De Facto Developer: A New Basis for Construction Lender Liab

DE FACTO DEVELOPER: A NEW BASIS FOR CONSTRUCTION LENDER LIABILITY

By:  Paul A. Sandars, III

Lenders on construction projects that do not become significantly involved with aspects of the project, other than lending, will usually not be found liable under a lender liability theory. This general proposition of law, however, is tempered by factual scenarios which affect the ultimate outcome. In a recent New Jersey jury case, a lender was held as the “de facto”developer of a condominium project since the Bank exercised such dominion and control over the project so as to step into the shoes of the nominal developer. This article will discuss the peculiar facts of the case, analyze the existing lender liability case law, and attempt to define that level of control which subjects construction lenders to potential developer liability.

The Condominium

The building at issue is an oceanfront condominium in Atlantic City, New Jersey, known as The Ocean Club Condominium, managed by the Ocean Club Condominium Association (“OCCA”). The complex contains twin 32-story high-rise luxury buildings situated on the Atlantic City Boardwalk. There is a common sixth floor terrace with a three-story parking garage below.

The case under discussion involved OCCA’s claims for defects in certain common and limited common elements, including balconies, sixth floor terrace, ventilation systems and roof access/egress. OCCA had undertaken certain temporary repairs to the balconies and sixth floor terrace under the direction of consulting engineers. However, these measures were only temporary; more elaborate (and expensive) remediation efforts are required to permanently cure the deficiencies.

OCCA brought suit against the developer, MLM Associates (“MLM”), a New Jersey limited partnership, various contractors, subcontractors, design professionals, as well as Bank of America (“BA”), the construction lender. OCCA’s theory against BA was that it became the “de facto”developer of the project by asserting such dominion and control over the project that it deviated from the role of a traditional lender. OCCA sought recovery for defects in the common and limited common elements. The case was mediated, reducing the parties to OCCA, BA and Albert Gardner (“Gardner”), general partner of MLM, for a bifurcated liability trial.

The Court framed the issue for decision on an all or nothing basis; that is, there could be only one developer of the Ocean Club Project; either MLM, the borrower/developer, or BA, the de facto developer. The borrower/developer, MLM, had brought its own lender liability action against BA, alleging interference with the development of the project, loss of the prospective economic advantage of the anticipated profits in the project, and other relief. Thus, both MLM (through its general partner, Gardner) and OCCA, were seeking to impugn BA with liability; Gardner, through traditional lender liability recovery, and OCCA, through a “de facto developer”theory. Both plaintiffs proved their case against BA by unanimous jury verdicts.

Evidence of BA's Control Over the Project

The salient facts in connection with the BA’s control, developed during this trial were, in a word, overwhelming. Based upon testimony and documentation the jury found as a matter of fact that BA imposed upon MLM its own choice of construction consultant, and then, without any business reason whatsoever, the project’s general contractor. The evidence revealed that loan terms were manipulated by BA to permit the imposition of its chosen contractor into the project, with much more favorable contractual provisions for the contractor than originally contemplated.
Furthermore, the evidence revealed that the BA’s inspector, who was visiting the project monthly, performed 30-50 hours per month of “construction project management” off-site. Numerous and detailed correspondence from the project revealed that BA’s inspector was involved in virtually every aspect of the project from pre-construction “value engineering”, to pre-approval of change orders to making day-to-day construction decisions to the detriment of MLM’s on-site construction manager.

In connection with the control of the project, it was confirmed that contrary to normal construction payment procedures, BA paid the contractor directly, by wire transfer, as opposed to including the contractor’s requisitions in the monthly payment draw to MLM. These direct payments precluded MLM the normal leverage associated with disbursement of money. The most telling example of BA’s control of the project was control of the project profit; MLM’s planned profit of $34.5M turned into a $15M loss, whereas BA’s $2.9M planned profit turned into an actual calculated profit of $6.2M, or a net increase of 114%.

