Court: Lender liable for project’s cost overruns

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A federal appeals court has ruled that an insurer is not always liable for cost overruns in ongoing construction projects.

In a decision released March 12, U.S. Seventh Circuit Court of Appeals Judge Diane Sykes ruled that First American Title Insurance Co. was not liable for the cost overruns of a Kansas City construction project even though it had sold a policy to BB Syndication Services Inc., a Madison-based company that had provided a loan for the project.

The case stems from a mixed-use commercial development in Kansas City called West Edge. Trilogy Development Co., a real-estate developer, contracted J.E. Dunn Construction Co., Kansas City, Mo., to build the project. The initial estimated cost was $118 million. Of that total, $86 million came from a loan issued by BB Syndication, which had bought title insurance from First American.

According to Judge Sykes, a provision in the title insurance policy shielded First American from liability because BB Syndication “had the authority and responsibility to discover, monitor and prevent” the loss that would occur if J.E. Dunn, the general contractor, refused to pay subcontractors and caused liens to be attached to the project.

The provision, standard in title-insurance policies, excludes coverage for liens that are “created, suffered, assumed or agreed to” by the insured lender.

According to Sykes, “Construction lenders have a significant ability to ensure that the projects they finance remain economically viable – both at the beginning when deciding whether to finance a project and how much money to commit, and also throughout construction.”

The court noted that as a condition for closing, BB Syndication required the developer, Trilogy, to submit various documents, including financial statements and the construction contract with J.E. Dunn. The loan agreement let BB Syndication request financial reports from Trilogy and inspect the project during construction. It also let BB Syndication cut off loan disbursements if Trilogy refused to supply cash for the project.

A year and a half after construction began, J.E. Dunn claimed changes Trilogy made to the plans had increased the construction costs by between $20 million and $30 million.

Despite those warning signs, BB Syndication, the court pointed out, chose not to shut off the loan spigot until the last minute, waiting a year from receiving the first hints of trouble.

“That was its prerogative, of course,” wrote Sykes, “but in the end this risky business decision resulted in $17 million in liens in unpaid work.”

BB Syndication did not stop lending until Trilogy failed to pay J.E. Dunn and construction on the project came to a halt. Trilogy then filed for bankruptcy protection and the subcontractors filed liens against BB Syndication.

The court pointed out that, early on, BB Syndication could have used the threat of default to force J.E. Dunn to pay. Alternatively, it could have shut off the loan disbursements, a decision that would have cost BB Syndication less than $5 million.  In the end, the company released more than $61 million in loan disbursements before declaring the project unfinishable, according to court documents.

As a result of the bankruptcy proceeding, the subcontractors got paid, but BB Syndication Services was left with only $150,000 of the $86 million it had loaned to J.E. Dunn., so it then turned to its insurer to recover the rest. The court decided that the coverage afforded by title insurance would be stretched too far if First American were to be made responsible for reducing BB Syndication’s losses.

“Since the amount of unpaid work will depend on the timing of a doomed project’s inevitable termination, lenders might strategically delay,” wrote Sykes.

Title policies insure against risk inherent in the payment process, not the business risks that arise from cost overruns, the court also noted. Follow @erikastrebel