FYI: Cal App Upholds Dismissal of "Deceptive Inflation of Value" Allegations Against Mortgage Lender

Tuesday, April 15, 2014

The California Court of Appeal, Sixth Appellate District, recently affirmed the dismissal of a complaint alleging fraudulent statements relating to the value of the house securing the mortgage loan at issue, in supposed violation of California’s unfair competition law under Bus. & Prof. Code § 17200 (“UCL”), holding that forecasts of future events are not actionable in fraud.

A copy of the opinion is available at: http://www.courts.ca.gov/opinions/documents/H038713.PDF

In 2000, the borrowers (“Borrowers”) obtained a $280,000 mortgage loan on their home.  In 2002, the Borrowers refinanced the loan, this time borrowing $386,000.  In 2005, the Borrowers refinanced again and borrowed $496,000 under a negative amortization loan.

According to the Borrowers, they relied on a $620,000 appraisal of the property in connection with the 2005 loan.  However, they later discovered that their home was valued between $350,000 and $400,000 when they were seeking another refinance in 2010.  After defaulting on loan payments, the Borrowers sued their lender (“Bank”) for fraud and UCL violations, alleging that Bank personnel made two false representations:

1.  “The current market value of the real property was $620,000 and appreciating;” and

2.  “By refinancing with the ARM loan being offered to [Borrowers], [Borrowers] could bring the early monthly payments down, obtain several years of appreciation to the value of the home, and sell or refinance the home at an appreciated value before having to pay the then due principal of $620,00 and before having to pay the much higher monthly payments.”

The trial court sustained Bank’s demurrer without leave to amend, concluding that the fraud and UCL claims were untimely and inadequately pled.

On appeal, the Appellate Court first considered whether forecasts of future events may be actionable as misrepresentations. 

The Borrowers cited Bily Arthur Young & Co. (1992) 3 Cal.4th 370, 408, which recognized that in certain circumstances a representation made by someone possessing superior knowledge or expertise may be regarded as fact.  Bily involved a fraud claim rooted in an opinion paragraph in an accounting firm’s audit report, and the appellate court in Bily held that the statements referred to a discrete period covered by the audit; it was making no prediction of the business’s future performance.  In contrast, the Bank’s alleged statements here were predictions of future events. 

The Appellate Court also considered Finch v. McKee (1936) 18 Cal.App.2d 90, which rejected as inactionable a vendor’s statements that a building was constructed “earthquake proof.”  The court in Finch reasoned that it is impossible to predict destructive forces of nature and such statements were pure speculations upon which no purchaser had a right to rely.  Agreeing with the reasoning in Finch, the Appellate Court held that the Bank’s alleged statements of future events were not actionable in fraud as a matter of law.

The Court then considered whether the fair market appraisal representations were sufficient to maintain a cause of action for fraud.  Because the Borrowers failed to allege with specificity or provide any documents to support their allegations, such as a copy of the appraisal, the allegations failed to meet the heightened pleading requirements necessary to maintain a claim for fraudulent concealment.

Moreover, the Appellate Court agreed that the claim is time barred.  As you may recall, the statute of limitations for fraud is three years.  CCP § 338(d).  However, the limitations period may be tolled until a plaintiff discovers or has reason to discover the fraud.  Id.

Borrowers alleged that the misrepresentations on which their fraud claim was based occurred in July 2005.  They filed their lawsuit six years later in July 2011.  Borrowers merely alleged that the fraud was not discovered until 2010, but the Court noted that they did not explain how they made their discovery or how they determined that the 2005 appraisal was a misrepresentation.  Thus, even if the Borrowers had pled their claim for fraud with specificity, the claim is still deficient because the claim is untimely.

Similarly, the Appellate Court also held that Borrowers’ allegations were also insufficient to maintain a claim under the UCL.  As you may recall, California’s unfair competition law prohibits “any unlawful, unfair or fraudulent business act or practice and unfair, deceptive, untrue or misleading advertising.”  Bus. & Prof. Code § 17200.

