Chapter 9 - § 9.6 • LENDER'S DUTIES AND LIABILITIES
| Jurisdiction | Colorado |
The vast majority of construction loans run their course with few problems and result in a finished project and a paid loan. However, a significant number of construction loans encounter difficulties as the project progresses, usually related to the pace or quality of construction, and oftentimes related to payment problems resulting in mechanics' liens. Lawyers advising construction borrowers and financial institutions must be aware of the types of claims that are commonly asserted when a construction loan goes sour.
§ 9.6.1-Claims by Borrowers
When all does not go well, the lender is frequently the focus of the borrower's disappointment, anger, and litigation. Usually, the borrower's dissatisfaction is related to the disbursement of construction loan proceeds. Before the funds are disbursed, the typical construction lender will require that the borrower and contractor submit a signed draw request accompanied by invoices for services rendered. The lender may inspect the project or otherwise obtain assurances that the progress of construction warrants loan disbursements. In the worst-case scenario, any diversion of loan funds by the contractor may cause the project to go unfinished, and subcontractors and suppliers will not be paid. Mechanics' liens will result, and the borrower may default on the loan. The lender will foreclose its deed of trust, and the battle will be joined.
Based on Contract
Borrower's counsel will scrutinize the construction loan agreement and may be able to formulate a breach of contract claim against the construction lender based upon the loan documents. If the lender does not follow its own procedures, a breach of contract claim may be viable, particularly in instances where the lender has failed to obtain the borrower's signature on a draw request or has failed to obtain and review invoices submitted with the draw request. However, the borrower should be aware that construction loan agreements are almost always drafted in favor of the lender and typically contain provisions that place the onus on the borrower to ensure that draw requests are appropriate and that loan proceeds are properly disbursed. For example, the construction loan agreement may contain a provision that the borrower represents and warrants to the lender that draw requests will be true and accurate. The agreement may also allow the construction lender to inspect the progress of construction at its sole discretion. As a consequence, a breach of contract claim against the construction lender may be difficult and will depend upon the explicit terms of the loan documents.
Colorado case law pertaining to breach of contract claims in the construction lending arena is sparse. However, the Colorado Court of Appeals considered a breach of contract claim against a construction lender in an unpublished opinion from 1992.60 In this case, a loan guarantor alleged that the lender had a contractual obligation to monitor disbursements made to the borrower. The trial court found no such obligation in the loan documents, and the court of appeals affirmed. Although the construction loan agreement required a request for advance signed and sworn to by the borrower, the court found that the provision did not constitute a promise by the lender to supervise the application of the loan proceeds. The court concluded that such a task was left to the borrower.
On the other hand, in Nolan v. Colorado Mortgage Co.,61 the Colorado Supreme Court held against a lender where the lender required that the borrower submit a construction contract for the lender's review. The lender's president directed that the contract be amended to require that the lender disburse loan proceeds instead of the borrower and to further require that the contractor make requests for payment as the work progressed. The construction loan funds were then placed in an escrow account and disbursed by the lender. As it turned out, work stopped with the residence only one-third complete, and the escrow fund had been reduced to $27.94. The court found that one of the controlling features of the construction contract was that the lender should pay the contractor in proportion to the amount of work completed, up to the balance of the escrow account; if the building was only one-third complete, then the lender was bound to pay not more than one-third of the escrow account. The court determined that the lender was grossly negligent in its handling of the escrow account, even though most of the opinion is devoted to a contract analysis.
In the more recent case of McDonald v. Zions First National Bank, N.A.,62 the borrower alleged that the lender breached the terms of the construction loan documents, as well as the implied duty of good faith and fair dealing, by modifying the project's cost breakdown, failing to notify the borrower of the modifications, and refusing to remit funds because the applications for such funding did not match the new cost breakdown. In setting forth the general law applicable to the borrower's claims, the court of appeals noted that construction loan agreements require "substantial performance," which is achieved when the "'other party has substantially received the expected benefit of the contract.'"63 Based on its determination that the parties' agreement provided the lender with discretion to modify the cost breakdown, the court concluded that the borrower "was entitled to rely on the implied duty of good faith and fair dealing to assert that [the lender] acted unreasonably or dishonestly."64 The court rejected the borrower's argument that the lender acted in bad faith by modifying the cost breakdown because the terms of the parties' agreement allowed such modifications without input from the borrower, and although it recognized that the implied covenant may have required the lender to notify the borrower of the changes so funds could be drawn, the court found in favor of the lender because the borrower's applications had also been rejected based on other contractual violations.65
Based on Negligence
A more common claim that borrowers assert against construction lenders is for negligent supervision, or sometimes more specifically described as negligent disbursement of loan proceeds. Borrowers typically assert that the lender owes a duty to the borrower, independent of any contractual duty, to use reasonable care in administering the loan and supervising disbursement of the loan proceeds. In Baldwin v. Bright Mortgage Co.,66 the Baldwins purchased a lot from a developer and then conveyed the lot to a home builder to assist the builder in obtaining a construction loan from the mortgage company. Problems arose, and the lender foreclosed on the property. The Baldwins were sued for breach of contract by the builder and the developer. The Baldwins were permitted to join the lender to the litigation as a defendant, and they asserted cross-claims against the lender. The lender filed a motion for summary judgment with respect to the Baldwins' claim of negligent disbursement, arguing that it did not owe a duty of care to the Baldwins to non-negligently disburse the loan proceeds. The court of appeals cited Grenada Ready-Mix Concrete, Inc. v. Watkins67 for the following proposition:
The general rule throughout the United States is that where a landowner agrees to subordinate his fee interest to a mortgage lien for the purposes of obtaining a construction loan, without an express covenant from the mortgagee (or lessee-developer) to the landowner, to see to the application of sums advanced, possible diversion of funds by the mortgagor-developer is a risk assumed by the landowner, unless the latter is able to demonstrate fraud or collusion between the mortgagor-developer and the mortgagee.68
The Baldwins had conveyed the property to the builder and did not retain a legal interest in the property. But even if they had retained an interest, the court of appeals held that the lender had no duty to protect such an interest.69
In Cox v. Midland Federal Savings & Loan Ass'n,70 Mr. and Mrs. Cox obtained a construction loan, and the home was ultimately completed. However, mechanics' liens were recorded against the property, and Mr. and Mrs. Cox sued the contractor. The contractor's debts were discharged in bankruptcy. Mr. and Mrs. Cox then focused their attention on the lender and asserted claims for negligence and misrepresentation. After a jury trial, judgment was entered against the lender on the negligence claim, but in favor of the lender on the misrepresentation claim.
The lender appealed and asserted that there was no evidence presented at trial of the standard of care applicable to construction lenders and it was therefore error to submit the case to the jury. The court of appeals agreed and reversed the judgment with directions that the complaint be dismissed. The court of appeals found that the contract between the borrower and lender provided no standard of care and further found that no evidence was presented at trial of any irregularity in the lender's handling of the construction loan. Further, no evidence was presented that the lender had any responsibility for construction delays, cost overruns, or the filing of mechanics' liens. The court stated: "Thus, there is no reason not to apply the general proposition of negligence law requiring evidence of a standard of care to cases such as this. To hold otherwise would be to make a construction lender an insurer or guarantor."71
The plaintiffs did introduce parol evidence at trial that the lender agreed to help select the contractor, guaranteed the contractor's competence, and agreed to supervise construction to ensure that the house would be built for the contract price. The court of appeals determined that the trial court should not have admitted parol evidence to vary the terms of the written loan documents.72 The parol evidence was inadmissible because upon execution of...
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