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High and dry in Nevada
When water rights trump development
By Dan Reaser, Shawn Elicegui, William McKean and Douglas Cannon
For almost two decades, Nevada has been the fastest growing state in the nation. It is also the driest. What do you get when you cross a booming economy, exponential population growth and plentiful land with extremely limited water supplies? The answer is pent-up demand for new apartments, homes, shops and office space.

The stream of speculators and developers rushing to take of advantage of this seemingly ideal opportunity appears almost endless. Their ability to capitalize on this situation, however, depends in large part on their ability to get water. Acquiring rights to water is becoming increasingly more difficult and expensive.

Surface water provides about 70 percent of the total water supply used in the state. Yet, Nevada's surface water sources have been fully used for many years. This leaves groundwater as an important source. New development in fact will have to rely primarily on groundwater sources.

Not surprisingly, the prices paid for groundwater rights have skyrocketed in recent years. In Las Vegas, where growth has exhausted the Colorado River supply, developers have moved west 60 miles to Pahrump and 80 miles northeast to Mesquite. There, developers pay upwards of $25,000 an acre-foot for groundwater rights when they can find any. To the north in Reno (about 425 miles north of Las Vegas), developers have paid $50,000 or more for an acre-foot. Thirty years ago, those water rights could be had for $50 an acre-foot (one acre foot is enough to supply one or two average homes). And, just two years ago, they were $4,000 an acre foot.

Now picture a typical scenario: A developer has identified the land for a new project. She has also identified someone willing to sell their "water rights." A cautious developer might ask, what will I be buying? The developer's project lender might ask, is this "water right" an asset that I can rely on as security for a loan? Such questions — by developers and lenders — are becoming more common in Nevada. To begin to find answers, their lawyers start with some basics of Nevada water law.

Under Nevada law, all water within the boundaries of the state belongs to the public. The owner of a water right does not own the physical water itself. In this light, some of the terms used to describe water rights — "vested," "perfected" and "certificated" — might convey a false sense of title, permanence or finality. No person can own or acquire title to water. Rather, they merely have the right to beneficial use.

In the first instance, the state engineer allocates such rights to beneficial use through a permitting process. The first step is to file an application with the state engineer, including a $250 fee, and a supporting map prepared by a water rights surveyor showing the point of diversion and place of use of the water.

If the application is approved, a permit is issued granting the right to appropriate, or when it comes to groundwater, pump, a certain amount of water for a particular purpose. The permit will contain mandatory conditions, a timeline for constructing wells and associated works.

When the conditions of a permit are satisfied, and certain filings have been made, including a proof of completion of works (that is, drilling of a well or installation of pump), and a proof of beneficial use (that is, showing that the quantity of water actually being used for the intended purpose), the state engineer will issue a certificate (representing a "certificated" or "perfected" water right).

For our hypothetical developer and her lender, that does not mean that all certificated (or so-called perfected) water rights are equal. Nevada water law boils down to two maxims: "first in time, first in right," and "use it or lose it." The former recognizes the first person to put the water to use has a right to that quantity of water senior to all subsequent users. The latter means that the water must be put to a beneficial use or the right is lost and the water reverts to public ownership. These two maxims generally comprise the prior appropriation doctrine.

The prior appropriation doctrine should be familiar to lawyers dealing with western water law. The various state legislatures, however, have enacted laws that add nuances to the strict application of first-in-time, first-in-right and use-it-or-lose-it maxims. The starting point in a particular case will be the specific state's statutes. (A good resource to begin researching the interplay between the prior appropriation doctrine and the various state statutory schemes is the Law of Water Rights and Resources by A. Dan Tarlock).

If the maxim, first-in-time, first-in-right, means anything, it means that not all water rights are equal; some, in fact, are more equal than others. Some developers may not realize that when a shortfall occurs, the water rights they've purchased may only be worth the paper they are printed on.

In the Pahrump Valley — a burgeoning bedroom community of Las Vegas — the basin only recharges 12,000-19,000 acre feet annually. However, water users in the basin have been authorized to withdraw approximately 85,000 acre-feet of water from the aquifer. Assuming growth continues and water consumption increases, a means for dealing with the shortfall will need to be developed. One way would be for the state engineer to implement a curtailment program. The order in which such curtailment would occur is a function of the first-in-time, first-in-right maxim, and Nevada's water statutes.

When the state engineer is forced to enforce restrictions, the prior appropriation doctrine holds that the first persons to have their water rights curtailed should be the most junior, (that is, the latest in time). Under a strict application of the first-in-time, first-in-right maxim, the curtailments would continue up the chain until there is sufficient water to meet the quantities allotted to the more senior appropriators. In the Pahrump Valley, for example, this would mean the curtailment for the youngest 61,000 acre-feet of water rights.

Alternatively, the state engineer might act under his statutory authority "to make such rules, regulations and orders as are deemed essential for the welfare of the area involved." Arguably, this could result in curtailment according to preferred uses (such as, curtailment of irrigation or stock watering in favor of domestic or municipal uses).

The use-it-or-lose-it maxim means what it says. Water is not to be held "hostage" by one who is not actively using it. Instead, such water rights can be canceled, forfeited or abandoned — meaning that it could prove difficult (and costly) to try to corner the market.

Cancellation of a water right permit can occur "at any time" the state engineer decides that the owner is not "proceeding in good faith and with reasonable diligence" to beneficially use the water. In such cases the state engineer will notify the holder of record, who has 60 days to request a review of the cancellation.

