Suppose you’re a prime contractor with a financially-shaky sub, and you agree with the sub’s secured lender to make payments directly to the lender. But someone forgets to alert your accounts payable person or group, and so your company continues to pay the sub directly, to the tune of $3.8 million. The sub later 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 you, 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[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 sub’s assignment of rights to the lender, the contractor could only discharge its obligations to the sub by making payment to the lender, and not the sub.

In response to the obvious argument that the lender would receive a windfall, the SJC noted that the lender can only retain 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 sub). The contractor can pursue the sub and establish its position as a subordinate creditor, but must 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, must follow the terms of that agreement. Every organization must take steps to ensure that this information is passed along to the accounts payable folks in the organization. The consequences of failing to do so could be disastrous.