September 29, 2016
Every community is supposed to have a downtown as a destination for people to live, shop and play. The town center ideally keeps retail dollars and tax income from leaving the community. When these developments pop up, you hear discussions about whether “gentrification” helps or harms blue-collar people who live or work there. How does a developer decide where to place a new town center? In many places in Virginia, the local government offers to help finance the project with a special assessment district called a Community Development Authority (“CDA”). A CDA is where millions of dollars are financed through issuance of bonds paid off over many years by owners of real estate in the CDA district. The locality collects the assessments for the Community Development Authority. I take a personal interest in these CDAs because there is one in Fairfax County near me called the Mosaic District. Like many CDAs, Mosaic mixes residential homes and retail development.
“The Residences at the Lofts at SodoSopa”
A few days ago the Supreme Court of Virginia issued a new case opinion that provides an example of CDAs’ particular vulnerability to changes in the economy. Before I describe the case, I must first share something from pop culture with insight into recent trends in town center developments. A year ago, the television show South Park aired an episode called “The City Part of Town.” This episode lampooned these kinds of developments. I don’t often watch South Park because of some toilet bowl type humor they employ in other episodes. As a denizen of Northern Virginia, I love this particular episode. In this show, the “socially conscious” leaders of South Park wanted something that would, “Instantly validate us as a town that cares about stuff.” They created a new town center designed to lure Whole Foods Market to South Park. They named the district SodoSopa, shorthand for “South of Downtown South Park”. The episode focuses on a boy named Kenny whose family struggles financially but manage to keep their heads above water. SodoSopa develops around their “historic” home. Hipsters at trendy SodoSopa bars cause nighttime disturbances. The episode also features Mr. Kim and his asian restaurant, City Wok. The residents of South Park lose interest in City Wok when swank new restaurants open in SodoSopa. Mr. Kim takes desperate measures to try to keep City Wok from going out of business. City Wok hires a “child labor force.” Mr. Kim broadcasts commercials for his own restaurant district in an effort to compete with SodoSopa. In classic South Park fashion, the moronic adults engage in foolish behavior in vain attempts to achieve vainglorious objectives. According to Wikipedia.com, Whole Foods Market does open a store in fictional South Park, but not in SodoSopa. South Park’s gentrified district becomes abandoned because it failed to land the desired anchor tenant.
CDAs & “Overlapping Debt”
Unfortunately, the cartoon’s satire is not too far from reality. On September 22, 2016, the Supreme Court of Virginia published a new opinion in Cygnus Newport-Phase 1B, LLC v. City of Portsmouth. The case confronted the issue of “overlapping debt” in CDAs. Both bank loans and the CDA bonds finance these developments. If the local government records the CDA ordinance in land records after the bank files their deed of trust, which takes priority in foreclosure? Does the Community Development Authority have “super-priority” over “ordinary” liens? This case is of interest to anyone who conducts real estate settlements, foreclosures or wants to understand what it means to own real estate in a CDA.
New Port CDA
In 2004, Portsmouth Venture One, LLC (“PVO”) acquired a 176-acre developable tract of land in Portsmouth, Virginia. PVO used a Bank of America (“BOA”) mortgage to finance the purchase. In 2005, PVO successfully petitioned the city to set up New Port Community Development Authority. New Port CDA entered into a “Special Assessment Agreement” with PVO for finance of almost $17 million in infrastructure, including roads, utilities and lighting. PVO agreed that the City of Portsmouth could collect the special assessments to pay off the bonds financing the infrastructure improvements. The agreement provided that the special assessments, “does not exceed the peculiar benefit to the Assessed Property … resulting from the improvements,” and that PVO’s successors would be bound by the agreement. In 2006, the CDA’s resolution authorizing the bonds, the city’s ordinance establishing special assessments on the CDA properties and a declaration of notice of special assessment were recorded in the land records. The declaration provided that its provisions would “run with the land” and bind future owners of the subject property. The CDA handed approximately 75% of the bonds proceeds over to PVO to make the infrastructure improvements. PVO then began selling individual lots.
This is a particularly powerful type of financing. CDAs allow a developer to obtain millions of dollars up-front to pay for public infrastructure required in large projects. The Community Development Authority, as a local government entity, issues the bonds. The millions are supposed to be paid back by special assessments owed by the present (and successor) owners of the properties in the CDA. In addition to federal income tax, county property tax, state and local sales taxes, mortgage payments and community association dues, owners in a CDA must pay the special assessments collected by the city or county. Some of New Port CDA’s bonds would not be retired for 30 years.
Mortgage Foreclosure Crisis
2006 was a particularly unfortunate time to undertake an ambitious real estate project. A few years after the mortgage crisis began, PVO defaulted on its debt obligations, eventually losing its investment. In 2011, BOA sold its real estate loans to a company called Cygnus VA, LLC (“Cygnus”). Cygnus instructed the foreclosure trustee to conduct a sale. Cygnus itself purchased the property at the foreclosure sale, thus becoming the succcessor. Cygnus conveyed the property to other holding companies, but for the sake of brevity I will refer to all of them collectively as “Cygnus.”
