Real estate development projects sometimes go awry. Unanticipated issues and overruns can push development costs over the projected value of the project, leaving lenders to decide whether to continue funding construction. A recent decision from the U.S. Court of Appeals for the Seventh Circuit highlights the risks lenders face in deciding when to pull the plug on a failing real estate development project.

In BB Syndication Services Inc. v. First American Title Insurance Company, No. 13-2785, 2015 U.S. App. LEXIS 3956 (7th Cir. March 12, 2015), a secured lender exercised its right to cease funding after it had previously advanced $61 million on a mixed-use development project in Kansas City, Missouri. When funding ceased, unpaid suppliers and subcontractors filed mechanic’s liens against the property, and under applicable state law, those mechanic’s liens primed the secured lender’s preexisting liens. The developer filed bankruptcy and its assets were liquidated, and the secured lender ultimately recovered only $150,000 of its $61 million in advances after satisfaction of the mechanic’s liens.

Some lenders seek to address mechanic’s lien risks by designating the title insurer as the disbursement agent, so when a draw request is made, the title company can verify subcontractors are paid, obtain lien waivers and update (or “date down”) the title policy. In BB Syndication Services, given that the title company served as disbursing agent, the secured lender demanded coverage for the mechanic’s lien obligations. As the ensuing Seventh Circuit decision shows, however, even careful lenders that obtain frequent title updates may not be protected from subsequently recorded mechanic’s liens.

Title policies typically contain an exclusion for liens that are “created, suffered, assumed or agreed to” by the lender. In the BB Syndication Services case, the title insurer asserted that the mechanic’s liens were “created” or “suffered” by the secured lender when the lender shut off funding with knowledge that subcontractors would go unpaid. The Seventh Circuit agreed and found the mechanic’s liens fell within the exclusion under the title policy, leaving the secured lender with no recourse. 2015 U.S. App. LEXIS 3956 at *37. Both the Eighth and Tenth Circuits have also held that the lender “creates” the lien by stopping advances even when the lender had a contractual right to cut off funding. See Brown v St. Paul Title Insurance Corp., 634 F.2d 1103 (8th Cir. 1980); Bankers Trust Co. v. Transamerica Title Insurance Co., 594 F.2d 231 (10th Cir. 1979).

The Seventh Circuit stated that, as between the lender and title company, the duty to prevent mechanic’s lien exposure lies with the lender. The lender can require financial reporting or further equity, and can protect itself through performance bonds and guarantees. In all events, when considering a problem real estate development loan, lenders should carefully consider the risks of terminating funding, particularly in states that allow mechanic’s liens to prime other preexisting liens.