When a project becomes distressed and the owner becomes unable to pay its contractors, the construction lender is an enticing target. After all, the bank typically has deep pockets, and is usually intimately involved in the project even before the owner default. After the default, the bank may take over the project and pay contractors selectively. With the owner (which is often a special-purpose entity with no assets other than the property) unable to pay, and liens extinguished by foreclosure, the lender may be the only remaining hope for recovery of unpaid construction invoices.

That was the position in which an architectural firm found itself in a recent case, Creative West Architects, LLC, et al. v. Downtown Natick Dev. Co., LLC. The developer of a residential condominium project in downtown Natick failed to pay the Architects more than $100,000 for work performed when the developer became insolvent, and defaulted on its $8.6 million construction loan from Needham Bank. After it defaulted, the developer had no further involvement in the Project. The Bank assumed all aspects of managing and completing the Project, including paying the existing project manager directly to oversee completion of the Project. The Bank contracted with its own general contractors and subcontractors pursuant to contracts it negotiated and drafted itself, and paid some of the existing contractors directly for construction work performed on the Project. The Bank did not use the Architects to complete the design and construction administration services. Instead, it hired a replacement design firm to complete the remaining architectural work, and it refused to pay the Architects the money owed to them under their contract with the developer.

The Project eventually was sold at a private foreclosure auction; before then, the Bank oversaw all aspects of the foreclosure process, and paid substantial sums of its own money toward marketing costs incurred in publicizing the auction. Ultimately, the Bank took over and controlled sales of the remaining units through foreclosure. After selling two units prior to auction, the Bank acquired the Property at foreclosure through a subsidiary, resulting in a deficiency on its construction loan.

The Architects sued both the developer and the Bank for their unpaid fees. Their primary claim against the Bank was based on the instrumentality theory, under which a lender can be held liable for the borrower’s debts where the lender “exerts such a degree of control over the borrower that the borrower becomes a mere business conduit for the lender.” The Architects alleged that, after default, the Bank effectively took the place of the developer in completing and auctioning off the Project, and that justice required holding the Bank liable for the developer’s debts to the Architects. In pursuing this theory, the Architects faced a high burden: as the Court noted, it required a “strong showing” that the Bank “assumed actual, participatory, total control of [the developer]” and that the developer “was being used to further the purposes of the [Bank] and that in reality the [developer] had no separate, independent existence of its own.”

Unfortunately for the Architects, the Court found that their claim against the Bank was designed to fail. The fundamental and fatal defect in the Architects’ theory was the absence of any control exerted over the developer by the Bank. To the contrary, the facts showed that after default, the Bank took control of the Project and thereafter acted independently and without any participation or involvement from the developer in managing all aspects of the Project’s completion and the foreclosure process. The Court’s conclusion was perhaps best summed up by its observation that “the instrumentality theory addresses control over the borrower itself, not the project.” In this case, the Court found that the Bank merely took control of the Property and acted to protect its security interest under its mortgage agreement with the developer. It never assumed any control over the developer, as opposed to the Project.

In addition, the Court found that the Architects’ plans to hold the Bank accountable were further flawed because of the specific provision in the Architects’ own contract with the developer acknowledging the Bank’s status as a senior creditor who would be paid ahead of the Architects. The Court concluded that the Bank merely exercised its rights as a senior lender under the mortgage – against plaintiffs who were aware of those rights and agreed to take a junior position. The Court reasoned that interference with the allocation of risk negotiated by agreement of sophisticated contractors, owners, and lenders “would impair the value of collateral and chill the extension of credit for housing projects.”

The Creative West decision demonstrates the high hurdle faced by unpaid contractors in holding a bank liable for the borrower’s construction debts, even if the bank takes over and completes the project. The critical question on which the lender’s potential liability will turn is whether the lender took control of the developer as opposed to the project. Liability will not attach to lenders who ensure that the defaulted party is fully removed from further participation or involvement in the project, and who take sole control of the remainder of the project and independently manage and oversee the project through to completion.