Fall-09 DeSimone - Sutter paper - Workshop H (00315269).DOC

Introduction

One of the more often over-looked relationships in the development of a new project, regardless of the type, is the relationship between the construction lender and the general contractor. One reason why it is often overlooked is that it, in many respects, it is not a direct relationship, at least not initially. Rather, between the construction lender and the general contractor is the owner who contracts separately with the construction lender and the general contractor. The owner enters into a financing arrangement with the construction lender and enters into a separate construction arrangement with the general contractor with both arrangements usually thoroughly considered and documented. The construction lender and the general contractor are aware of, and dependant upon, one another but this indirect relationship, which has the potential to become a direct relationship, gets relatively little consideration and, at times, even less documentation. Rather, the parties expect or assume that the financing and construction arrangements will proceed as planned with few, if any, issues developing. And usually that is exactly what happens. Aside from some possible cost overruns, slight delays in payment or other relatively minor problems, the project is financed and built as was generally expected.

At least that had been the case until recently. The current downturn in the real estate market reminds us that some times things do not go as planned. Over the past 18 months, more and more construction lenders and general contractors have found themselves in failed or failing projects and this trend is only expected to continue. This situation has placed a spotlight on the construction lender/general contractor relationship revealing, at times, serious gaps or conflicts in this relationship when a project fails. These gaps or conflicts can often be avoided or, at the least, should be thoroughly considered by the parties at the beginning of the transaction. Proper documentation and a better understanding of the relevant law that would apply in the event a project does not proceed as originally expected would likely avoid serious conflict, delay and cost. This paper will consider the nature of the construction lender/general contractor relationship, the contractual arrangement that construction lenders and general contractors often enter into or should consider entering into and the relevant law with respect to what duty or obligations the construction lender might owe the general contractor when there is no contract or an incomplete contract between the parties. The relevant law analysis is based, primarily, on the law in Pennsylvania, New York, California, Nevada, Arizona and Florida.

Initial Relationship and Considerations

Most development projects, among other things, involve the developer/owner arranging for construction financing with a bank or other financial institution. The construction lender, in addition to underwriting the viability of the project, the project’s expected value and cash flow, and the credit worthiness of the borrower and any guarantors will spend a significant amount of time considering, often together with an outside consultant, the construction plans and specifications, the proposed construction budget and schedule, and the credentials of the general contractor and major subcontractors to confirm that the project can be completed on time and on budget without any major issues developing. A key component of this analysis is the construction lender’s consideration of the general contractor and the proposed general contract. Often, the construction lender will require that the general contract be either a guaranteed maximum price or other fixed sum contract. Meanwhile, the general contractor is interested in entering into a general contract that it can fulfill in terms of timing and cost with an owner who is creditworthy and will pay the general contractor as and when required under the general contract. Knowing that the developer has arranged for construction financing often provides the general contractor with some degree of confidence that the necessary funds are or will be available to make the payment required pursuant to the general contract. At the inception of the project, the goals of the construction lender and the general contractor are usually not in conflict, if not actually aligned. The construction lender wants the project completed on time, on budget and lien-free in accordance with the approved plans and specifications. The general contractor wants to complete the project and get paid in accordance with the general contract.

As part of the construction lender’s standard construction loan documentation, it will, among other things, usually require that the developer assign to the construction lender all of the developer’s rights and interest in the general contract. This assignment is important to the construction lender in the event the developer defaults under the construction loan and the construction lender wishes to complete the project on its own. In such a situation, the construction lender would want to have the general contractor complete the project pursuant to the general contract as originally contemplated with as little delay or interruption as is possible. Meanwhile, the general contractor wants to get paid what it is entitled to pursuant to the general contract to the extent it performs the required work.

As described above, in many respects, at the inception of the project the interests of the construction lender and the general contractor are aligned or, at least, not in conflict with one another. However, when a project runs into trouble, the construction lender and the general contractor often have different objectives. The lender may not want to complete the project or, if it elects to complete, may not want to fund any amounts owed the contractor for work performed by the general contractor before the construction lender’s election. The general contractor may be owed money by the developer for work previously performed and wants to be paid accordingly. It is in these situations that the parties may turn to whatever agreement they may have entered into at the inception of the project or, in the case where there is no agreement or the agreement is incomplete, the relevant law to sort out the respective rights and obligations of the parties.

Contractual Arrangement/ Consent to Assignment

The most common agreement entered into by a construction lender and a general contractor is some form of consent to or acknowledgement of the collateral assignment of the general contract (“consent”). This consent is usually required by the lender as part of its standard loan documentation. As a general matter, this consent can set forth whatever terms the construction lender and the general contractor want to agree to with respect to how they intend to deal with one another both before and after any default on the part of the developer. This agreement is usually prepared by the construction lender or its counsel and, in addition to providing for the general contractor’s consent to the assignment of the general contract to the lender by the borrower, will often cover a number of key points from the construction lender’s perspective. The following are some of the more important points often covered by a standard consent to assignment (a sample consent to assignment is attached as Exhibit A to this paper):

At the request of the lender, the general contractor agrees to continue to perform under the general contract following the occurrence of a default by developer under the loan documents. – This provision is a key point for the construction lender in order to have any opportunity to hold the project together and to maintain the general contractor’s obligation to construct the project for the agreed to price and based on the agreed to schedule.

The contractor will be entitled to payment from the lender in accordance with the general contract for only such work as is performed by the contractor following written notice from the construction lender requesting that the general contractor perform such work. - This provision is often a point of discussion between the construction lender and the general contractor in that it does not require the construction lender to pay to the general contractor any amounts owed the general contractor by the developer for work performed prior to the construction lender exercising its right to take-over the project. As you would imagine, most general contractors resist this provision and seek payment for all sums that may be owed to the general contractor under the general contract.

