January 01, 2001

Six Provisions Important to Lender's Counsel (2001, 15:01)

The Construction Loan Agreement: Six Provisions Important to Lender's Counsel

Probate and Property, January/February 2001, Volume 15, Number 1

By Dianne S. Coscarelli

Once a lender has agreed to make a construction loan and a borrower has agreed to accept the loan, the ritual of loan document preparation begins.

Once a lender has agreed to make a construction loan and a borrower has agreed to accept the loan, the ritual of loan document preparation begins. Except in the most unusual circumstances, the lender's counsel initiates and controls the drafting of the construction loan documents. Among the myriad of papers, one essential document, the construction loan agreement, stands out. It addresses the procedures and conditions for the disbursement of loan proceeds. It sets the rules for the acquisition, development and construction of the improvements. In most cases the construction loan agreement is the battleground for competing interests. On the one side is the prudent lender, with the gold. On the other side is the eager borrower, with his dream and his hammer-toting contractor.

This article discusses six construction loan agreement provisions that are often negotiated between the lender and the borrower. Suggested sample provisions are provided.


Retainage is a powerful device. Its purpose is to instill an incentive for the contractor or subcontractor to return to the site and complete or remedy deficient job performance. Retainage is often the only leverage the lender and the borrower have to guarantee adequate and complete performance of contracts and subcontracts.

Soft costs are usually not an issue when it comes to retainage. Typically, there is no retainage on soft cost items, such as insurance, interest, legal, accounting and similar expenses. With hard construction costs for materials and labor, however, retainage is not always a simple issue. The retainage formula in any construction loan agreement must be consistent with the retainage provisions in the contracts and subcontracts.

Here is a sample of a traditional retainage provision:

Loan proceeds shall be disbursed as construction progresses upon satisfaction of all the conditions contained in this agreement, but not more frequently than monthly, as follows:

(a) As to each portion of the work, which portion shall be determined by Lender or its consulting engineer, 90% of the value of the materials and labor actually incorporated in the work from time to time, less the amounts previously advanced or paid; and

(b) 100% of the amount of the soft costs approved by Lender, less soft costs previously advanced or paid. In each case, payments must not render the loan out of balance.

The remaining 10% not advanced pursuant to subsection (a), excluding amounts previously advanced by Lender under this agreement (the "Retainage Amount"), may be reduced on a line item basis or advanced on a line item basis as construction progresses, but not more frequently than once a month, upon the occurrence of the following:

(i) Such portion of the work determined by Lender or its consulting engineer shall have been completed in accordance with the plans and specifications as approved by Lender (the "Plans"); and

(ii) The contracts or subcontracts for such portion of the work require the release of the Retainage Amount as to such portion of the work.

The retainage provision can be revised to accommodate special concerns. When work under some subcontracts, such as for grading and foundation work, may be performed and completed at the very early stages of the project, subcontractors will not tolerate waiting until the entire project has been completed to receive their retainage payments. Depending on the facts, lender's counsel may compromise by permitting retainage to be reduced over time-for example, from 10% to 5% once the project is 50% complete. Another variation is to permit early disbursement of retainage for a particular subcontract, if the subcontractor's work has been completed and the lender and its consulting engineer approve the work.

Stored Materials

The borrower desires as much flexibility as possible to store materials. In this way, the borrower can take advantage of discounts for bulk purchases of material such as lumber and steel. The borrower can also order materials far in advance so that they will be immediately available for installation when they are first needed.

Lender's counsel seeks the comfort of knowing that the loan proceeds are being used to pay for materials that ultimately will be actually installed in the project. Too often stored materials "grow feet" and find their way into the borrower's unrelated projects.

The lender may wish to consider the following sample provision:

Any advance that, in whole or in part, relates to materials, equipment or furnishings that are owned by Borrower and are not incorporated into the improvements, but are to be temporarily stored either on the land or off site (the "Stored Materials"), shall be made on a case-by-case basis and shall be subject, in addition to satisfaction of the other conditions to an advance contained in this agreement, to Lender's receipt of evidence reasonably acceptable to Lender that:

(a) such Stored Materials are included within the coverages of insurance policies carried by Borrower in accordance with this agreement;

(b) such Stored Materials have been or upon disbursement of the advance, will be, fully paid for and the ownership of such Stored Materials is vested in Borrower free of any liens or claims of third parties;

(c) such Stored Materials are stored either on the land or in a bonded warehouse, and if stored in a bonded warehouse the agreement between Borrower and the warehouseman is in form and substance reasonably acceptable to Lender, and the Stored Materials are protected against theft or damage;

(d) such Stored Materials, if they are finished components, are ready for installation and are appropriate for purchase during the current stage of construction; and

(e) Lender has a perfected first-priority security interest in the Stored Materials.