The Borrowers alleged that Bank violated the UCL in three ways:  (1) the two misrepresentations regarding the value of the home and ability to refinance in the future; (2) colluding with others in the housing industry to inflate the value of real estate to entice borrowers into “top loaded” loans and later refusing to refinancing based on the true value of the homes; and (3) misstating that the Borrowers will pay 1% interest on the loan documents.

The Appellate Court held that the allegations regarding the value of the home and ability to refinance in the future failed to state a claim due to lack of specificity, in the same way the fraud claim based on the same misrepresentations were deficient. 

The allegations of supposed collusion with others in the housing industry to inflate the value of real estate to entice borrowers into “top loaded” loans, and later refusing to refinancing based on the true value of the homes, also failed because judicially noticed loan documents contradict Borrowers’ allegations.  The Borrowers did not borrow money to purchase their home, but instead they took out an additional $216,000 over two refinances. 

Lastly, as to the alleged misstatement in the loan documents that the Borrowers will pay 1% interest, the Borrowers admitted they were aware of the negative amortization terms of their loan and accepted those terms in reliance on representations that their home would continue to appreciate.  Thus, their alleged injury did not result from the face of the loan document.

As another point, the Court noted that the UCL claim is time barred.  The statute of limitations for a UCL violation is four years.  See Bus. & Prof. Code § 17208.  The Appellate Court held that the Borrowers failed to plead facts to toll the limitations period, and like the fraud claim, the UCL claim based on events at loan origination fails as untimely.

Accordingly, the Appellate Court affirmed the judgment of dismissal.

Patrick J. Kane

McGinnis Wutscher Beiramee LLP

Emerald Plaza

402 West Broadway, Suite 400

San Diego, California 92101

Direct: (619) 618-2874

Fax: (866) 581-9302

Mobile: (858) 381-7860

Email: pkane@mwbllp.com

Admitted to practice law in California

          McGinnis Wutscher Beiramee LLP
CALIFORNIA   |   FLORIDA   |   ILLINOIS   |   INDIANA   |   WASHINGTON, D. C.
                                 www.mwbllp.com

FYI: 9th Cir Holds Nat'l Bank is Citizen Only of State of Its Charter Address for Diversity Purposes, and Not Any Other State

Tuesday, April 8, 2014

The U.S. Court of Appeals for the Ninth Circuit recently held that, under 28 U.S.C. § 1348, a national bank is a citizen only of the state designated in its articles of association as its main office. 

In so ruling, the Ninth Circuit stated that Wachovia Bank, N.A. v. Schmidt, 456 U.S. 303, 307 (2006), did not address whether a national bank is also a citizen of the state where it has its principal place of business.

The Ninth Circuit now joins the Eighth Circuit, noting differing rulings in the other circuits.

A copy of the opinion is available at: http://cdn.ca9.uscourts.gov/datastore/opinions/2014/03/27/12-55278.pdf

The borrowers (“Borrowers”) sued their lender (“Bank”) in state court alleging causes of action under state and federal law pertaining to their home loan.  Bank removed the action to district court, asserting subject matter jurisdiction on the basis of federal question and diversity citizenship.

Borrowers filed an amended complaint but this time raising only state law claims.  Following an order to show cause why the case should not be remanded for lack of diversity jurisdiction, the district court held that national banks are citizens of the state where their principal place is located, as well as the state where their main office is located as designated in their articles of association.  Because the Bank’s main office as designated in its charter is in South Dakota and its principal place of business is in California, and the Borrowers are citizens of California, the district court remanded the case for lack of jurisdiction. 

The dispositive issue on appeal is whether, under 28 U.S.C. § 1348, a national bank is a citizen of both the state in which its principal place of business is located and the state where its main office is located as designated in the bank’s article of association.

As you may recall, the citizenship of national banks is governed by 28 U.S.C. § 1348, which provides in pertinent part:  “All national banking association shall, for the purposes of all other actions by or against them, be deemed citizens of the States in which they are respectively located.”  28 U.S.C. § 1348.