Based upon the foregoing evidence, the ten person jury unanimously found that BA interfered with MLM’s development of the Ocean Club Project through the imposition of the general contractor, that BA improperly exercised effective control over the construction of the project, and that BA deviated from accepted standards of banking practice in its conduct with respect to the project.

Construction Lender Liability Law Prior to OCCA

A dearth of case law addressing lender liability existed at the time of the OCCA v. MLM trial in New Jersey and throughout the country. Nevertheless, the theme of control and its effect on a particular development are the linchpin of existing precedent. No case involving “de facto”developer liability had been reported, which made the task at hand formidable, to say the least.

The concept of lender liability has its roots in Connor v. Great Western S&L Assn, which dealt with the issue of lender liability for construction defects in a real estate development setting. The facts of Connor are important to gain an understanding of the ultimate holding in the case. The lender, Great Western, agreed to make loans to the developer to acquire developable land on which the developer was to construct homes. In return, Great Western had the right to make construction loans on the homes to be built and the right of first refusal to make long-term loans to the buyers of the homes. After analyzing the factual relationship between the parties, the California Supreme Court concluded that Great Western was not a joint venturer and therefore, not responsible for the negligence of the nominal developer, but rather, found that Great Western was responsible for its own negligence. The court explained Great Western’s role in connection with the relationship to the developers as follows,

“In undertaking these relationships, Great Western became much more than a lender content to lend money at interest on the security of real property. It became an active participant in a home construction enterprise. It had the right to exercise extensive control of the enterprise. Its financing, which made the enterprise possible, took on ramifications beyond the domain of the usual moneylender. It received not only
interest on its construction loans, but also substantial fees for making them, a 20% capital gain for ‘warehousing’ the land, and protection from loss of profits in the event individual homebuyers sought permanent financing elsewhere.

Based upon the foregoing, the California Supreme Court found that the lender was liable on a negligence theory, further concluding that the lender had knowledge that the inexperienced developer constructed homes built on expandable soil and approved plans without addressing those conditions, and further, that the lender knew or should have known that the developer was not adequately capitalized and lacked experience in construction of such magnitude.

However, the ambit of the Connors holding was severely impacted by the California Legislature, which enacted Civil Code §3434, which provided, inter alia, that a construction lender shall not be liable to third persons for any loss or damage in connection with the improvement of real property, “. . . unless such loss or damage is a result of an act of the lender outside the scope of the activities of a lender of money or unless the lender has been a party to misrepresentations with respect to such real or personal property.” Following the enactment of Civil Code §3434, lender liability claims in California were not favorably accepted.

Florida courts have dealt with potential construction lender liability in the context of subcontractors suing lenders for liability in connection with alleged negligence regarding disbursement of construction funds. One Florida court held that a lender may be liable, at least to an owner, for improper payments to a general contractor when the lender had knowledge of subcontractor’s lien claims. Another Florida court has held that, where a relationship of trust existed between the lender and homebuyers, the lender may be liable to the buyers for breach of fiduciary duty.

The imposition of construction lender liability has generally been limited to situations where the lender, either through a Deed in Lieu of Foreclosure, or through direct ownership, has assumed control of the project. The New Jersey case of Terrace Condominium Association v. Midlantic National Bank presents a situation where the borrower/developer, due to financial difficulties, gave a Deed in Lieu of Foreclosure to the construction lender, which lender completed construction and sold units. The court had little difficulty in concluding that the lender there was responsible to the condominium association as a builder for construction defects, including those which were constructed prior to the lender’s takeover of the project. Florida law is in accord with the foregoing.

Therefore, in the absence of the legal involvement by a lender taking over a project, courts have been loath to extend liability to construction lenders. However, the OCCA case represents a departure from this trend and signals a new threshold of lender liability for lenders whose activities during the development of a project exceed the normal level of anticipated lender activity.

