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.

 

I love that my clients and readers share my views on capitalism.  In response to my previous post, “Need a Construction Loan?  Consider Hard Money Lending,” I received an overwhelming number of questions asking how people can get into the business of lending, rather than borrowing, hard money. I will answer a three of the more frequently asked questions that were emailed to me.

1.  Do I need a license to become a hard money lender?

It depends.  State law governs licensing of mortgage lenders and, therefore, varies from State to State.  However, under Pennsylvania law, lenders making mortgage loans to borrowers  strictly for business or commercial purposes and for non-residential property are NOT required to obtain a mortgage brokers license.  Because the exception to the licensing requirement applies to a narrow classification of loan, lenders should consider obtaining a license.  Furthermore, those operating outside the Commonwealth of Pennsylvania should check with their State’s licensing commission on licensing requirements.

2.  Do I have to comply with the Truth in Lending Act or RESPA?

No, provided the mortgage loan is made to a borrower strictly for business or commercial purposes.    The Truth in Lending Act and the restrictions of Regulation Z, do not apply to “business, commercial, agricultural, or orginational credit.”  Therefore, the various restrictions that Regulation Z places on the types and amounts of fees a lender may charge in a residential mortgage transaction do not apply to typical hard money loans.

Moreover, Section 2606 of RESPA specifically exempts “credit transactions involving extensions of credit . . .primarily for business, commercial, or agricultural purposes.”   However, hard money lenders should be careful not to secure the loan with any part of the borrower’s primary residents, otherwise, TILA and RESPA may apply.

3.  Will you get back to blogging about construction?

Yes, as soon as clients and readers stop asking me about side hard money lending businesses they want to start. 

 

Both in the today’s print edition and on its real estate blog Developments the Wall Street Journal discusses the concept of hard money lending.

As many developers already know, hard money lending is not the dark underbelly of the lending world where loan sharks swarm.  Instead, hard money lending is interim financing similar to a bridge loan.  Hard money loans carry a higher interest rate than conventional financing and have terms that can last as short as a few months.  As the Journal notes,

Hard-money lenders don’t focus much on a borrower’s credit scores. They care more about asset valuations and loan-to-value ratios. Many lenders won’t lend more than 50% to 70% of the home’s value, while banks will lend as much as 80% and government-backed loans can go as high as 96.5%.

Those with shoddy credit are not the only ones that turn to hard money lenders.  Many, who are otherwise creditworthy, but that cannot qualify for traditional bank financing for not credit related reasons, such as current property values or cross collateral restrictions, often turn to hard money lenders.  When the project is completed, these creditworthy borrowers will refinance the hard money loan with traditional bank financing.

For example, consider a developer who may have several mortgages with a traditional bank.   The developer locates a depressed property that it feels can be rehabilitated and flipped for a profit.  The property may literally be depressed – as in the verge of collapse – or the developer may have acquired the property through a foreclosure or short sale.  In any event, the appraised value of the property in its current condition will not support a loan to value ratio sufficient for the developer’s traditional lender to extend it financing for the acquisition and construction of the property.  Or, the developer’s lender’s internal lending guidelines have changed and it no longer makes loans secured by the type of project the developer is proposing.  The relationship between the developer-borrower and the lender may be great and the developer’s loans may all be performing, nonetheless, financing is unavailable.

In this situation, a short term hard money loan is attractive to a developer.  The developer can quickly acquire the property and complete construction.  After completion, the developer will pay back the loan with traditional financing.

Obviously, using hard money for development can be tricky.  First, a developer needs to be sure that the construction can be completed before the hard money loan matures.  Many hard money lenders charge a hefty “roll over” fee if short term loans are not repaid at the end of the term.  Second, a developer needs to be certain that the finished project will have an appraised value sufficient to support traditional financing.  Otherwise, the developer may be stuck with paying a high interest loan to carry the project or, in the worst case scenario, losing the project to a foreclosing hard money lender.

Despite its unearned unsavory reputation, hard money lending can prove to be attractive to developers in unique situations.  For those interested in learning more about hard money lending and borrowing, I hope to have an interview with a hard money lending specialist up in the next few weeks, so be sure to check back.