New York's Highest Court Holds Construction Lender Liable to Subcontractors
 
October 5, 2004
 

New York’s Court of Appeals, the state’s highest court, recently issued a decision that applied a new theory to impose liability on a construction lender to subcontractors who had not been paid. In Aspro Mechanical Contracting, Inc. v. Fleet Bank, N.A., decided on February 12, 2004, a lender who apparently had properly applied monies received from the project to repay its loan was held to be a “trustee” under the New York mechanic’s lien law and was liable for misapplication of trust funds for repaying its loan prior to the repayment of subcontractors.

In Aspro, the developer entered into a contract to construct a project on a “turnkey” basis, with the obligation to convey the property to the ultimate user upon completion of the sites comprising the project. The contract provided for the user to make periodic payments to the developer and its general contractor as the work progressed. As additional security for the construction loan, the developer assigned its interest in the contract to the lender. In connection with the assignment, the user made contract payments directly to the lender, who applied such payments to repay the construction loan.

The New York Lien Law provides two forms of protection for contractors, subcontractors and suppliers. First, under Article 2 of the Lien Law, such persons may file a mechanic’s lien. However, construction lenders have priority over liens filed after an advance is made if they comply with a procedure involving the filing in the public records of a building loan agreement, together with an affidavit detailing the use of construction loan funds. In Aspro, there was no issue as to the lender’s compliance with such requirements and the priority of its mortgage lien.

A separate Article 3-A of the Lien Law makes funds received by an owner or contractor for a construction project “trust funds” that must be paid to contractors, subcontractors or suppliers before being applied for any other purpose. The owner or contractor is designated a trustee for such purpose by the law. Construction lenders normally are not trustees under Article 3-A and generally are not responsible for the proper application of trust funds. In Aspro, however, the lender was effectively found to have stepped into the shoes of the developer as a result of having taken an assignment of the developer’s contract with the user. As a result, the lender was deemed to be a “trustee” of “trust funds,” and its application of monies received from the user under that contract to repay its loan was found to be a diversion of trust funds since subcontractors had not been paid. This result is troubling because any construction lender that takes an assignment of monies that might be used for repayment could be treated as a statutory trustee under the rule in Aspro. An obvious example is the construction lender that takes an assignment of a take-out commitment from a permanent lender.

The Court acknowledged that a lender’s use of funds to repay its construction loan is proper as a general matter. It noted that this lender could have protected itself by filing a public notice of its right to repayment. This could be accomplished by filing an instrument known as a “notice of lending” under Article 3-A. Traditionally, this instrument has been used only by lenders advancing funds for construction without a filed building loan agreement, or to permit repayment of advances made prior to filing a building loan agreement. However, with construction lenders at risk of being considered Lien Law trustees under the holding in the Aspro case, the notice of lending can be expected to become a new documentary requirement to protect the lender’s right to repayment.

For more information, e-mail Stephen A. Linde at stephen.linde@hklaw.com or call toll free, 1-888-688-8500.