Lender Liability – A Bank Loses a Big Battle

Lender Liability – A Bank Loses a Big Battle

After a six-week trial in Franklin County Common Pleas Court, jurors awarded $18.95 million in compensatory and punitive damages against a Connecticut bank (Webster Bank) in favor of a local developer and several condominium owners for certain conduct by a banking institution that occurs every day.

This case is fascinating for a variety of reasons.  First, the facts of this case demonstrate how ridiculous the lending practices were in the commercial loan industry just prior to the financial meltdown that sent our economy into a downward spiral.  Second, the facts of this case are going to be eerily similar for many other lenders and commercial borrowers across the country.  Webster Bank’s response to the bad loan that they made was very predictable and typical of lending institutions across the country.  However, the outcome of this case is quite atypical compared to similar cases and situations in the past.

In the spring of 2006, a local developer planned on re-developing the Broadwin, a historical building located in Old Towne East (1312 East Broad Street) that had been abandoned and vacant for half a decade and required a complete renovation of the interior estimated to cost roughly $8.8 million dollars.  To raise capital for the project, the developer filed a Condominium Declaration, and began selling unfinished units to the public.  Each prospective buyer entered into a purchase agreement with the developer stating that the developer would use its best efforts to arrange construction, permanent financing commitments, and would timely complete construction upon financing.  Enter Webster Bank.   Instead of providing financing directly to the developer, Webster Bank entered into separate construction loan agreements with each buyer of a condominium unit in an amount equal to about 90-95% of the purchase price for a unit (ranging from $129,000 to $550,000 each).

Even though the bank lent money to the condo owners, the money was funded directly to the developer.  The developer was designated as an agent of each buyer for purposes of requesting Webster’s inspection of the construction, and receiving construction draws.  The developer was then supposed to direct payment to a general contractor upon inspections by the bank and approvals of the construction draws.  While the practice of a bank funding a loan from a home owner directly to a general contractor upon certain inspections is not all that unusual, this arrangement of Webster Bank is certainly a creative financing scheme that would certainly never be approved by a bank in today’s lending environment.

In 2006, these kinds of loans were certainly more widespread.  Under this arrangement, Webster Bank created a loan program (the National Construction Lending Center or NCLC) whereby it required the condo buyer to sign a construction loan agreement for the full amount of the purchase price of a “turnkey” unit that had not yet been constructed. Once a certificate of occupancy was issued and the developer paid in full by the bank, the buyer would then be refinanced through the NCLC program into a permanent financing arrangement.

The problem here was that delays occurred (arguments from the bank and developer go back and forth as to the causes), the bank refused to fund the construction draws (under various technical provisions of the loan agreement), and the units were never completed.  Moreover, the condo buyers were still responsible for the full amount of the loans for the condominium units that were never finished.

The construction loan agreements specifically granted Webster Bank the right to refuse to fund construction draws if the project could not be completed by the “Project Completion Date,” or if at any time Webster Bank discovered that the project was not being completed in strict compliance with plans and specifications.  The loan documents further provided that “if the progress of the work in place is not consistent with the draw schedule, the lender shall disburse only the amount of funds that it determines is appropriate based on the inspection of the progress of the work.”  This is not the first time that a bank has made the unilateral decision to curtail funding for a construction project and it is pretty safe to assume that this type of practice occurs every day.  However, this time Webster Bank’s actions resulted in a pretty big windfall for the developer.

The interesting part about this lawsuit is that the developer filed suit against Webster Bank on behalf of itself and as assignee of fifteen buyers’ claims (many of the buyers were relatives or close friends of the developer).  Because the construction loans were made directly to the condo buyers and not the developer, the developer needed the condo buyers to assign their own claims against the bank to the developer to assert against Webster Bank.  The developer’s Complaint alleged, among other claims, breach of the construction loan agreements and intentional interference with contract based on the purchase agreements in place between the developer and each buyer.

During the course of the lawsuit, the developer argued that Webster Bank was obligated to fund the draw requests within three days of the developer completing its draw requirements, such as timely completion days and inspection reports.  The developer claimed that it had fulfilled its obligations and that Webster Bank refused to fund the requests, thereby intentionally interfering with the developers purchase agreements with the buyers.

Webster Bank maintained that it was permitted to withhold payment pursuant to the terms of the construction loan agreements.  The bank claimed that the developer caused a default of the construction loans (as agent of the buyers) by failing to adhere to the construction schedule and further failing to accurately calculate the costs of the project.  Webster Bank cited the project manager’s inability to obtain a building permit for six months after the start date with little beyond demolition accomplished at that time.  Webster claimed that lack of decision making such as details about tenant upgrades, plumbing and selection of doors led to more delays in construction.

Ultimately, the jury believed that Webster Bank wrongfully withheld payment of the construction draws. The jury found that Webster Bank breached the construction loan agreements, and awarded nominal damages of $1.00.  The kicker was that the jury  awarded the plaintiffs $15,240,414, including $5,340,414 in compensatory damages, and $9,900,000 in punitive damages against Webster Bank on the intentional interference with contract claim. The jury believed that since Webster Bank had been aware at all relevant times of the condo purchase agreements between the developer and the buyers, that Webster Bank had wrongfully interfered with those contracts by failing to fund the draw requests.

The notable aspect of this story is that the bank actually lost.  Webster Bank maintained that it was permitted to withhold payment pursuant to the terms of the construction loan agreements.  This argument is routinely made time and again by all lenders in similar situations.  Banks are notoriously well protected by the agreements they enter into with borrowers and they rarely allow you to negotiate these terms.  In this case, it appears that Webster Bank granted itself too much discretion over the payment of construction draws, instead of having the results clearly dictated in the loan agreements themselves.  Loathe to accept the outcome, Webster Bank is currently fighting to overturn the jury’s verdicts based on key errors it claims were made during trial.

The other interesting point worth mentioning is that since 2006, the year in which this loan was made by the bank to the condo buyers and Webster Bank, 384 major US banks and/or subsidiary have either gone out of business or been taken over by the FDIC (see this link).  Many of these collapses were the result of losses incurred in sub-prime lending.  Many were simply the result of subpar lending practices by way of aggressive and creative schemes like the Webster Bank loan discussed in this case.   Regardless, loans of these types are certainly a thing of the past.  Will this case have an impact on the actions of other lenders in similar situations?  Only time will tell.  This case will most certainly have a good chance of being reversed on appeal.

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