P R O B A T E & P R O P E R T Y
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The American Institute of Architects (AIA) has traditionally revised its form documents every 10 years but is now accelerating the revision cycle to five years. Until the 1997 revisions, part of the tradition was to ignore the role of lenders in the form documents. In the latest revision, the AIA affected lenders with many of the over 150 substantive changes that were made to the Standard Conditions, AIA Document A201-1987. The impact on lenders will not necessarily be favorable.
The theme of the revised forms is to provide greater protection to the architect and the contractor yet reduce the safeguards that an owner could previously expect. This shifting of the risks is also problematic for a lender. A lender's concerns are often aligned with those of the owner, because at some point the lender may have to step into the shoes of the owner. The lender's goal should be to modify the 1997 forms to satisfy the mutual concerns of the owner and the lender as well as to protect the lender's unique interests.
This article highlights provisions of the 1997 AIA construction documents of particular concern to lender's counsel. All paragraph references are to AIA Document A201-1997 unless otherwise noted.
Information and Services Required of the Owner
Whether an owner has the ability to meet its financial obligations under a construction contract has been a perennial concern for contractors. Historically, under Subparagraph 2.2.1, on the contractor's written request before the commencement of work, the owner was required to provide reasonable evidence of the owner's financial arrangements for the project. That way, the contractor could assess the owner's ability to fulfill its obligations to pay the contractor.
The new version of this requirement takes the concept a step further by requiring an owner (1) to provide this information as a condition precedent to the contractor's commencing its activities or continuing its work and (2) to give the contractor notice before the owner materially varies its financial arrangements. The owner is no longer relieved of this burden once construction begins. The contractor can now request this information from the owner as construction progresses. These owner obligations in turn can affect a lender's relationship with the owner. Under these expanded provisions, the contractor can request this information on a daily basis.
Additionally, these provisions can interfere with the ability of a lender and owner to modify their financial arrangements during the life of the construction loan. Before taking steps to amend material loan terms, the lender and owner will have to notify the contractor.
Complying with these requirements can be difficult. There is no definition for "materially" varying the financial arrangements. Nor is there any objective standard for triggering the owner's obligation to give the contractor prior notice of a modification. One thing is clear. The notice must be given to the contractor before the owner and lender finalize the modification.
If the owner fails to provide the information to the contractor, the contractor can exercise its right to discontinue work. If work is stopped for a period of 60 consecutive days, the contractor can terminate the contract under Subparagraph 14.1.4 on account of the owner's failure to fulfill its obligations.
What should lender's counsel recommend? A lender should first seek to delete the troublesome provisions. If that cannot be done, the lender will need to involve the contractor in any future loan modifications. Also, the lender must evaluate each proposed loan modification to consider whether it has the potential to "materially" vary the financial arrangements. If it does, or if the lender is in doubt, the lender must require the owner to communicate the proposed modification in writing to the contractor before finalizing the modification. The lender should require the owner to forward copies of those notices as a precondition to closing the loan modification.
Assignment of the Contract to the Lender
It is common practice for a lender to require an owner both to assign the owner's interest under a construction contract to the lender and to obtain the contractor's consent to the assignment. Apparently, some contractors have experienced situations in which a lender has not recognized its obligations for payments due the contractor for work done before the lender has exercised its rights under an assignment. Subparagraph 13.2.2 is a new provision that, for the first time in the AIA forms, addresses the practice of assigning the construction contract.
This new provision permits an owner to assign the construction contract to the institutional lender providing construction financing for the project. The contractor's consent is not required, but the contractor is obligated to execute all consents reasonably required to facilitate the assignment.
This new provision allows an assignment to an institutional lender but never defines what is meant by an "institutional" lender. Perhaps the most unfortunate part of this new provision is that it requires the lender, which is not a party to the construction contract, to assume the owner's obligations under the contract.
To understand the significance of this change, compare the traditional assignment process with the process under Subparagraph 13.2.2. In the normal course, an assignment of the contract documents involves a three-party agreement among the lender, the owner as borrower and the construction contractor as consenting party. The assignment is often a "collateral" assignment. It is not effective unless and until there is a loan de- fault, and the assignment terminates when the owner repays the loan. If the lender, as assignee of the contract, agrees to assume the owner's obligations, the assumption is likely to be conditional and not effective contemporaneously with the execution and delivery of the assignment. The lender may agree to pay for work previously performed by the contractor, but only to the extent that the owner has not already received loan advances designated for payment of that work. A prudent lender will not willingly agree to make all payments that the owner owes to the contractor.