The Ninth Circuit began its analysis by focusing on the meaning of the word “located,” as the term is not defined under the statute. 

Both the Fifth Circuit and Seventh Circuits have held that national banks are not “located” in every state where the bank has a branch.  See Horton v. Bank One, N.A., 387 F.3d 426, 431 (5th Cir. 2004); Firstar Bank, N.A. v. Faul, 253 F.3d 982, 993-94 (7th Cir. 2001). 

By contrast, the Fourth Circuit held that a national bank is a citizen of the state in which its main office is located as well as every state in which it has a branch.  See Wachovia Bank, N.A. v. Schmidt, 388 F.3d 414, 432 (4th Cir. 2004).  The Second Circuit recognized the same in dicta.  See World Trade Ctr. Props., LLC v. Hartford Fire Ins. Co., 345 F.3d 154, 161 (2d Cir. 2003).

The Supreme Court granted certiorari in Wachovia Bank v. Schmidt, and held “that a national bank, for § 1348 purposes, is a citizen of the state in which its main office, as set forth in its articles of association, is located.”  See Wachovia Bank, N.A. v. Schmidt, 456 U.S. 303, 307 (2006).  However, Wachovia Bank v. Schmidt did not address whether a national bank is also a citizen of the state where it has its principal place of business.

Following Wachovia Bank, the Eighth Circuit addressed the exact issue in this appeal and held that a national bank is only a citizen of the state designated in its articles of association as its main office.  The Eight Circuit concluded that the world “located,” as used in the 1948 version of § 1348, could not mean both main office and the principal place of business because citizenship for state-chartered corporations based on principal place of business did not exist until ten years later when Congress passed § 1332 in 1958.  The Ninth Circuit agreed.

Although the Ninth Circuit viewed the Supreme Court’s declaration in Wachovia Bank on the scope of § 1348 to be definitive, the Court also determined that the historical landscape of § 1348 and its interaction with § 1332(c)(1) to supports its conclusion. 

Accordingly, the Ninth Circuit held that the national bank defendant is a citizen only of South Dakota, the state of its charter address, and reversed the district court’s judgment and remanded for further proceeding.

Eric Tsai
McGinnis Wutscher Beiramee LLP 
Emerald Plaza
402 West Broadway, Suite 400
San Diego, CA 92101
Direct: (619) 955-6989

Fax: (866) 581-9302

Mobile: (714) 600-6000

Email: etsai@mwbllp.com

Admitted to practice law in California, Nevada and Oregon

          McGinnis Wutscher Beiramee LLP

CALIFORNIA   |   FLORIDA   |   ILLINOIS   |   INDIANA   |   WASHINGTON, D. C.

                                 www.mwbllp.com

FYI: Cal App Ct Reverses Ruling in Favor of Lender on Trespass and Nuisance Allegations Following Lender's Foreclosure

Wednesday, February 26, 2014

The California Court of Appeal, Fourth District, recently reversed a trial court’s grant of summary judgment in favor of a lender regarding allegations that the lender maintained a nuisance and overused an easement that it obtained through a foreclosure sale.

A copy of the opinion is available at:  http://www.courts.ca.gov/opinions/documents/D062532.PDF

Plaintiffs owned a piece of real property located in La Mesa, California.  A condominium project (the “Aragon Project”) was to be constructed on another property adjacent to the Plaintiffs’ property.  The Aragon Project had three phases of construction and was to be governed by the Aragon Homeowners Association (the “HOA”).  The Aragon Project was funded via a revolving line of credit given by a bank (“Bank”).

The Aragon Project property had an “ingress and egress” easement over Plaintiffs’ property.  Specifically, the easement granted “the right of ingress and egress for public road purposes over, along and across the easterly 40 feet thereof.” This easement was created in 1941 by the previous property’s owner.

