A recent bench trial in the Cobb county Superior Court pitting a real estate developer David Pearson and several related entities against Delta Community Credit Union (“DCCU”) resulted in Pearson being awarded a lender liability judgment in the amount of $75 million. A copy of the Final Order and Judgment is available online here.  Pearson initially obtained credit from Delta Community Credit Union in early 2009 when one of his entities (“Gettysburg”) refinanced a $2,025,000 loan on an office park located in Cobb County, Georgia. DCCU obtained an appraisal showing a value of $4,800,000.

Following the Gettysburg loan, Pearson sought additional financing in the form of a $30 million credit facility for the purpose of buying distressed real estate in Florida and metropolitan Atlanta (the “Master Credit Facility”).  The Master Credit Facility was set up in conjunction with a formula referred to as the “Pearson Matrix” that required a certain loan to value ratio and first lien position for any real estate acquisition that Pearson might use the funding for.  In addition to the Master Credit Facility, DCCU also extended a line of credit (the “LOC”) that eventually grew to $9,900,000 secured by existing real property pledged by Pearson’s affiliates.

Pearson attempted to utilize the Mater Credit Facility to purchase a number of properties in Florida. At the same time he was trying to acquire that portfolio he was also seeking to purchase the note on a project in Florida called Nature Walk for $8.1 million. Nature Walk fronts on Highway 395, less than a mile from the beach, and is adjacent to the Watercolors Project, Sea Grove Community, and the community of Seaside. He hoped to free up availability under the LOC to purchase Nature Walk by moving the other unrelated properties into the Master Credit Facility.

During the time that Pearson was looking to purchase Nature Walk, DCCU became very concerned about the quality of the appraisals previously obtained on the Georgia and Florida properties the secured both the Gettysburg loan as well as the LOC. On February 10, 2010, DCCU informed Pearson that all of the valuations for both the Georgia and Florida Properties had been rejected by an independent third-party reviewer.  The reasons for the third-party reviewers’ rejections of the appraisals included: (1) USPAP violations for failure to reconcile sales of the subject property for the prior three years; (2) improper application of valuation methodologies; (3) insufficient adjustments to sales and rent comparables; (4) improper selections of sales and rent comparables; (5) insufficient accounting for current market conditions; (6) errors in proper zoning identification and reporting; (7) lack of historical operating data; (8) errors in vacancy rate calculations; and (9) errors and omissions regarding statistics and absorption data.  Pearson was also informed that DCCU would be engaging new appraisers to reappraise the properties and that once completed, these appraisals would also be submitted for independent third-party review.

The relationship between Pearson and DCCU deteriorated with the result that Pearson was never able to consummate the Nature Walk transaction. DCCU declared Pearson to be in default for various reasons including the fact that Pearson used almost $5 million of the loan proceeds to invest in the stock market instead of purchasing real property. Pearson eventually brought suit against DCCU seeking damages for the alleged breach of contract. The trial itself was a bench trial conducted over 14 days. The court for the most part resolved disagreements over the competing factual claims of the parties in favor of Pearson. Although the opinion is 131 pages long one can get the sense of where things are headed in just the first few pages of the opinion when you read the following references:

  1. the court refers to Pearson as a “successful real estate developer” who used “conservative” investment strategies,
  2. DCCU is a $4 billion dollar institution and one of the largest credit unions in the nation,
  3. Pearson negotiated a “unique and advantageous loan commitment” with DCCU,
  4. Because Pearson was looking to buy deeply discounted properties it was anticipated an “unrealized gain would be created at the time of purchase” that would capitalize on the unprecedented “deleveraging” that began in late 2008.

Pearson and DCCU presented dramatically different stories at trial about how the Master Credit Facility was supposed to work.  Pearson contended that while the line of credit counts against the $30 million capacity, properties purchased with line of credit funds do not count as properties purchased with “Credit Facility Funds” entitling DCCU to a first priority lien on them.  Pearson further contended that he could access funds under the Master Credit Facility in multiple ways, including under the LOC, and also directly through the Master Credit Facility.   The court found that the Pearson Matrix was essentially an underwriting system for Pearson to “self-approve” himself for a loan and a guaranteed closing date on a “time is of the essence” basis.  The court noted that the features of the Pearson Matrix and the Master Credit Facility were extraordinarily favorable to a borrower because DCCU was obligated to (very quickly) fund any acquisition that scored high enough on the Matrix to achieve “green light” status.

