CFO to CEO: “I have bad news, the developer on our biggest project has run out of money.” Frightening words for sure, but contractors should not overlook the bonded stop notice in situations where the construction lender seemingly has expended all construction funds. The recent case of Brewer Corporation v. Point Center Financial, Inc. 2014 WL 346636 illustrates this point.
Contractors have two options at their disposal to secure payment on private works of improvement. The first is the mechanics lien. However, construction loan trust deeds are normally recorded prior to the commencement of construction and therefore have priority over mechanics liens. Connolly Development, Inc. v. Superior Court (1976) 17 Cal.3d 803, 827. Enter the bonded stop notice. The bonded stop notice requires the lender to withhold unexpended funds and, if it fails to do so, it is personally liable to the claimant for the full amount of the claim. But the stop notice also has the power of “priority” over any assignment of construction loan funds, whether before or after a stop notice is served. Civil Code § 3166, now Civil Code § 8544.
Brewer involved a development of a condominium project in San Diego under which a real estate broker agreed to raise construction funds for the project, thus acting as a “construction lender.” In Brewer, all construction loan funds were expended by the time several contractors served bonded stop notices. Suit was filed during which it was revealed that the construction lender had entered into agreements and assignments with third parties to finance and secure the construction loan. The construction lender pre-paid itself $1.5M in interest, fees, and points, out of the construction funds in order to service the loans made by the third parties.
The central issue in Brewer was whether the construction lender could allocate funds to itself out of the construction loan to the detriment of stop notice claimants. The Brewer court, relying on Familian Corp. v. Imperial Bank (1989) 213 Cal. App. 3d 681, found that such a practice was contrary to Civil Code section 3166 (now Civil Code § 8544). As a consequence, the Brewer court held that the bonded stop notices had priority over the $1.5M payment the construction lender made to itself even though the stop notices were served after the pre-payment.
Prior to executing a contract, the contractor’s due diligence must extend to the financing details between the owner and construction lender. The level of diligence and risk taking are influenced by a number of factors, but two are prominent. First, a contractor light on work may be more tempted to take on more risk to stay busy. Second, a contractor doing business with a Grade A REIT will have a higher comfort level when compared to a project sponsored by a single purpose LLC or some other unknown entity. The financing arrangement between the owner and construction lender in Brewer may be atypical, but a contractor should normally, among other things:
- Familiarize itself with the structure of the owner’s organization;
- Research the construction lender;
- Be watchful of creative financing;
- Understand the payment and default terms within the loan documents; and,
- Request access to all loan documents and identification of funding sources.
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