The developer began construction on the Aragon Project and within 4 years, phases 1 and 2 were completed.  During the construction of phases 1 and 2, the developer made substantial improvements to the easement including installing sewers and storm drains ad well as paving it. After completing the first two phases of the Aragon Project, the developer transferred its ownership interest to the HOA.

During construction of phase 3, the developer went bankrupt.  As a result of the developer’s bankruptcy, Bank gained title to various portions of the Aragon Project via trustee sale including the deed creating the subject easement.

After the developer completed construction of phases 1 and 2, Plaintiffs filed a lawsuit claiming the easement’s improvements and structures were an overuse and were outside the scope of the easement’s description.  Plaintiffs alleged causes of action for trespass, nuisance, injunctive relief and declaratory relief.  Bank and the HOA were the named defendants.

Bank subsequently filed a motion for summary judgment arguing:  (1) it did not own the structures and improvements at issue;  (2) it did not maintain or control the structures and improvements at issue;  (3) it could not be held liable for tort actions under former section 1365.9, as it is not an owner of individual condominium units; ; (4) the structures and improvements at issue do not violate the reserved easement; and  (5) could not be held liable as it only acted as a lender to the developer regarding the Aragon project. The Court granted Bank’s motion for summary judgment, and Plaintiffs appealed.

The Appellate Court began its analysis by determining if there was a triable question of fact as to whether the easement’s improvements and addition of structures could constitute overuse.  The Court determined there was a triable question of fact regarding whether the easement was being overused.

The Court then addressed Bank’s argument that it did not own, control, or maintain any of the Aragon Project’s structures or improvements.  Plaintiffs argued that Bank took a security interest in the Aragon Project’s personal property, as well as an interest in the easement and improvements thereon. The Court held Bank did hold an interest in the Aragon Project’s structures and improvements.

Specifically, the Court examined the trustee’s deeds Bank gained through its foreclosure.  The initial trustee’s deed gave Bank ownership of the Aragon Project’s completed condominium phases as well as several uncompleted condominiums in final phase of the project. The subsequent trustee’s deed gave Bank ownership of the Aragon Project’s property including the easement at issue.  The only properties exempted from Bank’s trustee’s deeds were any property interests previously deeded to the HOA.  Thus, the Court held nothing established that Bank did not own the Aragon Project’s improvements and structures. 

Bank next contended the HOA owned the easement’s improvements and structures and thus, only the HOA is liable to Plaintiff.  Bank relied on a Covenants, Conditions and Restrictions’ (“CC&R’s) provision that stated the HOA had a duty to maintain the Aragon Project’s improvements and structures. However, the Court rejected this argument as Bank offered no explanation as to how the CC&R’s maintenance provision absolved Bank of an ownership interest in the subject improvements.

Bank next argued that when the Aragon Project developer transferred  a completed portion to the HOA, it automatically transferred all the easement rights to the HOA.  The Court found this argument unpersuasive as the developer transferred ownership rights to both Bank and the HOA, and therefore both have rights in the subject easement.

The Court then addressed Bank’s argument that it is merely a “lender” and is immune under California Civil Code section 3434.  Section 3434 states:

A lender who makes a loan of money, the proceeds of which are used or may be used by the borrower to finance the design, manufacture, construction, repair, modification or improvement of real or personal property for sale or lease to others, shall not be held liable to third persons for any loss or damage occasioned by any defect in the real or personal property so designed, manufactured, constructed, repaired, modified or improved or for any loss or damage resulting from the failure of the borrower to use due care in the design, manufacture, construction, repair, modification or improvement of such real or personal property, unless such loss or damage is a result of an act of the lender outside the scope of the activities of a lender of money or unless the lender has been a party to misrepresentations with respect to such real or personal property.

The Court rejected its immunity argument as Bank failed to show how its ownership interests were within the scope of activities a lender of money typically engages in.  Thus, Bank failed to meet section 3434’s burden and was not immune from liability.

