Bradley & Riley PC

On October 2, 2013, the Iowa Court of Appeals upheld a district court jury verdict finding a lender liable to its borrower for breaching a construction loan agreement.  The Court's decision in Vanvelzen v. Security State Bank, No. 3-648/12-1190, is an important reminder that lenders must take seriously the obligations they agree to undertake in connection with loan transactions.

The facts of the case are simple. The plaintiffs entered into a home construction agreement with a homebuilder and also a construction loan agreement with their bank.  As is typical of many home construction contracts, to fund the construction work, the home construction agreement permitted the homebuilder to submit to the lender requests for periodic advances or draws in accordance with the progress of construction.  The construction loan agreement contemplated multiple advances and provided:  "Conditions:  the conditions for future advances are in person or by phone upon receipt of lien waivers in multiples of $1000."

Later, to expedite the draw process, the borrowers and lender agreed to allow the homebuilder to submit draw requests directly to, and receive payment from, the lender without the homebuilder or lender first obtaining approval from the borrowers to make the draws.  Thereafter, the lender advanced money to the homebuilder without obtaining lien waivers and, eventually advanced the entire loan amount of $465,000 before the home was completed.  The homebuilder then defaulted on home construction contract.

The borrowers sued the lender, arguing that because the lender had failed to obtain lien waivers and monitor construction progress in connection with payment of draws on the loan, the borrowers incurred additional costs to payoff mechanic's liens filed by subcontractors who had not been paid by the homebuilder and to pay other contractors to finish the house.  They additionally claimed they had been damaged in that, because of the mechanic's liens and delayed completion of construction, there were delayed in closing on conventional long-term financing. They eventually obtained financing, but at a higher interest rate than originally planned.

Upon the conclusion of trial, the jury found that the lender had breached its contractual obligations under the loan arrangement by failing to obtain lien waivers prior to releasing draw funds to the homebuilder, and awarded damages to the borrowers to reimburse them for costs they incurred in paying off mechanic's liens and hiring other contractors to finish the house, and for the increased cost of the more-expensive mortgage.  The district court rejected the lender's challenge to the jury's verdict, and on appeal, the Iowa Court of Appeals upheld the jury's verdict and the district court's rejection of the lender's challenge to the jury's verdict.

In its ruling, the Iowa Court of Appeals appears to have been particularly concerned that in failing to obtain lien waivers prior to paying draws to the homebuilder, the lender deprived the borrowers of the contractually-agreed upon benefit that this process was intended to provide.  Specifically, they were deprived of the opportunity to ensure that work for which money was being advanced was being done and that subcontractors were being timely paid.

Vanvelzen does not recognize new liabilities for lenders.  Rather, it is a straightforward breach of contract case. In that sense, the case is an important reminder to lenders that if they agree to oversee the construction draw process, they must carefully perform that contractual duty.

That being said, if lenders agree to pay draw requests made directly by a builder, lenders may be able to help shield themselves from liability for claims like those made in Vanvelzen by doing all of the following:  (1) excluding language from loan agreements that would condition payment of draw requests only upon receipt of lien waivers or satisfaction of other requirements and (2) including language in loan agreements expressly providing that (a) the lender may pay draw requests from the homebuilder without assessing the propriety of the request or it's amount, investigating the progress of the work, determining whether subcontractors are being paid, or obtaining lien waivers or releases and (b) that if the lender does any or all of these things, it does so for its own sole and exclusive benefit and not for the benefit of borrowers or anyone else, and that no such conduct by lender shall in any way establish or result in a course of dealing or other modification of the construction loan agreement.

Of course, rarely are there guarantees in litigation, and lenders should be careful that notwithstanding any such disclaimer language, they may still find themselves on the receiving end of a lender liability claim.  Thus, lenders should be careful to price their loans accordingly to compensate them for the risk inherent in a loan arrangement that permits contractors to obtain draws on construction loans directly from the lender, without having to first obtain written permission from the borrower.

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