Court of Appeal Confirms that Laborers and Materialmen Have Priority over Construction Lenders to Funds Used to Develop the Project

A California Court of Appeal recently ruled that a construction lender must make available to stop notice claimants those amounts which the lender has already disbursed to itself on the construction loan.  (Brewer Corp. v. Point Center Financial, Inc. (January 31, 2014, D0616652014) — Cal.Rptr.3d —-, Cal.App. 4 Dist.).  In reaching this conclusion, the court confirmed its prior ruling in Familian Corp. v. Imperial Bank (1989) 213 Cal.App.3d 681 ("Familian"), concluding that preallocated construction funds that have been paid out to the construction lender do not take priority and defeat a stop payment notice claimant's statutory priority.  However, the court did note that construction lenders remain free to draft construction loan agreements to give themselves a contractual right to priority.

In 2006, Point Center Financial, Inc. ("Lender") lent $13,625,000 to fund the remaining construction of a condominium project located in San Diego, California, adjacent to Balboa Park (the "Project").  Lender agreed that it acted as a "[c]onstruction [l]ender" for purposes of the stop notice statutory scheme.  Under the terms of the construction loan, Lender was obligated to obtain about $2.8 million to close the transaction and agreed to use its best efforts to raise the balance of the loan amount in stages.  As Lender raised funds for subsequent stages of construction, it assigned portions of its interest in the construction loan trust deed to third-party investors.  Lender entered into private loan servicing agreements with its third-party investors, by which it served as each investor's agent with regard to the construction loan.  Significant to this action, Lender prepaid itself interest, loan fee/points, loan underwriting and other fees–totaling $1,555,771.37 as part of these private loan servicing agreements.

By October 2007, Lender had fully disbursed all monies in the construction loan fund.  Thus, when Lender began to receive in 2008 bonded stop notices from contractors providing work on the project ("Contractors"), such as Brady Company/San Diego, Inc., Dynalectric Company, Division 8, Inc., all construction loan funds held by it had already been disbursed.  Upon Lender's failure to withhold and pay funds pursuant to the bonded stop notice, the Contractors filed individual actions against Lender, the owner and others involved in the Project.  After the owner filed bankruptcy, the sole issue before the trial court was Lender's liability with respect to the Contractors' bonded stop notice claims.  Relying on Familian, the trial court determined that the Contractors' stop notice claims took precedence over Lender's alleged contractual right to pay itself all interest, loan fees and other preallocated expenses.

In affirming the trial court's decision, the Court of Appeal explained that California's mechanic's lien statutes prohibit assignments of construction loan proceeds before or after receipt of a stop notice.  Essentially, a stop notice claimant obtains priority over any "assignment" of the construction loan funds.  Assignment, for purposes of the mechanic's lien statutes, is defined as a "transfer of rights or property" and includes a preallocation of construction loan funds and periodic disbursements to the lender.  This statutory protection is designed to supersede the private arrangements of the borrower and lender to ensure that construction loan funds earmarked for construction purposes be used to pay suppliers of labor and materials.  Thus, because Lender's preallocation of funds defeated the express purpose of the stop notice procedure, Lender could not defeat the Contractor's claims with respect to the payments Lender received.

In denying Lender's appeal, the Court of Appeal rejected Lender's argument that it could not withhold funds for Contractors because they had already been distributed to Lender.  Regardless of when the distributions had been made, distributions cannot be made which defeat the express purpose of the stop notice procedure to essentially create a loophole in Lender's favor.  The appellate court further denied Lender's contention that the payments it received were earned in obtaining necessary construction loan funds, refusing to create an artificial distinction between "earned" and "unearned" funds.  Monies in a construction loan fund are intended to pay construction costs, not ordinary expenses incurred in the course of obtaining those loan funds.  Finally, the court did not accept Lender's claim that it did not profit in the transaction and therefore was not unjustly enriched, ultimately finding that equitable principles do not change application of the statutory stop notice procedures.

Finally, the Court of Appeal noted that its decision does not invalidate the pre-allocation of construction loan funds by lenders.  Lenders remain free to draft construction loan agreements to give themselves a contractual right to priority. "It is only in situations, such as the one presented here that lenders' contractual priority cedes to a stop notice claimants' statutory priority, allowing a court to reach back to funds a lender has disbursed to itself as a source to pay stop notice claimants."

In a related issue, the Court of Appeal also held that Dynalectric, a contractor at the Project with a direct contract with the owner, was required to provide a preliminary notice to Lender to enforce its stop notice claim.  The issue involved former Civil Code § 3097(b), which requires all direct contractors, except for the general contractor, to provide a preliminary notice to the construction lender in order to enforce a stop notice claim.  While acknowledging that some ambiguity existed in the former statute (that was applicable in this case), the court ultimately held that Dynalectric fell within the statutory requirement under both the former and current mechanic's lien statutes because the statutory exception for "contractors" only applied to the prime (general) contractor.  However, the court noted that Dynalectric's alternative defense – that it commenced work before Lender issued its construction loan funds – presented a factual issue that had not been addressed by the trial court, and remanded the case to the trial court on this issue.

Additionally, the Court of Appeal ruled that where a subcontractor fails to provide a notice of commencement of action, or provides its notice outside the required five-day notice period, this failure will not defeat the ability of a subcontractor to pursue its claim unless Lender can show that it was somehow adversely affected by the late notice.


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