Consider the following scenario: A prime contractor with a financially-shaky subcontractor agrees with the subcontractor's secured lender to make payments directly to the lender, but the word is not passed along to the accounts payable person or group, so the company continues to pay the subcontractor directly—to the tune of $3.8 million. Sometime later, the subcontractor goes out of business, and the lender ends up with a shortfall of $500,000 on its secured line of credit. The lender then sues the prime contractor, seeking not just the $500,000 shortfall, but the entire $3.8 million. What is the outcome under the Uniform Commercial Code (UCC)?

That was the case decided this week by the Massachusetts Supreme Judicial Court (SJC).1 On the facts as outlined above, the SJC held that the lender was entitled to recover, under the UCC, the entire amount of misdirected payments, even though that amount exceeded its actual losses. Once the contractor received notice of the subcontractor's assignment of rights to the subcontractor's lender, the contractor could only discharge its obligations to the subcontractor by making payment to the lender, and not the subcontractor.

In response to the obvious argument that the lender would receive a windfall, the SJC noted that the lender can retain only what it needs to make itself whole—principal, interest and costs of collection due under the line of credit agreement—and must disburse the excess amount to subordinate creditors and then to the assignor (the subcontractor). The contractor can pursue the subcontractor and establish its position as a subordinate creditor, and get in line to receive an appropriate portion of the excess payment.

Any project owner making an agreement with the contractor's secured lender, and any contractor or subcontractor making a similar agreement with a lender for a downstream participant, would be required to follow the terms of that agreement. Every organization should consider taking steps to ensure that this information is passed along to the accounts payable employees in the organization. The consequences of failing to do so could be dire.