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DE FACTO DEVELOPER: A NEW BASIS FOR CONSTRUCTION LENDER LIAB

Lenders on construction projects that do not become significantly involved with aspects of the project, other than lending, will usually not be found liable under a lender liability theory. This general proposition of law, however, is tempered by factual scenarios which affect the ultimate outcome. In a recent New Jersey jury case, a lender was held as the "de facto"developer of a condominium project since the Bank exercised such dominion and control over the project so as to step into the shoes of the nominal developer. This article will discuss the peculiar facts of the case, analyze the existing lender liability case law, and attempt to define that level of control which subjects construction lenders to potential developer liability.

The Condominium


The building at issue is an oceanfront condominium in Atlantic City, New Jersey, known as The Ocean Club Condominium, managed by the Ocean Club Condominium Association ("OCCA"). The complex contains twin 32-story high-rise luxury buildings situated on the Atlantic City Boardwalk. There is a common sixth floor terrace with a three-story parking garage below.
The case under discussion involved OCCA's claims for defects in certain common and limited common elements, including balconies, sixth floor terrace, ventilation systems and roof access/egress. OCCA had undertaken certain temporary repairs to the balconies and sixth floor terrace under the direction of consulting engineers. However, these measures were only temporary; more elaborate (and expensive) remediation efforts are required to permanently cure the deficiencies.
OCCA brought suit against the developer, MLM Associates ("MLM"), a New Jersey limited partnership, various contractors, subcontractors, design professionals, as well as Bank of America ("BA"), the construction lender. OCCA's theory against BA was that it became the "de facto"developer of the project by asserting such dominion and control over the project that it deviated from the role of a traditional lender. OCCA sought recovery for defects in the common and limited common elements. The case was mediated, reducing the parties to OCCA, BA and Albert Gardner ("Gardner"), general partner of MLM, for a bifurcated liability trial.
The Court framed the issue for decision on an all or nothing basis; that is, there could be only one developer of the Ocean Club Project; either MLM, the borrower/developer, or BA, the de facto developer. The borrower/developer, MLM, had brought its own lender liability action against BA, alleging interference with the development of the project, loss of the prospective economic advantage of the anticipated profits in the project, and other relief. Thus, both MLM (through its general partner, Gardner) and OCCA, were seeking to impugn BA with liability; Gardner, through traditional lender liability recovery, and OCCA, through a "de facto developer"theory. Both plaintiffs proved their case against BA by unanimous jury verdicts.

Evidence of BA's Control Over the Project


The salient facts in connection with the BA's control, developed during this trial were, in a word, overwhelming. Based upon testimony and documentation the jury found as a matter of fact that BA imposed upon MLM its own choice of construction consultant, and then, without any business reason whatsoever, the project's general contractor. The evidence revealed that loan terms were manipulated by BA to permit the imposition of its chosen contractor into the project, with much more favorable contractual provisions for the contractor than originally contemplated.
Furthermore, the evidence revealed that the BA's inspector, who was visiting the project monthly, performed 30-50 hours per month of "construction project management" off-site. Numerous and detailed correspondence from the project revealed that BA's inspector was involved in virtually every aspect of the project from pre-construction "value engineering", to pre-approval of change orders to making day-to-day construction decisions to the detriment of MLM's on-site construction manager.
In connection with the control of the project, it was confirmed that contrary to normal construction payment procedures, BA paid the contractor directly, by wire transfer, as opposed to including the contractor's requisitions in the monthly payment draw to MLM. These direct payments precluded MLM the normal leverage associated with disbursement of money.
The most telling example of BA's control of the project was control of the project profit; MLM's planned profit of $34.5M turned into a $15M loss, whereas BA's $2.9M planned profit turned into an actual calculated profit of $6.2M, or a net increase of 114%.
Based upon the foregoing evidence, the ten person jury unanimously found that BA interfered with MLM's development of the Ocean Club Project through the imposition of the general contractor, that BA improperly exercised effective control over the construction of the project, and that BA deviated from accepted standards of banking practice in its conduct with respect to the project.

