"Next" means "Next": The Court of Appeals Holds Lenders to the Plain Language of the Notice to Lender Statute

The Washington Court of Appeals (Division One) recently clarified the interpretation of Washington’s “Notice to Lender” Statute, RCW 60.04.221, in Pacific Continental Bank v. Soundview 90, LLC.   The Notice to Lender Statute protects lien claimants when a lender is providing interim or construction financing. Specifically, any potential lien claimant (i.e., any person furnishing labor, professional services, materials, or equipment for the improvement of real property and who has complied with the provisions of RCW 60.04, et seq.) who has not received payment within five days after the date required by its contract, may notify the lender of the amount due and, in turn, the lender “shall withhold from the next and subsequent draws the amount claimed to be due as stated in the notice.”  RCW 60.04.221(5).  If the lender fails to comply, the encumbrance securing the lender (e.g., deed of trust) is “subordinated to the lien of the potential lien claimant to the extent of the interim or construction financing wrongfully disbursed.” Meaning that the lien claimant will be able to recover its claimed amount before the lender.  Id. at (7). 

In Pacific Continental Bank, Pacific Continental Bank (“Bank”) provided construction financing to Soundview 90, LLC (“Soundview”) for the purchase and construction of an apartment complex in the amount of $10,300,000, which was secured with a Construction Deed of Trust. Village Framers Corp. (“VFC”) subcontracted with Soundview to perform wood framing for $430,372. 

VFC completed its work on June 26, 2009.  On August 5, 2009, VFC recorded a lien for the unpaid contract balance of $385,465.48.  VFC also served the Bank with a Stop Notice / Notice to Real Property Lender as authorized by RCW 60.04.221.  This Notice to Lender advised the Bank as to its statutory obligation to withhold from the next and future project construction draws the amount of $385,465.48, or have its security interest in the property subordinated to VFC’s mechanic’s lien.

At issue in the case are the Bank’s next steps.  When the Bank received the Stop Notice, it issued an alert message through its accounting system to hold back $386,000 for VFC’s lien.  The Bank, however, continued to fund Soundview’s other uncontested draw requests.  Essentially, the Bank created a reserve equal to the amount of VFC’s claim, which would prevent Soundview from taking a draw on the last $386,000 of the $10,300,000 loan commitment rather than withhold the amount claimed from Soundview’s next monthly draw. 

On November 1, 2009, prior to releasing the full amount of the loan, the Bank declared Soundview in default, and filed a Complaint for Monies Due, Judicial Foreclosure of Deed of Trust, and Appointment of a Receiver.  The Receiver moved to approve the sale of the Soundview property for $6,500,000, create a $400,000 escrow fund from the proceeds to cover VFC’s lien, and distribute the remainder to the Bank.  After applying the distributed portion of the sales proceeds, the Bank had a deficiency of unpaid principal and interest totaling $3,074,328.91.

On July 29, 2010, the Receiver moved for summary judgment on behalf of the Bank seeking an Order declaring the validity and priority of the Bank’s security interest in the $400,000 escrow fund and authorizing the distribution of those funds to the Bank.  The trial court granted the Receiver’s Motion, found that the Bank’s security interest took priority over VFC’s mechanic’s lien, extinguished VFC’s interest in the escrowed funds, and ordered distribution of the $400,000 to the Bank.

On appeal, however, the Court of Appeals reversed because of the Bank’s failure to comply with the Notice to Lender Statute.  As noted above, the court took issue with the Bank’s “reserve” fund and whether that satisfied the statute’s requirement that the lender “withhold from the next and subsequent draws the amount claimed to be due.”  Looking at the plain language of the statute as well as the dictionary definitions of “withhold,” “next,” and “subsequent,” the court sided with VFC, holding that the Bank was required to withhold the $385,465.48 from the “next and subsequent” draws to maintain its priority-not create a “reserve” preventing the final draw. The court further stated that a lender has the following three options when it receives a Notice to Lender:

(1)   If the lender chooses to allow further draws upon the construction loan fund, he ‘shall withhold’ funds to satisfy the stop notice from these ‘next and subsequent draws;’

(2)   If the lender chooses to continue draws without withholding funds, for the stop notice, he suffers the ‘penalty’…and his mortgage is subordinated to lien; or

(3)   The lender may avoid the effect of the stop notice altogether by making no further loan advances and foreclosing his mortgage. 

Thus, because the Bank chose to issue the next and subsequent draws in full, the Bank lost its priority and its entire deed of trust was subordinated to VFC’s lien. 

This decision serves as an important reminder of the additional protection available to lien claimants when there is a lender involved.  The Notice to Lender statute, however, is not without risk to the lien claimant.   Anyone injured by an unjust, frivolous, excessive, or premature Notice to Lender may recover from the claimant any “loss, cost, or expense” including lost profits and attorneys’ fees.  If a lender is involved, we recommend consulting with an attorney familiar with the Notice to Lender statute.

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