Daily Development for Tuesday, April 4, 2000

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

LENDER LIABILITY; LOAN PROCEEDS; DISBURSEMENT: Indiana court concludes that mortgagee has no liability when, with knowledge of an outstanding potential lien claimant, it disburses proceeds to contractor and accepts an affidavit that all potential lienors have been paid. (But it's a close call.)

Town and Country HomeCenter v. Woods, No. 54A01-9903-CV-89 (Ind. App. 4/4/00) http://www.ai.org/judiciary/opinions/completed/04040003.jgb.html

Lender had agreed to fund Borrower's acquisition of a newly completed house. Woods was the vendor of the house and the contractor. T&C was supplying materials for the construction, which preceded the loan funding. Lender's loan would "take out" the construction lender and compensate Woods for the balance of the purchase price.

Prior to the loan closing, T & C sent Borrower a "pre lien" appraising Borrower that lender had supplied materials for construction and was entitled to a mechanic's lien if it was not paid. Borrower took the notice to a loan officer at Lender, who told Borrower not to worry about notice, because such things were taken care of at closing.

Indeed, at closing, Lender asked Woods about the T&C account, and Woods readily admitted that T&C had not yet been paid, but told Lender that he, Woods, would pay T&C with monies he received from Lender at closing (monies debited to Borrower's loan account.) Lender required Woods to sign a letter indicating that all lienable claims had been paid prior to closing, although, as indicated, Woods had admitted that this was not true. It then disbursed the loan proceeds, taking out the construction loan and paying the bulk of the proceeds to Woods, based upon his contract. Borrower was aware of this procedure and agreed to it.

Predictably, Woods never paid T&C and apparently now lacks funds to do so. T&C, however, did not timely file its mechanic's lien, and was left without a lien against the home. It then sought recourse from lender, alleging, inter alia, that it was a third party beneficiary of the fiduciary obligation of the Lender to the Borrower to see to it potential construction liens are paid at closing out of loan proceeds. This common law duty toward Borrower, apparently an implied term of the loan agreement, has been recognized in several Indiana cases and is affirmed here.

The majority opinion held that although there may have been a duty to the Borrower relating to potential lien claimants, and that if T&C did have a lien, the bank would have a duty to release it in order to protect borrower. But that duty did not extend to all parties who supplied goods or services during construction. In particular, it would not apply here in any event because T&C was in fact not a potential lien claimant, having blown the timing of the lien filing.

The court acknowledged that, in addition to the special relationship obligation of the bank to the Borrower, there was the argument that the statement by the Lender's officer that the T&C letter would be "taken care of" at closing had the potential to create a contractual relationship between Lender and Borrower. But the court found that the statement was not clear enough to create such a contract, and in any event T&C, which was not in fact a creditor of Borrower's and had no lien claim, was not an intended beneficiary of any such contract. T&C then argued that there was fraud or even criminal deception in the Lender's action in inducing Woods to sign a false lien affidavit. The majority opinion concluded that T&C had not relied upon the affidavit, in fact did not even know of it at the time, and consequently had no claim as a victim of fraud. Similarly, the crime of deception requires that as a consequence of deception a party be induced to part with something of value. The Lender was the only party that parted with anything here - the loan proceeds. It couldn't commit a crime against itself, so there was no deception.

So far pretty cut and dried, and a result to be expected in most jurisdictions. But note that we are so far discussing only the majority opinion. Apparently we had a three judge panel here, and each judge filed a separate opinion.

The concurring judge agreed with the outcome of the majority opinion, but only with great regret. It advocated for a change in Indiana law to permit recovery in circumstances like those here. It pointed out that the bank's practices were a radical departure from typical practice, in which a check would have been cut in the joint names of the Contractor and T&C when the Lender had notice that T&C had not been paid. In the view of the concurring judge, the conduct of the Lender here was "reprehensible and indefensible. . . Such conduct represents a total disregard for the interests of persons known to have an interest in the proceeds of the real estate closing and in addition flies in the face of well established custom and practice within the lending industry." The concurring judge noted that T&C, an innocent third party, was deprived of the payment of its just debt by the Lender's conduct and maintained that justice demanded that the Bank be responsible for T&C's losses. But the court saw no basis for such recovery under the present state of Indiana law, so he concurred in the majority outcome. He urged the Supreme Court of Indiana, to take up the issue and create a duty of parties holding funds in trust for payment of debts to see to it that the funds are properly used, which duty would run to the creditors themselves.

The third judge filed a dissenting opinion. This judge concluded that a duty was created at the mortgage closing when Lender obtained knowledge of the money owed T&C for building materials. Where the relationship of the parties creates a justifiable reliance upon one of them and the circumstances are completely controlled by the party relied upon, a duty to use reasonable care exists.

This judge maintained that the operative principle ought to be that: "courts will find a duty where . . . reasonable persons would recognize it and agree that it exists." It was of the view that reasonable persons would have no problem here, as T&C, though it never relied upon lenders actions at closing, did have a fair claim for compensation of which it was deprived when Lender negligently misdisursed the funds. The dissenter noted that: A relationship that gives rise to a duty does not necessarily have to emanate from a contract. "In determining whether a legal duty arises, consideration must be given to the nature of the relationship between people and whether the party being charged with negligence had knowledge of the situation or circumstances surrounding that relationship"

Although T&C had no knowledge of what the Lender was doing, the dissenting judge concludes that a loss to T&C was a forseeable consequence of Lender's departure from standard good lending practices.

Comment: The Lender had its own reasons for controlling disbursements so as to avoid mechanic's liens. Most courts recognize that these reasons are sufficient, and that in controlling the proceeds Lenders undertake duties to no one but themselves.

Although a few jurisdictions, like, apparently, Indiana, seem to want to impose a duty on lenders to supervise loan proceeds for the benefit of borrower, most loan contracts provide specifically that there is no such duty, as the supervision of disbursement is for the lender's own benefit only.

But even if the borrower was in a "special relationship," and was protected implicitly by a fiduciary duty or other duty of care, is it appropriate to reach even further and extend that duty of care to third party material suppliers?

The argument seems particularly strained here, where the real reason for the loss was the fact that the supplier did not take advantage of statutory procedures to file a mechanic's lien - a method which would have provided protection for the material;s supplier and indeed would have focussed upon the obligation of the bank - at this point likely owed to the borrower under Indiana law - to pay that lien off straightaway.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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