The general contractor agrees to give the construction lender notice of any default on the part of the developer under the general contract and to give the construction lender an opportunity to cure such default before the general contractor exercises any right or remedy it may have under the general contract. - This provision is intended to give the construction lender an opportunity to cure a developer default so as to preserve the agreement. What can be somewhat controversial at times is what is meant by an opportunity to cure or, more precisely, how much time the general contractor must give the construction lender to cure and, while the general contractor is waiting, is the general contractor obligated to continue to perform during the cure period especially when it is uncertain whether the general contractor will actually get paid for such work (remembering the previous point above).

The general contractor acknowledges that it is not permitted to rely on the loan documents and is not an intended beneficiary of the loan documents. – As we will see in the discussion of applicable law, this relatively short provision is very important to the construction lender. Without it, the construction lender runs the risk that a court would find the general contractor to be a third-party beneficiary of the loan and, thereby, entitled to the loan proceeds to the extent of any unpaid work performed. Notwithstanding this provision, the construction lender needs to be careful in its communications with the general contractor and its administration of the construction loan so as not create a situation where the general contractor is relying on the words or actions of the construction lender such that the construction lender creates an obligation to pay the general contractor where such obligation would otherwise not exist.

The general contract cannot be amended or modified without the prior written approval of the construction lender. - This is a protective provision in that this prohibition is typically included in the loan documents with the developer but the construction lender wants to make sure that, if the developer tries to amend the general contract anyway, that the general contractor is aware of it and will either require the construction lender’s consent or will not be able to enforce the modification against the construction lender if the construction lender ever took-over the general contract.

No changes orders, or no change orders above a certain dollar threshold, are to be made without the construction lender’s prior approval. - Similar to the preceding point, this is often a repeat of a prohibition contained in the loan documents for the reasons stated above.

To summarize the consent to assignment, the construction lender wants, ideally, the right to decide to continue with the general contractor at the time of a developer default under the loan documents but not be liable for any sums owed to the general contractor by the developer. If the construction lender elects to proceed with the development, it wants the general contractor to be bound by the terms of the general contract going forward. The construction lender also would like to have the general contractor serve as its eyes and ears when it comes to administering the project, hence the notice of a default, no modification and no change order provisions.

Usually, the most controversial provision for the general contractor is the construction lender’s unwillingness to pay the general contractor any monies that are owed the contractor by the developer pursuant to the terms of the general contract if the construction lender elects to proceed with the project. From the general contractor’s perspective, it has performed the work which benefits the construction lender and, accordingly, the general contractor wants to get paid for such work. However, with a troubled project, the construction lender is focused on reducing any out-pocket advances, especially for the payment of costs which are the developer’s responsibility, and views the general contractor as having a legitimate claim against the developer for such monies owed and not having any claim against the construction lender for such monies.

In some cases, the money owed the general contractor may have actually been advanced by the construction lender to the developer but the developer failed to pay the general contractor. In this case, the construction lender is certainly not interested in advancing the same payment twice. For the construction lender, it wants its written election notice to be the line of demarcation when it comes to what the construction lender will be obligated to fund following a default on the part of the developer. At times, the construction lender and the general contractor may compromise on this point by having the construction lender liable for payments for work performed during the 30-day period prior to the developer’s default or for work performed following the developer’s default but before the construction lender’s notice of whether it will be proceeding with the general contract.

Having some type of an agreement between the construction lender and the general contractor that sets forth the relative rights and obligations of the parties in advance can be critical when a project runs into trouble. As we shall see below, proceeding without an agreement or with an incomplete agreement leaves the parties open to the application of applicable law which can lead, at times, to some unintended results.

Relevant Legal Theories

As important as the contractual relationship that may exist between the construction lender and the general contractor is the relevant law that courts have applied to construction lenders and general contractor when dealing with one another – specifically, the law as to whether the general contractor is entitled to construction loan proceeds or other payment from the construction lender. As set forth below, the law in this area is concerned with determining, what, if any, relationship or duty should be found to exist between the construction lender and the general contractor. The areas that courts frequently focus on are whether: (1) any fiduciary duty is owed by the construction lender to the general contractor, (2) a theory of promissory estoppel or unjust enrichment should be applied to create a duty on the part of the construction lender to the general contract, and (3) the general contractor is an intended third-party beneficiary of the loan and the loan documents.

Construction Lender’s General Fiduciary Duty to a General Contractor

Courts have been hesitant to find a general fiduciary duty owed by a construction lender to a general contractor in situations where the general contractor is known to the construction lender at the time of hiring or is subsequently hired by the borrower and the loan has been disbursed.[ii] Absent a misrepresentation or comparable act of negligence on the part of the construction lender, courts are reluctant to impose further obligations upon the construction lender with respect to the general contractor. Therefore, in most circumstances after the construction lender disburses the agreed-upon money to the developer in the form of an advance[iii] or final payment, the construction lender owes no auxiliary duty to the general contractor.[iv] Should the developer later default on the loan, the construction lender may foreclose upon the property and, subject to the state’s mechanics’ lien laws, has first priority to recover its share of the money.[v]

Faced with situations where the developer defaults and the construction lender foreclosures on the property, general contractors typically bring claims against the construction lender on two theories: (1) that the construction lender owed the general contractor a duty to warn the general contractor of the probable or actual loan default; or (2) that the construction lender owed the general contractor a duty to monitor the funds and supervise the uses to which those funds were put.[vi] Unfortunately for general contractors, courts are generally not willing to find a duty owed under either theory. A California court explained that to find such a duty is expensive and burdensome; construction lenders should be allowed to “concentrate on their primary duty of providing construction loans at lesser expense to the borrower and ultimately to the consuming public.”[vii] Additionally, a Florida court dismissed comparable claims alleging that the construction lender breached fiduciary duties by not supervising the expenditure of funds, not appropriately overseeing the development of the project, and failing to make each party account for the uses to which each of the disbursements were put.[viii]

