Jeffrey B. Steiner and Dino Fazlibegu

Given the recent construction boom going on in New York City, commercial mortgage lenders need to be aware of the unique risks associated with making construction loans secured by property located in New York. Construction lenders understand the underwriting risks arising from the performance (or lack thereof) by the developer of its obligations under the construction loan documents, such as the occurrence of delays in completing the project, the failure to ultimately complete the project or the incurrence of costs in excess of the amounts budgeted for construction of the improvements. However, under New York law, construction lenders can also suffer losses vis-à-vis the developer’s construction contractors. In addition to the filing of a mechanic’s lien against the property, an aggrieved contractor that has not been paid by a developer may bring a claim for payment directly against the construction lender if the construction lender does not take certain precautionary steps to avoid such liability.

Limitations on Third-Party Rights

Contractors that have commenced litigation against developers for unpaid sums due to them under construction contracts with developers have at times also included such developers’ construction lenders as defendants. In such cases, the contractors generally argue that the construction lender breached a duty owed to the contractor. For example, the plaintiff in one recent New York case, MLB Constr. Servs., LLC v. Lake Ave. Plaza, NY Slip Op 32823(U) (Sup. Ct., Saratoga Co. 2016) brought an action against the defendant developer’s construction lender based on, among other things, breach of the building loan agreement and of the New York Lien Law. In particular, the building loan agreement between the defendant developer and the construction lender stated that the construction lender may, in its discretion, make loan advances directly to the general contractor or subcontractors as payment under the applicable construction contract instead of making loan advances to the developer. The contractor argued that such a provision is intended to benefit the contractor by imposing the obligation on the construction lender, generally, to ensure that loan proceeds are ultimately used to pay contractors and, specifically, that such proceeds should be paid directly to contractors.

The court in MLB Constr. Servs., however, concluded, that the contractor could not claim that the building loan agreement was intended to benefit any party other than the actual parties to the agreement, namely, the construction lender and developer. The court reasoned that the contractor did not have direct privity with the construction lender since it was not a party to the building loan agreement and it was not a third-party beneficiary of the building loan agreement since the express language in the building loan agreement limited the benefits of the agreement to the contracting parties. Furthermore, the provision regarding construction lender’s ability to make payments to contractors was clearly discretionary, not obligatory, and was intended to protect the construction lender and not any other person. Such provision expressly provided that nothing within said section “shall be deemed to create any specific rights in favor of any third parties” (MLB Constr. Servs. at *11).

Therefore, when making construction loans, prudent construction lenders should limit their direct dealings with contractors and explicitly include in the building loan agreement limitations on the rights of third parties, including contractors, to be beneficiaries of the terms thereof, and the ability of construction lenders to exercise any rights under the building loan agreement that may be viewed as benefitting contractors should, to be extent possible, be discretionary, not obligatory.

“Will Serve” Letters

As discussed above, the lack of a contractual relationship between the construction lender and the contractor is an important factor in determining whether the construction lender has any obligations in favor of any contractors. In connection with the closing of a construction loan, however, the construction lender will usually require a direct agreement from contractors in the form of a contractor’s consent or “will serve” letter executed by a contractor and delivered to the construction lender. Such agreements create direct obligations of contractors to construction lenders by typically requiring the contractor to (i) deliver written notice to the construction lender of the developer’s default and provide the construction lender an opportunity to cure such default prior to the contractor terminating its contract, (ii) continue to perform under the contract even if the developer is in default under the contract (so long as the contractor is paid by the construction lender for all work performed), (iii) collaterally assign the contract to the construction lender and (iv) continue to perform under the contract if the construction lender forecloses or otherwise takes control of the property.

The plaintiff in MLB Constr. Servs. pointed to such “will serve” letter in an effort to establish privity between the construction lender and the contractor and, accordingly, argued that the construction lender had an obligation to indemnify the contractor for payments due to the contractor under the construction contract. The court, however, ruled that the consent “merely provides a basis upon which the lender…, in its discretion, could assume the right and obligations of the owner . . . in the event of [owner’s] default and does not serve to automatically make [the lender] a statutory trustee of the project proceeds” (MLB Constr. Servs. at *13). In reaching this conclusion, the court cited language in the consent providing that nothing therein “will be construed to impose any obligation upon the lender to oversee, assure or verify the application of the proceeds of the building loan agreement” (MLB Constr. Servs. at *11).

Additionally, the consent contains the acknowledgment of the contractor that lender’s obligations under the building loan agreement accrue solely to the benefit of the developer. Therefore, when entering into agreements directly with, or receiving certification directly from, contractors, construction lenders should require express language in such agreements and certifications limiting such lenders’ obligations under them and reiterating the lack of third-party beneficiary status of the contractor under the building loan agreement.

Section 71: Trust Assests

In MLB Constr. Servs. the contractor also tried to claim that the construction lender violated Section 71 of the Lien Law by making loan advances to the developer that should have been held in trust for payment of the construction of the improvements. Section 71 sets forth the manner in which trust assets are to be applied depending on whether the owner or the contractor is deemed the trustee of the trust assets. However, the court found no breach of Section 71 because the construction lender was neither an owner of the property nor a contractor of the related construction. Although the construction lender was entitled to assume the developer’s rights under the construction contract in the event of a developer default, the construction lender had not exercised such right, and, accordingly, the lender was not a statutory trustee subject to Section 71 of the Lien Law.

A different result was reached, however, in Aspro Mechanical Contracting v. Fleet Bank, 293 A.D.2d 97 (2002). In Aspro, the developer entered into a contract with the New York City Housing Authority (NYCHA) to acquire property in Brooklyn in order to construct multifamily residences. Once the property had been improved, the developer was required to convey the property back to NYCHA for an agreed upon sales price. The developer assigned its rights under the contract with NYCHA, including the sales proceeds that the developer would obtain from NYCHA, to the construction lender as additional security for the construction loan. Pursuant to the assignment, the sales proceeds to be received by the developer from NYCHA were paid directly to the construction lender, which sales proceeds were used to pay down the construction loan. Certain unpaid subcontractors claimed that the construction lender was a statutory trustee under the Lien Law and, therefore, the sales proceeds should have been used to pay the plaintiff subcontractors.

The court agreed with the plaintiffs because by virtue of the construction lender’s exercise of its rights under the assignment of the contract, the lender acquired the rights and obligations of the developer “whose rights to the proceeds of the sale were subject to the rights of the [contractors], as beneficiaries of the statutory trust” (Aspro at *99). A lender, therefore, must be mindful when enforcing any rights against the developer assigned to the lender, as such enforcement may create lender liability to contractors under construction contracts.

Conclusion

When making constructions loans, lenders need to be vigilant in their interactions with contractors. Agreements must expressly exclude contractors as third-party beneficiaries, and the ability of lenders to exercise certain rights that may appear to be benefit contractors should be discretionary. Additionally, when exercising remedies under a construction loan, lenders should consider whether the same may result in obligations owed to contractors under the Lien Law.

Jeffrey B. Steiner and Dino Fazlibegu are partners at McDermott Will & Emery. John Bauco, an associate at the firm, assisted in the preparation of this article.