Midconstruction Refinancing: A Plunge Into The Void?

by Blank Rome LLP
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Law360

Construction loans typically do not get refinanced before a project is completed. A construction loan is short-term in nature and both the lender and its customer expect that they will stay on the project until the project is complete, following the ground rules and administrative framework they negotiate.

There are some occasions, however, where midconstruction refinancing makes sense, particularly in the current environment where financing conditions are improving and more lenders are willing to finance projects in desirable markets (such as New York City) on better terms than were available a short time ago. Some projects that are currently underway were started when the markets were tighter, and are now better able to attract loans on more favorable terms.

A lender who steps into a project mid-course is a newcomer to a party that has already started: the borrower, its architect, contractor and sub-contractors have already negotiated their arrangements, and have established requisition and other procedures with the now-exiting lender. Whether the new lender will be welcomed to the party is uncertain, and separately (and potentially more troubling), there may be surprises that the newcomer will have to face lurking beneath the surface.

General Construction Lender Risks

Construction and its administration can be a rough and tumble process. There is an inherent tension between construction lenders, on the one hand, and design and construction companies, on the other hand, both seeking to protect their ability to recover as much as they claim entitlement to, ahead of other claimants, if a project fails to proceed as planned. New York's statutory scheme — embodied in the Lien Law — strikes an uneasy, and often unwieldy, compromise between the competing interests of the construction trades and banks and other construction lenders.

Funds received by an owner as advances under a "building loan contract" (i.e., a construction loan agreement) are trust assets under a statutory "trust fund" created by the Lien Law, for the benefit of those whose labor and materials improve real property, and the statute requires owners to act as trustees and to apply such assets for payment of the "cost of improvement" and for no other purpose. Included in the definition of "cost of improvement" are labor and materials, a number of other construction-related items, as well as interest and principal on building loan mortgages.

The main lender risk imposed by the Lien Law arises under Section 22, which requires that a building loan contract contain a statement sworn to by a borrower representative — known as a "Section 22 affidavit" — which sets out all expenses to be incurred in connection with the improvement, as well as the remaining amount, representing the "net sum available to the borrower for the improvement." If the requirements of Section 22 are not complied with, the consequences are severe — the parties to the building loan contract (most notably the mortgagee) lose lien priority to a permitted lienor's subsequently filed lien. Thus, although the lender does not sign the Section 22 affidavit, the statute puts the lender at risk if either (1) the contents of the Section 22 affidavit are false, or (2) the proceeds of the building loan are not applied in accordance with the Section 22 affidavit.

Another lender risk relating to construction loans is the risk that amounts paid to a lender will be required to be disgorged as improperly diverted trust funds. The owner, and not the lender, is generally charged with responsibility for maintaining the trust assets and ensuring that they are properly applied for the "cost of improvement." However, if trust funds are diverted, or are paid to payees in an improper order of priority, the recipient can be forced to return them, even if the recipient had no knowledge of the improper diversion.

Fortunately, the Lien Law provides a relatively clear route for a lender to avoid a diversion-of-trust-assets claim, by permitting a lender who expects to receive funds from the borrower in repayment of its loan to file a "notice of lending" under Section 70 of the Lien Law, specifying the advances it is making to the borrower for which it expects to receive payment out of the statutory trust funds.

Another possible trouble area relates to modifications of building loan contracts. Under the Lien Law (also Section 22), any modification of a building loan contract must be filed within 10 days after it is executed and, although not specifically prescribed by the statute, the filing offices (the applicable county clerk) generally require a newly sworn-to Section 22 affidavit to be submitted at the time a building loan contract modification is submitted for filing. Even if the parties abide by the filing requirements for a building loan modification, however, the parties cannot modify an existing building loan contract to adversely affect the rights of a party (i.e., a trust fund beneficiary) who is entitled to rely on the original terms of the filed building loan contract.

For example, if the lender and borrower determine that the hard cost budget will be reduced, and the interest reserve increased, a contractor (a beneficiary of the Lien Law trust) who is not a party to the modification would be able to claim reliance on the higher number specified in the originally filed building loan agreement.

Construction lenders and their counsel are (generally) careful to prepare and file the proper documents to protect the lender against the risks of violating the Lien Law and to be in a position to properly defend a Lien Law claim by a contractor or other party.

When a lender steps into a midconstruction loan, it is exposing itself to as yet unasserted claims — including lien subordination, trust asset diversion and others — relating to the project. Before stepping in, the lender should do as much as possible to identify any issues, obtain information and receive assurances from potential claimants that eliminate or reduce the risk of future claims relating to the exiting lender's regime.

Due Diligence and Administration Challenges

As construction loans are administered, the lender and its advisers (inspecting architects and, as needed, counsel) review monthly requisitions and periodic progress reports to determine how the project is proceeding. As part of the monthly requisition process, the lender obtains lien waivers, certainly from the general contractor or construction manager, and probably from identified "major subcontractors." Also, as part of the monthly draw process, the title insurer issues a title continuation, which indicates whether any mechanic's or other liens have been filed. If there is unsatisfactory work, design and field changes, or delays, the lender team is apprised of them, but may not always detail them exhaustively. Moreover, if things "all in all" seem to be progressing, a lender will often defer taking enforcement action, or threatening to do so, in the hopes that the ship will right itself.

