| Insights | Blogs

Alabama Supreme Court: Lender can sue directors of a public improvement district for negligence, breach of fiduciary duty

Alabama law permits the creation of public corporations known as “improvement districts,” which can then issue bonds that are similar to bonds issued by a municipal corporation. These bonds can be used to finance improvements within the district. In Aliant Bank v. Four Star Investments, Inc., the Alabama Supreme Court allowed claims against the directors of one of these improvement districts to go forward despite claims of immunity. The Court also allowed certain fraud claims to go forward against the directors as well as other related individuals and entities. In addition to authorizing lenders to bring suit, the opinion also serves as a strong reminder that lenders should monitor their collateral and promptly investigate any signs of misconduct.

Background

Four Star Investments, Inc. developed around 80 lots of a residential subdivision in St. Clair County, Alabama. In 2007, Four Star obtained a $2.3 million loan from Aliant—secured by the entire 197-acre subdivision—to develop about 270 additional lots. The loan was insufficient to finance all the needed improvements for the subdivision, however, and Bobby Smith, the principal of Four Star, sought additional financing. He ultimately settled on creating an improvement district under the Alabama Improvement District Act, Ala. Code § 11-99A-1 et seq., so that he could issue bonds that would be repaid by a special assessment on the property owners in the subdivision. The improvement district was approved by the town of Odenville, and Smith and two others were appointed as directors. Smith caused the district to file a bond-validation petition, which was confirmed by the St. Clair Circuit Court.

Before the bonds were issued, Smith asked Aliant to subordinate its mortgage to the bondholders. At that time, at least according to Aliant, Smith also made numerous representations regarding the viability of the subdivision as well as the controls on the release of the bond proceeds. While the parties dispute the content of these representations, the trust indenture does provide that, to access the funds, the district would have to submit a request for reimbursement along with appropriate documentation. Aliant ultimately agreed to subordinate its interest and the bonds were issued.

Unbeknownst to Aliant, Odenville had—before the district had even been created—approved a resolution authorizing the district to use the bond proceeds to pay for pre-issue improvements. Within a few weeks of the bond issue, Smith, in his role as a director, had approved reimbursement requests totaling $1.5 million, or over 50% of the total revenue raised by the bond issue.

Development of the subdivision failed, Four Star defaulted on its loan, and Aliant sued. Only then did Aliant learn that the bond proceeds had been used to pay for pre-issue improvements and that the amount of debt outstanding meant that its collateral was essentially worthless. Aliant then sued the district, Smith, the other directors, and several related individuals and entities. It alleged that the directors had negligently managed the development of the subdivision and that they had breached their fiduciary duties in their management of the bond proceeds. Aliant also asserted fraud and conspiracy claims against the district, the directors, and the several related individuals and entities. After the circuit court dismissed all claims, Aliant appealed.

Holding

The Alabama Supreme Court reversed in part and affirmed in part. First, regarding Aliant’s negligence and breach of fiduciary duty claims against the directors, the Court held that the directors had a duty to act with reasonable care and loyalty and that this duty was owed to the members of the improvement district. Because Alabama is a “title theory” state, Aliant’s mortgage made it a member of the district, meaning it was owed a duty of due care and loyalty. The Court rejected the directors’ argument that the Alabama Improvements Act afforded them immunity from Aliant’s negligence and fiduciary duty claims. The Act, which only grants directors the same immunity available to municipal officials, did not shield the directors from liability for their own negligent or reckless acts.

Because Alabama is a “title theory” state, Aliant’s mortgage made it a member of the district, meaning it was owed a duty of due care and loyalty.

The directors also argued that the statute of limitations barred Aliant’s claims. It pointed out that Aliant had a right to inspect the subdivision and that an inspection would have uncovered the lack of improvements. Thus, they claimed, Aliant should have discovered its claim more than two years before it filed suit. The Court held this question was for the jury. It based its conclusion on sworn testimony from Aliant that it had assumed that development was on hold and that the bond proceeds were being held in trust during this pause. Additional sworn testimony established that Aliant had no right to access the bank records regarding the disbursement of the bond proceeds. On these facts, the question of when Aliant should have discovered its injury could not be decided as a matter of law.

Turning to Aliant’s fraud claims, the Court held that the improvement district itself was entitled to immunity. The individual directors, on the other hand, were not immune from Aliant’s misrepresentation and suppression claims. Moreover, the Court held that several of the related entities and individuals that had assisted Smith in disbursing the funds could be liable for conspiring to defraud Aliant, though they had not made any fraudulent statements or omissions themselves. The Court thus allowed the fraud claims to go forward. At the same time, the Court affirmed the dismissal of several claims against the related individuals and entities for various reasons.

Lessons Learned

Aliant Bank holds that the directors of a public improvement district owe duties of care and loyalty to lenders with a mortgage on the property of the district. A director that breaches this duty can be held personally liable for his misconduct. Of course, this right to recover may be meaningless if the director lacks sufficient funds to satisfy a judgment. Conversely, an improvement district itself is immune from suit, at least when the plaintiff alleges fraud on behalf of the district’s directors. Thus, lenders will be unable to recover from the district itself or its individual members.

Aliant Bank also serves as a strong reminder that lenders must diligently monitor their collateral. The Supreme Court allowed the statute of limitations issue to go to the jury, but that does not mean the jury will ultimately side with Aliant. Thus, Aliant may still lose on limitations grounds. Further, the Supreme Court’s decision was based on sworn testimony from Aliant showing: (1) it assumed development was on hold, (2) it had assumed that the funds were being held in trust, and (3) that Aliant had no right to access bank records regarding the disbursements. If Aliant had not submitted sworn testimony or it had had a right to access the relevant bank records, then the Supreme Court might have reached a different conclusion.