Pearson and DCCU disagreed about the nature of the loan documents. DCCU argued that the promissory notes executed by Pearson and his affiliates were “demand notes” which could be called at any time. The notes themselves declared that the notes were payable on demand but until such time as the lender made demand the borrower was to make certain scheduled payments. The trial court rejected DCCU’s arguments and found that DCCU’s position was contradicted by documents subpoenaed from the Department of Banking and Finance (DBF) which showed DCCU had represented to the DBF that the Gettysburg loan was a ten-year term loan as follows:

  1. The Credit Memo Document prepared by DCCU and obtained from the DBF stated on its face: “Term-10 year balloon with principle and interest payments due monthly.
  2. The Risk Assessment Document from the DBF stated on its face: “Loan called in: 10 years.

As to whether Pearson violated the terms of the loan documents in using loan proceeds to invest in the stock market Pearson’s defense was that there was nothing in the loan documents that prohibited it.  The trial court agreed that the loan documents did not prohibit such investments and also noted that from the outset, a fundamental reason Pearson entered into a lending relationship with DCCU was to maintain “liquidity.”  The loan documents themselves simply indicated that the purpose of the loan was to provide “liquidity for ongoing operations” and “liquidity for working capital.” DCCU offered testimony from an expert witness that “trade usage” precluded Pearson’s “speculation” in the stock market with loan proceeds. The trial court sated that “It would be capricious for the Court to interpret the purchase of marketable securities as “speculation,” especially when the Loan Documents at issue not only permit, but were conceived for the purpose of facilitating Pearson’s “speculation,” albeit in real estate.”

There were numerous other allegations concerning the existence of defaults but suffice it to say that the trial court ruled in favor of Pearson on all of the issues. Having found that DCCU breached the agreement the challenge for the court then became how to determine damages and this is where the court got very creative. Recall what the court said at the beginning on the case about Pearson seeking to obtain “unrealized gains” by purchasing properties at a deep discount.  Following that logic, his measure of damages would be the difference between what he was going to pay for the property and what it should be worth in a more normalized environment. The court found that the lost bargain was worth $54,900,000 based upon appraisals submitted by Pearson. (Perhaps we could get the judge to discuss his theory of valuation with the FDIC!  I know a number of banks that would like to use the “unrealized gain” method of valuing their OREO.)

Once the trial judge determined the measure of damages he then turned to the question of legal fees. The Barnes Law Group was one of the law firms representing Pearson. They had an arrangement that if Pearson was awarded a judgment of $12,500,000 or more, Barnes Law Group receives $500,000 plus one-third (33.3%) of any amount exceeding the threshold of $12,500,000.  The way one would normally expect this to work is that The Barnes Law Group would get their percentage of Pearson’s award once Pearson was actually paid. Rather than burden Pearson the trial court took it upon itself to add The Barnes Law Group award for legal fees on top of the judgment for Pearson. Thus, the total judgment entered by the court against DCCU amounted to $75,406,000.

The judgment will no doubt be appealed and thus the final outcome of this case is still in doubt. There may be a number of “lessons learned” that lenders will learn from this case once it is completed. One immediate lesson though is probably about the use of “demand notes.” Lenders should take into account that there may be judicial antagonism to the enforcement of demand notes, particularly in complex transactions. Further, regardless of what a document is called, courts may look into the terms of a document and determine that the true intent of the parties was not to enter into a demand obligation. If the note is called a demand note but contains terms and conditions that more closely resemble a term note then one runs a risk that a court might conclude that the parties entered into a term loan and not a loan payable on demand. See Blanchard, Lender Liability: Law, Practice and Prevention, § 2:13 Demand Instruments.