Source: http://www.lexology.com, September 11, 2015
By: Jeffrey S. Wertman, Berger Singerman LLP
Construction lenders have a financial interest that construction projects are completed, completed on time, and completed without defects. But does a lender have a duty to oversee construction or uncover construction defects? And, if construction is faulty, can the lender be liable if its inspection should have uncovered defective workmanship?
A lender loaning money to a borrower for construction will typically retain a degree of control over the disbursements in agreed-upon installments. Loan documents, including mortgages and loan agreements, normally provide that an inspection is required by the lender before the loan proceeds are disbursed. Sometimes inspections are carried out by third-party architects or inspectors, and sometimes by the lender’s in-house staff. The purpose of the lender’s inspection is to confirm that loan disbursements are being used to pay for the construction and construction is proceeding on schedule. Lenders want to know if the value of the mortgaged property covers the bank’s loan. Can a lender’s inspection give rise to liability for construction effects?
Courts frequently hold, absent unusual circumstances, that a construction lender owes no duty to the borrower or third parties to supervise the construction and development of projects. Even if the loan documents between the lender and the borrower provide that the lender has the right to inspect the construction, this normally does not give rise to a duty by the lender to the borrower or third parties to ensure that the project is properly constructed or free from defects in the design or construction of the improvements. This is the case even if the lender charges an inspection fee.
Lenders, however, can be liable for construction defects if they are actively involved in the construction of the improvements or management of the project or assume control of the general contractor to the degree that a court can reclassify the lender-borrower relationship as a joint venture. The greater the lender’s participation or control in the development, the greater the possibility that a court may determine that the lender is acting outside the scope of its normal lending activities and is liable for construction defects.
Lenders often include provisions in their loan documents to minimize potential liability. For example, loan documents may provide that the lender’s right to inspect the mortgaged property and monitor the operations and activities conducted on the mortgaged property are for the sole and express purpose of protecting the lender’s security interest and are for the lender’s sole benefit. In addition, loan documents can further state that neither the borrower nor any third party shall have any claims against the lender as a result of such inspections, and that the lender assumes no obligation of the borrower or any third party as to the quality of construction of the project, compliance of said construction with the drawings and specifications, or any defects in said construction. As construction projects continue to flourish in South Florida, lenders should be cognizant of their rights and duties and how to lower their risk of litigation.