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The West Virginia Supreme Court of Appeals recently sent lending institutions a stern warning when disbursing funds related to a construction loan. When completing duties such as inspections before disbursing construction loan funds to a builder, the Court said flatly that banks will not be able to use common exculpatory language in loan documents that routine progress inspections are solely for the benefit of the lender as a shield from suit by an unsatisfied borrower.

In White v. AAMG Construction Lending Center, et al., No. 35286, September 16, 2010, the West Virginia Supreme Court of Appeals reversed in part and remanded a case from the Circuit Court of Kanawha County in which the borrower and would-be homeowner brought suit against the construction loan lender (as well as the builder) alleging both breach of contract and negligence claims contending that the lender improperly disbursed incremental construction loan funds to the builder when the contract only allowed disbursement for work that was inspected and found to be "work in place." While the good news for lenders is that the Court affirmed the Circuit Court's dismissal of Plaintiff's negligence theories, the reversal and finding that there are sufficient questions of fact for a jury to consider with respect to the contractual claims should sound alarm bells.

In reversing, the Court noted that the loan documents only allowed funds to be disbursed for finished "work in place" and that the bank "repeatedly" said in the loan documents that it would inspect the construction to gauge work progress and that funds would only be disbursed based upon those inspections. The documentation further clarified this point, stating that the inspections were "solely" for the bank's benefit to gauge work progress -- and not for the borrower -- and that the inspections were not meant to measure the quality of the work. As one would expect, the bank apparently leaned heavily on those provisions in having the case dismissed by the Circuit Court.

On appeal, the Supreme Court of Appeals noted that the borrower was ultimately in default at the upper limit of the construction loan with a home that was less than 90% complete. Recapping facts seemingly indicating that the lender may have approved and disbursed payments for work that subsequent inspections revealed had not been completed or even undertaken, the Court found that there were questions of fact for a jury to consider with regard to the issue of a contractual breach. Rejecting the bank's contention that the inspections were solely for its benefit, the Court, noted that exculpatory language and rejected it as enforcement would be akin to giving the bank free reign to disregard those inspections and distributing money for unfinished work - which the borrower would then be obligated to repay.

White underscores the need for lenders to conduct inspections scrupulously and to coordinate those inspections with individuals who perform the actual disbursements. Lending institutions may also want to revisit contractual language and consider modifying the terms for disbursement to some value-oriented concept as opposed to essentially assuming a work certification obligation.