Analysis of BA's Control Over The Ocean Club Project

While it is normal for a lender to inspect a construction site on a monthly basis, so as to ensure construction completion for monthly mortgage disbursements, it is extremely unusual for that inspector to be involved, on a day-to-day basis, with the project and bill his or her time to “construction project management”. It is also extremely unusual for such an inspector to have the authority to require pre-approval of change orders in amounts as little as $300.00 on a $122M condominium development. In fact, MLM’s project superintendent testified that absent telephonic change order approval from representatives at BA in California, work could not proceed at the Atlantic City, New Jersey site.

Such was the level of control that BA exhibited at the Ocean Club project. Coupled with BA selecting the general contractor, negotiating favorable terms in the general contractors’ construction agreement with the developer, and paying the general contractor directly, through wire transfer, it is understandable how the jury in this case came to the conclusion that BA exceeded the role of a traditional lender on a construction project and was therefore the de facto developer. A comparison of the profits earned by BA as compared to the losses of MLM establish BA’s financial gain to the detriment of MLM, not unlike the lender in Connors, whose control of downstream financing caused developer liability to imbue upon it.

Obviously, the Ocean Club facts are unique and the jury’s finding is a direct result of such particular facts presented. Whether other factual scenarios exist which would compel a finder of fact to establish de facto developer status of a construction lender is an open question. However, that quantum of control necessary for a lender to cross the line certainly has been shown to exist in the case at issue. 

The Economic Loss Doctrine in New Jersey

THE ECONOMIC LOSS DOCTRINE IN NEW JERSEY – APPLICATION AND EXCEPTIONS

By: Paul Alain Sandars III

Introduction

The Economic Loss Doctrine stands for the simple proposition that a party cannot recover for purely economic losses under tort theories where contractual remedies are available. Construction projects are comprised of numerous contracts between and among various parties. Thus, while a general contractor may have a contract with a project owner, the project architect or engineer is usually not a party to that contract subject instead to its own contractual arrangement with the project owner. Therefore, claims for money damages on a construction project must be made against a party with whom privity exists. This is the so-called “majority rule” which is adopted in New Jersey.

Since the Economic Loss Doctrine as it applies to construction projects is non-statutory, many reported and unreported decisions are seemingly contradictory and therefore analysis of the cases follows with the adage that perhaps the “exception swallows the rule”.

Paul Alain Sandars III

It is well-settled that the Economic Loss Doctrine prevents a party from being able to collect in negligence for solely pecuniary harm that is unaccompanied by personal injury or damages to property. 6 Bruner & O’Connor on Construction Law § 19:10 (“BOCL”). As stated above, New Jersey follows the majority rule of the Economic Loss Doctrine that a plaintiff cannot recover purely economic damages in tort. Thus, damages consisting of personal injury or damages to property are excluded from the ambit of the Economic Loss Doctrines’ claim preclusion. In addition, willful or malicious conduct causing damage is likewise not barred by the Doctrine.

In the construction law context, actions for recovery of damages from costs of repair or replacement of defective products, adequate value, consequential loss of profits, delay damages, and claims for differing site conditions are all considered purely economic and therefore are subject to the bar of the Doctrine. Alloway v. General Marine Insurance, 149 N.J. 620 at 627 (1997). The personal injury or property damage exclusions to the Economic Loss Doctrine do not appear to be at issue and are consistently applied.

While the second exception for lack of privity or a lack of contract is somewhat blurred, parties to construction projects are free to allocate risk by contract for reasonably foreseeable damages.

 

The Origins of the Economic Loss Doctrine in Commercial Transactions and Subsequent Application to Construction Projects

It is well settled that the Economic Loss Doctrine bars a tort remedy where an action arises from a contractual relationship. New Jersey courts have consistently held that contract law is better suited to resolve disputes which were within the contemplation of, or which could have been the subject of negotiation between parties to an agreement. Spring Motors Distribution v. Ford Motor Company, 98 N.J. 555, 489 A2d 660, 666, 670-71 (1985); Alloway v. General Marine Indus., 149 N.J. 620, 695 A.2d 264, 268, 275 (1997); Dean v. Barrett Homes, Inc., 406 N.J. Super. 453, 968 A.2d 192, 203-04 (App. Div. 2009); Menorah Chapels at Milburn v. Needle, 386 N.J. Super.100, 899 A.2d 316, 323-35 (App. Div. 2006).

