Construction Law Today

Mechanics Lien Priority: Contractor vs. Lender - Part 1

Joshua Glazov — Tue, 09 Mar 2010 07:01:59 -0500

When both a mortgage lender and a mechanics lien holder foreclose against the same piece of property, who gets priority to the money paid at the foreclosure sale? One recent Illinois judicial decision, LaSalle Bank, N.A. v. Cypress Creek 1, LP, says they both do, depending on what part of the property you're talking about:

The lender's mortgage gets priority on the value of the property before improvement by designers and contractors
The mechanics lien gets priority on value added to the property by improvements from designers and contractors
Then, to the extent the lender pays off someone who holds a properly perfected mechanics lien, the lender succeeds to the priority of that mechanics lien claim too. But that's only to the extent the lender pays off someone who holds a perfected mechanics lien. The lender doesn't succeed, and doesn't get more senior priority, just because they pay money to a designer or builder who provided lienable work, but didn't perfect a mechanics lien for that money against the property

LaSalle Bank, N.A., v. Cypress Creek 1, LP

Judges from the Illinois Appellate Court (Third District) addressed these issues in their Cypress Creek decision. They focused on who gets priority between two rival claims to the purchase money paid at the foreclosure of a property with a partially completed construction project.

The rivals for priority:

The construction lender with a mortgage against the property (the "Lender")
Two unpaid contractors, each with a perfected mechanics lien against the property (the "Perfected Contractors")

Priority Basics

Before we get into the details of the Cypress Creek decision and who got what, we first must divert our attention to a short introduction on the basics of priority, why it's important, and why it's important enough for the Lender and the Perfected Contractors to go to court over it.

Priority is about who gets something first (it's actually derived from the Latin word meaning "first"). Priority becomes especially important when there's not enough to go around.

I've found it helps to visualize priority by imagining yourself on a really hot and humid summer day. You see neighborhood kids selling ice cold lemonade in a front yard lemonade stand. Beads of condensation drip down the side of the cool lemonade pitcher. It draws you forward.

But there's trouble. There's only one pitcher of lemonade to serve you and a long line of thirsty customers. There's not enough lemonade to go around!

So you and the other erstwhile customers form up in a queue before the lemonade stand to fill your cups. These kids sell on a "first come, first served" basis. So when the lemonade runs out, whoever's still in the queue with an empty, or only partially filled, cup goes away with less than a full vessel. They're going to go away thirsty, disappointed, and grumpy too.

This is where "priority" matters. Priority sets where you stand in the queue relative to everyone else. The more "senior" your priority, the closer to the front of the queue you stand. The closer to the front you stand, the better your odds of filling your cup all the way.

So everyone wants the most senior priority. It's over priority seniority where the rivalries start. In front of judges is where the rivalries often end.

Coming Up Next

In Mechanics Lien Priority: Contractor vs. Lender - Part 2, we'll talk about:

The backstory of the Cypress Creek decision
How the judges divided up the money from the foreclosure sale into separate parts (or pitchers)
How, and why, the judges gave the Lender a more senior priority on one part of the money, and the Perfected Contractors a more senior priority on another part

Performance Bonds and Green Building: Interview With Green Building Law Update's Chris Cheatham

Joshua Glazov — Wed, 03 Mar 2010 12:46:35 -0500

Chris Birk from SuretyBonds.com recently interviewed Green Building Law Update's Chris Cheatham about how green building affects performance bonds and the DC green building law. The interview is informative and I enjoyed listening. It's 15 minutes well spent. Click here to tune-in.

Construction Contract Dispute Resolution: What Do You Prefer?

Joshua Glazov — Wed, 24 Feb 2010 06:55:28 -0500

In presentations I often mention that every construction contract is the beginning of a construction dispute. The same usually applies to architects agreements and other design contracts too. With that in mind, I'd like to hear from you. What terms do you prefer in your contracts for resolving disputes: nothing, mediation, arbitration? Vote below. And add a comment to elaborate on your vote...

What Do You Prefer In Your Contracts For Resolving Design and Construction Disputes?(trends)

Economic Loss Rule: Arizona Applies It to Construction Claims

Joshua Glazov — Thu, 18 Feb 2010 12:35:39 -0500

The Arizona Supreme Court applied the economic loss rule (the "ELR") to bar a construction related claim for the first time last week.

Overly simplified, the ELR is a judge-made rule that bars many extra-contractual claims for design and construction defects when those claims seek only damages for the cost to repair or replace defective work, not damages for death, personal injury, or damage to other property.

In Flagstaff Affordable Housing Limited Partnership v. Design Alliance, Inc. the Justices applied the ELR to deny an owner's claim against their architect for negligent design of an affordable housing project in Flagstaff, Arizona.

Backstory of Flagstaff Affordable Housing Limited Partnership v. Design Alliance, Inc.

It started when an owner hired an architect to design an affordable housing project. The United States Department of Housing and Urban Development ("HUD") required the project to comply with accessibility guidelines established under the Fair Housing Act. When the project failed to comply with those guidelines, HUD sued the owner.

After the owner and HUD settled, the owner sued the architect for negligence to recover part of the cost of complying with their HUD settlement. The owner alleged that that the architect's negligent design caused the project's failure to comply with accessibility guidelines, so the architect should pay for at least part of what the owner had to pay to HUD because of that failure to comply.

The architect's asked the trial judge hearing the case to dismiss the owner's lawsuit. The architect's principal reason: the ELR. The owner's damages: the cost to retrofit the project and ensure compliance with the accessibility guidelines. No damages for (a) anyone's death, (b) personal injury to anyone, or (c) injury to property other than the non-compliant project that the architect designed. Under the ELR the architect argued, retrofitting costs aren't eligible for payment under a negligence claim.

The trial judge initially hearing the case agreed with the architect and dismissed the owner's lawsuit. But the owner appealed to the Arizona Court of Appeals. The judges there disagreed with the architect and reinstated the owner's lawsuit. The architect appealed that decision to the Arizona Supreme Court.

Decision on Appeal

All of the Arizona Supreme Court justices hearing the case together agreed with the architect: the ELR bars the owner's negligent design claim against the architect for the cost to retrofit the project.

Policy Reasons

The judges focused on the ends served by negligence and its jurisprudential cousins in tort law: promoting safety and spreading the cost of accidents when safety measures don't avert injuries. Paraphrasing the judges explanation for why those ends aren't served by making the architect pay for retrofitting costs:

In construction defect cases involving only repair and replacement of the construction work itself, there are no strong policy reasons to impose common law tort liability in addition to contractual remedies.

The policies of accident deterrence and loss spreading also do not require allowing tort recovery in addition to contractual remedies for economic loss from construction defects. These considerations have less force when parties to a site-specific construction contract have allocated the risk of loss and identified remedies for non-performance in their contract.