Mississippi, however, takes the minority approach by imposing a duty on the construction lender to supervise the uses to which the loan is being put. In Cook v. Citizens Savings & Loan Association, the contractor, upon completing the job, asked the construction lender for payment.[ix] The contractor ended up not being paid because the construction lender negligently gave the money directly to the owner without taking further steps to see that it went to the proper party.[x] The court found that the construction lender “totally failed to discharge its duty” to use reasonable diligence to see that the funds were actually used to pay the contractor and held the construction lender liable to the contractor for sums owed on account of the work performed by the contractor.[xi] Courts in other jurisdictions read the Cook opinion narrowly, explaining that the Mississippi court held as it did because of the particulars of Mississippi law and no such law governs their state.[xii]

Circumstances When Courts Impose a Duty on the Lender – Promissory Estoppel and Unjust Enrichment

As a general matter, it is very difficult for a general contractor to be successful on a claim against a construction lender, though courts will impose a duty on the construction lender in some circumstances. Where courts do find such a duty, it is when there are sufficient facts to be able to rely on the theory of promissory estoppel or where the construction lender has been unjustly enriched from work completed by a general contractor.

Promissory Estoppel: The Doctrine in General

In the construction law context, courts within the United States use the terms “equitable estoppel” and “promissory estoppel” fairly interchangeably to refer to the same equitable remedy owed to parties relying to their detriment on inducements by others.[xiii] In these circumstances, courts find there to be a duty where one formerly did not exist because the inducing party should have known that the relying party would have acted in accordance with their misrepresentations. Whereas, in other situations, such as liens, the general contractor may have the duty of properly filing within the statutorily prescribed timeframe, in the case of promissory estoppel no such burden is placed on the general contractor. In order to recover under this theory, all the law requires is for the general contractor to rely on a material misrepresentation by the construction lender that causes the general contractor to be damaged in some way.

As with all equitable doctrines, the idea of fairness is essential to the theory of promissory estoppel. Courts rationalize imposing a duty on the construction lender because if they did not, it would be unjust and unconscionable. As a Pennsylvania court explained, “equitable estoppel is a doctrine of fundamental fairness intended to preclude a party from depriving another of a reasonable expectation, when the party inducing the expectation knew or should have known that the other party would rely to his detriment upon that contract.”[xiv] Therefore, although the general contractor may have acted improperly, because the general contractor relied on advice or instructions from the construction lender, it is the construction lender that should suffer the consequences of the misrepresentation; the general contractor is the innocent party in the eyes of the law.

Although the language differs slightly with respect to individual jurisdictions, “[t]he three elements of equitable estoppel are traditionally stated as: (1) the party to be estopped commits acts inconsistent with a position it later adopts; (2) reliance by the other party; and (3) injury to the latter resulting from the former’s repudiation of its prior conduct.”[xv] Pennsylvania imposes an additional burden that the party seeking estoppel cannot have a duty of inquiry in the circumstance.[xvi]

Material Misrepresentations versus Negligent Transmittal of Information

Across jurisdictions, it is clear that any intentional, material misrepresentation on which a party relies constitutes sufficient inducement for which the party can recover.[xvii] With regard to negligent misrepresentations or misrepresentations made in good faith, American jurisprudence[xviii] recognizes negligent misrepresentations as being “a vehicle for recovery of a loss sustained through a business or professional relationship.” In order to rise to the level of intentional misrepresentation, courts[xix] require that the parties first demonstrate that there is a relationship amongst them.[xx]

It is necessary that the relationship of the parties, arising out of the contract or otherwise, be such that one has the right to rely on the other for information, that the one giving the information should owe to the other a duty to give it with care, that the person giving the knowledge that the information is desired for a serious purpose.[xxi]

Further, not every negligent misrepresentation will rise to the level required to recover under promissory estoppel even if there was a relationship amongst the parties. The misrepresentation must be material and the reason the party acted.

[I]t is not every casual response, or every idle statement, no matter how damaging the result, which will give rise to a cause of action, and a false statement cannot give rise to a cause of action in negligence where the maker thereof was under no duty to the person addressed, or the person relying thereon, to advise him correctly, or the facts were equally within the observation of both, or where the nature and extent of the transaction that will be regulated by the information are not known.[xxii]

In Arizona Title Insurance and Trust Company v. O’Malley Lumber Company, the Arizona Court of Appeals held that Arizona Title’s duty as the construction lender “was to exercise reasonable care not to misstate existing, ascertainable facts. It could not be liable for statements of opinion or for representations as to future matters not reasonably understandable as being representations of existing facts.”[xxiii]

Therefore, not every incorrect representation detrimentally relied upon is sufficient to satisfy a cause of action under promissory estoppel. Particularly in the context of construction lenders and general contractors, the general contractor first must establish that there is a relationship between itself and the construction lender. The general contractor must then prove that the representation was intentional or, in the alternative, negligent and material.

When is Reliance “Reasonable?”

For the most part, courts are strict in requiring reliance to be reasonable in order to find there to be a duty. Typically, reliance is reasonable when a logical person would have been induced to act in the same or similar circumstances.[xxiv] The Fifth Circuit imposed this strict requirement in a case where a subcontractor claimed it should expect to receive a payment bond based on wording in purchase orders between a contractor and owner.[xxv] The court denied the subcontractor’s claim holding that “[w]e think that a contractor who chooses to rely on a payment bond which he has never seen, purchased by an owner with whom he has not communicated, and issued by a surety he has never sought to contact, has an obligation to exercise greater diligence than this.”[xxvi] Although this case does not involve a construction lender/general contractor relationship, it is illustrative of the level of reasonable reliance necessary to satisfy that prong of the test.

