• Overview
  • Services

Construction Contract Claims Against a Third-Party Lender? The Unforeseen Consequences of a Standard Practice
May 18, 2015

For those of us who commonly represent lenders, there is nothing more unsettling than hearing the words “course and pattern of conduct” or “dominion and control” or some variation of the same. Any suit where someone seeks to impose liability on a bank for something above and beyond the amounts loaned and repaid is a scary one for lenders (and ultimately should be a scary one for anyone who may need to borrow money in the future). One area in which lender liability has been recently trending is the construction area. A recent example of that trend came in the case of Atlantic Builders Group, Inc. v. Old Line Bank (In re Prince Frederick Investment, LLC), 516 B.R. 778 (Bankr. D. Md. 2014).

In this case, the general contractor for a medical facility sought to subordinate the construction lenders’ deed of trust lien claim (the author is unfamiliar with the pre-bankruptcy history, but presumably the contractor’s priming mechanic’s lien rights were unenforceable) on a theory of equitable subordination. The contractor claimed that, because the lender exercised significant control of the construction process, namely, when and how the money would be dispersed, and did not provide enough funds under the construction line to allow the project to be completed, the lender was not entitled to enforce its lien to the detriment of the contractor allegedly harmed most by the conduct.

Ultimately, the Bankruptcy Court found that the general contractor could not prove its case for a couple of reasons. First, the general contractor could not prove that the lender exercised dominion and control over the owner’s duties under the construction contract. Second, to the extent the lender exercised its limited control by reviewing and approving all change orders, the general contractor actually agreed to the same in a Contractor’s Agreement to Complete between the owner, the general contractor and the lender. This lender certainly averted the potential crisis.

This case, however, reminds us that the typical agreements made in sophisticated construction projects for which financing is obtained can have adverse consequences for lenders (that could ultimately trickle down to those in the construction supply chain). In particular, whatever iteration of the “Construction Loan Agreement” is used by the parties, if that agreement allows the lender to exercise too much control over the construction process, the lender may subject itself not only to equitable subordination claims if the project goes south, but it also may limit the effectiveness of waivers and even expose the lender to breach of contract liability. The nuances of these arguments are varied, and courts remain generally averse to applying this type of liability upon lenders, but the risk remains, and it really comes down to the concept of “dominion and control.” How much control over the day-to-day business dealings between contractor and owner the lender retains is directly proportional to how much liability the lender may face if the project does not conclude to the satisfaction of all parties to the contract. Obviously, the more control retained, the more potential risk for the lender.

This possibility not only impacts the lenders, though. It also has impact for the owners, developers, and contractors who rely on financing to complete projects. The more risk imposed on the financial industry, the less willing lenders may be to continue to participate in construction lending. Therefore, it benefits all parties to closely review the Construction Loan Agreement in their loan/construction contract packages to ensure a proper balance is struck between the interests of the lender in ensuring that the money loaned will not be squandered on an inefficient project and the interests of the owner and contractor that they retain freedom to make business decisions to ensure the project is completely correctly and efficiently.

If you have any questions about this particular issue, or any construction issue, please contact our Construction Law Practice Group.


Construction Law