Construction Lending–Do Lenders ever owe a Duty to Ensure Construction Funds are Used Properly?


Construction SiteI can count on one hand the number of times I’ve seen commercial real estate construction projects come in under budget.  It never fails that last minute changes, upgrades, or “surprises” cause costs to be higher than expected.  Most of the time, one’s construction budget has been pre-approved by the lender and all draw requests are made as one progresses from beginning to end of the project.  So what happens if the lender isn’t really paying attention, funds all draw requests, and construction funds run out while the project is only partially completed?  Whose fault is it?  A question raised by this perpetual problem is what obligation, if any, does your lender have to make sure that your project is progressing appropriately and that the money that the lender has provided for the project is being used appropriately or prudently.

Recently, the Tennessee Court of Appeals decided a case involving a construction loan obtained by Frank and Beverly Booker for the construction of a new home.  Suzich v. Booker, No. W2011-02583-COA-R3-CV, 2012 WL 3055991 (Tenn. Ct. App. July 27, 2012).  Even after increasing the principal amount of the loan from $1.35 to $1.7 million, the loan funds were used before the completion of the home.  The contractor filed notice of his claim for a materialmen’s lien against the property and filed a lawsuit to enforce it, naming the Bookers and the lending bank as defendants.  In response, the Bookers filed a cross-claim against the bank, alleging breach of contract.  The Bookers alleged that the bank breached the following provision of the construction loan agreement because the bank allegedly disbursed all of the loan funds without performing any of the inspections that were allegedly required by the provision:

8.         CONDITIONS PRECEDENT TO ALL LOAN DISBURSEMENTS.

The following conditions will be complied with before [the Bank] disburse[s] . . . and Loan reserves and proceeds. . . .

D.         Inspection.  [The Bank] or [the Bank’s] consulting architect will have inspected the Project and have found the Project at that time reflects good quality work and materials, complies with the Plans and Specifications and completes that construction stage.

The bank answered and denied that it failed to inspect the construction and also denied that it owed any duty to the Bookers to inspect the construction.  Regarding the bank’s alleged duty to inspect the construction, among other provisions, the bank referred the court to the following provision:

13.       AGREEMENTS. Until the Loan and all related debts, liabilities and obligations are paid and discharged, [the Bookers] will comply with the following terms, unless [the Bank] waive[s] compliance in writing. . . .

L.         Lender’s Actions Only for Lender’s Protection.  [The Bookers] agree that [the Bank] and your consulting architect are not obligated to inspect, supervise, prevent Construction Liens, or inform [the Bookers] about the Project’s progress or performance.  [The Bank] and your consulting architect act for your protection when inspecting the Project, procuring sworn statements and waivers of liens, approving change orders and similar actions.  An Inspection for or by [the Bank] does not waive any default and is not a representation that I have complied with this Agreement, any applicable laws or that the Project is free from defective materials or labor.

The trial court entered summary judgment in the bank’s favor, finding that the bank had no duty under the construction loan agreement to inspect the construction of the Bookers’ home for the Bookers’ benefit.  The Court of Appeals affirmed the trial court’s ruling on the bank’s summary judgment motion.

“In the absence of a contrary agreement between the parties, the general rule in Tennessee is that a lender owes no duty to a borrower to disburse loan proceeds for the borrower’s benefit.”  Goodner v. Lawson, 232 S.W.2d 587, 589-590 (Tenn. Ct. App. 1950).  However, an exception to the general rule arises when a lender assumes such a duty by express or implied agreement.  The Tennessee Court of Appeals and courts in other jurisdictions have determined that, under those circumstances, the construction loan agreement governs the lender’s duty.  See, e.g., Lomax v. Headley Homes, No. 02A01-9607-CH-00163, 1997 WL 269432 (Tenn. Ct. App. May 22, 1997).

In Suzich v. Booker, both the trial court and the Court of Appeals upheld summary judgment for the bank and determined that the bank did not have a duty under the terms of the construction loan agreement to inspect the property for the Bookers’ benefit.  The Court of Appeals noted that the construction loan agreement provided that the bank was obligated to disburse advances as long as the Bookers “have complied with all conditions precedent required for each advance.”  The Court of Appeals also noted the provision of the agreement cited by the bank, stating that the bank’s inspections were for its benefit only.

Practice Pointers:

  • Lenders should avoid assuming any duties to disburse funds directly to contractors or other third parties.  If possible the lender should either disburse directly to the borrower upon satisfaction of various conditions or disburse to through a third-party agent (title company).
  • This case demonstrates the importance of reading one’s loan contracts in their entirety to understand the rights and obligations of each party clearly or to be represented by counsel who specializes in real estate finance.  It is vital to be properly represented by counsel in negotiating these types of contracts, especially when the amount financed is considerable, to ensure that your interests are properly protected and to make sure that you understand the risk that you are undertaking in connection with the loan and the contract.  Whether you are the lender or the borrower, it is important to understand each party’s role and clearly lay out each parties duties under the agreement.
  • Construction of large commercial real estate projects (or even an individual’s home) can involve many parties, many loans, and a lot of money.  These projects can be very complicated and many additional complications are certain to arise during the course of the project.  This is why it is so important to involve professional legal counsel from the outset who is trained to anticipate each eventuality and provide for those in the contracts, such as Thompson Burton PLLC.