Once Cygnus acquired these vast tracts, New Port CDA demanded the outstanding special assessments. Cygnus refused, insisting that the foreclosure stripped off the latter-recorded CDA lien that PVO allowed to encumber the property. Not wanting to pay the money or lose the property in a subsequent foreclosure, Cygnus filed a lawsuit. Cygnus argued that the foreclosure sale extinguished the special assessment lien. BOA was never party to the agreements with the CDA and city. Cygnus alleged that, physically speaking, there was very little to show for the millions provided to PVO by the CDA. The property purchased at the foreclosure was largely unimproved by infrastructure. How could New Port CDA claim a lien when there was little or no improvements to the foreclosed property that the new owner would be benefitting from? The circuit court found that this didn’t matter. Circuit Court Judge William S. Moore dismissed the lawsuit on the CDA’s motion. The Supreme Court of Virginia granted Cygnus’ petition for appeal.
Race-Notice Land Recordation & Super-Priority Liens
This New Port CDA case was a closely decided case by a 4 justice majority over 3 dissenters. Virginia appellate law blogger Steve Emmert describes this opinion as a “bar fight” among the members of the Supreme Court. I like his bar fight analogy because it makes me think of South Park’s fictional restaurant districts. The court majority decided that the bank foreclosure did not extinguish what was found to be a “super-priority” CDA lien. Virginia is a “race-notice” jurisdiction as far as real estate law is concerned. This means that between two parties who both recorded liens against real estate, the first one to record has priority. Cygnus appealed the case confidently – its title derived from BOA’s earlier-recorded deed of trust. However, the majority found that a special assessment lien is paramount over other encumbrances including a prior-recorded lien. They explained that a tax lien is superior in dignity because it is made by local governments for purposes of public improvements. The court found that it is not proper for a prior mortgage to defeat the process by which municipalities make property tax liens.
In response to this argument, the dissent points to the sections of the Virginia Code that specifically authorize the attachment of these CDA special assessment liens to real estate. The statutes mirror the “race-notice” rules that apply generally to land recordings. How can these special assessment liens enjoy “super-priority” status if the statute specifically provides otherwise? The Court ruled that because the city filed the ordinance before the foreclosure trustee’s sale, when Cygnus purchased the property, it was on notice of the special assessment liens.
The Shelter Doctrine:
Cygnus’ litigation strategy relied upon what is called the “shelter doctrine,” which has nothing to do with the habitability of any physical construction. Cygnus took title through BOA as a party without notice of any special assessment liens at the time the deed of trust was recorded. Under the “shelter doctrine,” if the mortgage lender’s interest in the real estate had priority over a later-recorded lien, then any party which takes title through the bank foreclosure enjoys the same lien priority. Under the shelter doctrine, the successor in interest of one who purchases the real property in good faith stands in the same position as the good faith purchaser even when the successor had notice of the lien through title examination. The shelter doctrine underlies the nonjudicial foreclosure system in Virginia. The purchaser at the trustee’s sale takes title from the trustee whose authority comes from the deed of trust made to benefit the lender.
The majority remarked that, “To permit such belated challenges would not only be contrary to the [Virginia] Code, it would completely unravel the entire legislative system of local improvements funded by special assessments.” The dissent argued that the majority rewrites the super-priority feature into the special assessment legislation which says otherwise.
“The Villas at Kenny’s House”
Remarkably, a CDA only requires the approval of the locality and 51% of the landowners’ interests in order to set it up. The 51% might be calculated by relative acreage or tax assessment appraised values. If non-consenting landowners oppose formation of the CDA, they have a very short deadline in which to petition the court to block it. In the South Park episode, Kenny’s family owned a small home included within the encompassing SodoSopa district. Of all the townspeople, only Kenny’s family attended a hearing where South Park heard public input on the creation of SodoSopa. If an owner has a larger developable tract as a neighbor, potential imposition of a CDA by the 51% and the county upon other landowners is a legitimate concern. The local government, not the owners, appoint the members of the CDA’s board.
What Might All of this Mean to Buyers and Owners?
I expect lenders to re-write their commercial loan underwriting and documentation processes in the wake of the Cygnus case. I can’t imagine Bank of America now agreeing to finance a project like this without forcing the developer to agree to obtain lender consent before petitioning for a Community Development Authority, or otherwise protecting their interests in writing. Why would a bank knowingly permit overlapping debt to obtain priority over their mortgage? Look for underwriting standards and loan documentation to tighten. Industry and governmental leaders want town center developments to continue and will want the players to get along.
The term “Community Development Authority” seems like a euphemism, like calling serfs “agricultural interns.” Someone who runs across the term might think that it is in charge of parks, libraries or children’s sport programs. CDAs are more accurately called a Higher Tax Area.
What does this new Cygnus case mean to owners of condos or townhouses in CDAs? An owner in one of these districts must pay the special assessments in order to avoid a sale to satisfy the liens. Like everything else in real estate, the owner must understand what the ordinances, abstracts, agreements and memoranda of liens mean. Owners should not assume that every CDA has the same governing provisions as one elsewhere. Likewise, anyone shopping for real estate should check whether it is located in a CDA and what those assessment obligations might be.
Independent Professionals Can Help with Understanding CDA Documents
Between HOAs, CDAs, mortgages and taxes, property owners have many potentially overlapping obligations and rules. HOAs & CDAs provide developers and local governments with means of shifting burdens to build and maintain common areas and infrastructure off of the county budget. While these strategies may work fine for creating these communities, they don’t always work well for owners, as shown by the South Park episode and the Supreme Court of Virginia opinion.
CDAs are a relatively new and potentially confusing phenomenon. Owners or prospective buyers should seek a qualified attorney to help them understand the obligations that come with the benefit of living in one of these districts. Investors should protect themselves against the potential risks that come with unanticipated responsibilities and town center developments that might fail.
For Further Reading: