A New Decision Reinforces Stop Payment Notice Risks to Lenders

Lenders have long chafed at the notion that, even after a construction loan is fully disbursed, a construction lender still can be compelled to disgorge earned fees and interest to a stop payment notice claimant.  In Brewer Corporation v. Point Center Financial, Inc., January 31, 2014, 2014 S.O.S. DO61665, the Fourth District of Appeal confirmed this risk, upholding, reinforcing and extending existing law.  For construction lenders, a bad situation just got worse. Brewer Corporation serves as a cautionary tale for construction lenders who have not recently assessed their internal policies and practices vis-à-vis stop payment notice risk management.

A stop payment notice is a payment remedy available to contractors and suppliers.  Where certain prerequisites are satisfied, a claimant may serve a stop payment notice obligating an owner or lender to withhold undisbursed loan funds for the benefit of the claimant.  The failure to honor a perfected and bonded stop payment notice by withholding funds renders a lender personally liable to the claimant.

In “Stop Notice Risks For Construction Lenders” (LA Lawyer Magazine, January 2010)¹,  this author described the bonded stop payment notice risks confronting construction lenders, particularly in light of the harsh decision in Familian Corporation v. Imperial Bank, 213 Cal.App.3d 681 (1989).  In Familian a lender was served with multiple stop payment notices in amounts far exceeding the amount of the undisbursed loan fund.  The lender then foreclosed on its deed of trust, wiping out mechanic’s lien claims.  Under the loan agreement, the lender had segregated portions of the loan proceeds in preallocated accounts from which it paid itself interest and fees.  The lender sought to limit the recovery of stop notice claimants to the amount of the undisbursed loan fund, excluding the preallocated amounts for interest and fees.  The Familian court refused to allow the construction lender to pay itself interest and fees, effectively reducing the loan fund amount, and thereby achieving priority over stop payment notice claimants.  The lender was ordered to disgorge to the claimants interest and fees it paid itself from the loan fund to satisfy the claims.  The Familian decision has long been an anathema to lenders, and many lenders have made efforts to circumvent, distinguish and overturn it.

Similarly, the lender in Brewer Corporation also was served with multiple stop notices.  In this case the lender was a real estate broker who agreed to raise money for a condominium project.  The owner borrowed $13,625,000 from the lender pursuant to a written loan agreement pursuant to which the lender agreed to obtain and lend $2.8 million initially to close the transaction, and to raise and lend additional construction funds in stages.  

The initially raised funds were disbursed to the owner at closing, per the terms of the loan agreement.  As the lender later raised the funds for the balance of the loan, it assigned its beneficial interest in the construction loan trust deed to third-party investors.  Lender then entered into private loan servicing agreements with the investors, by which the lender served as each investor’s agent with regard to the construction loan.  Under this unusual arrangement, the lender paid itself interest, fees, underwriting and other expenses pursuant to these private loan servicing agreements totaling more than $1.5 million.  

Lender disbursed just over $12 million in total loan proceeds, but failed to fund the remaining loan balance.  After the loan fund was fully disbursed, three bonded stop payment notices were served.  The sole issue was the liability of the lender with respect to the stop payment notices.  Relying on Familian, the trial court awarded the claimants $1,555,771—the entire amount the lender had paid itself under the loan and servicing agreements.  The Court of Appeal affirmed the judgment, with one minor exception not relevant here.

For lenders, the Brewer Corporation decision offers this bad news:

•    The court concluded “Familian Is Not Legally Flawed” and endorsed its analysis.

•    Attempts to distinguish the lender’s unusual loan arrangement from the loan agreement in Familian were rejected.  A lender may not through its agreement with its borrower pay itself from loan proceeds in preference to claimants.

•    A lender’s exposure to a bonded stop payment notice claim is not limited to the undisbursed loan amount, and the lender can be required to disgorge amounts paid to itself from the loan.

•    A lender cannot pay itself interest and fees from the loan in preference of bonded stop payment notice claimants irrespective of whether it pays itself fromsegregated preallocated accounts or not.

•    It does not matter that the fees and interest paid to the lender were earned “as earned versus unearned is of little consequence…” in the context of bonded stop payment notices.

•    Unlike in Familian where the lender foreclosed on its deed of trust, thereby arguably achieving a double recovery, the lender’s deed of trust in Brewer Corporation was wiped out by a “super-priority” first trust deed.  The Court rejected this attempt to distinguish Familian stating, “whether a lender forecloses on its trust deed or ultimately realizes a gain or loss is not relevant . . .” in the context of bonded stop payment notices.

The favorable record in Brewer Corporation offered the lender a seemingly ripe opportunity to attack the Familian decision and weaken its foundation.  That attack, however, failed in every relevant respect.  Not only does Familian survive, it is unscathed and remains stronger than ever.

As a practical matter, the Brewer Corporation decision underscores the need for lenders to rely on good underwriting:  a creditworthy borrower and payment guarantor, and good real estate collateral are the first line of defense against stop payment notice risk.  However, if a stop payment notice is asserted, the Brewer Corporation decision underscores the need for both lenders and claimants to carefully assess whether all necessary legal requirements to enforcement have been satisfied.  This is particularly important since the prevailing party on a bonded stop payment notice claim is entitled to recover its attorneys’ fees. 

¹The article is cited in the Court’s decision in Brewer Corporation.

If you have any questions concerning the subject of this article, please contact a member of our Construction team:

Robert Campbell at 310.284.2259 or rcampbell@coxcastle.com

Chad Hales at 415.262.5158 or chales@coxcastle.com