In Spring Motors Distribution v. Ford Motor Company, 98 N.J. 555 (1985), the New Jersey Supreme Court considered whether a commercial buyer should be permitted to pursue a cause of action predicated upon principles of negligence and strict liability, solely for economic loss caused by the purchase of defective goods, or should instead be restricted to a cause of action under the Uniform Commercial Code. Id. at 560. The court held that “a commercial buyer seeking damages for economic loss resulting from the purchase of defective goods may recover from an immediate seller and a remote supplier in a distributive chain for breach of warranty under the UCC, but not in strict liability or negligence.” Id. at 561. Critical to the Doctrine was the Court’s rationale highlighting the distinctions between tort and contract duties and principles:

  • The purpose of a tort duty of care is to protect society’s interest in freedom from harm, i.e., the duty arises from policy considerations formed without reference to any agreement between the parties. A contractual duty, by comparison, arises from society’s interest in the performance of promises. Generally speaking, tort principles, such as negligence, are better suited for resolving claims involving unanticipated physical injury, particularly those arising out of an accident. Contract principles, on the other hand, are generally more appropriate for determining claims for consequential damage that the parties have, or could have, addressed in their agreement. [Id. at 579-80.]

Several years later, in Alloway v. General Marine Indus., 149 N.J. 620, 695 A.2d 264 (1997), where a purchaser of a boat sought to recover for economic losses from both the dealer and the manufacturer, the Court expanded upon the principles in Spring Motors, plainly disfavoring the application of tort law in what is an otherwise clearly contractual context. The Court in Alloway concluded that the purchaser’s tort claims were barred by the Economic Loss Doctrine, and noted that: “[i]mplicit in the distinction” between tort and contract principles “is the Doctrine that a tort duty of care protects against the risk of accidental harm and a contractual duty preserves the satisfaction of consensual obligations”. [Id. at 268]

Our Supreme Court has explained that, “economic loss encompasses actions for the recovery of damages for costs of repair, replacement of defective goods, inadequate value, and consequential loss of profits.” Alloway v. Gen. Marine Indus., 149 N.J. 620, 627 (1997). In Saltiel v. GSI Consultants, Inc., 170 N.J. 297 (2002), the Supreme Court emphasized that economic losses have no place in tort, because, “generally speaking, there is no general duty to exercise reasonable care to avoid intangible economic loss or losses to others that do not arise from tangible physical harm to persons and tangible things.” Saltiel at 310, quoting Prosser & Keeton

The Doctrine enunciated in Spring Motors and Alloway has been specifically applied to transactions involving construction and design. In New Mea Construction Corp. v. Harper, 203 N.J. Super. 486 (App. Div. 1985), a builder sued a homeowner alleging that sums were due and owing for the construction of a single-family residence. Id. at 489. The homeowner’s counterclaims for negligent supervision and negligent workmanship were dismissed because there was no personal injury or consequential property damages suffered. Id.

In Dean v. Barrett Homes, Inc., 204 N.J. 286 (2010) the Court summarized the history of the Economic Loss Doctrine in New Jersey, and discussed its application in determining whether a claim sounds in tort or contract. The Dean court affirmed the principles outlined in Spring Motors, namely that, “when addressing economic losses in commercial transactions, contract theories were better suited than were tort-based principles of strict liability”. Id. at 296.

