The Borrower on a Residential Construction Loan calls on Monday and explains that he/she terminated the Builder on Friday. What should I do?

Explain to the Borrower that it’s not quite that simple. The Builder was approved by the Lender and the mechanic’s lien, which is the basis of the Lender’s lien, is insured by the title company. Before any work can be done by a substituted builder, the Lender must approve the replacement builder and the title company and Lender must approve the document purporting to substitute the replacement builder under the original mechanic’s lien, which in most cases will need to be recorded before work resumes.

Is there any downside in allowing the Borrower to replace the original builder?

Yes. The Lender, Borrower and Builder have signed the loan agreement, and if the Lender wrongfully refuses to fund, the Builder may have a claim against the Lender. Typically, in substituting a replacement contractor, the cost of construction will increase twenty to forty percent. This may create loan to value and liquidity issues and may cause the Borrower to no longer be qualified for the permanent loan. Many times, the Builder believes it has been wronged and will file an affidavit claiming a lien against the property.

Would it be appropriate to get the original Builder and Borrower together to resolve the dispute?

Yes, in many cases, the dispute involves miscommunication or lack of communication. The Lender has an interest in resolving the dispute without termination, if possible. Lender representatives need to make sure in correspondence and in meetings that it is clear to the parties involved that the Lender is acting on its own behalf and in its own interest, and not as agent for the Borrower or Builder.

What other steps should be taken?

Gathering information is very important. The Lender needs to know the scope and size of the problem. Is the problem due to personality conflicts, builder incompetence, time delays, budget shortfalls or payment problems? The Lender should determine how much is owed to the existing builders and subcontractors for work done to date and if the Borrower is over budget at that time.

What if the only solution is termination of the Builder and replacement with a new contractor?

The Lender should request written instructions from the Borrower not to further fund advances to the original builder. The new Builder should provide a revised budget for completion and the new Builder should be underwritten for Lender approval. The title company should be consulted to obtain its requirements in substitution of the new Builder under the original mechanic’s lien. These requirements may include one or more inspections of the property and a "cooling off" period before construction can resume. Financial assurances should be obtained from the Borrower as to adequate funds to complete the house, and the permanent lender should provide written confirmation that the permanent commitment is unaffected by the substitution and the new budget.

What other issues will arise?

New builder’s risk insurance, extension of the completion date, retainage and mechanic’s lien issues will exist. Will the existing construction contract be assumed by the new builder or replaced by a new construction contract for the remainder of the work? The Lender’s counsel should be involved in documenting the substitution of contractor and modification documents.

Is Lender liability an issue?

Many times when a builder fails to perform under a construction contract, the Borrower or Borrower’s attorney attempts to look to the Lender to make it right. If the Lender has properly monitored draws, the Builder’s default will not create liability for the Lender, but does create greater scrutiny of its draw administration. The officer should proceed with caution. Agreements should be in writing, notes should be kept of telephone conversations and in person meetings. In all cases, the loan officer should maintain a professional demeanor and not get caught up in the emotional nature of the situation. Consultation with Lender’s counsel is imperative.