Lastly, Bank argued that former Civil Code section 1365.9 entitled it to summary judgment.  Former section 1365.9(b) states:

Any cause of action in tort against any owner of a separate interest arising solely by reason of an ownership interest as a tenant in common in the common area of a common interest development shall be brought only against the association…

The Appellate Court held that, in order to be afforded protection under section 1365.9(b), Bank was required to show the HOA maintained and had in effect one or more policies of insurance which included coverage for general liability of the association. Cal. Civ. Code §1365.9(b)(1). Additionally, the insurance policies had to cover the causes of action alleged by Plaintiffs. Id. 

The Court held that section 1365.9 was inapplicable as Bank failed to show that any of the HOA’s insurance policies covered the Plaintiffs’ claims.  Therefore, the Court determined that Bank was not entitled to summary judgment under former Civil Code section 1365.9(b).

Accordingly, the California Court of Appeals, Fourth District, reversed the lower’s court’s ruling granting Bank’s motion for summary judgment.

Eric Tsai
McGinnis Wutscher Beiramee LLP 
Emerald Plaza
402 West Broadway, Suite 400
San Diego, CA 92101
Direct: (619) 955-6989

Fax: (866) 581-9302

Mobile: (714) 600-6000

Email: etsai@mwbllp.com

Admitted to practice law in California, Nevada and Oregon

          McGinnis Wutscher Beiramee LLP

CALIFORNIA   |   FLORIDA   |   ILLINOIS   |   INDIANA   |   WASHINGTON, D. C.

                                 www.mwbllp.com

FYI: Cal App Ct Upholds Denial of Class Cert in Call Recording Case Under California Penal Code § 632

Friday, February 28, 2014

The California Court of Appeal, Second District, recently affirmed a trial court’s denial of class certification in an action challenging the defendant’s alleged failure to inform its customers that outbound calls were being recorded.

In so ruling, the Court held that there was no per se violation of California Penal Code § 632 (“section 632”), which prohibits the recording of confidential communications without the consent of all parties to the communication, as section 632 requires an individual plaintiff to have an objectively reasonable expectation that a phone call will not be recorded.

Therefore, the Court held that “determining whether an individual plaintiff had an objectively reasonable expectation that his or her telephone conversation would not be recorded is a question of fact subject to individualized proof.”

A copy of the opinion is available at:  http://www.courts.ca.gov/opinions/documents/B244769.PDF

The plaintiff putative class representative (“Plaintiff”) had an insurance policy with an insurer (“Insurer”).  Over a three year period, Plaintiff called Insurer approximately 12 times to renew her policy or to make a claim.  During each inbound call, Plaintiff was advised the call was being recorded for quality assurance purposes.

Plaintiff also received several calls from Insurer which were recorded.  However, Plaintiff was never advised that the calls were recorded.

As a result of the Insurer’s failure to disclose that outbound calls to Plaintiff were recorded, Plaintiff filed a putative class action alleging statutory invasion of privacy under California Penal Code § 632.

Section 632(a) states:

Every person who, intentionally and without the consent of all parties to a confidential communication, by means of any electronic amplifying or recording device, eavesdrops upon or records the confidential communication, whether the communication is carried on among the parties in the presence of one another or by means of a telegraph, telephone, or other device, except a radio, shall be punished…

Section 632(c) defines a confidential communication as:

any communication carried on in circumstances as may reasonably indicate that any party to the communication desires it to be confined to the parties thereto, but excludes a communication made in a public gathering or in any legislative, judicial, executive or administrative proceeding open to the public, or in any other circumstance in which the parties to the communication may reasonably expect that the communication may be overheard or recorded.

Pursuant to Penal Code § 637.2, Plaintiff filed a putative class action lawsuit seeking statutory penalties of $5,000 for each alleged violation, and sought recovery of all attorneys’ fees and costs. 