Promissory estoppel is more relevant when a construction lender tells a general contractor that the loan is not in default and the general contractor then continues work on the project. “A construction lender who falsely advises a materialman or subcontractor that the mortgage is not in default must suffer the consequences if further work and materials are incorporated into the project in reliance thereon.”[xxvii] California courts[xxviii] rationalize this imposition on the construction lender by explaining that “[e]ven though there may be no duty upon a vender to speak upon a subject affecting the desirability of a sale to which he is a party, if he does speak, whether voluntarily or in response to an inquiry, he must make a full disclosure.”[xxix]

Courts have, at times, applied a high standard in considering a promissory estoppel argument. For instance, in a Florida case the court held that a telephone call between the contractor and the construction lender’s loan disbursement representative, where the representative advised the contractor that there were enough undisbursed funds in the loan to cover what the contractor was owed, was not a sufficient affirmative misrepresentation to create a duty upon the construction lender.[xxx] The court reasoned that “[the] parties were not in privity. The mortgage was not in default at the time of the conversation. There was no promise to retain monies specifically for the benefit of [the contractor].… There was no evidence [the construction lender] was seeking to induce [the contractor] to continue to work on the project.”[xxxi] Based on the absence of such facts, the court could not in good faith hold the construction lender liable for the mistakes of the contractor. The court stated that such a holding would “inject an unnecessary degree of uncertainty into the construction loan industry.”[xxxii]

Promissory Estoppel and Construction Funds

An existing construction loan fund is a fairly common target of general contractors seeking to recover under promissory estoppel. General contractors argue that the establishment of a construction loan fund creates the reasonable impression that the funds are available and that they will be paid for their work; that a reasonable person, seeing the establishment and maintenance of a construction fund, would continue to work with the belief that the construction loan was not in default; and that any detrimental reliance thereon is reasonable and warranted.

California and Arizona each have had the opportunity to specifically consider how best to treat this unique promissory estoppel argument. Both jurisdictions are in agreement that the existence of a construction loan fund, without anything else, is insufficient for recovery under promissory estoppel.[xxxiii] However, “[a]n equitable lien may be imposed on a construction-loan fund… if it is established that the borrower or lender induced the supplier of labor materials to rely.”[xxxiv] The courts set a high threshold for recovery under this theory of “inducement.” In Arizona, a court held that a construction lender’s knowledge of overruns from a building fund was not enough to establish a legitimate promissory estoppel argument.[xxxv] Similarly, in California, a contractor seeking to recover assets from a construction fund must establish that it has a right to its contents for it to be relevant to the analysis.[xxxvi] Should the contractor be successful in establishing such a right, the court will then treat the existence of construction funds in the same manner as it would any other evidence; no more weight is afforded to its existence than any other factor established by the contractor.[xxxvii]

The treatment courts give the existence of construction funds further illustrates their hesitancy to hastily decide a promissory estoppel case in favor of the general contractor. As the construction fund example makes clear, no one factor is determinative in the analysis. To impose a duty where there typically is not one, general contractors must present substantial evidence of inducement to be successful.

Unjust Enrichment

Courts will also find that the construction lender owes a duty to the general contractor when the construction lender has been unjustly enriched by the actions of the general contractor. This situation generally arises when the developer defaults on the loan and the construction lender forecloses upon the completed, or substantially improved, property. Unjust enrichment is an attractive theory of recovery for a general contractor allegedly wronged by a construction lender because the essence of the doctrine is that there is no direct relationship between the parties.[xxxviii] Therefore, recovery is possible regardless of the absence of an agreement specifically explaining what would happen in the event of a default by a developer. “Sometimes, of course, there will be a direct relationship, in the form of a promise either to the subcontractor or for the benefit of the subcontractor. In such a case, the subcontractor has a right to recover on the promise.”[xxxix]

Most jurisdictions require the following three elements in order to successfully recover on a theory of unjust enrichment:

(1) lack of an adequate remedy at law;

(2) a benefit conferred upon the defendant by the plaintiff coupled with the defendant’s appreciation of the benefit; and

(3) acceptance and retention of the benefit under circumstances that make it inequitable for him or her to do so without paying for it.[xl]

Pennsylvania, like most jurisdictions, does not require “a showing of wrongdoing or wrongful intent on the part of the benefited party” for the benefitted party to be found unjustly enriched.[xli] Pennsylvania case law is clear that the primary focus of the court is on the result of the unjust enrichment.

Ascertaining whether the construction lender was enriched, and unjustly at that, can be a difficult process. “[I]t is not the value of the services rendered by the subcontractor, but the value of the benefit received by the owner which is of paramount importance.”[xlii] A typical defense against a claim of unjust enrichment is that the benefits received were “worthless” and could not be considered a substantial enrichment.[xliii] General contractors who are successful in their claims of unjust enrichment are able to differentiate between substantial improvements and incidental ones, emphasizing material improvements.

Proving the construction lender was enriched is only one step in the three-prong test; further evidence must be presented to show that this enrichment was “unjust.” “In order to have been unjustly enriched, a party must have received the benefit without paying for it. For example, where an owner allows a [contractor] to improve property, knowing that the contractor would default…, it would be unjust for the owner to retain the benefit of the work without paying.”[xliv]

Most jurisdictions agree that when a contractor does not complete a project, the construction lender cannot be deemed to be unjustly enriched.[xlv] For example, Florida had the opportunity in J. G. Plumbing Service to consider whether a construction lender is unjustly enriched in a situation where the contractor had not completed its work. The court adopted the bright line rule that in cases where the default occurs before the construction has been completed on the property, the construction lender is not unjustly enriched.[xlvi] “[T]he construction lender is left with the remedy of foreclosing upon a partially completed building. More often than not, the market value of a partially constructed building will be substantially less than the total cost of the labor and material which has already been incorporated in its construction.”[xlvii]