Lender may require a separate security agreement and Uniform Commercial Code financing statements to cover any such Stored Materials.

This sample provision could be expanded to further protect the lender by specifically listing items that the borrower expects will be stored materials. In addition, the provision could be expanded to require the recommendation of the lender's consulting engineer before specific stored materials are accorded this special treatment.

Interest Reserves

It is typical and non-controversial for the lender to require a budget line item for interest reserves. However, the amount of the reserve is often the subject of negotiation. It is in the lender's interest to have the reserve amount be adequate to cover interest during the expected period of construction. The lender must anticipate what interest charges will be incurred over the construction period. The lender must also account for the possibility, because of force majeure or other reasons, that construction will not be completed on schedule. On the other hand, the borrower would like to establish a less conservative interest reserve so that more loan proceeds are available for actual construction costs.

Lender's counsel should make certain that the construction loan agreement includes adequate treatment of interest reserves. The following provision is suggested for the lender's protection:

The budget includes, as a line item, a reserve (the "Reserve") in the amount of $________ for interest to be paid on the loan.

Lender may, if an event of default has occurred, disburse the Reserve for the purpose for which it has been set aside, or for any other hard costs or soft costs as Lender may determine in its reasonable discretion (although Lender shall have no obligation whatsoever to apply the Reserve to the payment of hard costs or soft costs) either by payment of such items or by reimbursement to Borrower for payments actually made by Borrower for such items. Additionally, Lender shall disburse such Reserve from time to time, for the purpose for which it has been set aside, on a monthly basis or upon the reasonable request of Borrower, provided no event of default has occurred (other than any event of default that will be cured upon the application of the requested disbursement of the loan in accordance with the terms of this agreement and the applicable disbursement request), and so long as the loan is in balance and all other requirements under this agreement for disbursement have been satisfied.

Lender's counsel can further expand this provision to provide that if the loan is out of balance because of a shortfall in the amount of the interest reserve, the lender may require the borrower to increase the amount of the reserve to bring the loan in balance.


The line item for contingency in the budget functions as the safety valve for both the lender and the borrower. Without the inclusion of a contingency, the project is at risk of having no means to fund cost overruns. Project costs are rarely totally predictable; there are always unanticipated expenses or situations that require resorting to the contingency account.

Conflict often occurs between the lender and the borrower when it is time to make an allocation to the contingency line item. The construction loan agreement should include a discussion of contingency. The following sample affords the lender flexibility to allocate portions of the contingency to keep the loan in balance:

The budget also includes a line item designated as the general administrative contingency (the "Contingency"), which shall apply to both hard costs and soft costs in the amount of $___________. The Contingency represents an amount necessary to provide assurances to Lender that if additional hard costs or soft costs are incurred, or unanticipated events or problems occur, Borrower will, nonetheless, be able to keep the loan "in balance" as required by this agreement.

Lender may, if an event of default has occurred, allocate portions of the Contingency for the purposes for which it has been set aside, or for any hard costs or soft costs as Lender may determine in Lender's reasonable discretion (although Lender shall have no obligation whatsoever to make any such allocation).

Lender may, in its reasonable discretion, increase the amount of the Contingency to be maintained from time to time as circumstances may require.

A dispute arises when the lender makes an allocation of contingency for purposes that may not necessarily coincide with the borrower's opinion. In the above sample, there is some comfort to the borrower. The lender must make a determination in its "reasonable discretion."

In-Balance Provisions

Lenders require the in-balance provisions to guarantee that there will be adequate loan proceeds to complete the project within budget. One of the greatest risks to a lender is that after significant loan proceeds have been disbursed toward a half-built project, there will not be adequate loan proceeds to complete the project. If construction costs stay within budgeted projections, there is no need to resort to the in-balance provision. However, the borrower is often troubled by the in-balance provision because it obligates the borrower, in some instances, to advance its own funds in the event of a shortfall in projected funding. The following is a sample in-balance provision:

The loan shall at all times be in balance. The loan shall be "in balance" only at such time and from time to time as lender may determine (based on Lender's Construction Cost Estimate), in its reasonable discretion, that (a) the undisbursed portion of loan proceeds allocated to each line item in the Budget, as amended from time to time, is sufficient to complete each such line item, and (b) the then undisbursed portion of the loan, less an amount equal to the Contingency, equals or exceeds the amount necessary to pay for all work done and not previously paid for or to be done in connection with the completion of the improvements substantially in accordance with the Plans.