Plaintiff moved for class certification defining the putative class as “all persons within the state of California who received telephone calls from employees, agents or representatives of Insurer … and whose telephone calls were recorded without warning from July 13, 2006 to October 27, 2009.”  Plaintiff claimed there were common questions of fact and law predominated because: (1) Insurer was the only defendant; (2) Insurer’s policy was to record all outbound calls placed by its sales group; (3) outbound calls were not preceded by an automated warning that the call would be recorded; and (4) prior to 2009, Insurer did not direct its sales group to advise customers it was recording outbound calls.

In opposition, Insurer argued that class treatment is not appropriate for a section 632 claim such claims present multiple individual factual issues.  Specifically, Insurer argued that each individual putative class member had a unique experience with Insurer including the relationship of the individual with Insurer, the number of times the individual heard the automatic disclosure when placing a call to the Insurer, and the individual’s experience with other companies that monitor calls for quality assurances.  The Insurer also claimed that Plaintiff raised additional fact questions as to what type of phone received the Insurer’s calls, as section 632 does not apply to cell phones or cordless phones. 

The trial court ruled that an individualized inquiry was necessary to determine whether each putative class member had an objectively reasonable expectation that his or her phone calls were not being recorded by Insurer. Furthermore, the trial court held there needed to be an individual inquiry as to what type of phone was used by each class member. Therefore, the trial court denied Plaintiff’s request for class certification and Plaintiff appealed. 

On appeal, Plaintiff argued there were common questions of law and fact to support class certification.  As you may recall, “a class action cannot be maintained where each member’s right to recover depends on facts peculiar to his case…because… the community of interest requirement is not satisfied if every member of the alleged class would be required to litigate numerous and substantial questions during his individual right to recover.” Caro v. Procter & Gamble Co. (1993) 18 Cal. App. 4th 644, 667-668. The Court proceeded to examine whether common questions of law and fact predominated over individualized ones.

The Court began its analysis by examining the language of section 632 and focused its attention on defining the term “confidential communication.” The Court concluded a conversation is “confidential under section 632 if a party to that conversation has an objectively reasonable expectation that a conversation is not being overheard or communicated.” Flanagan v. Flanagan (2002) 27 Cal.4th 766, 775.

Plaintiff argued that liability is established by showing there was no notification that the communication was being recorded. Put another way, Plaintiff contended that recording of any conversation without advising the other party was a per se violation of section 632.   Thus under Plaintiff’s view, there was no need to have each class member individually prove his or her objectively reasonable expectation that a phone call was not being recorded. 

The Court disagreed with Plaintiff, noting that nothing  “in the language of section 632 or case law interpreting a ‘confidential communication’ suggests recording a conversation without advising the other party constitutes a per se violation of the statue.”  Thus, the Court held there needed to be an individual determination to decide what each putative class member’s objectively reasonable expectation was regarding whether a phone call was being recorded.

In addition, the Court stated that a jury could reach different conclusions concerning different putative class members, as one putative class member may have had limited experience with the Insurer and was not aware all calls were recorded, while another putative class member may have an extensive relationship with the Insurer and understood all calls were recorded.  The Court also noted that due process gives Insurer the right to cross-examine each putative class member regarding those experiences that may affect the reasonableness of an individual’s alleged confidentiality expectation.

Therefore, the Court affirmed the trial court’s ruling that the requirements for a class certification were not met.

Eric Tsai
McGinnis Wutscher Beiramee LLP 
Emerald Plaza
402 West Broadway, Suite 400
San Diego, CA 92101
Direct: (619) 955-6989

Fax: (866) 581-9302

Mobile: (714) 600-6000

Email: etsai@mwbllp.com

Admitted to practice law in California, Nevada and Oregon

          McGinnis Wutscher Beiramee LLP

CALIFORNIA   |   FLORIDA   |   ILLINOIS   |   INDIANA   |   WASHINGTON, D. C.