The ELR applies in this context because construction contracts typically are negotiated on a project-specific basis and the parties should be encouraged to prospectively allocate risk and identify remedies within their agreements. These goals would be undermined by an approach that allowed extra-contractual recovery for economic loss based not on the agreement itself, but instead on a court's post hoc determination that a construction defect posed risks of other loss or was somehow accidental in nature.

We accordingly apply the ELR and hold that a contracting party is limited to its contractual remedies for purely economic loss from construction defects.

Treat Professional Negligence Differently

The owner urged that whether or not the ELR bars negligence claims for retrofitting costs against a contractor, it shouldn't apply against professional negligence claims against an architect. Architects aren't the same as contractors the owner argued because:

The relationship between an owner and their architect is special and should get special treatment from judicial treatment
Architect are license professionals governed by statutorily imposed duties and standard

And because of these difference the owner argued, the ELR shouldn't apply.

The Justices didn't agree. They applied the ELR to bar the owner's professional negligence claim for the cost to retrofit the project.

Conclusions

For Architects and Other Design Professionals: This is a great decision for you. It says that, at least when it comes to claims for the cost to correct for design defects, your clients must bring their claims under the contract between you and them. That could benefit you, especially:
- If those contracts include an enforceable limitation of liability clauses
- Because the damages allowed for breach of contract claims (e.g., consequential damages) are more limited than damages allowed for extra-contractual claims (e.g., negligence)
- If the limitations period on breach of contract claims is shorter than extra-contractual claims
For Owners: This decision re-affirms how critical it is to ensure you protect your interests in your contract with your architect, engineer, or other design professional. This decision suggests that the same applies to your construction contracts too. If it costs you money to repair or replace work because of a design or construction defect, your contract may provide the only means to recover that money from those responsible for the defect. That means focusing on things like:
- Defining the standard of care in contracts with your architect, engineer, or other design professional and having them promise in the contract to comply with that standard
- Ensuring your contract has robust warranties from your prime contractor in your contract. Focus extra attention on the scope and duration of warranties from subcontractors and material suppliers and get assignments of those warranties to you. When the ELR applies to bar extra-contractual claims, your only recourse for the cost to repair, replacing, or retrofitting defective work is your warranties. When defects surface, you'll usually be better off when you can point to warranties in in your contract that haven't yet expired
- When the statutes of limitation and statutes of repose on design and construction defects are set start running and expire. Consider carefully, with a lawyer, terms in your contract that may start either running earlier or make them expired sooner.
For Contractors: Even though no contractor was involved here, the Justices' remarks suggest this decision will affect you too.
- The good: Dealing with people up the chain from you (e.g., the owners, or, if you're a subcontractor, the prime contractor or upper tier subcontractors), this decision suggests that defective construction claims against asking for repair or replacements costs must be breach of contract claims. You benefit because the damages available for those claims are more limited and terms in your contract may reduce your exposure (e.g., limitations of liability, warranties with a more limited scope and shorter duration)
- The bad: Dealing with people down the chain from you (i.e., your subcontractors), the tables are turned on all of the good things mentioned just above. You need to ensure that if a repair or replacement claim comes down to you from up the chain because of defective work by someone down the chain, the terms of your subcontract don't prevent you from passing responsibility down the chain to whomever was actively responsible for the defect. Limitations of liability and narrow or short warranties could be just the kinds of things that could prevent you from passing that responsibility down.

For Everyone: Like most ELR decisions, the reasoning in this one is difficult to follow. And because it's difficult to follow, it will be difficult for other Arizona judges to decide whether to apply the ELR in other situations. Odds are good that Arizona will join states like Colorado, Florida, and Wisconsin where the ELR jurisprudence is unclear and unpredictable, regardless of whether it's in the context of design and construction defects or for other defective goods, services, real estate, or intellectual property. Be prepared for years of protracted ELR litigation in the courts sitting in Arizona.

Uncertainty fostered by, and surrounding, the ELR is a call to everyone to focus on what their contract say, regardless of whether they're inside, or outside, of Arizona. Contracts, and the warranties within them, often will be the only recourse there is for the cost to repair, replace, or retrofit a project suffering from defective design, material, or construction work.

Construction Claims and Cases On The Rise

Joshua Glazov — Tue, 09 Feb 2010 16:07:43 -0500

In Building Overrun Cases on the Rise, journalist Ed Hammond at the Financial Times reports that late completion disputes are already rising this year in the UK. He also mentions:

With projects started in better times now yielding lower occupancy and returns, owners are more inclined to pursue claims against their contractors
Liquidated damages claims for late completion are rising in frequency and amount
Austere times and pressure on margins are compelling owners and contractors to become more contentious and adversarial
The Construction Products Association predicts a 3% decrease in spending for 2010

Will these tends continue in the in the UK? Will they cross the Atlantic to North America too?

As construction disputes intensify and relationships become more strained, your contracts will come under more scrutiny. Are you and your contracts fortified for that?

Green Construction Curb Appeal: Looks Matter

Joshua Glazov — Fri, 05 Feb 2010 07:01:38 -0500

In Overcoming the Ugly Factor in Building-Integrated Solar Design, journalist Jennifer Kho reports on how Skidmore Ownings, & Merril and the Rensselaer Polytechnic Institute are collaborating to make solar energy-gathering materials look better.

One source says "most applications thus far are pretty ugly and impede your view."

While visual elegance may not seem like a serious concern to those determined to generate electricity from the sun, for architects and developers looking to sell or rent properties, looks matter.

The SOM/Rensselaer collaboration is focusing on a dynamic solar facade, a panel composed of glass elements like the one to the right. In its current design, it's hung on wires that move up and down and twist from side to side to track the sun. The idea is to produce a system that combines aesthetic appeal with more efficient capturing of the sun's UV radiation.

Engineers and designers recognize that for building owners and operators who must rent and sell property to meet pro formas and satisfy investors and lenders, energy efficiency and government incentives aren't the only factors in the green building calculus. Like it or not, curb appeal attracts tenants and buyers. The engineers and designers are addressing that factor too.

Real Estate and Construction in Chicago: Crain's Sobering Video Forecast

Joshua Glazov — Thu, 04 Feb 2010 07:01:21 -0500

Focusing locally today on my own hometown, this Crain's broadcast offers a sobering forecast for the Chicagoland residential real estate and construction markets. Do you agree? Watch the video, vote, and elaborate by posting a comment using the link below below.

Arbitration Waived by Demand to Foreclose Mechanics Lien

Joshua Glazov — Tue, 02 Feb 2010 07:09:00 -0500

Judges to owner: demanding that your contractor foreclose their mechanics lien within 30 days or lose it forever waives your right to require arbitration.

The Backstory of Illinois Concrete-I.C.I., Inc. v. Storefitters, Inc.

