This blog post appeared as a guest blog post on Christopher Hill’s blog “Construction Law Musings.”   Many thanks to Chris for allowing me to be a guest blogger.  

When a developer defaults on a loan and subcontractors are left unpaid who “owns” the unpaid funds?  That is what must be decided in a dispute between unpaid subcontractors and the project’s lender on a Radisson hotel project in Wisconsin.    ENR reports that the unpaid subcontractors on the project are competing with the project’s lender over unpaid funds in a foreclosure action.  ENR concludes that

“[b]ecause [the lender’s] claim for legal remedy outweighs that of the subcontractors, there is a possibility that the missing payments will never reach the contractors’ mailboxes.”

In most jurisdictions this is true if the battle is over the superiority of a mechanics lien versus a construction loan lien (because the construction loan lien is usually superior) or over whether a subcontractor has a third party beneficiary right in un-dispersed loan proceeds (they do not).  However what about earned funds that the insolvent developer is still holding?  Or, what about funds held in the developer’s account with the bank that the bank seeks to use to off-set any amounts owed to it under the loan agreement (which loan documents often give lenders the right to do)?  In many jurisdictions, case law suggest that in either of those situations, the subcontractor may prevail.

Since the U.S. Supreme Court’s 1962 decision in Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962), federal courts and several state courts have recognized unpaid subcontractors have a “super-priority” to unpaid funds against a competing third party.  Indeed, federal courts hold that in a bankruptcy context money retained by an owner from a bankrupt general contractor is not property of the bankruptcy estate.

In Pearlman, a dispute arose between the trustee and a payment bond surety over funds retained by the construction project’s owner, the federal government. In constructing what has become known as the Pearlman doctrine, the Court held that not only were the retained funds not property of the bankruptcy estate, but also that unpaid subcontractors had a right to be paid directly from the retained funds.  Numerous Circuits  have applied the Pearlman doctrine in varying contexts to uphold a subcontractor’s super priority to unpaid funds against a competing third party.

The scope of relief that the lender in the Raddison case requested is unclear.  If it is a run of the mill foreclosure action against the property, then as the ENR article suggest it would likely prevail, as it would in most jurisdictions.  However, if scope of relief goes beyond simply seeking title to the hotel property and seeks to foreclose on funds the insolvent developer has not paid or is holding in an account with the lender, then the subcontractors may want to keep checking their mailboxes.


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