However, in F.W. Eversley & Co. v. East New York Non-Profit HDFC, a federal court in New York upheld a general contractor’s unjust enrichment claim where the work had been completed. This case involved claims brought by a general contractor against housing development fund corporations, the Secretary of Housing and Urban Development and a bank for amounts due after the completion of low-income housing developments.[xlviii] The defendants argued that there was no unjust enrichment because the housing developments sold at a price less than their actual market value.[xlix] The court rejected this unjust enrichment defense finding that the plaintiff was entitled to recover the full value of the services rendered. The court explained that “[i]t is unfortunate, if true, that the government will lose money upon foreclosure of these properties…. [the contractor’s] claim cannot be destroyed by the aberrations of the market or the national economy. It speaks as of the date of the completion of the project, not the date of the foreclosure sale.”[l]

Unjust enrichment claims can also arise when construction lenders have previously funded part of the project and cannot recover that expended sum when a later default occurs. In these situations, courts tend to find in favor of the construction lender.[li] For example, in Pennsylvania, a court found that a construction lender was not unjustly enriched since it had already advanced the money budgeted for the site preparation. “[T]he court concluded that it could not be said that by receiving the benefit of the site preparation work, the lender had been unjustly enriched; it had been enriched, but… not unjustly.”

As with promissory estoppel, recovery under a theory of unjust enrichment is not determined by any single factor. A general contractor may be able to establish that the construction lender was enriched, but fail to show that such enrichment was unjust. A general contractor bringing forth an unjust enrichment claim has the greatest chance of success if they are able to demonstrate that the improvements were substantial, that they greatly improved the property, and that they were completed without any comparable consideration on the part of the construction lender.

Third Party Beneficiary

Another legal theory that may support a general contractor’s claim for payment against a construction lender is one based on a third party beneficiary theory. Third party beneficiary theory provides that an individual or entity, although not a party to a contract, may nonetheless sue for breach of the agreement as an intended beneficiary.[lii] Generally,[liii] a third party becomes a third party beneficiary when the contracting parties intend to confer a benefit on the third party through the terms of the agreement.[liv] However, the third party must not simply have been provided an incidental benefit resulting from the performance of the contract.[lv] Rather, the contracting parties must have contemplated and affirmatively granted a benefit to the third party.[lvi] Because of the requirement of an affirmatively granted benefit to the third party, courts, with narrow exception, typically find against claims of third party beneficiary status.

In Twin County Construction Co., Inc. v. Signet Bank, a general contractor claimed third party beneficiary status under a loan agreement between the developer and the construction lender for the financing of the construction of a commercial office building.[lvii] In addition to a loan agreement between the developer and the construction lender and a construction agreement between the developer and the general contractor, the general contractor entered into a contractor agreement directly with the construction lender.

The loan agreement provided a number of construction lender protections, including an express “No Third Party Beneficiary” clause,[lviii] and the contractor agreement contained a provision stating that the contractor had read the loan agreement and accepted terms thereof.[lix] Construction delays and budget overruns ensued and the developer consequently defaulted under the loan agreement. When the general contractor sought payment from the construction lender, the construction lender informed the general contractor that it would no longer make disbursements for the project.[lx] The construction lender foreclosed on the project and the general contractor filed suit against the construction lender to recover payment for labor and material costs.[lxi] The general contractor claimed third party beneficiary status under the loan agreement.[lxii] Applying Pennsylvania law, the court used the test announced in Spires v. Hanover Fire Ins. Co.,[lxiii] which held “a party becomes a third party beneficiary only where both parties to the contract express an intention to benefit the third party in the contract itself.”[lxiv] The court quickly dispatched the general contractor’s claim, relying upon the express “No Third Party Beneficiary” clause in the loan agreement.[lxv] The court held that the general contractor was bound under the contractor agreement, which specifically incorporated the provisions of the loan agreement, including the “No Third Party Beneficiary” clause.[lxvi] Accordingly, the court found that neither the construction lender nor the developer had intended to confer third party beneficiary status upon anyone not a party to the loan agreement.[lxvii] This decision is a reminder of the importance for the construction lender to obtain an agreement from the general contractor at the inception of the project as described earlier in this paper – even to simply state that the general contractor is not intended as a third party beneficiary of the loan or the loan documents.

A similar result occurred in Gordon Building Corporation v. Gibraltar Savings and Loan Assoc., which also involved a specific contract provision expressing the parties intent not to benefit a third party. [lxviii] In Gordon, a California court held that the construction lender was not liable to the general contractor for unpaid fees because the general contractor was not a party to the loan agreement.[lxix] The lawsuit arose when a subcontractor sued the general contractor for unpaid fees and the general contractor counterclaimed against the subcontractor, the developer and the construction lender.[lxx] The general contractor argued that the construction lender breached a third party beneficiary duty to the general contractor by failing to pay the subcontractor for work performed.[lxxi] The loan agreement clearly stated that only the undersigned were parties to the agreement.[lxxii] The general contractor, citing cases which held that subcontractors, as a class, were considered intended beneficiaries to construction loan agreements, argued that it too should be considered an intended beneficiary under the loan agreement.[lxxiii] The general contractor also claimed that it should be considered a third party beneficiary under the loan agreement because the loan agreement was a form contract that contained a signature line for a general contractor to sign. However, the general contractor never signed the loan agreement.[lxxiv] The court rejected both theories and found the signature line in the contract insufficient evidence of an intent to confer third party beneficiary status on the general contractor.[lxxv] The court further held that a “No Third Party Beneficiary” clause in the loan agreement foreclosed the general contractor’s claim.[lxxvi] The loan agreement stated that the contract was “made for the sole protection of the undersigned. . . and no other person or persons shall have any right of action hereon.”[lxxvii] The court held “[a] contract made solely for the benefit of the contracting parties cannot be enforced by a stranger or one who stands to benefit merely incidentally by its performance.”[lxxviii] The court also dismissed the general contractor’s equitable lien argument,[lxxix] a theory more thoroughly discussed in Pankow Construction Co. v. Advance Mortgage Corp.

