For this week’s Guest Post Friday here at Construction Law Musings, we welcome Wally Zimolong for his debut post. Wally is one of Super Lawyer Magazine’s “rising stars” of construction litigation. He publishes the Supplemental Conditions blog and is a member of Sigman & Zimolong.
He represents general contractors, subcontractors, and developers, helping them face the challenges of the construction business. He has successfully litigated cases that resulted in published court opinions and changes in substantive law.
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 line 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 is 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.
As always Wally and I welcome your comments below. Please subscribe to keep up with this and other Guest Post Fridays at Construction Law Musings.
These battles go on and on, with no end in sight. I work primarily in Missouri (where unpaid mechanic’s lien claimants have priority over construction lenders) and Kansas (where priority of all mechanic’s liens is determined by the first day of work by the earliest UNSATISIFIED mechanic’s lien claimant). Night and day.
Thanks for checking in with the midwest perspective Rob
Great post. It’s a tale as old as time that subcontractors and suppliers will think up creative arguments to claim money floating around on a construction project, and lenders will think up creative provisions to protect that money in the event of a default. Something subcontractors and suppliers have to remember is that when things go really, really bad (which is when this stuff comes up), they don’t even get invited to this party unless they file a mechanics lien.