Unfortunately, the Illinois Appellate Court (Second District) decision in Illinois Concrete-I.C.I., Inc. v. Storefitters, Inc. (PDF) doesn't give us too many background details. Here's what we can gather: an owner entered into a contract with a contractor to provide some type of construction work for the owner. The contract had an arbitration clause, presumably one that says that if the owner and the contractor get into a dispute, they must submit the dispute to binding arbitration instead of resorting to the courts.

The owner and the contractor got into a dispute. The owner didn't pay. So the contractor recorded a lien against the property they'd worked on.

Under Section 34 of the Illinois Mechanics Lien Act (PDF) an owner (and others too) can serve a written demand on anyone holding a mechanics lien against their property (a "mechanics lien holder") demanding that the mechanics lien holder sue to foreclose their mechanics lien within 30 days (a "Section 34 demand"). And if the mechanics lien claimant doesn't go to the clerk of the court and file their foreclosure complaint before that 30 days expires, the mechanics lien claimant forfeits their lien.

The idea behind Section 34: owners and others can clear mechanics liens off of their property in a short amount of time. The owner can tell the mechanics lien claimant: you've got 30 days to fish or cut bait. At the same time, it gives mechanics lien claimants time to gear-up, get to the courthouse, and sue to foreclose their mechanics liens.

The owner in this case decided to use Section 34, probably hoping that the contractor wouldn't pick up the gauntlet within 30 days. But the contractor did pick up the gauntlet, went to the McHenry County courthouse, and filed a complaint to foreclose their mechanics lien. By the way, the old McHenry County courthouse, made famous as the backdrop for Bill Murray in the movie Groundhog Day, sits on the main square in Woodstock, Illinois.

The owner responded by asking the judge to divert the case to arbitration as provided in the contract. The contractor opposed arbitration, arguing to the judge that by serving a Section 34 demand, the owner backed the contractor into a corner and compelled them to sue. By doing so, the owner waived whatever right they might have had to arbitrate their disputes instead of taking them to court.

Hearing the case, Judge Michael T. Caldwell agreed with the contractor and denied the owner's request to send the dispute to arbitration. The owner appealed.

Decision on Appeal

On appeal, the owner offered six arguments for why their demand on the contractor to sue to foreclosure or lose their lien shouldn't be considered a waiver of the owner's right to require arbitration. The judges hearing the appeal agreed with none of the six. Instead, they said something like this:

The key issue is whether the owner, by filing their demand, acted in a manner inconsistent with their right to seek arbitration. We hold that they did. Following such a demand, a mechanics lien claimant must sue to foreclose within 30 days or lose their lien. Nothing compelled the owner to make this demand. They could have simply sought arbitration. The demand was not responsive to any action that the contractor took. Judge Caldwell properly determined that owner, by making their Section 34 demand, waived their right to compel arbitration and we affirm his decision.

By imposing a Hobson's choice on the contractor - take this to court or lose your lien forever - the owner should have expected their disputes would wind up in court. And that's enough to waive the owner's right to insist on arbitrating those disputes.

How Does This Affect You?

Owners: If you're an owner beware! That goes for anyone else with an interest in a piece of property encumbered by a mechanics lien too. At least in the counties within the Second Appellate District, serving a Section 34 demand is considered your waiver of a mandatory arbitration provision that may be in your contract. You might consider a Section 34 demand to clear up title to your property before selling or refinancing. But you should talk with a lawyer first. A Section 34 demand is something a lawyer should be preparing for you anyway. Before they start is the time to have that talk. After this case, you need to add to the agenda for your talk:
- Whether your contract requires arbitration
- The pros and cons of arbitrating
- Whether a Section 34 demand will waive your right to arbitrate
Mechanics Lien Holders:
- If you get a Section 34 demand, recognize that you're now under a strict deadline. That deadline is short. You must rapidly decide to sue to foreclose your mechanics lien or lose that lien. Don't wait! The consequences of delay for you are catastrophic. Get a copy of the Section 34 demand to a lawyer and talk to them about what you should do
- If you sue and your contract includes a mandatory arbitration provision, you may be able to derail the Section 34 demand sender's later attempt to force your dispute into arbitration. But that may, or may not, be the best move for you. There's advantages and disadvantages to arbitrating your dispute. Each case is unique depending on what your contract says, what's at stake, who's involved (now and possibly later too), where you and the project are located, and a lot of other factors. Whether you have the right to derail arbitration, and whether it's the right thing to do, is another thing to talk with a lawyer about

Everyone: Regardless of which side you're on, you really need to think about how a Section 34 demand could affect not just the immediate relationship, but others too. There's hardly a construction dispute that involves only two sides. They may start out with only two, but others (e.g., subcontractors, architects) usually get drawn in too.
The others often also have mandatory arbitration provisions in their contracts as well. Frequently the arbitration provisions in each affected contract will allow consolidation of the multiple, bilateral, arbitration proceedings into one, multilateral, arbitration proceeding. They often permit joining new parties to an ongoing arbitration too. Section 15.4.4 (PDF ) of the American Institute of Architects A201 General Conditions (2007) is a prime example.
Ideally, consolidating arbitration proceedings and joining each affected party gets everyone involved in the same room with the same people deciding disputes among them. Usually that's better than hearing and deciding their disputes in different places. Different decisions in different places can lead to contradictory and unfair results.
A Section 34 demand, or derailing arbitration in its wake, could ensure that similar and interrelated disputes get heard and decided in different places. They can take what had been a dispute otherwise headed to arbitration and send it to court instead. Meanwhile the other disputes still go to arbitration somewhere else.
So before you send a Section 34 demand, or decide to resist arbitration after suing in response to one, consider and talk with a lawyer about:
- Who else could get involved?
- Who else may you have claims against?
- Who else may have claims against you?
- Do you want these claims decided separately, or together?

Green Building Surge

Joshua Glazov — Mon, 01 Feb 2010 09:54:17 -0500

AuggieV over at Building Green CT reports a Recent Surge In Connecticut Green Building News May Be A Good Sign. Some of the things he mentions:

Connecticut tied with Georgia for No. 1 in the fifth annual Global Green USA analysis and ranking of state Qualified Allocation Plans used by state housing finance agencies and guide annual distribution of federal Low-Income Housing Tax Credits

Reckson (a division of SL Green Realty Corp.) installed a new 100 kilowatt photovoltaic solar panel system on the roof of their facility on Greenwich

The state of Connecticut and Gateway Community College just broke ground on a $198M campus in downtown New Haven. It's the largest construction project the state undertaken to date and its first public building designed gold LEED certification. The project is also estimated to employ 350 workers

Nestle Waters North America announced they will move their headquarters from Greenwich to Stamford in late 2010. The company plans to renovate the new Stamford headquarters for LEED certification. They've already got nine LEED certified facilities. The Connecticut Department of Economic and Community Development is providing a $4M low-interest loan to equip the new building and Nestle Waters is also eligible for up to $5 million in tax credits

Krahl Construction: Lender and Surety Lawsuits

Joshua Glazov — Fri, 29 Jan 2010 13:14:19 -0500

The latest Krahl Construction developments: Fifth Third Bank and Travelers Casualty and Surety Company of America each sued Krahl Construction's President in federal court last week.

