Opinion ID: 1721223
Heading Depth: 1
Heading Rank: 5

Heading: Construction Lenders Vs. Landowner

Text: We now turn to the conflicting priority claims of the landowner and its supposedly subordinated purchase money deed of trust vis-a-vis the construction lenders. The landowner's claimed priority is arguably more troublesome than that of unpaid materialmen and construction lienors who are claimants normally thought to stand upon a much higher plane than would the subordinated landowner who contributes no materials or efforts to the construction job, and who has at his disposal a means for protecting his interest in any commercial venture by insisting upon the inclusion of protective language in the documents compromising the [subordination] agreement. Grenada Ready-Mix Concrete, Inc. v. Watkins, 453 F. Supp. 1298, 1314 (N.D.Miss. 1978). The Chancery Court nevertheless held that the landowner was the holder of a perfected security interest in Tracts I, II and III prior in right to any claims or interests of the two construction lenders. The Chancery Court emphasized its previously described findings of fact of lack of reasonable diligence on the part of the construction lenders and that no part of the construction funds went into the still uncompleted improvements on Tracts I and II. The decision of the Chancery Court was ultimately predicated upon inequitable conduct participated in by the construction money lender (banks) and the builder (Bruce) over which the landowner (L & T) had no control, and who is damaged unless this Court intervenes. In the absence of an authoritative decision from this Court, the Chancery Court made its adjudication within the framework recognized by the United States District Court for the Northern District of Mississippi in Grenada Ready-Mix Concrete, Inc. v. Watkins, 453 F. Supp. 1298 (N.D.Miss. 1978). In Grenada Ready-Mix the District Court, faced with a duty to apply substantive Mississippi law (likewise in the absence of guidance by an authoritative decision of this Court [9] ) stated the general rule as follows: Absent express clauses in the loan documents directing or restricting the use of construction funds to a particular project, the subordinating landowner bears the risk of diversion by a developer who obtains a mortgage to finance improvements. 453 F. Supp. at 1314. Judge Keady then recognized an exception to the general rule in cases where the landowner can show fraud, collusion or other inequitable conduct participated in by the mortgagee and the mortgagor-developer. 453 F. Supp. at 1314. Under these circumstances, the landowner's claims to the property should be given priority over those of the construction lender. Relating this exception to the facts of the case under consideration, Judge Keady stated: Of course, had Watkins [builder] used none of the loan funds at the Grenada site, and had Guaranty [construction lender] been aware of such diversion, that would constitute fraud or collusion justifying the Court in invalidating both the ground lease and the subordination executed by the landowner. 453 F. Supp. at 1313. Fraud or collusion are strong words which in our view are inappropriate in the present factual context. [10] Negligence is a fairer appellation applied to the conduct of the construction lenders here. The Chancery Court described it as inequitable conduct. Pretermitting the necessity for deciding whether we should fall in line with the majority rule or the minority rule and likewise without worrying about whether we are dealing with the general rule recognized in Grenada Ready-Mix or the exception there noted, we think the rule which must be applied in this case is clear. That rule is this: Absent express agreement to the contrary, [11] a construction lender owes a duty to the landowner who subordinates his purchase money deed of trust. That duty is to exercise reasonable diligence to see that the funds loaned are in fact used in the construction project. If the construction lender fails to exercise reasonable diligence in this regard, its deed of trust will be prior in right to the landowner's purchase money deed of trust only to the extent that proceeds of the construction loan actually went into the construction project. [12] The California case of Middlebrook-Anderson Co. v. Southwest Savings and Loan Association, 18 Cal. App.3d 1023, 96 Cal. Rptr. 338 (1971) justifies this rule as follows: As between the seller and the lender, the lender is by far in the better position to control the use of the loan proceeds and thereby prevent misappropriations by the developer. The lender can require documented evidence that expenses have been incurred and can corroborate this by on-site inspections. It is common for lenders to control disbursements, since they, too, have an interest in preventing misuse of loan proceeds ... An implied agreement in the instant case can and, in equity, should be spelled out from the lender's actual knowledge of the provisions of the seller's lien in general, and of the subordination therein in particular. In the superior position of a financial institution constantly engaged in professional construction lending, Southwest had no reason to believe their trust deed conferred any lien to which the fee was subordinate other than to the extent of money spent for construction purposes. Its loan under the circumstances cannot be viewed other than as subject to the fair application of the construction funds. Accordingly, we conclude that such lien as the trust deed might have conferred on the seller should not be advanced or preferred over the seller. 18 Cal. App.3d at 1036-1037, 96 Cal. Rptr. at 346-347. [13] We recognize, of course, that relative degrees of sophistication and bargaining power will vary from seller/landowner to seller/landowner and from construction lender to construction lender. Still it is a fair assumption, generally speaking, that (A) The typical construction lender has greater expertise due to experience and proximity when it comes to supervising application of disbursements under a construction loan, and (B) The typical construction lender because of his control of the actual disbursements has a far greater capacity to see to the application of the loan proceeds than does the typical landowner. We emphasize that the rule enforced here in no way imposes upon the construction lender a standard of care foreign to that to which he is already subject under the positive law in this state. In our discussion in Section IV(B) above, we have noted that construction lenders for years have been subject to the duty to exercise reasonable diligence to see that their loan proceeds actually go into the construction project. For reasons which are surely obvious, the standard of care to which the construction lender should be held here should be the same vis-a-vis the original seller/subordinator/landowner as it is vis-a-vis the materialman/construction lienor. The law either should  or should not  impose upon the construction lender the duty to exercise reasonable diligence to see that the funds loaned are in fact used on the project. No rational loan officer will choose to exercise such diligence  or decide to worry about that loan tomorrow  by reference to whether he happens to be thinking of potential conflicts with unpaid materialmen or with the unpaid subordinated purchase money lienor. The duties imposed by the law should be no more schizophrenic than are the people whose conduct they order. For these reasons, so much of the decision of the Chancery Court as affirms the priority of the landowner L & T over the claims of the construction lenders is and should be affirmed.