Banks vs. Contractors

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A legal battle between banks and contractors in Illinois has now turned into a legislative fight, with bankers trying to derail a proposed bill that they claim would jeopardize construction lending in the state.

The legislation seeks to overturn an Illinois Supreme Court ruling from 2011. The decision, favorable to banks, was based on a controversial interpretation of a law governing the proceeds from a foreclosure sale.

In better times, foreclosure sales usually generate enough money to satisfy all claimants, including lenders and contractors, says Joshua Glazov, a principal at the Chicago law firm of Much Shelist.

"It only becomes an issue when there are more cups than there is lemonade, and that doesn't happen very often," says Glazov, who has worked as a technical consultant to the Illinois Bankers Association. He testified about the legislation on the group's behalf.

Illinois law carves up proceeds from a foreclosure sale into two pools, according to construction law attorneys. The first pool reflects the proportional value of the unimproved land. The second pool reflects the value of any improvements.

The mortgagee, typically a bank, gets the first pool. Mechanics lien claimants—generally contractors, subcontractors and materials suppliers—argue they take precedence when the second pool is divided.

In a 5-2 ruling, the Illinois Supreme Court awarded a share of the second pool to LaSalle Bank, now part of Bank of America. Because the bank's loan had been used to pay some of the contractors on a project, LaSalle should have had equal footing with mechanics lien claimants, the court said.

Bankers generally applauded the ruling as upholding existing law. But contractors reject it as a departure, and they have been seeking to reverse it in the state legislature. The vehicle is known as House Bill 3636. The bill, which would give mechanics lien claimants a priority stake in the second pool, was approved by the state House and amended by the Senate. The amended version is back in the House but has yet to be voted on.

Bankers warn that the legislation would force them to adopt measures that throttle construction lending.  To solidify their claim to the second pool, for example, banks might ask contractors on every project to file mechanics liens and assign them to lenders. Liens are typically filed by contractors only when they are concerned about getting paid.

"It's going to end up costing everybody," says John B. Ward, president of First American Bank, a $2.9 billion-asset company in Elk Grove Village, Ill.

If banks are concerned about a given project, they can already insist on liens, argues James Rohlfing, a Chicago-based construction law attorney who mostly represents contractors, subcontractors and suppliers. He is active in the Illinois Mechanical and Specialty Contractors' Association.

If the ruling stands, contractors will start to feel they have more to lose in a default. As a result, they may ask to see more of the information held by bankers before they agree to do any work, Rohlfing said.

"The concern is that it is not a good allocation of risk, and it's an allocation of risk that ends up slowing down the entire economy," Rohlfing says. "Banks are in a better position to assess the creditworthiness of developers than are contractors, and certainly they are in a much better position than people further down the construction chain who have no relationship with the developer."

Whether the legislation ultimately passes or fails, lenders and contractors would benefit from certainty, says Clifford J. Shapiro, chair of the construction law practice group in the Chicago office of law firm Barnes & Thornburg LLP.

"The one thing we don't want is for this kind of problem to hold up the ability of money to be lent and projects to go forward," Shapiro says.

Coming up with an equitable solution for distributing proceeds after a foreclosure is no easy task, he adds. "Everybody is taking a haircut, and the question is to what extent."

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