                                 www.mwbllp.com

FYI: Cal App Ct Holds Lender Liable Under CA Construction Lien Claimant "Stop Notice" Provisions

Sunday, February 16, 2014

The California Court of Appeal, Fourth District, recently interpreted several California construction lien claimant “stop notice” statutory provisions (Cal. Civ. Code §§ 8000-9566), and reached the following conclusions:

(1) a construction lender must make available to stop notice claimants those amounts the lender has already disbursed to itself on the construction loan;

(2) a stop notice claimant’s failure to serve a preliminary 20-day notice prevented the claimant from recovering under its bonded stop notice unless a recognized exemption applied; and

(3) a stop notice claimant’s failure to give the lender a notice of the commencement of the stop notice action did not bar the claimant from recovering where the lender suffered no prejudice.

A copy of the opinion is available at: http://www.courts.ca.gov/opinions/documents/D061665.PDF

The case involves a large condominium construction project involving several contractors. The lender was a licensed real estate broker that facilitated the raising of construction loan funds for the project. The owner of the project borrowed $13,625,000 from the lender to fund the remaining construction of the project.  The lender agreed that it acted as a construction lender for purposes of the California “stop notice” statutory scheme. 

Under the terms of the owner’s loan, the lender was obligated to obtain $2.8 million to close the transaction and agreed to use its best efforts to raise the balance of the loan in stages.  The lender obtained the initial funds and distributed them to the owner.   The lender, as it raised funds for subsequent stages of construction, assigned portions of its beneficial interest in the construction loan trust deed to third-party investors. 

The lender entered into private loan servicing agreements with its third-party investors, under which the lender served as each investor’s agent with regard to the construction loan.  The lender paid the third-party investors interest on their fractional loan interest and charged a servicing fee.  Under the private loan placement and fee agreements on each of the loans, the lender prepaid itself interest, loan fee/points, loan underwriting and other fees totaling $1,555,771.37.  The loan servicing agreements between the lender and the third-party investors were not recorded as public record.  The lender contributed some of its own money to fund the construction loan, resulting in a small beneficial interest in the construction loan trust deed and promissory note.  The lender raised and disbursed a total of $12,018,612.50 and never funded the remaining balance of the loan amount. 

The Court summarized the California “stop notice’ procedure as follows:

After giving a 20-day preliminary notice, a laborer or materialman may serve a stop notice upon the owner or the construction lender.  A timely served stop notice obligates the owner or lender to withhold funds for the benefit of the stop notice claimant.  Once a stop notice is timely served on an owner or lender, an action to enforce the stop notice must be commenced within 90 days of the deadline to serve the stop notice, regardless of whether the stop notice was served early.

The party whom received the timely stop notice is required to withhold funds in the amount of the stop notice until the expiration of the claimant's deadline to file an action to enforce the stop notice, plus five additional days for receipt of a notice of commencement of the action to enforce the stop notice.  If several stop notices have been filed and not enough money exists to pay them all, stop notice claimants share pro rata in the available funds.  If a lender fails to withhold funds required by the bonded stop notice, it is personally liable to the claimant for the full amount of the claim.

A stop notice claimant obtains priority over any "assignment" of the construction loan funds, whether the assignment is made before or after a stop notice is served.

The dispute involved 4 specific contractors.  One of the contractors served its bonded stop notice in June, 2007 when the lender was holding sufficient unexpended construction loan funds to cover the claim.  The lender, however, did not withhold sufficient funds to satisfy the claims and the parties agreed that the lender had stop notice liability as to that contractor.  By October 2007, the lender had fully disbursed all monies in the construction loan.  The lender received additional bonded stop notices from the other 3 contractors in March and April 2008, by which time all construction loan funds held by the lender had been disbursed. 

All of the contractors filed actions against the lender and others.  The sole issue before the trial court was the lender’s liability with respect to the contractors’ bonded stop notice claims. The contractors argued that the lender was prohibited from assignment of the construction loan funds, before or after receipt of a stop notice, and that under Familian Corp. v. Imperial Bank (1989) 213 Cal.App.3d 681, the lender could not avoid a stop notice claimant’s priority by private agreement. 