Forfeiture of an underground water right — be it permitted or certificated — can occur in cases where the water is not put to beneficial use for a five-year period (subject to certain cure rights). The only requirement is to show a failure to beneficially use the water for five successive years. The state engineer will notify a holder of record when four years of nonuse have elapsed, and if the holder fails to file a proof of beneficial use or extension request before the fifth year, the water rights will be forfeited.

Abandonment occurs where an owner "relinquishes the right" with the "intention to forsake and desert it." This has occurred, for example, where a person has ceased all business and corporate operations in the area, left the community, and allowed his property to be sold for delinquent taxes. Again, the state engineer will so notify the water right holder.

Back to our typical developer and lender scenario. Assuming that our developer has acquired valuable water rights, she will likely want financing for her project. Her lender will likely want a valuable asset as security for a loan. How does a lender or other interested person ensure that its collateral (or security interest in a water right) is adequately protected given the risks discussed above?

It's pretty easy to obtain a security interest in a water right. Nevada water rights are conveyed just like other real property — typically by a deed recorded with the local county recorder. And a lender takes a security interest in a water right just like real property — typically by a deed of trust recorded with the local county recorder. A lender must be more cautious, however, when it accepts water rights as security for a loan because they are capable of being lost by cancellation, forfeiture or abandonment.

So what's a lender to do to ensure that it will receive notice of an impending order by the state engineer that a water right is subject to being canceled, forfeited or abandoned? One thing that a lender can't do is rely on the real property records, as the Nevada Supreme Court recently made clear in the case of Nevada Dep't of Conservation and Natural Resources, Division of Water Resources v. Foley et al. , 121 Nev. Adv. Op. 8 (April 14, 2005). While not directly involving the developer/lender scenario, Foley does clarify who will, and will not, be entitled to notice.

In Foley, a developer got a permit for four subdivided parcels. After selling two of the lots, the developer failed to file the proof of beneficial use required as a condition of the water right permit. Consequently, the state engineer notified the developer, but not the purchasers of the two lots, that the permit was canceled.

After considering the statutory scheme governing water rights in Nevada, the court held that the state engineer is not required to give notice to interested persons who have failed to file their interest in the permit with the state engineer. Because the purchasers of the lots had failed to file their interests, the state engineer had no obligation to provide notice to them, and had properly canceled the water right permit that authorized the use of water on their lots. The rule of Foley, then, is that the state engineer is not required to give notice to persons who have failed to file their interest in the permit with the state engineer — even if they own the land on which the water is being used.

After Foley, then, the perfection of a security interest should include appropriate filings with the state engineer. A typical filing will include a report of conveyance, abstract of title, notice of pledge and appropriate filing fee. The forms can be modified for a specific transaction. If the state engineer initiates abandonment, forfeiture or cancellation proceedings, persons who have filed a "report of conveyance" are entitled to notice.

Great — so now that the lender has filed a report of conveyance, everything's OK, right? Wrong.

The state engineer can take up to two years to process a report of conveyance and notice of pledge. To protect the security interest during this period, the "Instrument Filing Fee" method should be followed. The security interest holder should submit a letter describing the security interest, including a $1 filing fee for each water right in which a security interest is asserted. The letter will be placed in the respective water right file in the state engineer's office within days of receipt, and will serve to provide some notice until the report of conveyance and notice of pledge are processed.

Being on file with the state engineer only gets a lender or other interested person notice. What can be done substantively to mitigate the risk of an abandonment, forfeiture or cancellation? Remember that the continuing validity (or perfection) of a water right requires compliance with the terms of a permit, completion of works and a proof of beneficial use filing. If those terms are not satisfied, the permit can be canceled. And, even after the terms of a permit have been satisfied, and a certificate has been issued by the state engineer, the water right can be lost by forfeiture or abandonment.

A lender who intends to rely on a water right permit or certificate as collateral should include in the loan documents provisions that provide the lender access to necessary documentation and the right, but not the obligation, to forestall the cancellation of water rights by filing extension requests or putting water to beneficial use. Typically, the loan documents will state that the lender's expenses in preserving the "water rights collateral" are added to the principal amount of the loan.

Alternatively, instead of taking a water right as collateral, the lender might take a counterintuitive approach. The lender might require that the developer dedicate the water rights to the local water purveyor in exchange for a development credit or a "will-serve" commitment from the purveyor. The credit or will serve will allow the developer to get the governmental approvals it will need to subdivide the land and sell lots. Nevada law, moreover, allows utilities to hold water rights for future development. This departure from the use-it-or-lose-it maxim means that the development credits or will-serve commitment could be worth more than the water right itself.

But, development credits and will-serve commitments are not water rights. The nature of those rights or assets is defined by a different body of law — namely, state public utility law and the regulations of the local water provider. Any lender considering this option must carefully review the provider's rules and regulations (commonly found in tariffs filed with the state utility regulatory agency when the provider is a regulated utility) to determine how best to protect her interests where development credits or will-serve commitments are involved.

In conclusion, water rights in Nevada often represent one of if not the most valuable asset associated with a new development. This asset, however, can be lost in numerous ways. Knowing this, both developers and lenders have an interest in taking steps to ensure that their valuable rights and interests are protected.
Reaser, Elicegui and McKean are partners and Cannon is an associate at Lionel Sawyer & Collins, in Reno, Nev. Their e-mails are: dreaser@lionelsawyer.com, selicegui . . . wmckean . . . and dcannon . . . .

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