A common feature of residential construction loans is the requirement for periodic inspections of the progress of work, usually by an independent inspection company hired by the bank, before disbursements are made. The idea is that the loan disbursements should pay only for properly completed work (or suitably stored materials on site), and the inspector is better able than the homeowner/borrower to gauge this. Banks insist on this as a way to ensure that the mortgages securing their construction loans are supported by enough value on the ground to collateralize repayment. Owner/borrowers like it as well; preventing the contractor from getting ahead of them in payments incentivizes proper contract performance, and a set of professional eyes to determine whether the contractor’s draw requests are justified is a welcome feature.
While owner/borrowers may well be relying on proper inspections when signing off on bank disbursements, they are wrong to assume that the bank requires inspections in support of loan disbursements in order to protect them from overpayments. Seymour v. New Hampshire Savings Bank, 131 N.H. 753, 759 (1989), held that “no duty is imposed upon a lender of a construction loan to exercise reasonable care in its inspection of the borrower’s premises, even where the borrower pays the lender’s inspection fee, unless the lender voluntarily undertakes to perform such inspection on behalf of and for the benefit of the borrower.” And such a voluntary undertaking is exceedingly rare.
Suppose the bank’s inspector overestimates the amount of work properly completed by the contractor, resulting in a larger disbursement than justified, and the contractor thereafter abandons the project or refuses to correct shoddy work. That puts the owner/borrower in a pickle. If the Seymour case shuts out a claim against the bank, do owner/borrowers have a legal claim against the inspector, with whom they have no contract? Don’t count on it. In Coachman Estates of Barrington, LLC v. REI Service Corporation, No. 2009-0848 (September 29, 2011), our Supreme Court held that “the role of the construction inspector was to ensure that the bank’s security interest was adequately protected, not to provide technical assistance to the plaintiff in determining the quality of work,” and on that basis rejected the claim that the borrower was a “third-party beneficiary” (see Blog #84) of the inspector’s contract with the bank. Nor does a negligence claim against the inspector appear promising. The economic loss rule, which generally precludes recovery in a negligence lawsuit absent personal injury or property damage and absent a special relationship between the parties (see Blog #29), will be an obstacle here.
Negligently performed inspections can work both ways; inspectors occasionally approve lower disbursements than objectively justified by the contractor’s performance. Usually the owner’s contract with the contractor will require payments as particular performance milestones are achieved regardless of whether the construction lender makes a disbursement – and the owner will be in breach unless personal funds are used to cover the gap. But the owner may not have sufficient personal funds to tap, or may be reluctant to tap them because of faith in the bank inspector’s accuracy. Except in the rare case where the contractor has agreed to abide by the bank inspector’s assessment of amounts earned, this puts the owner at risk of having the contractor suspend or even abandon work if the amount of the underpayment is substantial. Worse, the contractor or one of its unpaid subcontractors could place a mechanic’s lien on the property – which is sure to result in a breach of the owner/borrower’s loan agreement!
There are possible ways to contract around all of these pitfalls, including loan agreements that undertake additional duties to borrowers and contractor agreements to continue the work and waive lien rights despite disagreement with the amount of bank-approved disbursements. All such contractual solutions depend on the leverage possessed by and the negotiation savvy of the parties to these arrangements. Residential owners are usually on the short end here. If you’re wondering how often an owner has hired me to review the documents in advance, I can tell you, it’s a round number. Very round.
While owner/borrowers may well be relying on proper inspections when signing off on bank disbursements, they are wrong to assume that the bank requires inspections in support of loan disbursements in order to protect them from overpayments. Seymour v. New Hampshire Savings Bank, 131 N.H. 753, 759 (1989), held that “no duty is imposed upon a lender of a construction loan to exercise reasonable care in its inspection of the borrower’s premises, even where the borrower pays the lender’s inspection fee, unless the lender voluntarily undertakes to perform such inspection on behalf of and for the benefit of the borrower.” And such a voluntary undertaking is exceedingly rare.
Suppose the bank’s inspector overestimates the amount of work properly completed by the contractor, resulting in a larger disbursement than justified, and the contractor thereafter abandons the project or refuses to correct shoddy work. That puts the owner/borrower in a pickle. If the Seymour case shuts out a claim against the bank, do owner/borrowers have a legal claim against the inspector, with whom they have no contract? Don’t count on it. In Coachman Estates of Barrington, LLC v. REI Service Corporation, No. 2009-0848 (September 29, 2011), our Supreme Court held that “the role of the construction inspector was to ensure that the bank’s security interest was adequately protected, not to provide technical assistance to the plaintiff in determining the quality of work,” and on that basis rejected the claim that the borrower was a “third-party beneficiary” (see Blog #84) of the inspector’s contract with the bank. Nor does a negligence claim against the inspector appear promising. The economic loss rule, which generally precludes recovery in a negligence lawsuit absent personal injury or property damage and absent a special relationship between the parties (see Blog #29), will be an obstacle here.
Negligently performed inspections can work both ways; inspectors occasionally approve lower disbursements than objectively justified by the contractor’s performance. Usually the owner’s contract with the contractor will require payments as particular performance milestones are achieved regardless of whether the construction lender makes a disbursement – and the owner will be in breach unless personal funds are used to cover the gap. But the owner may not have sufficient personal funds to tap, or may be reluctant to tap them because of faith in the bank inspector’s accuracy. Except in the rare case where the contractor has agreed to abide by the bank inspector’s assessment of amounts earned, this puts the owner at risk of having the contractor suspend or even abandon work if the amount of the underpayment is substantial. Worse, the contractor or one of its unpaid subcontractors could place a mechanic’s lien on the property – which is sure to result in a breach of the owner/borrower’s loan agreement!
There are possible ways to contract around all of these pitfalls, including loan agreements that undertake additional duties to borrowers and contractor agreements to continue the work and waive lien rights despite disagreement with the amount of bank-approved disbursements. All such contractual solutions depend on the leverage possessed by and the negotiation savvy of the parties to these arrangements. Residential owners are usually on the short end here. If you’re wondering how often an owner has hired me to review the documents in advance, I can tell you, it’s a round number. Very round.
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