Fifth Third Bank had loaned money to Krahl before Krahl closed for business earlier this month. Fifth Third's Complaint (PDF) alleges that Krahl's President personally guaranteed repayment of the loan but hasn't paid as required under the guaranty.

Travelers served as Krahl's surety providing payment and performance bonds on many of Krahl's projects. With Krahl's closing and assigning their assets for the benefit of creditors, odds are some owners are going make claims under the performance bonds and some subcontractors are going to make claims under the payment bonds. Travelers's Complaint (PDF) alleges that under an indemnity agreement between Krahl's President and Travelers, the President must reimburse Travelers for money that Travelers pays out to owners and subcontractors under the bonds. Travelers claims that Krahl's President hasn't paid.

And to try an ensure that Krahl's President's assets are available to pay future liability under the indemnity agreement, Travelers also asks the judge to enjoin the President from transferring, or encumbering, any of his money or other assets.

Statutes of Limitations for Retainage Payments

Joshua Glazov — Tue, 26 Jan 2010 07:28:44 -0500

The Question

Reader Gil Anko asked this question on a past post about retainage:

If the contractor fails to request the release of the funds retained, is there a statute of limitations within which contractor must request release of the retainage???

The answer: yes.

How Long Does It Run?

How long is the statute of limitations on a claim for unpaid retainage? Like so many legal questions, the answer is: it depends. And it depends principally on two things:

The contract, and

The law governing the relationship between the working side and the paying side

The Contract

What does the contract say about retainage? Traditionally retainage is established by contract. The contract says that the paying side may withhold a certain amount of money from each payment while the work is in progress. Then at some point at or approaching completion of the work, the paying side must pay the withheld retainage to the working side. The contract usually identifies the point in time when that duty to pay retainage matures and the paying side is obliged to pay.

So you must first look at the contract when the paying side become obliged to pay retainage. Does that occur:

When, or within a specified time after, a particular event occurs?

Only after a particular event, plus a request for payment?

Section 9.8.5 of the American Institute of Architects (the "AIA") A201 General Conditions (2007 edition) - .PDF says that the paying side (the owner) must pay retainage when they and the working side (the contractor) each accept their respective responsibilities concerning the work as assigned in the architect's certificate of substantial completion. When you identify when that happens you've got the first part of the answer.

You'll need to look at statutes and judicial decisions too. Many states have enacted, or have bills pending to enact, statutes regulating retainage (frequently in Prompt Payment Acts). Some may even mandate deadlines for paying retainage regardless of what the contract says.

Governing Law

The next part of the answer comes from the the governing law which identifies three crucial things:

Which statute of limitations applies. The one that applies sets how long the limitations period runs before it expires

When the limitations period begins to run (the LP Start Date)

What may suspend running of the limitations period

But you can't stop at the breach of contract statute of limitations. Many states have a specific statute that applies to construction claims. Because it's more specifically focused than the general breach of contract statute of limitations, the construction claim statute of limitations may be the one that applies. But ,according to some judicial decisions (PDF) in some states, those construction claim statutes apply only to claims for construction defects, not to claims for payment owed for construction work.

Another statutes of limitations may apply too. Each state (and the federal government too) have different statutes of limitations for different types of claims. But these statutes overlap. So you must look closely not just at the statutes, but also at judicial decisions applying those statutes (PDF), to find which statute that governs the unpaid retainage claim that you're involved in.

When Does the Statute Start to Run?

After you identify which statute of limitations applies, you must next Identify when the limitations period begins to run: what is the LP Start Date. Here too you'll need to look at the statutes and judicial decisions too. Is the LP Start Date when the paying side first owes the retainage but doesn't pay, when the working side requests the retainage but doesn't get it, when the working side first suffers injury because they weren't paid, or some other date.

Going back to the contract for a moment, you also need to check there to see if it includes any terms that shorten, or lengthen, the limitations periods for filing claims. A prime example is Section 13.7 (PDF) of the AIA's A201 General Conditions (1997 edition) starts limitations periods on claims related to the contract running at the date of substantial completion. Without that section, the limitations periods would ordinarily start running later. To see Section 13.7 in action, take a look at this case claiming design defects on a home in suburban Chicago.

Suspension

Once you've identified when the limitations period starts and when it expires, last you need to see if there is anything that suspends it from running. You look for that in the statutes and judicial decisions too, especially in the judicial decisions.

Conclusion

Yes, there is a statute of limitations on claims for unpaid retainage! But there's no quick or easy answer to when it expires. It depends on:

What the contract says, and

When the limitations period starts to run, whether anything suspends its running, and when it expires

And I regret to have to tell you that you should hire a lawyer to review the contract to address the first point and identify and analyze the applicable statutes and judicial decisions so you can address the second.

Green Building: Arizona Proposes New Minimum Green Design and Green Construction Requirements

Joshua Glazov — Mon, 25 Jan 2010 07:01:42 -0500

A bill (HB2356) was introduced last week in the Arizona State Legislature that, if enacted, will require certain building and construction projects to achieve at least a silver LEED certification.

Bill Summary

Projects that will need to achieve at least a Silver certification:

Each Major Project of a state agency, including state universities and colleges

Each Major Project of a school board that receives state funding

Each private Major Project that receives at least 50% of its funding from the state

All existing public buildings under energy efficiency retrofitting of at least a 35% share of the total value of the existing building, regardless of whether the retrofitting project qualifies as a Major Project

A "Major Project" is:

New construction of more than 5,000 gross sq.ft. of occupied or conditioned space

Renovation if the cost exceeds 50% of the assessed value of the project and the project is more than 5,000 gross sq.ft. of occupied or conditioned space

The Director of the Arizona State Energy Office will be able to grant waivers of these requirements, including waivers that require a project to achieve a lower level of LEED certification.

The State Energy Office will be required to establish a Green Buildings Advisory Committee composed of representatives from the design, construction, and building operations communities that are involved in Arizona public contracting.

The bill also encourages:

Local financing programs for improving weatherization and energy efficiency

Energy efficiency job training and education programs

Am I Affected? What Can I Do?

Among the many who this bill could affect are:

Designers and contractors working on State of Arizona public projects, public school projects, or local government projects with at least 50% state funding

Arizona developers receiving state funding, as well as their investors, partners, and lenders

Manufacturers of building materials and equipment that enhance energy efficiency

If this bill could affect you, just click here to take a look at it, identify its sponsors, and keep track of its progress.

Krahl Construction: Liquidation and Notice to Creditors

Joshua Glazov — Wed, 20 Jan 2010 09:11:31 -0500

Crain's Eddie Baeb reported this morning that the Liquidation Process Starts For Krahl Construction.