Construction Lender Liability Law Prior to OCCA


A dearth of case law addressing lender liability existed at the time of the OCCA v. MLM trial in New Jersey and throughout the country. Nevertheless, the theme of control and its effect on a particular development are the linchpin of existing precedent. No case involving "de facto"developer liability had been reported, which made the task at hand formidable, to say the least.
The concept of lender liability has its roots in Connor v. Great Western S&L Assn, which dealt with the issue of lender liability for construction defects in a real estate development setting. The facts of Connor are important to gain an understanding of the ultimate holding in the case. The lender, Great Western, agreed to make loans to the developer to acquire developable land on which the developer was to construct homes. In return, Great Western had the right to make construction loans on the homes to be built and the right of first refusal to make long-term loans to the buyers of the homes. After analyzing the factual relationship between the parties, the California Supreme Court concluded that Great Western was not a joint venturer and therefore, not responsible for the negligence of the nominal developer, but rather, found that Great Western was responsible for its own negligence. The court explained Great Western's role in connection with the relationship to the developers as follows,

"In undertaking these relationships, Great Western became much more than a lender content to lend money at interest on the security of real property. It became an active participant in a home construction enterprise. It had the right to exercise extensive control of the enterprise. Its financing, which made the enterprise possible, took on ramifications beyond the domain of the usual moneylender. It received not only
interest on its construction loans, but also substantial fees for making them, a 20% capital gain for 'warehousing' the land, and protection from loss of profits in the event individual homebuyers sought permanent financing elsewhere.

Based upon the foregoing, the California Supreme Court found that the lender was liable on a negligence theory, further concluding that the lender had knowledge that the inexperienced developer constructed homes built on expandable soil and approved plans without addressing those conditions, and further, that the lender knew or should have known that the developer was not adequately capitalized and lacked experience in construction of such magnitude.
However, the ambit of the Connors holding was severely impacted by the California Legislature, which enacted Civil Code §3434, which provided, inter alia, that a construction lender shall not be liable to third persons for any loss or damage in connection with the improvement of real property, ". . . unless such loss or damage is a result of an act of the lender outside the scope of the activities of a lender of money or unless the lender has been a party to misrepresentations with respect to such real or personal property." Following the enactment of Civil Code §3434, lender liability claims in California were not favorably accepted.
Florida courts have dealt with potential construction lender liability in the context of subcontractors suing lenders for liability in connection with alleged negligence regarding disbursement of construction funds. One Florida court held that a lender may be liable, at least to an owner, for improper payments to a general contractor when the lender had knowledge of subcontractor's lien claims. Another Florida court has held that, where a relationship of trust existed between the lender and homebuyers, the lender may be liable to the buyers for breach of fiduciary duty.
The imposition of construction lender liability has generally been limited to situations where the lender, either through a Deed in Lieu of Foreclosure, or through direct ownership, has assumed control of the project. The New Jersey case of Terrace Condominium Association v. Midlantic National Bank presents a situation where the borrower/developer, due to financial difficulties, gave a Deed in Lieu of Foreclosure to the construction lender, which lender completed construction and sold units. The court had little difficulty in concluding that the lender there was responsible to the condominium association as a builder for construction defects, including those which were constructed prior to the lender's takeover of the project. Florida law is in accord with the foregoing.
Therefore, in the absence of the legal involvement by a lender taking over a project, courts have been loath to extend liability to construction lenders. However, the OCCA case represents a departure from this trend and signals a new threshold of lender liability for lenders whose activities during the development of a project exceed the normal level of anticipated lender activity.

Analysis of BA's Control Over The Ocean Club Project


While it is normal for a lender to inspect a construction site on a monthly basis, so as to ensure construction completion for monthly mortgage disbursements, it is extremely unusual for that inspector to be involved, on a day-to-day basis, with the project and bill his or her time to "construction project management". It is also extremely unusual for such an inspector to have the authority to require pre-approval of change orders in amounts as little as $300.00 on a $122M condominium development. In fact, MLM's project superintendent testified that absent telephonic change order approval from representatives at BA in California, work could not proceed at the Atlantic City, New Jersey site.
Such was the level of control that BA exhibited at the Ocean Club project. Coupled with BA selecting the general contractor, negotiating favorable terms in the general contractors' construction agreement with the developer, and paying the general contractor directly, through wire transfer, it is understandable how the jury in this case came to the conclusion that BA exceeded the role of a traditional lender on a construction project and was therefore the de facto developer. A comparison of the profits earned by BA as compared to the losses of MLM establish BA's financial gain to the detriment of MLM, not unlike the lender in Connors, whose control of downstream financing caused developer liability to imbue upon it.

Obviously, the Ocean Club facts are unique and the jury's finding is a direct result of such particular facts presented. Whether other factual scenarios exist which would compel a finder of fact to establish de facto developer status of a construction lender is an open question. However, that quantum of control necessary for a lender to cross the line certainly has been shown to exist in the case at issue. 
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