In Pankow, a general contractor sued the construction lender seeking an equitable lien to recover fees due under a general contract for the construction of a housing project as a third party beneficiary to a loan agreement.[lxxx] When the developer defaulted under the loan agreement as a result of construction delays, the construction lender stopped disbursement of loan funds.[lxxxi] The general contractor then sued the construction lender for the balance due under the construction contract as a third party beneficiary to the loan agreement.[lxxxii] The general contractor argued that, as a fully performing contractor, it was entitled to an equitable lien on the construction loan funds.[lxxxiii] The court focused on a California state statute[lxxxiv] prohibiting contractors from placing liens against undisbursed construction funds.[lxxxv] The California statute “was drafted in response to lender protests that even after completion of construction, a lien claimant may have an equity interest in the building loan account that is prior and superior to the rights of both the lender and the builder.”[lxxxvi] The statute serves to encourage private investment by lenders in construction projects by limiting the remedies of contractors and subcontractors in the event of owner default.[lxxxvii] The general contractor argued by limiting a contractor’s remedies against a construction lender the statute discourages contractors from participating in housing projects.[lxxxviii] However, the court found no evidence that such concerns had materialized.[lxxxix] Furthermore, the court noted that contractors and subcontractors possessed other remedies, such as securing payment bonds or suing the owner under the construction contract.[xc] The court held that the general contractor could not recover on a third party beneficiary claim because the statutory language specifically excludes such recovery and does not allow third party beneficiaries to recover because the contractual exception provides only for “a right created by direct written contract.”[xci] The court held that, by definition, third party beneficiaries cannot satisfy this requirement.[xcii]

Gebco Investment Corporation v. Monroeville Electronics Co. is a case illustrating the narrow exception where a contractor successful recovered under a third party beneficiary claim. In Gebco, a construction lender expressly agreed to provide financing for labor and materials on a construction project.[xciii] A subcontractor on the project began performing work and, after delays in receipt of payment, was referred to the construction lender.[xciv] The construction lender assured the subcontractor that the construction loan funds were sufficient to satisfy debts of materialmen upon completion of the project.[xcv] The subcontractor returned to the job and completed its work.[xcvi] While the subcontractor continued to work under the construction lender’s assurances, the developer defaulted on the loan.[xcvii] In turn, the construction lender declined to release any further construction funds.[xcviii] The developer then filed for bankruptcy and a trustee took possession of the project.[xcix] The trustee sold the project and brought suit against the construction lender to recover the balance of undistributed funds.[c] The construction lender joined the subcontractor to the litigation.[ci]

The subcontractor claimed a right to the undistributed loan money.[cii] On appeal, the trustee argued they had a legal entitlement to the undisbursed money superior to that of the subcontractor because the fund was not created for the benefit of the laborers.[ciii] The subcontractor claimed that the unreleased funds were specifically set aside for the benefit of subcontractors. The court, relying on the terms of the loan agreement that provided that the funds were explicitly given to satisfy invoices for labor and materials and were to be used for no other purpose, held that the subcontractor was an intended third party beneficiary under the loan agreement.[civ] The court further noted that since the loan agreement required that no liens be filed by subcontractors, it would be inequitable to deny the subcontractor the right to recover as a third party beneficiary despite the fact that subcontractors were not expressly named as such in the loan agreement.[cv] Accordingly, the subcontractor could recover from the fund as a third party beneficiary[cvi] of the loan agreement.[cvii]

As the Gebco opinion instructs, explicit contract language interpreted to provide a benefit to an unnamed party may result in a finding of third party beneficiary status for a contractor. The contractor’s reliance on the construction lender’s statements in Gebco may also have been a factor in the equitable relief afforded by the court.

Conclusion

As described above, it is usually quite prudent for construction lenders and general contractors to consider the nature of their relationship at the inception of a development project. Often the parties, especially the construction lender, are best served by entering into an agreement at the commencement of a project setting forth the scope and particulars of their relationship. Having such an agreement will go a long way to avoiding potential unintended consequences if a dispute arrives before a court. As set forth above, there are a number of potential legal theories that may be used to establish a duty owed on the part of the construction lender to the general contractor which may create liability on the part of the construction lender where no duty was intended. Though not all cases will have facts sufficient for general contractors to rely on theories of promissory estoppel, unjust enrichment or third party beneficiary for judicial redress, there are certainly a number of situations that might support the same.

[i] The authors would like to acknowledge the contributions of Ballard Spahr Summer Associates Paul J. Koob and Ashley Wilson.

[ii] Inversiones Inmobiliarias Internacionales de Orlando Sociedad Anomino, et al v. Barnett Bank of Cent. Fla., 584 So. 2d 110, 110-111 (Fla. Dist. Ct. App. 1991); J. G. Plumbing Serv., Inc. v. Coastal Mortgage Co., 329 So. 2d 393, 395 (Fla. Dist. Ct. App. 1976).

[iii] Claims of unjust enrichment frequently fail when trying to recover for the full sum after an advance is given and the borrower defaults. Pennsylvania and Florida are examples of two states that will not find the lender to have been unjustly enriched if they advance money, the borrower defaults without completing the project, and the lender later forecloses on the property.

[iv] J. G. Plumbing Serv., Inc. v. Coastal Mortgage Co., 329 So. 2d at 396.

[v] Mercantil Intercontinental, Inc. v. Generalbank, 601 So. 2d 293 (Fla. Dist. Ct. App. 1992).