Yesterday, the trustee of Krahl's assets, Howard Samuels of Rally Capital Services, LLC, sent this letter to Krahl's creditors announcing his appointment, providing a preliminary introduction to the assignment for the benefit of creditors process (frequently called an "ABC"), and asking Krahl's creditors to submit affidavits identifying their claims against Krahl and the amount of money Krahl owes them. Mr. Samuels's letter also gives a brief breakdown of Krahl's assets and liabilities. Krahl has significant assets, though most are intangible, like Krahl's accounts receivables for work they've provided. For more on recent Krahl Construction developments, go to last week's post announcing Krahl's ABC.

FDIC Statute of Limitations Extension: Private Assignees Can Extend Too

Joshua Glazov — Wed, 20 Jan 2010 06:09:55 -0500

An anonymous commenter left this question on a past post about the FDIC extending statutes of limitations:

What if the FDIC sells the loan to another bank (not FDIC)? When the purchaser wants to sue to enforce the note, does the statute of limitations for the subsequent note-purchaser begin running on: (a) the the ordinary starting date under state law or (b) the date the FDIC is appointed as receiver for the failed bank?

According to several judicial decisions in the wake of the last financial crisis of the late 80s and early 90s, the answer is: whichever is later. And that's almost always the date the FDIC is appointed as receiver.

The FDIC's transfer of a loan to a private purchaser doesn't change the LP Start Date. The purchaser may defer the LP Start Date just as the FDIC can. The purchaser may also postpone expiration of the limitations period the same as the FDIC can.

With so many banks failing recently, and the FDIC selling so many of their loans, this has become a compelling question. Thanks to our anonymous reader for asking it!

Green Building: Washington Bill Requires LEED Certification For Sales and Use Tax Deferral

Joshua Glazov — Tue, 19 Jan 2010 10:42:00 -0500

A bill was introduced in the Washington State Legislature yesterday that will require LEED certification for sales and use tax deferral on select construction projects. If this bill (SB 6598) becomes law, projects will have to achieve a certain level of LEED certification to qualify for deferral of sales and use tax on materials and other components of the work. The higher the project's LEED certification, the greater the amount of sales and use tax that's deferred.

This chart identifies the percentage of sales and use tax each level of certification will deliver:

LEED Certification Level	Percentage of Sales and Use Tax Deferred
Platinum	100%
Gold	75%
Silver	50%
Less Than Silver	25%

Construction Contracts: The 10 Most Important Terms - Price

Joshua Glazov — Mon, 18 Jan 2010 12:27:22 -0500

No. 2: Price

Price is No. 2 on the list of ten most important construction contract terms. Sometimes you'll see the price called the "contract price" or the "contract sum." To keep it simple today, we'll just keep it as the "price."

The price makes it to No. 2 because it's another of those few things you must have in a construction contract: one side (a prime contractor, subcontractor, sub-subcontractor, etc.) provides the Work (the "working side") in exchange for the other side paying the price (the "paying side").

There's three common ways to price construction work and many issues that affect each. Today we'll talk about each of the three types of pricing and introduce some of the important issues affecting each. At the end we'll also talk about Schedules of Value, an important price breakdown device that helps you keep track of how, when, and where the price is spent as the Work progresses.

Lump Sum Price

The lump sum is the simplest and easiest price. The working side estimates their cost to provide the Work, adds a profit margin, then proposes the sum as a price to the paying side. When the paying side accepts that amount, it's included in their contract and becomes a lump sum price for the Work. Keep these issues in mind when considering a lump sum price:

Working Side Benefits. The working side benefits from a lump sum price because, if they manage to keep costs below their estimate, they keep the money they would otherwise have spent on costs. The result is a higher profit margin on the contract. A lump sum price also requires less intense accounting, reporting, and back office work. So it imposes fewer overhead costs on the working side too

Working Side Drawbacks. The lump sum price has risks for the working side too. Among them, if they underestimate their costs, their profit margin shrinks. It may even disappear. Depending on their contract terms, the working side might even have to come out of their own operating profit on other projects, use cash reserves, or even borrow, to pay the extra costs and complete the Work in exchange for the lump sum price

Paying Side Benefits. The paying side benefits from a lump sum price too. Depending on their contract terms and the working side's creditworthiness, they get a level of certainty on how much the Work will cost. If it's a prime contract, the paying side's lender usually likes this too

Paying Side Drawbacks. Among the drawbacks, there there's no "transparency." The paying side doesn't know how large or small a profit margin the working side has. If the paying side suspects it's too big, they're inclined to think they're overpaying. If they suspect it's too little, they could think there's a risk of too little quality control with the working side tempted to cut corners to maintain their margin. Though it doesn't fix everything, competitive bidding for a lump sum price can allay at least some of the paying side's overpayment concerns

Payment Timing and Sequence. One of the most important issues with lump sum pricing is identifying when the paying side pays. Although the price is a lump sum, the paying side doesn't usually pay it all at once. Instead, they usually pay once a month in proportion to the amount of Work completed during the immediately preceding month (i.e., pay in August for Work provided in July). For example: if, during July, the Work goes from 45% complete to 53% complete, in August the paying side will pay 8% of the lump sum price, less a certain amount for retainage depending on other terms of the contract

A lump sum price is simple to structure and easy to manage. It usually has more appeal when:

One or both sides, especially the paying side, has no, or only little, construction management resources and experience, and

The price is modest

Cost Plus A Fee Price

Cost plus a fee pricing, usually referred to as just "cost plus," is set by adding two components together: (a) costs the working side incurs to provide the Work (usually just referred to as the "cost of the Work") and (b) the working side's fee for providing the Work.

Cost plus pricing provides the transparency missing from a lump sum price. It allows the paying side to share in benefits that come from more efficient Work and costs that are lower than originally estimated.

But cost plus pricing is not simple and not easy. It raises many issues and complications. Some examples:

Cost Identification. Identifying what does, and what does not, qualify as a cost of the Work. For instance:
- Should the working side's cost to re-perform rejected Work qualify as a cost of the Work?
- If the working side rents equipment needed to provide the Work (e.g., a crane, a hoist) from an affiliated rental company, how much of the rental fee should qualify as a cost of the Work?
Amount of the Fee. How much should the working side's fee be? How should it be structured?
- As a percentage of the cost of the Work? This is simple, but it rewards the working party for increasing the cost of the Work
- A fixed fee regardless of the the cost of the Work? This is simple too, but if the scope of the Work changes, when amending the contract to change the Work, both sides need to remember to adjust the amount of the fee to preserve its proportion to the cost of the Work

High Maintenance. Cost plus pricing is more burdensome for both sides. The working side must devote extra time to tracking and reporting on costs and getting cost data from those providing Work on their behalf downstream. The paying side must scrutinize the working side's reporting to ensure it's accurate. Cost plus a fee contracts require a lot of professional expertise, familiarity with construction costs, and back office work. That makes them more labor intensive and more expensive

Audit. If the money at stake is big enough and the paying side wants to ensure that the cost of the Work and amount of the fee is accurate, they'll need to perform at least one audit. Audits take time and cost someone money. They also require the working side to maintain records for some minimum amount of time and impose disruption on the working side's operation while auditors scrutinize records and analyze data. That adds costs for both sides

Challenging Contracts. Because there's more issues, negotiating a cost plus contract often takes longer and requires more involvement from lawyers and consultants. That also means higher costs for both sides. And those are "soft costs" that aren't popular with investors and lenders

Guaranteed Maximum Price

With few exceptions, cost plus contracts include a guaranteed maximum price (the "GMP", sometimes called a "GMAX"). Under a GMP contract, the working side guarantees that the paying side will pay no more than the GMP for completion of the Work. Ideally, regardless of how high the actual cost of the Work, plus the working side's fee actually gets, the paying side won't pay more than the GMP in exchange for the Work.

