With the uncertainty posed by state-level marijuana legalization in direct conflict with federal drug laws that impose strict penalties on marijuana-related activities, real estate lenders must use caution now more than ever to avoid potential negative consequences resulting from illegal activity occurring at the collateral property.
One of the most powerful tools in the federal government’s law enforcement toolbox is the power to seize private property that is associated with criminal activity, including real estate and any proceeds derived from such property. Unlike criminal forfeiture actions brought by the federal government, which are in personam actions requiring the government to indict the property along with the related criminal defendant, civil forfeitures are in rem actions brought against the property and do not require criminal charges to have been brought against the owner. A civil forfeiture action under 18 U.S. Code §981 is the federal government’s preferred method of seizing property involved in illicit activities because the government need only prove a property’s connection to illegal activity by a preponderance of the evidence (18 U.S. Code §983(c)), whereas a criminal forfeiture actions requires proof beyond a reasonable doubt. Additionally, a successful civil forfeiture action can result in the property being deemed forfeited as of the date the criminal activity occurred (18 U.S. Code §981(f)), which allows the government to capture proceeds that were generated from the property prior to the final adjudication of the proceeding.
In any event, civil and criminal federal forfeiture proceedings can result in the liquidation of property with the resulting sale proceeds distributed to federal authorities, bypassing the secured lender. Furthermore, in personam criminal forfeitures are not subject to a Bankruptcy Court’s automatic stay under 11 U.S. Code §362(b)(1) (see U.S. v. Troxler Hosiery, 41 B.R. 457, 460 (M.D.N.C. 1984)), and although there is some debate on the issue of whether the automatic stay applies to in rem civil forfeitures, the majority view is that they fall within the police power exception to the automatic stay set forth in 11 U.S. Code §362(b)(4). Accordingly, while a secured lender would be prevented from foreclosing on collateral after their borrower files for bankruptcy, the federal government would likely be permitted to proceed with a forfeiture action unimpeded.
Lenders are afforded limited protection in connection with federal forfeiture actions. Federal law allows an innocent third party to obtain equitable relief from forfeiture. In federal forfeiture actions pursuant to the Controlled Substances Act, 21 U.S.C. §801, (CSA), the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. §1961-1968 (RICO), and other money laundering and obscenity statutes, third parties can assert their interest in collateral through an ancillary hearing process pursuant to Rule 32.2(c) of the Federal Rules of Civil Procedure. Furthermore, in U.S. v. 92 Buena Vista Avenue, 61 USLW 4189 (U.S. Feb. 24, 1993), the Supreme Court confirmed that, although not literally “owners,” mortgage lenders can invoke the “innocent owner” defense provided in 18 U.S. Code §983(d).
“Innocent Owner” Status
In connection with such a proceeding to determine a lender’s status as an innocent third party, the government will insist on reviewing the lender’s loan file, which may either confirm the lender’s “innocent owner” status or indicate the lender’s awareness of illegal activity at the property. A lender can avoid losing its collateral security if it can show it is an “innocent owner by a preponderance of the evidence” (18 U.S. Code §983(d)). In United States v. Funds Held in the Name or for the Benefit of Wetterer, 210 F.3d 96, 104 (2d Cir.2000), the court stated that “[o]nce the government establishes that there is probable cause to believe that a nexus exists between the seized property and the predicate illegal activity, the burden shifts to the claimant to show by a preponderance of the evidence (1) that the defendant property was not in fact used unlawfully, or (2) that the predicate illegal activity was committed without the knowledge of the owner-claimant, that is, that the claimant is an innocent owner.” To qualify as an innocent owner, a lender must either be unaware of the illegal activity or do everything reasonably expected to prevent the illegal activity after becoming aware of it (including, without limitation, issuing a notice of default under the loan documents and/or notifying authorities of the illegal activity). If the lender does qualify as an “innocent owner,” it would then be entitled to recover the value of its interest in the forfeited property and, if provided for in the mortgage documents, their attorney fees and costs. (See United States v. Federal National Mortgage Assoc., 946 F2d 264 (4th Cir. 1991); United States v. 6960 Miraflores Avenue, 731 F. Supp. 1563 (S.D. Fla. 1990). The quality of the lender’s recovery as an innocent owner would, of course, depend on the amount of the ultimate post-forfeiture sale proceeds.
In a civil forfeiture action, the government can defeat a lender’s “innocent owner” defense simply by showing it is more likely than not that such lender knew or should have known of the illegal activity, which can be demonstrated by circumstantial evidence. Also, given the potential for forfeitures to relate back to the date of criminal activity, it is conceivable that a lender could be forced to disgorge loan payments received from a borrower the lender knew or should have known was engaged in illegal activity.
If a lender is unsuccessful in presenting an innocent owner defense, they are likely to be unsuccessful in pursuing a title claim against its title insurer because title policies generally do not protect against forfeitures based on illegal activity at the property. The American Land Title Association’s form Loan Policy of Title Insurance, adopted June 17, 2006, specifically excludes coverage for, and “will not pay loss or damage, costs, attorney fees, or expenses that arise by reason of…any government police power” unless “a notice of the enforcement action, describing any part of the land, is recorded in the Public Records” at the time such policy is issued. Furthermore, in light of the conflict between state and federal laws on marijuana, some title companies are hesitating to close or insure any transaction involving land that is associated with the cultivation, distribution, manufacture or sale of marijuana. If there is any question as to whether the property may be used for such purposes, title companies – would be prudent in requiring an affirmative statement from the fee owner that it is not being used in such a manner.
The Prudent Lender
To protect themselves, prudent lenders should conduct adequate diligence when underwriting a loan secured by real property, including reviewing rent rolls, leases and tenants, and conducting on-site property inspections. Lenders should also consider requiring borrowers, pursuant to covenants in the loan documents, to provide periodic updates and immediate notification of any new leases entered into at the property, in order to monitor possible illegal activity occurring at the property. Lenders who have not done so should also begin to include language in their loan documents protecting against potential forfeitures due to criminal activity, such as the following:
There shall never be committed by borrower, and borrower shall never permit any other person in occupancy of or involved with the operation or use of the property to commit any act or omission affording any governmental authority the right of forfeiture against the property or any part thereof or any monies paid in performance of borrower’s obligations under the loan documents. Borrower covenants and agrees not to commit, permit or suffer to exist any act or omission affording such right of forfeiture.
The loan documents should also provide for recourse against the borrower and a personal guarantor in the event of a breach of the foregoing covenant.
The potential negative ramifications of a federal forfeiture action against real estate collateral securing a non-recourse loan could be disastrous, especially without the protection of title insurance coverage, so lenders should be careful to protect themselves through thorough, prudent diligence and robust protections in their loan documents.
Jeffrey B. Steiner and Jason R. Goldstein are members of DLA Piper. John U. Bauco and Sean S. Thorsen, associates at the firm, assisted with the preparation of this article.