Materialmen Caught In Payment Loophole

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The $16.7 million Legacy Building in Fayetteville crashed soon after Brandon Barber opened the seven-story, 37-unit condominium project in 2007.

Among the financial wreckage was a string of suppliers and subcontractors owed hundreds of thousands of dollars for material and work. National Home Centers Inc. of Springdale was left holding an outstanding bill of $153,232.

“This project is much like others in that nobody knows where the money is going after it is loaned out,” said Brent Hanby, former chief financial officer at National Home Centers. “There are hundreds of residential properties like this.

“The system of lending is broken. There is no protection for those of us who supply materials and labor.”

Changes in Arkansas law and enforcement of criminal sanctions are viewed as remedies. Hanby said bankers and prosecutors were sympathetic to the situation.

However, he isn’t hopeful anything will change until bankers sign on to help pass new legislation – and until fear of criminal prosecution becomes reality for offenders.

The uncollected bill on the Legacy Building was part of $12 million in bad-debt write-offs National Home Centers endured during the past several years. Nearly all of that money should’ve been covered by construction loans that flowed to contractors.

But it wasn’t, which could subject the contractors to criminal penalties under the state’s “Defrauding a Materialman” statute:

“A person commits the offense of defrauding a materialman if, being the principal contractor or subcontractor, the person knowingly or willfully with the purpose to defraud fails to pay any supplier or subcontractor for a material or good furnished to the project within 30 days of final receipt of payment under the contract.”

The crime is a Class D felony if the amount is $5,000 or more and a Class A misdemeanor if less than $5,000.

The criminal statute drew special attention from the Residential Building Contractors Committee, which regulates contracting licenses for Arkansas homebuilders. The state agency addressed the topic in the November/December 2009 issue of Arkansas HomeBuilder:

“Many times in an economy like it is now, it is common for the contractor to take payment from an owner and use it to pay subcontractors or suppliers on another job, or use the payment to pay off a credit card bill or something other than payment of the subs or suppliers on that particular job.

“This might also be referred to [as] robbing Peter to pay Paul. … [I]f payment is not made to the subcontractors or suppliers upon receipt of full payment under the contract, a felony conviction could result.

“We are seeing more and more complaints filed with this Board concerning the failure of contractors to pay subcontractors or suppliers.

“Many times, it is evident that this failure to pay is caused by the contractor using the money received on a certain project to pay past debts or something other than the suppliers or subcontractors on that particular job.

“Although it may seem like this is acceptable in the construction community, it is a violation of criminal law to do so. The Board is aware of prosecutions in other states with similar statutes.

“Considering the current conditions, it would not be surprising to see criminal charges brought in Arkansas when a contractor is paid and does not timely pay his subcontractors or suppliers.”

Actually, it would be surprising for an Arkansas prosecuting attorney to bring charges.

“The reality is contact is made all the time with prosecutors,” said Donnie Rutledge, partner at the Lisle Rutledge law firm in Springdale. “When it’s come down to issues like that, they say it’s a civil matter. That’s the resistance I’ve gotten in the past.

“Are they going to look at it? Yes. Will they prosecute? My experience is they won’t.”

Rutledge has lost count of the cases where a contractor has received money from an owner or a construction loan to pay suppliers and subcontractors but spent the money elsewhere.

“We do need a fix,” he said. “It is just a real problem. Contractors go down and sign affidavits that everyone is paid, and they’re not.

“There seems to be, for whatever reason, a culture of acceptance. I don’t get it.”

 

‘Left Hanging’

Arkansas is not unique among states in how it deals with the issue of protecting subcontractors and suppliers. With few exceptions, lenders are given first priority among creditors but are not required to monitor if borrowers use the loan properly.

When things go bad on a project, the chief collection weapon for a subcontractor or supplier is to file a lien claim. With a lien in place, a property can’t be sold until the claim is paid. That’s a hit-or-miss prospect that can be an exercise in futility

“Liens are worthless once it goes through foreclosure,” Hanby said. “Banks get the value of the project that we’ve put in it, but we don’t get paid.”

A bank might make progress inspections on construction work before releasing funds, but the same can’t be said for checking to see if a contractor is paying the project bills.

“We’re just left hanging,” said Kaye Dunlap, credit manager with the Northwest Arkansas operations of Meek’s Lumber Co. “We do everything right under the law, and we’re just SOL. Arkansas banks have no responsibility to follow the money to make sure it’s paid.”

A few states do require more oversight by lenders, including Missouri.

“Missouri lenders are concerned that if they don’t track the money, a supplier’s lien can have priority over their construction mortgage lien,” said Carl Circo, associate professor of law at the University of Arkansas.

In Missouri, title companies often are used to administer construction funds for a nominal fee covered by the borrower. Disbursements aren’t made unless lien waivers from subcontractors and suppliers are provided, indicating the money is flowing properly to all the interested parties.

Ken Hammonds, president and CEO of the Arkansas Bankers Association, indicated his constituents were not likely to support any legislative changes that placed more requirements on lenders.

“If they put one more regulatory obligation on a bank, you’re going to see an uprising,” he said.

Little Rock attorney J.B. Cross helped champion much-needed housecleaning of Arkansas lien laws last year. He said the banking lobby was given a wide berth to avoid any opposition to the changes.

That meant shelving any proposals such as giving subcontractor and supplier liens first priority on improvements, a Missouri contrivance.

“One of the reasons we didn’t touch on that is that several past efforts [to clean up existing lien law] were derailed because the banks don’t want it changed,” Cross said.

One simple solution to better protect everyone’s financial stake in a construction project is mandated insurance. The trade-off in additional cost is additional security.

“I’ve often wondered why banks don’t require all jobs to be bonded,” Cross said.