Keep these issues in mind when considering a cost plus with a GMP contract:

Who Gets the Savings? "Savings" is the difference between (a) the GMP and (b) the final cost of the Work, plus the working side's fee:
Savings = (GMP) - ((Total Cost of the Work) + (Total Working Side Fee))
By default, the paying party benefits from savings. They're obliged to pay no more than the cost of the Work plus the fee. So if that amount is lower than the GMP, the paying side owes no more and they enjoy all of the savings

Sharing the Savings. To offer the working side extra incentive to minimize the cost of the Work - thereby maximizing savings - some GMP contracts set up a sharing of any savings. Usually the contract will identify a percentage of savings that goes to the working party. Sometimes it's a single percentage of all savings. Other contracts increase or decrease the percentage at various levels of savings. For example, the working party may get 25% percent of the first $50,000 of savings, 40% of the savings between $50,001 and $100,000, and 50% of all savings above $100,001

Sub-GMPs. Some contracts set a sub-GMP for select cost categories. A frequent example in prime contracts is a sub-GMP on the prime contractor's general conditions costs (sometimes called "jobsite overhead" costs). Some cost plus contracts take a hybrid approach, they set:(a) a sub-GMP for some cost categories, (b) a lump sum for some cost categories, and (c) no limit on other categories (as long costs in those categories don't make total of the cost of the Work, plus the working side's fee, exceed the overall GMP)
But be cautious if you're on the paying side! Proposing spending limits in specific cost categories ordinarily arouses controversy with the working side. They may be inclined to accept a sub-GMP, or a lump sum, for general conditions costs, but you'll usually find them very reluctant, often with good reason, to impose limits on other cost categories. So before you ask for these kinds of limits, make sure you really need them and carefully analyze whether they're really going to be worth your while

Cost vs. Benefit. The allure of keeping savings often attracts the paying side to a GMP contract, especially when the paying side is an owner. But it's easy to overlook the extra costs that come with the GMP contract. It may be worth it for owners (a) with the in-house construction expertise to analyze and manage the payment process and scrutinize cost of the Work reporting or (b) have the budget to hire qualified consultants. But owners who don't have either should really stop and think twice before opting for a GMP contract. They may just be better off with a lump sum contract, especially if the project isn't really big enough to justify the extra professional costs needed to negotiate a GMP contract and review cost of the Work in each application for payment

Unit Prices

Unit pricing is another simple way to price the Work. The working side simply sets a price for each unit of Work, or category of cost. Road building contracts are a good example. The paying side pays the working side a set unit price for each kilometer or mile of road they build over a specified area or type of terrain.

Because units of Work usually must be very similar for accurate unit pricing, you'll see unit pricing most often used on public infrastructure projects (e.g., roads, runways). You'll see it only infrequently on private building projects, and then usually only on select cost categories (e.g., door handles, faucets).

Schedule of Values

A Schedule of Values breaks the price down and allocates it among various components of the Work: excavation, foundation, superstructure steel, curtain wall, electrical, plumbing, HVAC, vertical transportation, drywall, paint, general conditions costs. This sample contract has a scaled-down example of what a Schedule of Values ordinarily looks like.

This breakdown helps you compare progress of the Work to how much of the price has been paid to date. It's critical to architects, engineers, other consultants, and lenders who review the Work each month, compare its progress to how much money has already been paid, and how much the working side is requesting in their latest monthly application for payment. The Schedule of Values allows everyone to see whether progress of the Work is "in balance" with payment of the price. And, if it's not, identify how far it's out of balance.

A Schedule of Values is especially critical to a prime contract. Construction lenders often insist on them before they'll fund any loan proceeds. If you're the paying side on a prime contract, be you need to use extreme caution approaching a contract that doesn't have a Schedule of Values, or that says the Schedule of Values will come later, after you sign.

Coming Up Next

Coming up next at No. 3 is the contract time: deadlines for completing the Work.

Krahl Construction Closes: FBI Raid and Assignment For The Benefit of Creditors

Joshua Glazov — Fri, 15 Jan 2010 15:23:25 -0500

Serving search warrants earlier this month in a raid on Krahl Construction's headquarters, the FBI seized the Chicago company's computers and files. Several days later, company executives announced the company would shut its doors.

Then today Krahl set up a trust and assigned its assets into the trust for the benefit of its creditors. Howard Samuels of Rally Capital Services LLC will serve as assignee for the benefit of Krahl's creditors to oversee collection of debts owed to Krahl and payment of debts Krahl owes to others in what is akin to a private bankruptcy to wind up the company's affairs. More information is available in the Trust Agreement and Assignment available here.

Construction Contracts: 10 Most Important Terms - Identifying The Work

Joshua Glazov — Wed, 30 Dec 2009 06:32:49 -0500

No. 1: Identifying the Work

Every construction contract is about building something: the "Work". You can have a construction contract without many of the other nine things on this top ten list, but you can't have one without the Work. That's why identifying the Work tops the list at No.1.

The Work is what the owner pays the prime contractor for, the prime contractor pays their subcontractors for, subcontractors pay their sub-subcontractors for, etc., etc. It's the most important thing one side wants out of the contract. When the contract doesn't identify the Work very well, controversy abounds. At best those controversies stress relationships among the those involved in the project. At worst, as Sir Topham Hatt says, they cause "confusion and delay!" And confusion and delay often lead to claims and disputes.

This post is about improving how you identify your Work, saving time and money, and reducing scope of Work claims and disputes.

