding mechanics’ liens. Recovery on general unsecured claims is typically low (or near 0%), especially if the builder ended up in Chapter 7 liquidation.
Warranty Insurance ProceedsThere are larger home builders such as Dunmore Homes which provided buyers with warranties insured by its own captive insurance company as well as third party insurers. Recoveries on warranty claims are more viable in these cases, e.g., Dunmore Homes stated in its Disclosure Statement that claimants, albeit considered unsecured creditors in the classification of claims, would receive payment equal to the amount of warranty insurance proceeds received by its liquidation trustee.
Builder in Reorganization, Liquidation or Sale? Another important question which home buyers should ask when monitoring the developments in a builder’s bankruptcy proceedings: is the builder likely to be reorganized and emerge from bankruptcy? Alternatively, is the builder going to be liquidated, or sold off to another company?
Why is this important?
One thing which bankrupt builders can do in bankruptcy proceedings is to file a court motion requesting permission to honor warranty claims and other pre-petition customer obligations. A typical motion of this kind would request court authorization for the matter, but providing flexibility for the builder by leaving it in “its sole discretion”.
From our review of 2007-8 cases, this motion is rarely filed by builders going into liquidation. These builders are usually focusing their attention on responding to banks and other lenders filing motions for relief from stay to pursue foreclosure.
On the other hand, bankruptcy sales nowadays are typically undertaken free and clear of all liens, encumbrances and interests. Known as the “section 363 sale” of substantially all the assets of the builder, the buyer would not be obligated under warranty contracts, unless the latter fall under agreed “permitted encumbrances”. An example of this is PFP Holdings (Trend Homes) where the new entity, T2 LLC, would not be responsible for any warranty claims.
In the third scenario, a builder which plans to reorganize and continue selling homes is most likely to make special provisions to pay warranty claimants, such as WCI Communities, Woodside Group, Renaissance Custom Homes, Den-Mark Homes, etc. For example, Heritage Highgate stated that it would honor warranties and included warranty expenses in its post-petition cash budget submitted to the court.
Note, however, that this does not necessarily mean that such builder would actually emerge from bankruptcy as a reorganized entity. For example, Kimball Hill obtained authorization to honor pre-petition warranties, with the intent of restructuring. However, as the turmoil in the real estate market worsened, Kimball Hill made the decision to wind down operations.
The builder had recently stated in court filings that it would pursue an orderly liquidation, with a plan to complete the remaining projects for which construction had commenced and sell these homes. In order for the sale of these homes to yield higher recoveries for creditors, it appears that the builder would continue to honor warranties. It stated in the Disclosure Statement that the “unavailability of a home warranty would be anticipated to limit demand for the Debtors’ homes, limit the universe of potential homebuyers, and/or significantly reduce home sale recoveries.”
Limits on Warranty Claims While some builders were able to obtain court authorization to honor pre-petition warranty claims generally, there are cases where caps were imposed on such claims. A recent example is Mercedes Homes which had gotten limited authorization – the company cannot expend more than 1% of a home’s final sale price on prepetition customer program obligations related to that home.
Other examples include Caruso Homes and The Woodside Group. Caruso Homes was authorized to honor warranty claims, subject to a cap of $1,500 per home (inclusive of any sums which the builder had already spent prior to bankruptcy). However, for claims owing to water damage arising from workmanship defects, the claims would be honored irrespective of the amount at issue. On the other hand, Woodside Group would honor claims under the warranty program, excluding construction defect claims.
Underlying Dynamics in Bankruptcy ProceedingsWhile courts have routinely authorized builder to continue to honor customer programs, including warranties, these requests have to be supported by evidence that the course of action is essential to business operations, or that the estate may suffer post-petition damages that would prejudice stakeholders.
Furthermore, in cases where lenders believe that they may suffer a shortfall on their claims, they may object to such motions. To illustrate, in case of Legend Homes (aka Matrix Development Corp), Columbia River Bank objected to the motion to honor prepetition obligations under customer warranty program. Excerpts from the bank’s court filings stated:
“Matrix’s request for payment of pre-petition warranty claimants post-petition are factually insufficient and should be rejected by this Court. Matrix asserts without support that a failure to satisfy prepetition obligations to customers who have already purchased a home will jeopardize customer loyalty and trust as well as generate negative publicity for Matrix, thus making it less likely Matrix can attract new customers…
The Debtor appears to assert that having and maintaining a warranty is necessary to improve its market share and to retain a competitive advantage over other contractors and developers. However, pursuant to ORS 701.320 all licensed contractors are required to offer a one year warranty to purchasers of residential real property. Given this statutory requirement, it is difficult to conceive of how permitting pre petition warranty claims to be resolved post petition creates a competitive market advantage in the market place.”
A similar tone seemed to surface in M&T Bank’s objection to the company’s motion to sell real estate inventory in the ordinary course free and clear of liens, where the bank stated that “business in the ordinary course, as described by debtor, is a depletion of their assets as well as the assets available to secured creditors for payment”.
AfterthoughtsA few more points to note on this issue of warranties made prior to bankruptcy. First, it may be good news if the bankrupt builder obtains permission to pay critical vendors. In many cases, like Wall Homes, the construction vendors have entered construction contracts under which they provided warranties. A builder’s inability to maintain such relationships may void warranties, which the vendors would have been obligated to cover.
Second, it is possible that the affiliate or subsidiary providing the warranties is not in bankruptcy. Fulton Home Sales Corp, which provides warranties for buyers from Fulton Homes, did not file for bankruptcy, along with Fulton Homes. Third, there may be alternative recourse in the form of state warranty programs, e.g., the New Jersey New Home Warranty Security Fund was established to guarantee builder warranties.
Finally, we will continue to monitor recent developments of bankrupt home builders and publish our observations on this issue. Home buyers from distressed builders should prepare themselves for the possible scenario of bankruptcy and be prepared to seek advice from legal counsel.
The information contained herein is for informational purposes and is not legal advice or a substitute for legal counsel.
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housesale | admin, 23 Jun 10 | 
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