The Potential Liability of Construction Escrowee

Owners often use escrows to administer payments to contractors to minimize mechanics lien claims. What happens when the lender funds the escrow, the escrowee pays the contractor, the contractor fails to pay the subcontractors, the contractor goes out of business and the subcontractors lien the project© A recent Illinois case illustrates the issue. The owner's rights primarily will depend on the language of the Escrow Agreement.

Owners often use escrows at title insurers to administer payments to contractors and subcontractors. Sometimes construction lenders demand that a construction escrow be used.

The goal is to minimize subcontractor mechanics lien claims arising from a contractor's failure to pay subcontractors despite having received payment from Owner. The escrow provides assurance to the contractor and subcontractors that their lien waivers will not be delivered to owner until payment.

In the typical construction escrow situation, the owner provides a sworn owner's statement to the escrowee listing all project expenses and to whom payment of the particular funding is to be made and requests disbursement. The construction contractor typically provides a sworn contractor's statement setting forth, at a minimum, the identity of subcontractors and the amount of the past payments and the current payment and the amount to become due. The escrowee collects mechanics lien waivers from the contractor and subcontractors listed on the contractor's sworn statement. (Sometimes, the subcontractors' waivers are for the immediate past payment).

Depending on the escrow agreement, the escrowee might pay the contractor directly or might pay subcontractors directly. In the latter case, the escrowee normally will insist on sworn subcontractor's statements listing sub-subcontractors and suppliers and will obtain the sub-subcontractors' and suppliers' waivers.

Sometimes, aside from signing necessary documents, the owner has little other involvement in the payment process. The lender might disburse loan proceeds to the construction escrowee who then pays the contractor based on an approved percentage complete. The approval often is by the Owner's architect, sometimes with monitoring or concurrence by lender's consultant.

Enter the Lender

What happens in the situation where the construction lender funds the escrow, the escrowee pays the contractor, the contractor fails to pay the subcontractors, the contractor goes out of business and the subcontractors lien the project© In the first instance, the owner normally must pay the subcontractors if they have valid lien claims. But will the owner have any rights against the construction lender or construction escrowee©

The owner's rights primarily will depend on the language of the Escrow Agreement.

The case of R & B Kapital Development, LLC v. North Shore Community Bank & Trust Co., 2005 Ill. App. LEXIS 607 (1st Dist. June 21, 2005), is illustrative. R & B Kapital concerns a motion to dismiss the owner's complaint so the factual allegations of the owner's complaint were accepted as true in determining whether owner stated a claim.

In R & B Kapital, the owner of property wished to renovate it. Apparently, the owner contracted with a general contractor who hired subcontractors but later abandoned or was terminated.

The owner approached a lender, North Shore Community Bank & Trust Co., requesting construction financing. The owner allegedly told the lender about the owner's prior bad experience with the former contractor. The lender suggested use of a construction escrow.

The lender granted a construction loan. According to the owner, the lender also prepared a construction loan escrow trust and disbursing agreement ("Escrow Agreement"). The Escrow Agreement provided that Chicago Title & Trust Co. would be the disbursing agent for payment for the construction and related development costs. The owner and lender signed the Escrow Agreement. (Normally, the escrowee also signs, but that fact does not appear in the opinion.)

For disbursements from the escrow, the Escrowee Agreement provided that owner was required to furnish the escrowee with the following: (1) a current dated sworn owner's statement; (2) a current dated sworn statement to owner by contractor; (3) sufficient funds to cover the required disbursement; (4) written approval by the owner of the current construction draw; (5) certification that the work had been completed; and (6) "statements, waivers, affidavits, supporting waivers, and releases of lien from such persons" for the purposes of extending title insurance.

After signing the loan documents, the owner also signed a "disbursement request and authorization." The disbursement request authorized $981,505 in loan funds to be issued to the escrowee to fund the escrow. From this amount, four subcontractors hired by the former contractor were to be paid after the loan administration officer (apparently not the escrowee) collected and reviewed the subcontractors' lien waivers. Also, some amount was paid to the replacement general contractor leaving $581,109 in the escrow.

Subsequently, the lender's loan authorization officer established a procedure for later construction draws against the escrow. The lender completed an "Owner's Payment Authorization", "Sworn Owner's Statement to Chicago Title Insurance Co." and "Certificate of Completion." The lender provided the completed forms to the owner's principal who executed the documents on behalf of the owner.

Using this procedure, the escrowee made payment of $143,000 to an engineer and two payments totaling $365,000 to the replacement general contractor. At the time of the payments to the replacement general contractor, the lender's loan administration officer dealt with the president of the replacement general contractor.

Agreement Not Followed

Nevertheless, the lender and the escrowee - despite the requirement in the escrow agreement - each failed to insist on the sworn contractor's statements listing the subcontractors and the amounts due them as a condition to paying the replacement general contractor.

The replacement general contractor abandoned the work and made an "assignment for benefit of creditors" (a type of out-of-court liquidation). The subcontractors recorded mechanics lien claims against the property for $708,784, all or much of which related to amounts the escrowee had disbursed to the replacement general contractor but which the contractor had not paid the subcontractors.

The owner sued the lender and the construction escrowee. The trial court dismissed the owner's amended complaint. The owner appealed.

On appeal, the appellate court agreed with the trial court that claims against the lender were barred by the Credit Agreements Act, 815 ILCS 160/2. The owner's claims against the lender were based on alleged oral statements by the lender that payment would be made direct to the subcontractors. The R & B Kapital court held that the Act made such oral statements not actionable against the lender (R & B Kapital, 2005 Ill. App. LEXIS 607, *14 - 15).

The owner's claim for breach of contract against the escrowee, however, fared better. The escrowee raised two arguments for why owner could state no claim.

First, the escrowee claimed that owner waived the requirement for the escrowee to pay only subcontractors by directing escrowee to pay the contractor. The burden to plead and prove waiver was on escrowee.

While the owner did authorize payment directly to the contractor in the periodic payment authorizations, the Escrow Agreement established a condition to that payment. Under the Escrow Agreement, "before [the escrowee] could disburse funds from the escrow, he [owner] was required to furnish [the escrowee among other documents] with a 'current dated Sworn Statement to Owner by the General Contractor.' This document would have listed the subcontractors and the material suppliers" R & B Kapital, 2005 Ill. Ap. LEXIS 607, *22.

The escrowee never received the contractor's sworn statement but paid the contractor anyway. According to the R & B Kapital court, the facts in the amended complaint and the exhibits did not establish that the owner intended to waive the requirement of the Escrow Agreement for sworn contractor statements.

Second, the escrowee argued that the escrowee itself had no obligation to provide lien waivers. That might be true, but the amended complaint also alleged that the disbursements were wrongful for escrowee's failure to insist on sworn contractor's statements as a condition to payment. That was the key, the appellate court reasoned (R & B Kapital, 2005 Ill. App. LEXIS 607, *23 - 24).

The appellate court held that owner's amended complaint stated a claim against escrowee for breach of the Escrow Agreement. Further proceedings will determine whether the escrowee ultimately will be held liable.

R & B Kapital shows, though, that if owner or lender desires direct payment to subcontractors, the escrow agreement must say so. On the other hand, R & B Kapital reminds escrowees that, even in the absence of a direct payment to subcontractor provision in the escrow agreement - at least in Illinois - the escrowee still must collect and review the contractor's sworn statement.

John S. Mrowiec is a partner with Chicago-based Conway & Mrowiec, a construction and public contracts law and litigation practice. He may be reached at (312) 658-1100. For information, go to the firm's Web site atwww.cmcontractors.com.

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