When a Construction Lender Steps into the Shoes of the Developer, the Door is Open for Claims by the General Contractor

Work boot

Thank  you to my partner Garret Murai for giving me the opportunity to post again on his excellent California Construction Law Blog.  I am the author/editor of the  Money and Dirt Blog, where I focus on issues relating to real estate investment, development, and secured lending.

On the Money and Dirt Blog, I recently posted an article on an interesting new secured lending opinion from the California Court of Appeal (Fourth District in Riverside), California Bank & Trust v. Del Ponti.  That blog post focused on guaranty liability, and the court’s holding that there are limits to the defenses that a guarantor can lawfully waive.

But that same decision also highlights valuable lessons regarding the relationship between construction lenders and general contractors in distressed projects, which I’ll cover here.  In short, the court held that when a construction lender “steps into the shoes” of the developer to manage a distressed project, the lender might open the door to liability to the general contractor under theories of breach of contract and promissory estoppel.

First, the factual background ….

The Construction Loan

In 2006, the bank made a $22.5 million construction loan for a 70-unit townhome project in Rialto, California. The developer contracted with a general contractor (Advent) to build the project in two phases for $14 million.  Each month, Advent submitted payment applications to the developer on behalf of subcontractors based on percentage of completion.  The developer would then sign off on the applications and forward them to the bank for final approval.

Under the construction loan agreement between the bank and the developer, the bank was obligated to provide the requested incremental funding as long as the developer was not in default.

All went well — at first.

By early 2008, serious problems emerged.  With work nearly complete on the first phase of the project, the bank withheld payments on several timely draw requests.  The bank did NOT declare the loan in default or issue a notice to cure, but nonetheless continued to withhold funds.  Due to the bank’s failure to pay on the outstanding payment applications, Advent did not have money to pay subcontractors to complete the construction.

The Failed Workout: Lender Steps Into the Developer’s Shoes and Breaks Promises

During an attempted workout, the bank took an active role in the development, relying on a provision in the loan agreement allowing the assignment of the construction agreement to the bank.  The bank made adjustments to the scope of work established by the construction contract.

The bank and the developer agreed on a “global strategy” — the developers would have Advent finish the remaining construction for the first phase (for which the bank would pay advances), market and sell the units quickly, negotiate discounts with the unpaid subcontractors (who would be paid by the bank), and continue working on the project with the understanding that the bank would modify the loan.

Advent accomplished the remaining work and successfully negotiated discounts from most of the subcontractors.  Advent paid the subcontractors itself.  The bank never paid Advent, leaving almost $1 million due.  The bank continued to withhold payments, and eventually declared the loan in default and foreclosed on the property via trustee’s sale.

Court Confirms that Lender is Liable to Contractor on Claims of Breach of Contract and Promissory Estoppel

Advent initially pursued “traditional” claims against the bank based on its unbonded stop notice and for foreclosure of mechanic’s lien.  But at trial, Advent added the claims that would eventually succeed: breach of contract (the construction agreement) and promissory estoppel.

The trial court found that the bank had taken over the construction contract between the developer and Advent, and that the bank wrongfully withheld funds to pay approved fund requests, which doomed the project.  The court  awarded Advent damages, interest, attorney fees, and costs totaling over $1.25 million.

The court of appeal affirmed.  The court first rejected the bank’s argument that it couldn’t be liable to Advent under the assignment of the construction contract because the assignment was for “security only” (transferring the rights but not the obligations under the contract).  The court noted that the language of the assignment was broad, and pointed to testimony by bank representatives confirming that the bank essentially “had stepped into the developer’s shoes.”  The court concluded that the bank had effectively exercised the assignment by demanding further performance by Advent.

The court of appeal also confirmed that “abundant evidence” supported Advent’s claim of promissory estoppel — an equitable doctrine allowing enforcement of promises that induce detrimental reliance.  The court found that the “global strategy” workout arrangement between the bank and the developer required Advent to complete additional work beyond the scope of the construction contract with the expectation of getting paid for that work.

The court rejected the bank’s attempt to “backpedal” with testimony that no one had promised to pay Advent for the additional work.  The court observed that while the bank communicated directly with only the developer’s representatives regarding the  workout “global strategy,” the bank clearly understood that the developers would, in turn, induce Advent to perform the required work with the clear expectation of payment.  The court also held that since the bank stepped into the shoes of the developer, the bank and Advent had contractual privity, and the bank’s workout promises to the developer included Advent.

Lesson

This case highlights the thinking behind some lenders’ refusal to touch construction loans.  When a construction lender steps outside the conventional role of lender, and “steps into the shoes of the developer,” many things can go wrong.  One potential pitfall highlighted here is contractual and equitable liability to the general contractor.  Lenders should approach distressed construction loans with caution and a carefully crafted plan.

General contractors should also heed the lessons from this case.  In appropriate circumstances, contractors who are left unpaid for their work should think outside of the “stop notice/mechanic’s lien” box, and evaluate whether they have remedies based on the lender’s promises and assumed contractual obligations during the workout.

3 Responses to “When a Construction Lender Steps into the Shoes of the Developer, the Door is Open for Claims by the General Contractor”

  1. Ronny McNamara

    It seems mechanical lien, the usual last resort for the contractors is not sufficient and effective enough to get back their payment, as evident from this case. You are right that lender should continue to remain lender and never don the hat of a developer with out a proper plan.

    Reply

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