When a lender steps into a partially completed project, it must be mindful that the parties may have accumulated issues that require ongoing dialogue and negotiation. Things may have deviated from the original plan, as they often do, with the parties understanding, more often informally, that they will revisit and reconcile identified issues in a later month. The task of the replacement lender is to understand both the written record and the rest of the story that may be unwritten.

Although the exiting lender would be a good source of information, it is likely to be uncooperative. First, normal commercial prudence (and advice of counsel) will likely dictate that the exiting lender make as few representations as possible. Perhaps more importantly, the exiting lender may have been replaced unwillingly, for example because the new lender's terms are better, giving the exiting lender an added disincentive to cooperate. This dynamic may change somewhat if the exiting lender is itself eager to make an exit.

How then can a replacement lender get comfort that it is not stepping into a mess? It can require that copies of the entire draw package for each advance be delivered to it by the borrower, as they were delivered to the exiting lender. It can inquire of the title insurer whether it has omitted (insured over) any recorded mechanic's liens either currently or in the course of construction.

While "insurance over" is a matter that should be disclosed to the insured (the lender and the borrower), there are instances where title insurers will issue a clean title continuation based on an indemnity (or other underwriting consideration) from the borrower (who is in many instances the party with the relationship with the insurer or its agent). If a lien has been insured over, a subsequent lien that is not insured over will "date back" to the earlier filing date, as a matter of law. The new lender may insist that a new title insurer be brought in, to give the project a fresh start, but the feasibility of pursuing this course may depend on the extent to which existing insurance arrangements will be retained or replaced and may be driven by cost.

The new lender should also review with care the existing architect and construction documents. The borrower and its representatives can be counted on to press the new lender not to "reinvent the wheel" and to accept the arrangements that are in place. There are wide variations in the marketplace relating to the level of scrutiny of design and construction documents, and the lender protections that are required. If the original lender was careful and well-represented at the time of the original loan closing, the architect/engineer and construction contracts will have been reviewed for adequacy and collateral assignments, including "will serve" agreements, will have been executed by the design and construction parties, and consented to by the borrower.

Assuming these documents are determined to be adequate and are by their terms assignable to, or run to the benefit of, a successor lender, they can continue to operate for the new lender. If any inadequacies are identified, the new lender can require modified or new agreements.

Even if the existing documents are strong, it may be appropriate to "downdate" some of the representations and other statements by design and construction parties, to reflect changes to the project design, budget, or scope of work since the time that the original loan closed. For example, a statement by the architect that the plans and specifications comply with law may have been accurate when issued, but may not apply to a set of plans that has been modified internally since the original closing date.

In addition to satisfying itself with the existing arrangements, it is crucial for the new lender to obtain from the main design and construction parties an estoppel certificate or other document that speaks as of the date of the new lender's arrival. The new lender is entitled to know that the contracts it is reviewing have not been modified and that there are no claims that the contractor (or design professional) has for unpaid amounts, additional work, or for matters that were agreed to be addressed or resolved at a future date.

Also, because the design and construction parties are beneficiaries of the Lien Law's trust provisions, if the new lender is modifying the building loan contract or anything else agreed to by the exiting lender, it should get the express consent of the applicable design and construction parties to the modification, to ensure that they agree to be bound by what the new lender and borrower are agreeing to.

Like all construction lenders, those stepping in midconstruction should consider the strength of the borrower and guarantors, and obtain (or succeed to) completion guarantees. Because there are additional risks inherent in a midconstruction scenario, including claims that are allegedly attributable to the acts or omissions of the exiting lender, a new lender should also consider requesting protection from the guarantors with regard to these incremental lender risks arising from acts or omissions prior to the date of refinancing.

The new lender will likely require an assignment of all documents from the exiting lender, and the exiting lender should not object, provided that the assignments are nonrecourse (or limit recourse to the assigning lender to a very short list of matters). Notwithstanding the assignment, it is advisable for the new lender to require a new notice of lending. If for no other reason, a new notice of lending is prudent to obtain because the county clerk may refuse to accept an assignment of notice of lending, and the statute does not provide sufficient comfort that a successor lender will be protected by an assigned notice of lending.

Conclusion

There are many reasons a lender may want to take over a construction loan. Perhaps the lender sees the loan as an opportunity to establish or strengthen a relationship with a developer client. Or maybe the lender has an opportunity to make a "mini-perm" loan that will enable it to capture the post-completion financing that it would otherwise lose to competitors.

Whatever the reason, it is clear that refinancing a building loan during construction raises unique and potentially costly risks for a lender. By careful due diligence and proper documentation, however, a replacement lender may get sufficiently comfortable that the shoes it is stepping into can be made to fit as comfortably as possible.

"Midconstruction Refinancing: A Plunge Into The Void?" by Michael J. Feinman and Beth A. Bernstein appeared in the January 12, 2015 edition of Law360, and was first published in Blank Rome’s Foundation quarterly real estate newsletter, published in December 2014. To read the full article in Law360, please click here, or read Blank Rome’s December 2014 Foundation newsletter here. Reprinted with permission from Law360.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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