Sophisticated contractors and material suppliers (and their counsel) understand the benefits of serving a stop payment notice upon an owner, lender, or other construction fund holder on both private and public works of improvement. In essence, the stop payment notice places a lien on the undisbursed construction funds and is often considered a complementary remedy to a mechanics lien on private projects, and to a payment bond on public works of improvement.
It is generally understood that stop payment notices for public projects and owner-financed private projects are straightforward. Often times, claimants simply complete a one-page stop payment notice form, and timely serve it by certified mail upon the owner or public entity that contracted for the work and/or is responsible for administering the loan fund.
It is also generally understood that claimants seeking to enforce liens on construction funds for lender-funded private projects, however, must serve a bonded stop payment notice in order to force the lender to withhold monies for the claimant. A bonded stop payment notice refers to a stop payment notice that is accompanied by a bond issued by a surety in the amount equal to 125% of the amount of the claim. Such bonds are often times expensive to procure through a broker (e.g., a 1-2% premium on an amount equal to 125% of the total claim amount), and many claimants do not want to be bothered with the financial disclosures required by underwriters and the delays in securing such a bond.
Contrary to popular belief, no statute provides that a claimant is barred from enforcing an unbonded stop payment notice against a construction lender. While Civil Code § 8536 allows a lender to elect not to withhold funds when served with an unbonded stop payment notice, it does not prohibit a claimant from moving to enforce such a claim, particularly with respect to two pools of money: 1.) the construction loan funds that remain undisbursed to the project owner; and 2.) any non-construction expenses or disbursements the lender pays itself or any third-party pursuant to the construction loan agreement. Although it is preferable for suppliers and contractors to secure a bond to ensure the effectiveness of their stop payment notices (and to trigger a right to attorney’s fees to the prevailing party), for the following reasons, it may be worthwhile to consider serving an unbonded stop payment notice if a bonded stop payment notice is out of the question for the claimant for one reason or the other.
Enforceability of an Unbonded Stop Payment Notice Against the Undisbursed Loan Funds
Language in the Civil Code suggests that claimants may successfully enforce unbonded stop payment notice claims to the extent that the lender continues to hold undisbursed construction loan funds. In setting forth the priority of payment where multiple stop payment notice claims have been served, Civil Code § 8540 provides that claimants who served a bonded stop payment notice should be paid first, followed by claimants who served an unbonded stop payment notice. There is no language distinguishing between claims made against project owners and claims made against construction lenders. If, generally speaking, an unbonded stop payment notice could not be enforced against a construction lender, then § 8540 would indicate that the order of distribution for unbonded stop payment notices does not apply to a construction lender. The absence of such language is telling.
Additionally, Civil Code § 8550, which governs the time to file a stop payment notice enforcement action, does not distinguish between an unbonded stop payment notice and a bonded stop payment notice. If, again generally speaking, an unbonded stop payment notice could not be enforced against a construction lender, the appropriate limiting language would have been included in this statute. Instead, § 8550 indicates that a claimant may file an action to enforce a stop payment notice, bonded or unbonded, against the project owner or construction lender if done within a certain time frame.
Enforceability of an Unbonded Stop Payment Notice Against the Dispersed Non-Construction Expenses
Unbonded stop payment notice may be enforceable against the non-construction expenses or disbursements (including interest payments, construction administration fees, etc.) to the extent such payments have been allocated by the lender to itself or to any third-party pursuant to the construction loan contract. Civil Code § 8544 states the following:
The rights of a claimant who gives a construction lender a stop payment notice are not affected by an assignment of construction loan funds made by the owner or direct contractor, and the stop payment notice has priority over the assignment, whether the assignment is made before or after the stop payment notice is given.
This statute does not distinguish between bonded and unbonded stop payment notices served on a construction lender. Either type of claim takes priority over an assignment.
Additionally, and more significantly, California courts have held that non-construction expenses allocated to a construction lender or third-party investor constitute an invalid assignment and are subject to the claims of a stop payment notice claimant. See Familian Corp. v. Imperial Bank (1989) 213 Cal.App.3d 681; see also Brewer Corp. v. Point Center Financial, Inc. (2014) 223 Cal.App.4th 831. Following therefrom, a contractor’s stop payment notice, whether bonded or unbonded, may arguably attach to the portion of a construction loan allocated to pay such expenses. Assuming the lender or another investor has received such payments, a claimant can therefore assert its claim on those funds because such payments are considered an assignment for purposes of § 8544 and, thus, the claim takes priority.
Serving an Unbonded Stop Payment Notice on a Lender
If a supplier or contractor decides that serving a bonded stop payment notice is not practical, that’s not the end of the road. Claimants should consider serving an unbonded stop payment notice to the construction lender along with a written request (which must be accompanied by a preaddressed, stamped envelope) pursuant to Civil Code § 8538 for a notice of an election by the lender not to withhold funds. If the construction lender elects not to withhold funds under § 8536, the lender must give you notice of that fact within 30 days. Moreover, if the basis of the lender’s election not to withhold is the recordation of a payment bond under Section 8600 of the Civil Code, then the lender must include a copy of the bond with its notice that it has elected not to withhold funds.
The existence of Civil Code § 8538 further demonstrates that claimants should not overlook the effectiveness of an unbonded stop payment notice against a construction lender. If Civil Code § 8536 permits a construction lender to elect not to withhold funds, but § 8538 allows a claimant to make a written request for notice of such an election, then it follows that an unbonded stop payment notice claimant may successfully file an enforcement action. If such a claimant could never successfully file an action to enforce an unbonded stop payment notice, there would be no need to advise the claimant of a construction lender’s election not to withhold construction loan funds pursuant to that unbonded stop payment notice.
Bottom line: don’t underestimate the value of the unbonded stop payment notice in California.
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Samantha Riggen is an associate in the Los Angeles office of Gibbs Giden where she practices and represents clients in the areas of business, commercial, and construction litigation.