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 Proceeds
There 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. Other examples include Caruso Homes and The Woodside Group.
Underlying Dynamics in Bankruptcy Proceedings
While 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, e.g., Legend Homes.
A 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.