The borrower will especially want to include in the construction loan agreement provisions entitling the borrower to apply cost savings for one line item or cost category in the budget to the contingency and to apply the contingency to bring the loan in balance. The flexibility for the borrower to use such provisions is not readily available. Often lender's consent is required (but is not to be unreasonably withheld). A recommendation by the consulting engineer is also necessary, as the following sample provides:

Subject to the prior consent of Lender, which consent shall not be unreasonably withheld, and which shall be based in part upon recommendations made by the consulting engineer, and provided no event of default has occurred (other than an event of default that will be cured upon the application of the amount of the requested allocation of the Contingency in accordance with the terms of this agreement and the applicable disbursement request), and so long as the loan is in balance (or after such allocation will be), Borrower shall be entitled (a) to apply cost savings for one line item or cost category in the Budget to the Contingency; and (b) to apply the Contingency to bring the loan in balance.

Without limiting the generality of the foregoing, the loan shall be out of balance if at any time Lender in good faith reasonably estimates that the Reserve is not sufficient for the purposes in-tended or the amount of the Contingency will not be sufficient to correct an imbalance in the loan.

Lender's counsel should consider including remedies for the borrower's failure to maintain the loan in balance. The following is a good example of remedy provisions:

If at any time the loan shall be out of balance, then, in addition to any other provisions contained in this agreement,

(a) Lender shall be entitled, without notice, to withhold advances pursuant to this agreement until such loan imbalance is corrected; and

(b) It shall be an event of default hereunder if such loan imbalance is not corrected within ten days after Lender notifies Borrower of such imbalance by Borrower's depositing with Lender the full amount of such deficiency in cash, which funds will be first applied to all costs and expenses of the project.

Lender's Estimate of Construction Costs

In order for the lender to make a reasoned analysis about whether the loan is in balance, the lender must have an appropriate frame of reference. The construction loan agreement should establish a test for determining unbiased and realistic construction costs. This can be troublesome to the borrower to the extent the borrower's budget is lower and more optimistic than the budget determined by the lender.

The following sample provision is beneficial to the lender in that it allows the lender to revise the budget from time to time. This is especially important for a long-term project, where costs and the contractor's ability to perform may vary over extended periods of time.

Prior to the first loan disbursement, Lender shall make, and thereafter, from time to time, have the right to revise, in its reasonable discretion, an estimate of the cost of construction of the improvements (the "Lender's Construction Cost Estimate"). In the first instance, Lender's Construction Cost Estimate shall be made upon the basis of the executed contracts and subcontracts, and purchase orders that have not yet been let, or Lender's estimate of such costs, and shall take into account such allowances for reserves as Lender shall deem appropriate. Thereafter, Lender's Construction Cost Estimate shall take into account, in addition to the contracts, subcontracts and purchase orders, other considerations that Lender, in its reasonable discretion, deems relevant or likely to have an impact upon the cost of the improvements, including current costs for and availability of materials and supplies, the provisions of the contracts, subcontracts and purchase orders, the ability of the contractors to perform under the contracts, and the ability of parties to perform under and in accordance with the terms of subcontracts and purchase orders.

If lender's counsel is concerned about an identity of interest between the borrower and a contractor or subcontractor, the following provisions should be added:

If there is an "identity of interest" between Borrower and any contractor or subcontractor, any contract between parties having such "identity of interest" shall be regarded solely as an estimate for the purpose of this section. There shall be deemed to be an "identity of interest" if Borrower acts as a contractor in its own name or through a separate entity in which it or any entity related to it has a significant interest or control.

In identity-of-interest situations, the lender must be careful that the borrower is not padding the construction contract to create a more than customary profit margin. Also, if the borrower and contractor have a sweetheart arrangement such that the contract price is unrealistically low, the lender risks future harm. In such a situation, if the lender takes over the project after a default, the lender could experience higher contract costs, more in line with the market, to complete the project.


All provisions of the construction loan agreement are important to lender's counsel. The six provisions discussed here are often negotiated and redrafted. These suggested provisions are offered as a useful guide to lender's counsel.

Dianne S. Coscarelli is a partner with Thompson Hine & Flory LLP in Cleveland, Ohio. She is co-chair of the Real Property Division's Construction Lending (I-4) Committee and a member of the Division's Legal Opinions in Real Estate Transactions (B-4) Committee.