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In a key interpretation of the lien law as it applies to diversion and disgorgement, the Court of Appeals last week sent a loud, clear and potentially costly message to banks: Failure to file a notice of lending is a fatal error. The court’s 6-0 ruling in Aspro Mechanical Contracting Inc. v. Fleet Bank, N.A., 7, means the bank is out $1.9 million that it could have protected merely by filing the proper documentation. The ruling is likely to alter what had become common practice in the lending industry. Fleet in 1989 made $12.5 million in construction loans to Berry Street Corp., which had entered into a turnkey contract with the New York City Housing Authority to buy up property, build houses and then convey title to the agency. When the project was finished, the Housing Authority paid the sum due to Fleet, which then applied that money to the mortgages. Aspro Mechanical Contracting and other subcontractors, who were not paid, sued, alleging that the bank wrongly diverted trust assets in violation of the lien law. Fleet acknowledged that the funds in question were trust assets under the lien law and that it assumed the status of trustee upon the assignment. However, the bank claimed the self-payment, which occurred at a time when Fleet contended the funds were not yet trust assets, was allowable. Fleet contended that the funds were used to pay properly recorded and secured loans and that its interests were superior to the plaintiffs’ under the statutory priority provisions of the lien law. State Supreme Court and the Appellate Division, 2nd Department, found Fleet liable. Thursday, the Court of Appeals affirmed in an opinion by Judge Victoria A. Graffeo that scrutinizes the requirements under Article 3-A of the lien law. The gist of the complicated ruling is that Fleet could have achieved the result it sought if it had filed a Notice of Lending, a commonly ignored requirement under the lien law. Graffeo said the simple filing of that document “would have satisfied Fleet’s fiduciary duty to provide notice to the trust beneficiaries of its use of trust assets to discharge Berry Street’s debt. … Fleet failed to file any document that served as adequate notice to beneficiaries of its status as a trustee and its depletion of trust funds to repay its loans.” Fleet had claimed that mere reference to the assignment in its properly filed mortgage documents fulfilled the practical effect of the notice requirement. But the Court of Appeals looked on that assertion with disdain, especially since in the early stages of the litigation Fleet insisted the assignment had not placed it in a position as trustee. “In essence, Fleet seeks to escape the effect of the assignment by arguing that plaintiffs should have appreciated the implications that Fleet itself refuted,” Graffeo wrote. “Even if plaintiffs had surmised Fleet’s role as the trustee by examining the mortgage documents, those filings would not have informed beneficiaries that Fleet planned to use trust assets to repay itself.” Since the parties stipulated to the amount of damages, $1.9 million, the court did not comment on whether “Fleet’s repayment to itself invalidated its statutory priority as a secured mortgage lender and rendered Fleet liable to plaintiffs for the full amount of the transferred trust funds.” Stuart S. Zisholtz of Mineola appeared for Aspro. Evan A. Davis of Cleary Gottlieb Steen & Hamilton argued for Fleet. “I think that what will happen now is every time a bank has a building loan and has an assignment, they are going to file notice,” Zisholtz said. “That would have protected them. Instead, they didn’t file anything, and no one knew about the assignment until after the fact and the payments had already been made to Fleet Bank.” Davis was not immediately available for comment.

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