It happens this way: A contractor or subcontractor borrows money from a lender, and as security for the loan it gives the lender an assignment of or lien on its receivables and contract rights. The borrower defaults, and the lender notifies everyone who may owe the borrower money of the lender’s rights to its customer’s receivables, demanding that any further payments owed to the borrower be remitted directly to the lender.
If the construction project is not yet complete, this puts the recipient of the notice in a quandary: paying the lender instead of the general contractor or subcontractor will likely induce a cessation of the work. Worse, a lawsuit against the general contractor or subcontractor for breach of contract after abandonment of the project will almost certainly be futile; the default on its loan usually signals that it won’t be able to pay a judgment and is probably headed for bankruptcy.
Can the recipient of the notice – in legal parlance, an “account debtor” – ignore the lender’s demand and continue to pay his contractor or subcontractor? Not unless he is prepared to pay twice! The Uniform Commercial Code, enacted in all fifty states, favors the lender here, but also provides that paying the lender discharges the account debtor’s payment obligation to the contractor or subcontractor (called the “assignor” in this context). Section 9-406 states that the account debtor “may discharge its obligation by paying the assignor until, but not after, the account debtor receives a notification, signed by the assignor or the assignee, that the amount due or to become due has been assigned and that payment is to be made to the assignee. After receipt of the notification, the account debtor may discharge its obligation by paying the assignee and may not discharge the obligation by paying the assignor.”
The account debtor can and should ask for proof of the assignment and keep his checkbook closed until it arrives, but on receiving that proof the check should be payable to the lender, not the contractor. Payment should be in the full amount currently owed to the contractor, regardless of how much is still owed on the contractor’s loan. Reading Cooperative Bank v. Suffolk Construction Co., 464 Mass. 543, 553, 984 N.E.2d 776 (2013), held that a general contractor receiving notice from a lender who nevertheless paid its subcontractor over $3 million was liable to the lender for “the total value of all payments wrongfully misdirected” even though the subcontractor’s loan balance was only a sixth of that amount. Any subsequent square-up was between lender and borrower, and not the account debtor’s concern.
If the account debtor has a valid legal defense to paying the contractor, the lender/assignee is stuck with that defense under Section 9-404(a), as long as it “accrues before the account debtor receives a notification of the assignment signed by the assignor or the assignee.” This accrual provision prevents the receipt of a lender’s notice from itself being the breach which authorizes the account debtor to stop paying the contractor. Together with Section 9-406(d)(2), it stops construction contracts from thwarting the lender’s statutory rights.
In the commercial setting, sophisticated owners and even some general contractors often protect themselves from the risk of contractor abandonment by requiring a performance bond. In the residential setting, this never happens. No one thinks to ask whether the contractor has pledged its receivables to secure a loan or line of credit. Worse, homeowners often let their payments get ahead of the work performed, putting them in the hole if their contractor abandons the project when its lender pulls the plug on its income stream.
Section 9-404(c) does have a place marker for a different result in the residential construction setting: “This section is subject to law other than this article which establishes a different rule for an account debtor who is an individual and who incurred the obligation primarily for personal, family, or household purposes.” Thus far New Hampshire has enacted no such protective law for homeowners. (A draft Bill is in my desk drawer, if anyone in the Legislature cares to call me.)
If the construction project is not yet complete, this puts the recipient of the notice in a quandary: paying the lender instead of the general contractor or subcontractor will likely induce a cessation of the work. Worse, a lawsuit against the general contractor or subcontractor for breach of contract after abandonment of the project will almost certainly be futile; the default on its loan usually signals that it won’t be able to pay a judgment and is probably headed for bankruptcy.
Can the recipient of the notice – in legal parlance, an “account debtor” – ignore the lender’s demand and continue to pay his contractor or subcontractor? Not unless he is prepared to pay twice! The Uniform Commercial Code, enacted in all fifty states, favors the lender here, but also provides that paying the lender discharges the account debtor’s payment obligation to the contractor or subcontractor (called the “assignor” in this context). Section 9-406 states that the account debtor “may discharge its obligation by paying the assignor until, but not after, the account debtor receives a notification, signed by the assignor or the assignee, that the amount due or to become due has been assigned and that payment is to be made to the assignee. After receipt of the notification, the account debtor may discharge its obligation by paying the assignee and may not discharge the obligation by paying the assignor.”
The account debtor can and should ask for proof of the assignment and keep his checkbook closed until it arrives, but on receiving that proof the check should be payable to the lender, not the contractor. Payment should be in the full amount currently owed to the contractor, regardless of how much is still owed on the contractor’s loan. Reading Cooperative Bank v. Suffolk Construction Co., 464 Mass. 543, 553, 984 N.E.2d 776 (2013), held that a general contractor receiving notice from a lender who nevertheless paid its subcontractor over $3 million was liable to the lender for “the total value of all payments wrongfully misdirected” even though the subcontractor’s loan balance was only a sixth of that amount. Any subsequent square-up was between lender and borrower, and not the account debtor’s concern.
If the account debtor has a valid legal defense to paying the contractor, the lender/assignee is stuck with that defense under Section 9-404(a), as long as it “accrues before the account debtor receives a notification of the assignment signed by the assignor or the assignee.” This accrual provision prevents the receipt of a lender’s notice from itself being the breach which authorizes the account debtor to stop paying the contractor. Together with Section 9-406(d)(2), it stops construction contracts from thwarting the lender’s statutory rights.
In the commercial setting, sophisticated owners and even some general contractors often protect themselves from the risk of contractor abandonment by requiring a performance bond. In the residential setting, this never happens. No one thinks to ask whether the contractor has pledged its receivables to secure a loan or line of credit. Worse, homeowners often let their payments get ahead of the work performed, putting them in the hole if their contractor abandons the project when its lender pulls the plug on its income stream.
Section 9-404(c) does have a place marker for a different result in the residential construction setting: “This section is subject to law other than this article which establishes a different rule for an account debtor who is an individual and who incurred the obligation primarily for personal, family, or household purposes.” Thus far New Hampshire has enacted no such protective law for homeowners. (A draft Bill is in my desk drawer, if anyone in the Legislature cares to call me.)
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