Traditional Work Identification and Its Problems

Your average construction contract does a fair job of identifying the Work. By fair I mean about "C+". The average contract usually identifies the Work in one of these two ways:

General Verbal Description: The contract includes a general verbal description of the end product: an office building, a runway, a movie theater, a refinery, a bridge, a power plant. Maybe it adds a little more detail: square footage, dimensions, strength, production capacity, and the like. But there's no detailed specifications and no drawings or other graphics
The general verbal description's virtues: it's fast, easy, and cheap. But it doesn't tell you much about what the Work includes and what it doesn't. So it's fertile soil for disappointed expectations and disputes, especially when costs start going up or when something that someone expects to be included in the Work isn't included

Design Document Reference: The "legal" documents (the ones lawyers prepare) refer to "design" documents that design professionals prepare (e.g., drawings, specifications, project manual) by some identifying data (e.g., alpha-numeric code, revision numbers, revision dates). Combined, the legal documents and the design documents together compose the "Contract"
This is a big improvement over the general verbal description. But design document reference has drawbacks too:
- Are the references from the legal documents to the design documents correct? Design documents get revised so often that it's easy to refer to a superseded document or leave one out, especially when you're preparing the Contract in haste. And it seems like we prepare contracts in haste more often than we don't
- If you want to look at the design documents, you first have to find them. Often they're separated from the legal documents. So you have to go hunt them down. That's tedious and time consuming. And you're usually doing it at the most inopportune time when you really need a quick answer. It's like having one glove and searching for the other in the airport departure gate as the agent gives the last call to board your flight.
  You may have to ask lawyers and design professionals to help you find the design document you want. Their help means spending their time. And spending their time means spending your money
- Design documents are often scattered in fragments, like shards of broken glass. Assembling them in the right sequence and ensuring you have the right pieces in the right place is no mean feat.
- Once you find the design documents you're looking for, you're forced to toggle between the references in the legal documents and your stack of design documents, if for no reason other than to audit one against the other. Doing that long enough will make you dizzy
- And even after you've located and audited your design documents, there's still that nagging doubt: do I really have the right documents? Do I really have all of them? Am I sure this was the current edition when we signed? It wasn't superseded before we signed the Contract, or after we signed that Change Order five Change Orders ago?

Why Not Keep Legal and Design Documents Together?

A few of the reasons few keep the legal documents and design documents together:

Design documents are voluminous, often hundreds of 24" x 36" mylars. Packaging 8.5" x 11" (or worse, 8.5" x 14") legal documents together with design documents is ungainly and unwieldy

Circulating such large stacks of documents is a logistical challenge. They're a burden to package and expensive to ship because they're so heavy

They consumed a lot of storage space. Who wants to pay rent for stacks of paper?

Until recently these were all very good reasons. Keeping legal documents and design documents together was too impractical, too burdensome, and too expensive. And the legacy of those reason is what I suspect keeps many from changing course. But software innovations of the last ten years have changed that. They make keeping legal and design documents together practical, easy, and cheap. They also add extra benefits not available before.

One Contract In One File

So how do you keep legal and design documents together and reap extra benefits? Use Adobe Acrobat. Here's how:

Your lead design professional prepares a .pdf file that includes all of the design documents by printing or converting the original CADD files into .pdfs (not scanning them as an image into a .pdf file)

Your lawyer prepares a .pdf file that includes all of the the legal documents by printing or converting the original Microsoft Word files into .pdfs (not scanning them as an image into a .pdf file). The legal documents file have "stubs" that refer to, and accept insertion of, the design documents. Here's two examples of the stubs I'm talking about:
- Language in the main agreement like: "the Work is identified in the Drawings and Specifications attached as Exhibit 1.1.2 to this Agreement", and
- An exhibit cover page with space behind it ready to accept insertion of the design document .pdf file behind that cover page
  Open up this scaled down sample contract and look at the parts inside the blue bubbles to see these kinds of stubs in action

Your lead design professional e-mails the design document .pdf file to your lawyer

Your lawyer then inserts the design document .pdf file into the legal document .pdf file behind the exhibit cover page I mentioned above. The result is a single .pdf file that has both the legal documents and the design documents: the "Contract File"

Your lawyer circulates the Contract File one last time among the (a) principals (owner, prime contractor, subcontractor, sub-subcontractor, as the case may be) and (b) the lead design professional so everyone can confirm that the Contract File includes all the documents that should be there, and none of the documents that shouldn't

After everyone confirms, your lawyer circulates a final signing edition of the Contract File for each principal to sign

Each principal signs the Contract File's signature page. Then they each scan their respective signature pages and e-mail them back to your lawyer

Your lawyer then deletes the blank signature page from the Contract File and inserts the scans of each principal's signature page where the blank signature page formerly was

Last, your lawyer circulates the Contract File that includes (a) all of the legal documents, (b) all of the design documents, and (c) each principal's signature, to everyone involved

The result: a Contract File that looks like this sample. You now have an authoritative duplicate of the entire Contract that you can open-up and refer by clicking on just one .pdf file icon. The other principals enjoy this too. No more looking for the other glove. No more sorting shards of shattered glass.

And one more thing about preparing Contract Files. You don't have to use a lawyer. But you should. If you ask, I'll suggest you to hire me. But really you can hire any lawyer, as, long as (a) they're properly licensed, (b) they're qualified, and (c) you like the way they represent you.

Extra Benefits

Putting all the documents that compose the Contract into a single .pdf file delivers extra benefits too:

It's easy to save the Contract File on your company's network, in an e-room, on a cloud, on a DVD-R, or some other electronic medium. You reduce clutter and save shelf space

It's easier to find the Contract File when you need it later. Stored electronically, you can find it by just browsing file names or searching for data you populated into the Contract File's document profile. Plus, stored electronically, you'll back-up the Contract File. So there's less chance you'll lose it in a fire, a move, or in one of those records department black holes

Because the Contract File is digitally converted from other file formats instead of being scanned into a .pdf file as a graphic image like a photograph, you'll be able to word search in the Contract using Adobe Acrobat search function (hit Control+F while viewing the Contract in Acrobat). Need to find a term dealing with a specific topic quickly? Searching the Contract File for a specific word on your topic sure beats scanning hundred of pages trying to find what you're looking for and possibly missing it the first few times through the Contract. Try this out by opening up the sample and searching through it

The Contract will have better visual quality. It will be more legible. No more reading a copy of a copy that was copied off of a fax

You can use Acrobat Bookmarks to speed navigation through the Contract (see illustration to the right). Open the sample and click the bookmarks. Notice how fast you can jump from the front page to confirm each party signed on the signature page, and then jump to the start of the design documents. No more turning page after page after page. It may seem trivial on a contract the size of the sample, but imagine how much bookmarks will help on a contract that's hundreds of pages long with ten or more exhibits

You can share the Contract quickly, easily, and cheaply. Just attach it to an e-mail and send it to an auditor, a title insurance company, or someone in the field

This approach promotes using digital instead of manual signatures. Maybe one day predictions will come true and people really will embrace digital signatures. If that day ever arrives, you'll be ready. And if it doesn't, at least you'll look cutting-edge

Limits and Drawbacks

The one Contract File approach isn't perfect and it doesn't work everywhere:

It doesn't apply very well, at least initially, to design/build contracts, EPC contracts, fast-track contracts, and some construction management agreements. The reason: when you initially sign those kinds of contracts, the design documents are only in their preliminary stages, or there's no design documents at all. So there's few, if any, design documents to put into the Contract. But you can use the Contract File technique later. Usually one side must approve a design before later design phases or before building begins. You can attach the then-current design document to the approval certificate or a contract amendment that comes later to identify the Work

Contract Files are usually very large, often more than 50MB. That's because the graphics in design documents make big data files, even after using Acrobat features that reduce file size. Some of your e-mail recipients may not be able to receive such large files attached to your e-mails. So you may need to compress the Contract File in a Zip file, upload the Contract file to an e-room or file sharing site like Google Documents, or use a large file transmission service like YouSendIt

Conclusion

With software like like Adobe Acrobat you can save all the documents that compose a construction contract - legal documents and design documents - together in one convenient place. It's fast and makes you, your company, and your project team efficient by improving your ability to navigate the Contract, find select terms, and share it with others. It costs little money because it uses software you probably already have and saves you money by freeing up time and file space for other things.

