Equitable Subordination: Construction Lenders Beware

Atlantic Builders Group, Inc. v. Old Line Bank (In re Prince Frederick Inv., LLC), 516 B.R. 778 (Bankr. D. Md. 2014) –

A construction contractor contended that the claim of the debtor’s construction lender should be equitably subordinated based on the fact that the lender (1) approved payment applications and change orders, and (2) did not disclose to the contractor that there were insufficient funds to complete construction of the project.

The contractor (ABG) had a contract with the debtor to construct a medical center.  After it began construction, a bank made an initial construction loan of $2,976,000, which was subsequently increased by $350,000 to $3,326,000.  The construction loan was secured by a first priority lien on the medical center.

Under an agreement between ABG and the bank, ABG could not terminate its construction contract with the debtor until the bank had an opportunity to cure any default, provided that as a condition of ABG continuing to provide services under the construction contract, the bank had to advance funds required for completion of construction.  The agreement with the bank also provided that ABG would not permit any change orders in excess of specified thresholds without the prior approval of the bank.

Procedurally, ABG submitted monthly payment applications that included all open change orders, which were reviewed by both the debtor and the bank.  The bank’s agent in turn prepared a monthly report that approved funding requests, including increases in costs associated with change orders.  With the bank’s approval, the debtor increased the amount due to ABG from $2,082,000 to $2,382,614, of which $2,172,950 was paid.

The project experienced numerous problems that added to the costs.  The bank routinely approved requested change orders and authorized disbursements to pay ABG.  It did not indicate that there were insufficient funds to cover additional projected costs.

ABG alleged that the bank (1) had actual knowledge that the debtor was undercapitalized and could not fund construction and (2) knew that the $350,000 loan increase was still insufficient to cover projected costs.  Further, ABG contended that the bank withheld this information in order to induce ABG to complete construction.

The court outlined the test for equitable subordination as follows:

  1. The claimant must have engaged in some type of inequitable conduct;
  2. The conduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant;
  3. Equitable subordination must not be inconsistent with the provisions of the Bankruptcy Act.

After parsing case law on inequitable conduct, the court determined that ABG was required to allege either (1) the bank breached a fiduciary duty that benefitted ABG or (2) “egregious conduct that shocks the conscience of the court.”

Generally a lender does not owe a fiduciary obligation to its borrower.  The exception is when it exercises “dominion and control.”  Basically this translates into usurping the power of the borrower to make business decisions and taking operating control of the debtor’s business.  Typically the lender must actually exercise control, as opposed to merely having the right to do so.

In one example of dominion and control, a lender terminated all employees not necessary to liquidate the borrower’s business, contracted for a security guard, decided which creditors would be paid, and told a corporate officer he could quit if he did not like what the lender was doing.  In contrast, generally courts do not find operating control when a lender only enforces standard loan provisions, monitors finances, or makes business recommendations.

The court concluded that the conduct alleged by ABG fell far short of the required standard for inequitable conduct.  The primary allegation was that the bank reviewed and approved payment applications and change orders.  However (1) ABG entered into an agreement with the bank in which ABG specifically agreed that the bank could review and approve change orders. so the bank was just exercising its contractual rights; (2) as a matter of substance the bank approved every payment application and change order, so there was no basis for asserting that the bank exercised control, and (3) it “does not shock the conscience” that a construction lender would want to review and approve payment applications and change orders for construction work.  Thus, ABG did not state a plausible claim that the bank exercised dominion and control over the debtor.

As to egregious behavior that induced ABG to continue work, ABG did not allege that the bank made any affirmative representation that there would be sufficient funds.  Instead, ABG had a contractual right that gave it a procedure to obtain an affirmative commitment from the bank: When the debtor defaulted, under its agreement with the bank ABG was required to give notice of the default.  Unless the lender agreed to provide funding to complete the project, ABG had a right to terminate its construction contract with the debtor.

On the one hand, the right to approve changes did not create an implied duty to advise that there were insufficient funds, and on the other hand, ABG was required to give notice of any payment default, which would then trigger the bank’s decision of whether to fund payments or allow ABG to terminate.

Thus, the parties agreed on their own procedures for dealing with payment defaults, and the court concluded that those procedures should control:  “ABG seeks to impose a duty on the Bank that was not required by the Contractor Agreement [with the Bank], while absolving itself of an obligation with which it did not comply.”  The court concluded:

[W]e are not willing to embrace a rule that requires participants in commercial transactions not only to keep their contracts but also do “more” – just how much more resting in the discretion of a bankruptcy judge assessing the situation years later.  Contracts specify the duties of the parties to each other, and each may exercise the privileges it obtained.

So, the court found the claim that the bank engaged in egregious conduct was implausible, and thus there was no basis for equitable subordination.

Although the construction lender prevailed in this case, when a project runs into trouble and there are insufficient funds to complete construction, the players will naturally look for options to cover the shortfall.  Claims against a construction lender will often seem like the most viable alternative.  Carefully defining the conditions for a lender’s obligation to fund can reduce the likelihood that there will be a dispute when faced with a shortfall.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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