The trial court awarded the contractors a total of $1,555,771.37, which was apportioned among them, plus costs, prejudgment interest and attorneys’ fees under the stop notice statute.  The trial court also denied the lender’s motion for entry of judgment against two of the contractors based on those contractors’ alleged failure to comply with the stop notice statutes.

On appeal, the Court of Appeal recognized that Familian was a case of first impression, but that it unequivocally established that a secured lender could not defeat a stop notice claimant’s statutory priority to construction loan proceeds by segregating the fund into pre-allocated accounts and thereafter deducting charges and interest as accrued.  Under Familian, the lender’s pre-allocation of funds to pay points, interest and other non-construction costs, like the lender had in this case, constituted an “assignment” of the construction loan funds within the meaning of the stop notice statutory provisions that was subordinate to the perfected claims of contractors.  The Familian court further realized that limiting a stop notice claimant’s priority to “unexpended or “undisbursed” loan funds would render the stop notice statutory provisions meaningless because the lenders would then simply arrange to deduct their profits at the inception of the loan to assure a double recovery at the expense of the contractors responsible for enhancing the value of the property. 

The Court of Appeal rejected the lender’s attempt to overturn Familian or otherwise distinguish it in such a way to render it inapplicable to the facts of this case.  The Court of Appeal was clear: “the Legislature created the stop notice law to give laborers and materialmen priority over lenders to payments from the construction loan fund.”  The Court of Appeal also clarified that Familian did not invalidate the pre-allocation of construction loan funds by lenders.  Instead, according the Court, lenders were free to draft construction loan agreements to give themselves a contractual right to priority but those agreements will cede to a stop notice claimant’s statutory priority. 

The Court rejected the lender’s argument that a “super-priority” first trust deed wiped out the lender’s priority and, as a result, it was not unjustly enriched by the stop notice claimant’s contribution to the project.  The Court concluded that the holdings from Familian did not attempt to avoid unjust enrichment and did not depend on whether the lender ultimately realized a gain or loss on the project.  The Court established that the stop notice claims took priority over any monies the lender received from the construction loan funds.   

In addition, the Court of Appeal provisionally reversed the trial court as to one contractor and remanded the matter to resolve a factual issue.  As to that contractor, the Court concluded that because it was not the prime or general contractor, it was required to provide the 20-day notice under the stop claim statute.  It was undisputed that the contractor had not provided the required notice.  The contractor asserted, however, that it was exempt under the statute because it had a direct contract with the owner, and had commenced work on the project before the lender recorded its construction loan trust deed.  The Court remanded the matter to the trial court on this potentially dispositive factual issue. 

Finally, the Court addressed the issue of one of the contractor’s failure to give the lender a required notice of the commencement of the stop notice action.  According to the Court, by the time the contractor served its bonded stop notice the lender did not have any undisbursed funds left in its control.  Thus, the contractor’s failure to give the lender notice of the commencement of the action did not prejudice the lender because the lender had no funds to release.  The Court held that the contractor’s failure to strictly comply with the stop notice statute was excused where there was no prejudice to the lender.  

In sum, the Court affirmed that the lender was required to honor the stop notice claims, even in the presence of a private agreement that allowed the owner to segregate and pre-allocate funds to be used for deducting charges and interest as accrued to the lender.  In addition, the Court held that there was a question of fact as to whether the recognized exemption for contractors with direct contract with the owner applied here. Finally, the Court held that a contractor’s failure to strictly comply with the stop notice statute was excused where there was no prejudice to the lender.

Eric Tsai
McGinnis Wutscher Beiramee LLP 
Emerald Plaza
402 West Broadway, Suite 400
San Diego, CA 92101
Direct: (619) 955-6989

Fax: (866) 581-9302

Mobile: (714) 600-6000

Email: etsai@mwbllp.com

Admitted to practice law in California, Nevada and Oregon

          McGinnis Wutscher Beiramee LLP

CALIFORNIA   |   FLORIDA   |   ILLINOIS   |   INDIANA   |   WASHINGTON, D. C.

                                 www.mwbllp.com