By Thomas J. Hall and Douglas M. Fried

Lenders want to be repaid. Taking prudent steps to protect the value of collateral enhances this prospect. In construction financing, lenders have a legitimate interest in assuring that loan proceeds are put to good use and that the construction work is properly performed in a timely manner.

However, where is the line between a lender taking responsible and prudent steps to protect its capital and security, and the lender exercising management over the construction so as to expose itself to liability for construction defects?

A recent jury verdict in the New Jersey Superior Court can be instructive for all types of construction lending.

The Allegations

In 1999, the Ocean County Club Condominium Association brought suit against the developer of its Atlantic City high-rise condominium complex alleging, among other things, defective construction work including leaks, deteriorating balconies and building code violations. The developer, in turn, brought suit against its construction lender, Bank of America National Trust and Savings Association, alleging that the bank was responsible for any such construction defects.

The developer’s complaint charged that the bank, as a condition to its financing, required the developer to retain Pavarini Construction Company, Inc. as the general contractor. The developer charged further that the bank knew, or in the exercise of reasonable diligence should have known, that Pavarini was not competent to construct or promptly complete the project. The project needed a contractor with experience in high-rise, ocean-front construction. The developer claimed that the bank required that Pavarini be hired to further that bank’s own business relationship with Pavarini. The developer also claimed that the bank misrepresented the ability and qualifications of Pavarini and induced the developer to accept Pavarini as the contractor.

The Verdict

Following a three-month trial, the jury found the bank liable in late September, concluding that the bank had deviated from accepted standards of banking practice and improperly exercised effective control over the construction. The jury returned a punitive damage verdict against the bank in the amount of $6.6 million. In a procedural quirk, a separate jury will now determine the amount of compensatory damages, if any, to be awarded to the developer. These verdicts are subject to post-trial motions and appeal.

The Lesson Learned

There are various ways by which a construction lender can protect its collateral while minimizing its potential liability exposure. The key is to leave decision-making with the borrower while establishing certain parameters to protect the lender. For example, instead of requiring the developer to use a particular contractor, the lender could have retained approval rights over the developer’s choice of contractor. Alternatively, the lender could have withheld commitment to the financing until such time as the borrower selected a reputable contractor acceptable to the lender, or the lender and borrower might have agreed to a list of acceptable contractors from which the contractor could choose. Variations on these approaches exist. With any of these approaches, appropriate disclaimers in the loan documents would be helpful as well as a contractual obligation that the borrower thoroughly investigate the qualifications of the contractor it chooses. These concepts could also be made applicable to the selection of major subcontractors and other professionals.

What may have doomed the bank in this case is the charge that the bank directed the use of a particular contractor out of its own self interest. The developer alleged — and apparently the jury believed — that the bank imposed the contractor, not to assure that the construction would be satisfactorily performed, but to advance its own relationship with the contractor. In the jury’s mind, this may have been where the line was crossed.