[vi] See Boyd & Lovesee Lumber Co. v. W. Pac. Fin. Corp., 118 Cal. Rptr. 699, 700-01 (Cal. Dist. Ct. App. 1975).

[vii] Id. at 702.

[viii] Inversiones Inmobiliarias Internacionales, 584 So. 2d at 110-111.

[ix] 346 So. 2d 370 (Miss. 1977).

[x] Id.

[xi] Id.

[xii] E.g., Rockhill v. United States, 418 A.2d 197, 202 (Md. 1980); Hoida, Inc. v. M&I Midstate Bank, 717 N.W.2d 17 (Wis. 2006).

[xiii] See In re Turner-Dunn Homes, Inc., 2007 Bankr. LEXIS 3067 at 20 (Bankr. D. Ariz. 2007); Rinehimer v. Luzerne County Cmty. Coll., 539 A.2d 1298, 1306 (Pa. Super. Ct. 1988).

[xiv] Straup v. Times Herald, 423 A.2d 713, 720 (Pa. Super. Ct. 1980).

[xv] See, e.g., Valencia Energy Co. v. Ariz. Dep’t of Revenue, 959 P.2d 1256 (Ariz. 1998).

[xvi] Rinehimer, 539 A.2d at 1236.

[xvii] See, e.g., Nibbi Bros. v. Home Federal Sav. & Loan Ass’n, 253 Cal. Rptr. 289, 294 (Cal. Dist. Ct. App. 1988).

[xviii] See, for example, New York, Montana, Prosser’s Handbook on Torts, and the Restatement (Second) of Torts.

[xix] Arizona, the Eighth Circuit, and Mississippi are examples or jurisdictions following this requirement.

[xx] Ariz. Title Ins. & Trust Co. v. O’Malley Lumber Co., 484 P.2d 639, 645 (Ariz. Dist. Ct. App. 1971).

[xxi] 65 C.J.S. Negligence § 20 (1966).

[xxii] Ariz. Title Ins. & Trust Co., 484 P.2d at 645.

[xxiii] Id. at 646.

[xxiv] See Rinehimer, 539 A.2d at 1236.

[xxv] Thermo Tech Inc. v. Goodyear Tire & Rubber Co., 643 F.2d 1173 (5th Cir. 1981).

[xxvi] Id. at 1179.

[xxvii] J. G. Plumbing Serv., Inc. v. Coastal Mortgage Co., 329 So. 2d at 396 (claim by contractor failed because, although contractor thought the project would be completed, there was no evidence that it was the lender that gave them that impression).

[xxviii] California is the only jurisdiction that specifically connected the requirement of the duty to speak truthfully to lender/contractor situations.

[xxix] Nibbi Bros. v. Home Federal Sav. & Loan Ass’n, 253 Cal. Rptr. at 294.

[xxx] Indiana Mortgage & Realty Investors v. Peacock Constr. Co., 348 So. 2d 59, 60-61 (Fla. Dist. Ct. App. 1977).

[xxxi] Id.

[xxxii] Id. at 61.

[xxxiii] See Pioneer Plumbing Supply Co. v. Sw. Sav. & Loan Assoc., 428 P.2d 115 (Ariz. 1967).

[xxxiv] Id. at 121.

[xxxv] Watson Constr. Co. v. Amfac Mort. Corp., 606 P.2d 421, 429 (Ariz. 1979).

[xxxvi] J. G. Plumbing Serv., Inc. v. Coastal Mortgage Co., 329 So. 2d at 395.

[xxxvii] Id.

[xxxviii] Gee v. Emberle, 420 A.2d 1050, 1060 (Pa. Super. Ct. 1980).

[xxxix] Id.

[xl] Challenge Air Transport, Inc. v. Transportes Aereos Nacionales, S.A., 520 So. 2d 323 (Fla. Dist. Ct. App. 1998).

[xli] Gee v. Emberle, 420 A.2d at 1059.

[xlii] D.A. Hill Co. v. CleveTrust Realty, 573 A.2d 1005, 1009 (Pa. 1990).

[xliii] H. Hugh McConnell, LXXI Distinguishing Quantum Meruit and Unjust Enrichment in the Construction Setting 88 (1997), http://www.floridabar.org/DIVCOM/JN/JNJournal01.nsf/c0d731e03de9828d852574580042ae7a/7e3d8e3a6c36217485256adb005d6116?OpenDocument&Highlight=0,mcconnell*.

[xliv] Id.

[xlv] Myers-Macomber Engineers v. M.L.W. Constr. & HNC Mortgage & Realty Investors, 414 A.2d 357 (Pa. 1979) (subcontractor could not recover after borrower defaulted; lender was not unjustly enriched because it already advanced money for the project that was never completed); Morgen-Oswood & Assoc. of Fla. v. Cont’l Mortgage Investors, 323 So. 2d 684 (Fla.1975); (contractor finished hotel but the lender refused to make a final advance on the project because owner had defaulted; the court found that the lender had been unjustly enriched because it had received the security of a completed hotel without making all the advances required); Trans-Bay Eng’r & Builders, Inc. v. Hills, 551 F.2d 370 (D.C. Cir. 1976) (contractor may recover retained mortgage payments from mortgagee assignee where contractor finished construction project); Miller v. Mountain View Savings & Loan Assn., 48 Cal. Rptr. 278 (Cal. Dist. Ct. App. 1966) (a trust may be imposed on undisbursed mortgage funds contractors who complete project because through their efforts lender has received the security it bargained for).

[xlvi] J. G. Plumbing Serv., Inc. v. Coastal Mortgage Co., 329 So. 2d at 395.

[xlvii] Id.

[xlviii] F.W. Eversley & Co. v. East New York Non-Profit HDFC, Inc., 409 F. Supp. 791, 793-94 (S.D.N.Y. 1976).

[xlix] Id. at 795.

[l] Id. at 800.

