The lender on a Virginia commercial property has seen its deed of trust held void after it dealt with a person who pledged his company’s property, without authority, for the benefit of his own separate business. The case underscores the need for lenders and investors to be diligent regarding not just the property owners they deal with but also the particular individuals who negotiate and sign the documents — and to proceed with extreme caution when red flags arise.
Background
Based on the facts as recited in the case:
Farm Life LLC owns 100 acres in Hamilton, Virginia. One of its members/managers, Zhongwei Lu, is an attorney and the only Farm Life member to speak and read English proficiently.
Lu applied to RCN Capital for a loan with the stated purpose of an “[i]nvestment in Blue Coast Bakery,” intending to pledge Farm Life’s real estate as collateral. The problem was that Farm Life’s business had nothing to do with cakes and pies. It just owned the Virginia property and rented it out for events.
The bakery was in Florida, and Lu’s partners in Farm Life were not involved — nor did he tell them about the loan, even though pledging the property required their consent.
From the outset, RCN had concerns about Lu’s loan application, which Lu tried to assuage by submitting a fraudulent document reflecting that he was the majority owner of Farm Life. RCN’s counsel “immediately noticed issues with” this document, but the third time was the charm. Apparently putting aside its suspicions, RCN approved the loan and accepted a deed of trust on Farm Life’s property, based on yet another, also fraudulent submission by Lu.
Farm Life got wise and sued, and the Loudoun County Circuit Court quieted title in favor of Farm Life and held the deed of trust void.
The Ruling
The Court of Appeals of Virginia affirmed the judgment based on Virginia Code § 13.1-1021.1(C). The appeals court explained that a deed of trust signed by an LLC manager who acts without authority is still valid if the lender was “without knowledge of the lack of authority of the person.” It added that “knowledge” means not just actual knowledge but also constructive knowledge, which arises when a party should have known something based on reasonable diligence and is therefore deemed to have known it.
Thus the Court of Appeals held that, since Lu’s loan application was riddled with red flags, and since RCN was a sophisticated lender, Farm Life’s property could not be encumbered by a deed of trust based on Lu’s actions. The court stated:
Reading “knowledge” in Code § 13.1-1021.1(C) to mean “actual knowledge” would excuse third parties [such as lenders] even when they fail to exercise minimum care, effectively holding LLCs strictly liable (in a civil sense) for the actions of a manager who conducts unpermitted real estate transfers in secret.
The court warned that “some transactions by their nature should strike a dissonant chord for a reasonable [lender]” because of “the nature of the [borrower] or its activities,” citing as one example “a transaction that lacks any evident connection with a [borrower’s] interests” and is “on its face inconsistent with the fiduciary character of the relationship between [the borrower] and [its alleged] agent.” We can only agree.
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