These principles were reiterated in Spectraserve, Inc. v. The Middlesex County Utilities Auth., et al., 2013 N.J. Super. Unpub. LEXIS 2173, (Law Div. 2013), which held that the Economic Loss Doctrine barred a plaintiff’s negligence claim, finding that the plaintiff could have invoked remedies by virtue of its contract with another party in the case. Spectraserve outlined the particular policies underpinning the Economic Loss Doctrine which apply in litigation of construction disputes:

  • In the context of larger construction projects, multiple parties are often involved. These parties typically rely on a network of contracts to allocate their risks, duties, and remedies. Construction projects are multiparty transactions, but it is rarely the case that all or most of the parties involved in the project will be parties to the same document or documents. In fact, most construction transactions are documented in a series of two-party contracts, such as owner/architect, owner/contractor, and contractor/subcontractor. Nevertheless, the conduct of most construction projects contemplates a complex set of interrelationships, and respective rights and obligations. [Spectraserve, at *26-27]

In Horizon Group of New England, Inc. v. New Jersey Schools Construction Corp., et al., 2011 N.J. Super. Unpub. LEXIS 2271 (App. Div. 2011), the court was faced with extra work and differing site conditions claims. The Horizon Group court held that:

  • [A] plaintiff with a direct contractual relationship [and] with contractual remedies to address changes in the scope of work or unexpected conditions [cannot] jettison these remedies and procedures and proceed on a tort theory of recovery. Id. at 20.

The court affirmed that the Economic Loss Doctrine “bars resort to tort theories of liability when the relationship between the parties is based on a contractual relationship”. Id. at 13, citing Dean v. Barrett Homes. Inc.

As stated above, New Jersey law has long recognized that purely economic loss, if reasonably foreseeable, is recoverable against the party in the absence of contractual privity. Conforti & Eisele, Inc. v. John C. Morris Associates, 175 N.J. Super. 341 (Ch. Div. 1980) aff’d 199 N.J. Super. 498 (App. Div. 1985), and People Express Airlines, Inc. v. Consolidated Rail Corp., 100 N.J. 246 (1985).

In Conforti, the Superior Court held that a design professional was chargeable in tort to a contractor who has sustained purely economic damages as a result of the negligence of the design professional in the absence of privity of contract between the two entities. Conforti, at 344. The court held that denying the contractor the ability to bring a tort claim under these circumstances, “would in effect, be condoning a design professional’s right to do his job negligently or with impunity as far as innocent third parties who suffer economic loss. Public policy dictates that this should not be the law. Design professionals, as are other professionals, should be held to a higher standard”. Id.

In People Express, a commercial airline brought an action in tort against a railroad for economic damages it suffered due to the evacuation of its offices following a fire. People Express, at 249. The railroad moved for summary judgment arguing that the airlines purely economic losses were not recoverable. The Supreme Court of New Jersey denied the railroad’s motion characterizing the “per se” rule against recovery in tort for economic losses as “hopelessly artificial”. Id. at 261. The Court held that, “when the plaintiffs are reasonably foreseeable, the injuries directly and proximately caused by defendants’ negligence, and liability can be limited fairly, courts have endeavored to create exceptions to allow recovery”. Id. Notwithstanding the decisions in Conforti and People Express, many advocates on behalf of defendants seek application of the per se rule barring recovery of economic damages in tort in the form of the Economic Loss Doctrine. However, it has been observed that the Economic Loss Doctrine operates to bar tort claims only where plaintiff seeks to enhance the benefit of the bargain she contracted for”. Saltiel v. GSI Consultants, Inc., 170 N.J. 297 (2002). In Saltiel, claims of negligent design and misrepresentation by a landscape architect against the turf grass corporation were dismissed as the landscape architect’s claim for economic damages essentially involved a breach of contract claim arising from a contract between the parties. Thus, it is clear where a contract between the parties exists, the New Jersey Supreme Court has concluded that claims should sound in breach of contract rather than in negligence because the Economic Loss Doctrine helps to maintain the “distinctions between tort and contract actions” by precluding the parties’ “negligence action in addition to a contract action unless the plaintiff can establish an independent duty of care. Saltiel, at 310.