Coming Next

Next up in this top ten list: No. 2: the Price.

Merry Christmas From Construction Law Today

Joshua Glazov — Fri, 25 Dec 2009 12:05:05 -0500

From me and my family to you and yours: have a safe, cheerful, and Merry Christmas!!!

D'Oench, Duhme Doctrine Recap, Wrap Up and Ways To Avoid Trouble

Joshua Glazov — Wed, 16 Dec 2009 16:24:14 -0500

In the last bank failure post I promised a recap and wrap up on the D'Oench, Duhme doctrine and Section 13(e) of the Federal Deposit Insurance Act. Well, here it is:

A recap of the D'Oench rule
A brief explanation why federal judges and Congress created, expanded, and maintain the rule
Practical observations on how to avoid trouble

Rule Recap

The best recap of the rule in D'Oench, Duhme and Section 13(e) is this paraphrase from Judge Phyllis Kravitch's decision in Baumann v. Savers Federal & Loan Association:

In a lawsuit over the enforcement of an "agreement" originally between a bank and a private party, the private party can't enforce against the bank's receiver any obligation that's isn't specifically memorialized in a written document that the bank's primary regulator would be aware of when examining the bank's records

Interested in more details of how this rule works? Just go to the TOPICS on the right sidebar of this page and click on D'Oench, Duhme.

Why Have This Rule?

Because federal judges and then Congress decided that primary bank regulators should be able to rely on the face of a bank's official written records during their financial and solvency examinations. When reviewing a bank's financial health, regulators shouldn't have to ferret out every document in the bank's possession and interview every bank executive and loan officer. The same goes for the FDIC after they're appointed as receiver on the Appointment Date. Justice Antonin Scalia put it best speaking about Section 13(e) in Langley v. FDIC:

One purpose is to allow federal and state bank examiners to rely on a bank's records in evaluating the worth of the bank's assets. Such evaluations are necessary when a bank is examined for fiscal soundness by state or federal authorities, and when the FDIC is deciding whether to liquidate a failed bank, or to provide financing for purchase of its assets (and assumption of its liabilities) by another bank. The last kind of evaluation, in particular, must be made with great speed, usually overnight, in order to preserve the going concern value of the failed bank and avoid an interruption in banking services. Neither the FDIC nor state banking authorities would be able to make reliable evaluations if bank records contained seemingly unqualified notes that are in fact subject to undisclosed conditions

The FDIC and buyers of loans from a failed bank have time for only summary due diligence. Loan buyers are purchasing a proverbial pig in a poke. In normal circumstances, not knowing the problems, defenses, and counterclaims they might inherit, they'd be inclined to dramatically discount their price or insist on higher subsidies from the FDIC. But the immunity from defenses and counterclaims that buyers get from D'Oench and Section 13(e) removes uncertainty and allows buyers to reduce discounts and live with lower subsidies. And reduced discounts and lower subsidies mean that the FDIC can keep more money in the Bank Insurance Fund, one of the principal goals of their very existence.

It's Unfair!

You're right. D'Oench and Section 13(e) are unfair. Your banker gives you terms and assurances that keep your deal alive. You're relieved, and you rely on those terms and assurances as you put your plans into action. Then the FDIC shows up and won't honor your banker's terms and assurances. Doesn't sound fair! Judge Kravitch responded to that in the Baumann decision:

Although this seems unfair to the guarantor, he had the opportunity to include the entire agreement in writing. By not doing so, he lent himself to a scheme or arrangement whereby the banking authority was, or was likely to be, misled. That the guarantor may have had no intention of misleading regulators is of no moment. As between private parties and the FDIC, both Congress and the Supreme Court have placed the burden on private parties to document fully the contours of their obligations from the inception of the transaction

The lesson here: if you're dealing with a bank, ensure you comply with D'Oench's and Section 13(e)'s 4 Requirements. If you don't, and your bank fails, don't expect the FDIC or any loan buyer to live up to non-compliant terms and assurances that your bankers gave you before the bank failed.

But I Had Only the Best of Intentions

It doesn't matter. The FDIC and loan buyers can D'Oench you whether or not you intended to mislead or deceive banking regulators or anyone else. Tell them D'Oench of Section 13(e) shouldn't apply because your intentions were good and your heart pure. Their reply will probably sound something like this....

Heed Judge Sam Crow's remarks in Adams v. Walker:

There is no requirement of malfeasance, negligence, or intent to deceive on the part of the borrower. Consequently, the [D'Oench] doctrine operates even when the only fault of the borrower was in not reducing the entire agreement to writing

Balancing the Harm

It's a tough job to decide who should bear the cost of an informal agreement after a bank fails. Different people have very different views on this and I think which side they're on usually depends on whose ox is getting gored. But the borrower, guarantor, etc. usually loses. Judge Garnett Thomas Eisele explained why in FSLIC v. Smith:

The issue raised by the borrower's defenses is whether a borrower should be allowed to raise personal defenses against FSLIC collection efforts. D'Oench, Duhme and Section 13(e) do not directly answer that question, but in this Court's judgment they identify the policy decisions necessary for the answers. As the Supreme Court said in Langley, it is a question of which equities are to prevail: those in favor of an otherwise innocent borrower who has signed a note with unwritten conditions upon its repayment, or those of FDIC and the depositors and creditors who look to the facially unconditional note for assets against which to assert their claims. And, again as explained in Langley, the equities the borrower invokes are not the equities the law regards as predominant

Staying Out of Trouble

If you're a borrower, guarantor, or even someone putting new senior money into a deal, the first critical step to avoiding trouble if the bank fails: ensure you've complied with D'Onech's and Section 13(e)'s 4 Requirements.

I understand you can't ensure those things 100%. You can't control whether your bank does a good job managing their files so examiners will see all the terms of your loan.

Ask your banker for certified minutes of the board's or loan committee's approval of your deal, yes, they probably will look at you like you have a third eye in the middle of your forehead.

But you have to take these things into account. And now, at least, you know that failing to satisfy each of the 4 Requirements puts you at risk and how big that risk could be.