[li] See, e.g., Myers-Macomber Engineers, 414 A.2d 357.

[lii] Flickinger v. Harold C. Brown & Co., 947 F.2d 595, 600 (2d Cir. 1991).

[liii] The Restatement (Second) of Contracts § 302 (1981) provides:

(1) Unless otherwise agreed between promisor and promisee, a beneficiary of a promise is an intended beneficiary if recognition of a right to performance in the beneficiary is appropriate to effectuate the intention of the parties and either

(a) the performance of the promise will satisfy an obligation of the promisee to pay money to the beneficiary; or

(b) the circumstances indicate that the promisee intends to give the beneficiary the benefit of the promised performance.

(2) An incidental beneficiary is a beneficiary who is not an intended beneficiary.

[liv] Restatement (Second) of Contracts § 302 (1981); see also Souza v. Westlands Water Dist., 38 Cal.Rptr.3d 78, 88 (Cal. App. 2006)(determining third party beneficiary status from intent of parties within contract’s terms); Flagstaff Med. Center, Inc. v. Sullivan, 773 F.Supp. 1325, 1359 (D. Ariz. 1991) (citing Supplies for Industry, Inc. v. Christensen, 659 P.2d 660, 662 (Ariz. App. Ct. 1983))(recognizing Arizona has adopted section 302 of Restatement); Rebman v. Follett Higher Education Group, Inc., 575 F.Supp.2d 1272, 1276 (M.D. Fla. 2008)(citing Biscayne Inv. Group, Ltd. v. Guarantee Mgmt. Servs., Inc., 903 So.2d 251, 254 (Fla. Dist. Ct. App. 2005)) (finding non-party must be intended beneficiary to be considered third party beneficiary).

[lv] Souza, 38 Cal.Rptr.3d. at 88; see also Restatement (Second) of Contracts § 302(2) (“[a]n incidental beneficiary is a beneficiary who is not an intended beneficiary”).

[lvi] Souza, 38 Cal. Rptr.3d at 88.

[lvii] No. 94-5915, 1995 U.S. Dist. LEXIS 18317, at *1 (E.D. Pa. December 12, 1995).

[lviii] Id. at *2-3.

[lix] Id.

[lx] Id.

[lxi] Id.

[lxii] Id. at * 6.

[lxiii] 70 A.2d at 830-31.

[lxiv] Id.

[lxv] Id. at *7-8.

[lxvi] Id. at *10.

[lxvii] Id. at *10-11.

[lxviii] 55 Cal. Rptr. 884, 884, 885 (Cal.App. 1966).

[lxix] Id. at 889.

[lxx] Id. at 886.

[lxxi] Id.

[lxxii] Id.

[lxxiii] Id. at 887. The court does not cite the cases upon which Gordon relied.

[lxxiv] Id. at 886.

[lxxv] Id.

[lxxvi] Id.

[lxxvii] Id.

[lxxviii] Id. at 888.

[lxxix] Id. at 889.

[lxxx] 618 F.2d 611, 612 (9th Cir. 1980).

[lxxxi] Id.

[lxxxii] Id.

[lxxxiii] Id.

[lxxxiv] California Civil Code § 3264 provides:

The rights of all persons furnishing labor, services, equipment, or materials for any work of improvement, with respect to any fund for payment of construction costs, are governed exclusively by Chapters 3 (commencing with Section 3156) and 4 (commencing with Section 3179) of this title, and no person may assert any legal or equitable right with respect to such fund, other than a right created by direct written contract between such person and the person holding the fund, except pursuant to the provisions of such chapters (emphasis added).

[lxxxv] Id. at 614.

[lxxxvi] Id.

[lxxxvii] Id. at 615.

[lxxxviii] Id.

[lxxxix] Id.

[xc] Id. (citing Cal. Civ. Code §§ 3096, 3226 (2008).

[xci] Id. at 616 (citing Cal. Civ. Code § 3264).

[xcii] Pankow, 618 F.2d at 616.

[xciii] 641 F.2d 143, 144 (3d Cir. 1981).

[xciv] Id. at 145.

[xcv] Id.

[xcvi] Id.

[xcvii] Id.

[xcviii] Id.

[xcix] Id.

[c] Id.

[ci] Id.

[cii] Id.

[ciii] Id. at 146.

[civ] Id. at 147.

[cv] Id. at 147.

[cvi] The Third Circuit also held that the subcontractor could recover under theories of unjust enrichment as well as an equitable assignee of the construction loan. Gebco, Inv. Co., 641 F.2d at 149.

[cvii] Id. at 149.

2. General Contractor represents and warrants that to the best of its knowledge (i) the General Contract is in full force and effect, and (ii) neither Borrower nor General Contractor is in default thereunder.

4. General Contractor acknowledges and agrees that it is not entitled to rely upon any of the provisions of the Loan Agreement and it is not an intended third party beneficiary thereof.

6. Subject to paragraph 8 hereof, General Contractor shall not, without your prior written consent, which may be withheld in your sole discretion, agree to the amendment or modification of the General Contract.

7. General Contractor shall not assign its rights or obligations under the General Contract without your prior written consent, which may be withheld in your sole discretion.

11. General Contractor hereby waives any and all rights to bring an unjust enrichment claim against you.

12. General Contractor hereby acknowledges that you have not made any representations or warranties other than as set forth herein and that any statements made by you shall not be binding unless made in writing and executed by an authorized officer of [Bank].

13. The officer executing this instrument on behalf of General Contractor hereby personally certifies that he or she is authorized to do so.

14. General Contractor represents and warrants that it has full authority under all applicable state and local laws and regulations to perform its obligations under the General Contract in accordance with the terms thereof.

15. This letter shall be binding upon General Contractor and its successors and permitted assigns and shall inure to the benefit of you and your successors and assigns.