By Mark Edelstein chairs the Real Estate Finance and Distressed Real Estate practices at Morrison & Foerster LLP.

You can’t just assume an architect’s plans come with the OREO. If you do, you just might get creamed. Here’s how to stay out of the middle

Incomplete construction projects, common now, raise issues for property owners as well as construction lenders. But a critical issue receiving little attention is what happens to an architect’s claim for unpaid services in a borrower bankruptcy. The rights of property owner, lender, and even a potential buyer through bankruptcy sale to use the architectural plans to finish the project can make or break a solution.

Questions arise, and the answer lies in the intersection of laws governing real estate finance, bankruptcy, and intellectual property.

Who owns the blueprints?
Architects and owner/developers typically enter into Form AIA, or similar agreements, that outline the scope of services to be provided, and the fees to be paid. Such agreements often provide the developer with a limited license and right to use the architect’s drawings, specifications, and related documents (referred to as the “plans”).

However, the architect often retains ownership of the plans and the intrinsic designs reflected in them (called the “designs”). Typically, a lender requires the architect to sign what is commonly referred to as a “will-serve” letter. In that document the architect acknowledges the mortgage lien on the property and agrees that the lender (or its successor, or a buyer of the property through foreclosure or bankruptcy sale) can use the plans and designs to complete the project.

Ideally, this will-serve letter, among other things:

• Indicates that the lender’s lien at all times is superior to any claim of the architect on the property.

• Caps architectural fees that accrue without the lender’s prior consent.

• Prohibits modifications or amendments to the agreement without the lender’s prior consent.

• Indicates that the lender or any subsequent buyer can use the plans and designs upon paying fees stipulated in the will-serve letter.

Matters don’t always go smoothly, however, underscoring the need to be on sound legal ground.

Architect cries “foul”!
The recent case of In re Locust Street Managers, LLC, filed in the U. S. Bankruptcy Court for the Southern District of New York, involved an unfinished apartment building in Westchester County, N.Y.  The borrower filed Chapter 11 bankruptcy in response to the first mortgage lender’s foreclosure action. Ultimately the borrower worked with the lender to auction the property under Section 363 of the Bankruptcy Code. This section generally allows property to be sold free and clear of all liens, claims, and encumbrances, with such claims to apply to the proceeds of sale of the property in the same order of priority as existed against the property itself.

So far, so good—except the architect filed an objection to the Section 363 sale motion. In an attempt to recover what was claimed to be owed to him, the architect asserted that no party—including a successful bidder—could use the plans or designs without his prior consent. The architect claimed that doing so would result in violation of the architect’s copyrights.

If successful, the architect would have prevented the property from being sold truly “free and clear,” and the winning bidder might have chosen to not pursue its acquisition. At the least,  the bidder would have adjusted its bid for the fees.

Recognizing this conundrum, and questioning whether Bankruptcy Code Section 363 could in fact override the copyright protections to the plans and designs, Bankruptcy Judge Robert Gerber took a practical approach to the situation.

Gerber entered an order that allowed for the “free and clear” sale of the property (including free and clear of the pre-petition fees owed to the architect) while preserving the architect’s ownership rights in the Plans and Designs. What made this work? Judge Gerber gave the purchaser enough latitude to be able to hire its own professionals and finish the project (without infringing upon the architect’s intellectual property rights).  A key point in his reasoning, as published, was that sale could proceed “so long as the new owner or its architect or agents do not use the Plans…” The new owner was permitted to use, occupy, photograph, and measure the property, to permit a new architect to be hired, all without being deemed a use of the plans.

Judge Gerber’s rationale avoided having to decide the contentious issues of assignability of intellectual property rights under section 365(c)(1) of the Bankruptcy Code (and related successor liability issues).

(The details of the case, and the text of Judge Gerber’s reasoning, are interesting and relevant. For your counsel: Locust Street is a single-asset real estate case pending in the U.S. Bankruptcy Court for the Southern District of New York, Case No. 08-14621 (REG). )

What this may mean to your bank
Judge Gerber’s common-sense approach to this potentially thorny issue should, if followed by other judges, provide real estate lenders with some comfort that there may be ways to accomplish “free and clear” sales in bankruptcy court. This would free the property’s buyer from having to pay pre-petition architectural fees.  Moreover, Judge Gerber’s approach provides lenders and counsel with language that could prove useful.

Although Judge Gerber’s decision in the Locust Street case enabled the property to be sold without the encumbrance of the architect’s claim, construction lenders should consider adding these express provisions to will-serve letters:

1. The construction lender’s lien on the property is at all times senior to any claim of the architect.

2. Upon a construction loan default, and sale of the property, the architect’s claim for unpaid fees will not be an obligation that encumbers any portion of the property and will not become a claim against the purchaser of the property. (This would apply whether by foreclosure sale, deed in lieu of foreclosure, bankruptcy sale, or other sale. And it would be regardless of whether the purchaser is the lender or successors or assigns (whether by deed in lieu, credit bid, or otherwise); an affiliate of the borrower; or a third party.)

3. Notwithstanding any assertion of copyright or other ownership interest in the plans or designs or in related electronic software, the architect expressly agrees that the plans, designs, and software files may be used to complete the construction on the property upon a sale of the types referred to in 2.

This would be so, provided that the architect is paid an agreed-upon amount of fees. Thus, a purchaser’s decision to use the plans, designs, or software files would not obligate the purchaser to continue to use the services of the architect. In no event would the lender (or its successors or assigns) be liable to the architect for any claim related to the borrower or property. This would include the fees owed by the borrower to the architect unless the lender (or its successor or assign) is the purchaser, and then only to the extent provided in the will-serve letter.

A carefully worded will-serve letter is an important preventative measure, one best taken at the outset of a construction loan. 

The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj0610/index.php?startid=16