The case of SRC Construction Corp. of Monroe v. Atlantic City Housing Authority, 935 F.Supp.2d 796 (D.N.J. 2013) stands for the proposition that the Doctrine does not bar a plaintiff from asserting a tort claim for economic damages against the defendant with whom it does not have a contract. In SRC Construction, the contractor, SRC which was involved in the construction of an assisted living facility sued the owner for breach of contract for unjust enrichment and wrongful termination of the contract and conversion. In a separate action, SRC sued the architect on a project with whom SRC did not have a contract. The architect moved for summary judgment seeking protection under the Economic Loss Doctrine.

The United States District Court Judge disagreed and analyzed the decision of the Superior Court of New Jersey, Giuliano v. Gastone, 187 N.J. Super. 491 (App. Div. 1982) where the Appellate Division refused to apply the Doctrine to the plaintiff homeowners “negligence claims against the subcontractors who participated in the construction of their home.” In Giuliano, just like in SRC, there was no contract between the parties. Thus, the Giuliano court ruled that the negligence claims were not barred.

The SRC Construction court distinguished the two unreported decisions, Horizon Group of New England, supra and Spectraserve, supra observing that, “in both cases, the courts held that the Economic Loss Doctrine barred the plaintiff’s negligence claim even in the absence of a direct, contractual relationship between the plaintiff and defendants. Moreover, both courts’ decision seemed to turn on the finding that the plaintiffs could have invoked contractual remedies in their contract with another defendant in the case”. SRC Construction, at 800 (citations omitted).

The SRC court stated as follows:

  • “Horizon and Spectraserve, cannot be reconciled with Giuliano. Not only could the Giulianos have sued the homebuilder with whom they had a direct contract, they did sue the homebuilder in a separate suit and obtained a judgment. (citation omitted).

The SRC Construction court attempted to reconcile the tension between lack of privity cases, lack of contract cases and lack of available other remedies as follows:

  • Leaving open an avenue of redress because no other exists is one thing but foreclosing an avenue of redress simply because another exists is quite another. … the reason for foreclosing a tort claim is not simply because a contract claim exists, but rather that the tort claim is not really a tort claim at all; it is a contract claim in tort claim clothing. … but whether there is no direct contractual relationship between the plaintiff and the defendant, frequently there can be no contract claim at all and therefore any tort claim asserted cannot possibly be a contract claim in tort clothing. SRC, at 801.

The SRC Construction court’s analysis was followed in Bedwell Co. v. Camden County Improvement Authority, Civ. A.14-1531 JEI, 2014 WL 3499581 (DNJ 2014). The Bedwell court held that a general contractor’s claim for negligent misrepresentation against an architect alleging that the architect provided defective designs was not barred under the Economic Loss Doctrine because there was no contract between the parties. The Bedwell court further recognized that even though there were third party agreements between (1) the general contractor and the owner and, (2) the owner and the architect, the third party agreements had no effect on the law on the ability to bring a tort claim because “a contract cannot define the legal obligation between two entities unless those two entities are party to the contract *3. Therefore, it may be that New Jersey is backing off from the per se application of the Economic Loss Doctrine.

Conclusion

Where a contract exists between the parties there is agreement that the Doctrine would bar tort claims. Where there is another party involved in a construction team with whom the plaintiff has a contract and thus another remedy is available seems to imply that tort claims will not survive the ambit of the Doctrine. It is only where there is no contract between the parties and there is no other available means of redress for the plaintiff that the tort claims will survive the application of the Doctrine. Nevertheless, plaintiff practitioners should be wary of the potential filing of dispositive Economic Loss Doctrine motions by defendants with whom no contract exists.

Paul A. Sandars, III is a Member of the Firm of Lum, Drasco & Positan LLC and practices in the Firm’s Litigation Group.