In contrast, Subparagraph 13.2.2 requires a lender to assume, unconditionally, the owner's obligations as of the time that the assignment is made. This arrangement is too simple; it puts the lender at risk of becoming a surety of all of the owner's performance obligations. The assignment contemplated by this new provision varies considerably from currently routine construction contract assignment procedures.
Lenders must be cautious when taking an assignment of a construction contract on this 1997 form. Because a construction lender is not a party to the construction contract, the lender could argue that it is not bound by and did not agree to its terms. That argument is probably lost, however, after a lender has taken an assignment of a contract that includes this disturbing language. By taking an assignment, the lender will be in privity with the contractor. It will then be difficult to argue that the lender is not bound by the contract terms.
What advice can lender's counsel offer? Avoid any implication that, by taking an assignment of the owner's rights under the construction contract, the lender has assumed the owner's obligations. The lender should require that the assumption sentence be deleted from Subparagraph 13.2.2. As an alternative, the lender should include the specific terms under which the assignment and assumption will occur. This inclusion can be accomplished by incorporating the lender's three-party assignment and consent as an exhibit to the construction contract.
Payments Held by a Contractor for Subcontractors
Contractors often hold progress payments that are ultimately payable to subcontractors. Understandably, contractors have concerns about cases and statutes under which contractors have been charged with fiduciary liability in this context. New Subparagraph 9.6.7 responds to that concern. It states that, unless a contractor provides the owner with a payment bond in the amount of the contract sum, the contractor holds for subcontractors payments that the contractor receives for work properly performed by the subcontractors. Then, amazingly, it pronounces that the contractor is not a trustee for these funds.
One apparent motive for disclaiming trustee capacity for the contractor is to circumvent the expanded fiduciary duties and the increased potential for fiduciary liability under state law. The risks include criminal charges and personal liability for officers and directors. Whether or not this provision is adequate to avoid fiduciary liability under state law will be a subject for interpretation from jurisdiction to jurisdiction.
The shortfalls and ambiguity of this new provision should be troubling to a lender, especially when coupled with a related shortcoming. The AIA contract forms fail to require the contractor to furnish lien waivers with each application for payment. Subparagraph 9.10.2 requires lien waivers only with the final payment. Unfortunately, the time of final payment may be too late to avoid trouble. By then, the problems that lien waivers are meant to prevent may be overwhelming. This risk can be minimized with regular, periodic lien waivers.
How can lender's counsel help the situation? First, in its loan documents, a lender should require the owner to indemnify the lender and protect against the filing of mechanic's liens. The owner should likewise insist on indemnification from the contractor against the filing of mechanic's liens and should require the contractor to bond off or otherwise remove any such liens.
Second, a lender should require a modification to the construction contract so that, with each application for payment, the contractor must furnish the owner with affidavits and lien waivers from the contractor and all subcontractors and sub-subcontractors. To avoid any misunderstanding, the lender's approved form of lien waiver should be made part of the contract.
One of the most controversial revisions to the AIA documents is the addition of Subparagraph 3.12.10, which allocates certain ancillary design functions to contractors. The procedure works as follows: the architect specifies performance and design criteria; the contractor retains a licensed design professional to perform the actual design; the delegated design professional must attach his or her seal to the design document; and the prime design architect reviews and approves the design documents for conformance with the "design concept" under the contract documents.
These procedures put in writing what has been a longstanding industry practice of having subcontractors perform design functions for specific aspects of a project. Liability for the delegated design will pass through to the general contractor, shifting the risk from the architect.
This provision has raised serious issues. Do the subcontractors that provide the delegated design services hold the proper professional licenses? What additional insurance coverage is needed? Is public safety being compromised?
Lender's counsel has several concerns to address. First, a lender and owner must know at the outset whether the architect intends to shift any design responsibility to the contractor. The lender should insist that the owner have the architect identify in the owner/architect agreement any design services that the architect plans to delegate to the contractor.
Second, insurance issues will be more complicated. A lender should add to its insurance checklist a re-quirement to confirm that the contractor has adequate insurance to cover its potential liability for any delegated design work passed through to the contractor.
Finally, a lender should inquire whether state law prohibits a proposed delegation. For example, some states require, for public safety reasons, that the owner must retain an architect to prepare the detailed plans and specifications for public projects.
Mutual Waiver of Consequential Damages and Indemnification
Another significant change in the 1997 revisions is the addition of Subparagraph 4.3.10, which provides for a waiver of consequential damages by the owner and the contractor. This provision is perceived as being more beneficial to contractors than to owners. For instance, if an owner incurs added interest expense because of contractor delays that necessitate an extension of the loan maturity date, the owner can no longer recover those increased interest payments as consequential damages. Other examples include situations in which contractor delays result in an owner's inability to open for business or to deliver space to a tenant on time. The owner loses its expected income or rental stream. The owner must resort to a costly remedy, obtaining insurance protection, if it is even available. The waiver of consequential damages has implications for lenders. It severely diminishes a potential source of repayment to the owner for escalating interest and missed mortgage payments.
