A federal district court has held in a construction lending dispute that claims that a bank breached its contract by allowing loan disbursements in excess of the loan budget, and by failing to perform inspections before disbursement, could proceed to trial.

The scope of the court’s holding in LaSalle Bank Nat’l Assoc. v. Paramount Properties, 588 F.Supp.2d 840 (N.D. Ill. 2008) is limited—i.e., the court ruled the case could go to trial but made no underlying determination of liability. Nonetheless, the decision provides some cautionary warning for lenders. In LaSalle Bank, the court considered a motion to dismiss various counterclaims asserted by a borrower and guarantor to a simple collection action commenced by the bank. The facts are not unlike routine construction lending arrangements; however, the court’s holdings raise questions about the role of the lender in such arrangements.

LaSalle made a loan to Paramount for the acquisition and development of approximately 250 lots (to be developed in two phases) in Missouri. The borrower entered into an agreement with a contractor to perform the improvements on the property. The terms of the loan were consistent with a relatively routine construction lending scenario. The arrangement permitted the bank to honor requests for loan advances signed by the contractor (not the borrower), and provided that the bank could inspect the project and otherwise verify any matters set forth in a request for advance prior to honoring an advance.

The borrower alleged that, despite those provisions in the underlying loan documents, the bank never performed any inspections, and made advances that exceeded the original budget attached to the loan documents. Defaults occurred as a result of the borrower’s failure to make payments, and the bank instituted a collection action against the borrower and guarantor. The defendants counterclaimed, alleging breach of contract and other claims for negligence and negligent misrepresentations. The bank moved to dismiss the defendants’ counterclaims.

Negligence in Loan Servicing

The court held that the defendants’ claims resulted from the bank’s alleged failure to administer the loan in accordance with the terms of the loan documents. Concluding that Illinois law applied, the court further noted that Illinois law prohibits negligence claims based on the failure to perform contractual obligations absent some other, particularized duty, which did not arise under the contract.

Although the defendants pointed to a “general duty” by lenders to supervise loan disbursements, the court stated that various cases decided by courts in California, Florida and Massachusetts expressly rejected such a duty. Therefore, the court dismissed the defendants’ negligence claims. The court further dismissed claims asserted for negligent misrepresentation, noting that any claims related to an oral promise are barred by the integration clause in the applicable loan documents.

Breach of Contract Claim

The court then turned to the defendants’ counterclaim asserted for breach of contract. In its counterclaims, the defendants asserted that the bank breached obligations under the loan documents by failing to make inspections of construction progress, and by allowing disbursements to be honored without the prior written approval of the borrower. The bank sought dismissal, arguing that the terms of the note do not “require” any preconditions to advances; rather, the note simply “authorized” the bank to require compliance prior to funding.

The court noted that the terms of the loan documents are written as a mandatory precondition (i.e., using the word “shall”); therefore, the bank’s assertion was inconsistent with the terms of the documents. Further, the documents did not have a provision that permitted the bank to unilaterally waive conditions prior to advances. As a result, the court held that the defendants could assert that the bank breached its contract with the borrower by allowing loan disbursements in excess of the loan budget, and by failing to perform an inspection before each disbursement.

Because the bank could not establish that the defendants’ claims were barred by the express terms of the documents, the court permitted the case to proceed to discovery.

While the language of the court’s decision is somewhat troubling for lenders, the scope of the court’s holding is limited. The court’s decision is only at the “sufficiency” phase of the litigation and merely allows the case to proceed to trial. There is no determination of liability and assessment of damages against the bank.

The decision in LaSalle Bank, however, does raise areas of concern for lenders. As a result, lenders should ensure that their loan documents: (i) provide the lender sufficient flexibility to determine when strict compliance with conditions is required; (ii) allow the lender to waive conditions when in its best interests; and (iii) otherwise limit any “obligations” a lender could be deemed to incur as a result of entering into a construction loan agreement.