In addition, the AIA has also modified the indemnification language in Subparagraph 3.18.1 to exclude indemnification for loss of use (in light of the inclusion of the mutual waiver of consequential damages provision) and to clarify that indemnification only applies to the extent of the contractor's own responsibility in causing the loss. This reduction of the contractor's indemnity obligations minimizes the opportunities for reimbursement to the owner for damages that could be directly related to the owner's financing.
With the addition of the waiver of consequential damages and these major changes to the indemnification provisions, one previous potential source of loan repayment may no longer be available to owners. For that reason, a lender should consider requiring the parties to delete the mutual waiver of consequential damages provision.
Mediation and Arbitration
The 1997 forms have retained the arbitration clause as a means to resolve disputes, but with an additional twist. As a precondition to arbitration, the parties must endeavor to resolve the issues by mediation under the American Arbitration Association procedures. Mediation is not required for claims relating to aesthetic effect. Consolidated arbitration is prohibited, as is the joinder of parties other than those that signed the contract.
Mediation has proved to be an effective means to resolve disputes because it reduces the adversarial nature of identified problems. A lender's concern is to have disputes resolved effectively, quickly and with the least amount of disruption in the continuous construction of the project. Lenders should view mediation as positive.
On the other hand, owners have not favored arbitration as a means of resolving construction disputes. This is especially true when there are complex issues or large sums at stake. Because a lender's concerns are aligned closely with those of the owner, the lender should resist the arbitration provisions.
What approach can a lender's counsel take? One alternative is to eliminate the arbitration requirement altogether. Litigation can be the agreed means to resolve all disputes following unsuccessful mediation. Another alternative is to specify that an arbitration demand will not exceed a stipulated sum. In this way, arbitration can be reserved for small claims that can be handled quickly and economically.
Termination by Owner for Convenience
The 1997 revisions include a new final Paragraph 14.4, for the first time permitting an owner to terminate the contract for convenience. This option does not come without a price. If the owner elects to terminate for convenience, the contractor is entitled to compensation for work performed before the termination and for costs incurred by reason of the termination. The contractor is also entitled to reasonable overhead and profit on the work not performed.
This new option brings both a blessing and a curse to a lender. It will make it much easier for an owner to terminate contracts with architects and contractors when ending the relationships is desirable and acceptable to the lender, but there is no basis for termination for cause. On the other hand, if an owner has the opportunity to terminate contracts under these "no fault" provisions, it may be simply too easy for the owner to switch contractors. The lender must diligently monitor the status of the contract to confirm that the owner has not terminated it without the lender's consent. Terminating the contract could subject the project to unplanned cost overruns.
The owner's right to terminate for convenience is a welcomed provision. It is one that needs to be considered carefully, however. The lender must be included in any decision to exercise the option. How can lender's counsel provide protection? Loan documents should require that the construction contract and architect's contract will not be terminated for cause or without cause, unless the construction lender's consent and approval is first obtained.
As a condition to loan closing, a construction lender will typically require that the architect provide a written certificate of compliance with applicable laws, ordinances, rules and regulations and similar matters. The substance of these certificates often exceeds the architect's standard of care and addresses issues that are not insurable by the architect. Consequently, they are negotiated.
In the past, Paragraph 4.11 of AIA Document B141 (1987 edition) afforded some protection to the architect in this circumstance. The 1997 edition strengthens the architect's position and moves this provision to Clause 188.8.131.52. In the 1987 edition, the owner could not request certificates that required knowledge or services beyond the scope of the architect's contract. In the latest edition, the wording is expanded to provide that the architect is not required to execute certificates requiring knowledge, services or responsibilities beyond the scope of the contract. Lender's counsel should be aware that, although this revision As minor, it offers more leverage to the architect in negotiating the substance of an architect's certification to the lender.
Traditionally, the AIA documents did not specifically address the concerns of construction lenders. The 1997 edition AIA documents have changed that. If the parties use the 1997 edition AIA documents for a project being funded by a construction loan, lender's counsel must carefully consider the issues facing his or her client and be prepared to require the borrower to amend the forms to protect the lender's interests.
Dianne S. Coscarelli is a partner with Thompson Hine & Flory LLP in Cleveland, Ohio. She is a Vice Chair of the Real Property Division's Construction Lending (I-4) Committee and a member of the Real Property Division's Legal Opinions in Real Estate Transactions (B-4) Committee.