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A Gordian Knot: Construction Lending and Oregon House Bill 2415

by Erich Paetsch, Chair, Financial Services Industry Group and Daniel Reynolds, Chair, Construction Industry Group

 

In 2019 Oregon’s legislature explored a concern surrounding the availability of retainage payments required in construction contracts.  Developers, general contractors, subcontractors, and others could not agree on all the details, but Oregon House Bill 2415 (“HB 2415”) was passed into law establishing a process. The industry anticipated that it could fill in omitted details in a subsequent legislative session. However, no one anticipated the COVID-19 pandemic, and many details remain unresolved. The resulting gordian knot leaves construction lenders significant questions on how to implement HB 2415.

 

Effective January 1, 2020, HB 2415 alters retainage requirements under Oregon’s construction prompt payment laws. For all public and private residential and commercial projects where the contract price exceeds $500,000, HB 2415 requires retainage amounts included as part of an approved draw or otherwise earned to be placed into an interest-bearing escrow account. The new law imposes obligations on state agencies, owners, and contractors. It does not reference financial institutions. Even with this omission, HB 2415 indirectly affects financial institutions’ construction lending practices.

 

Previously, Oregon’s prompt payment laws required the contracting agency, owner, contractor, or subcontractor to pay interest on an invoice 30 days after receipt or 15 days after approval of the invoice, whichever was earlier. However, this requirement did not address interest on properly withheld retainage amounts. Under HB 2415, the retainage amounts should be transferred to interest-bearing escrow accounts rather than withheld from an approved draw or otherwise until completion of the project. The law requires interest on the retainage amounts to run from the date the payment request is approved until the date the retainage is paid.

 

While the basic framework is established by HB 2415, the legislation is silent on practical application and leaves many issues unresolved. Among the open questions, lenders should consider whether they must advance or disburse funds on a construction operating line at the time a retainage is earned and deposit those funds into an escrow account. While there is no express timing requirement on when retainage funds must be deposited into an escrow account, HB 2415 does state that the payor “shall place amounts withheld as retainage” into the account. HB 2415 also states that interest accrues from the date of the approved pay application, as opposed to when the funds are disbursed to the payor from the owner or a lender. Read together, these provisions are reasonably interpreted to require the payor to deposit funds into the escrow account at the time of the approved pay application, which in turns means that the retainage amounts need to be disbursed to the payor at the time of the payment application and not withheld until project completion.

 

Some borrowers may not be eager to have funds for retainage disbursed at the time of the payment application and incur related interest charges, instead preferring to draw upon and release funds to the contractor at the end of a project. One option for lenders may be to delay disbursement but reserve an amount equal to the retainage plus the estimated amount of accrued interest from a construction operating line until the end of the project. Shortly before the retainage is due to the contractor, the retainage and the accrued interest can be disbursed and deposited into the escrow account. The intent of HB 2415 is arguably satisfied using this practice so long as the contractor receives the accrued interest, from the date of the payment application, at the time the retainage is released from the escrow account. However, this approach provides less protection for the contractor entitled to payment and may be viewed as a way for the payor or lender to improperly hold funds that are otherwise due to the contractor contrary to the intent of HB 2415. If this approach is considered, lenders should only proceed after the borrower and the impacted contractor entitled to retainage agree to this practice in writing.

 

In fact, as a best practice, lenders may wish to require the parties (e.g. owner and contractor) to memorialize their agreement on the treatment of retainage as part of the construction contract. The parties should agree in advance on the applicable interest rate, who is responsible for the account fees, the timing of the deposit(s) into the account, the procedure for the release of the funds upon completion of the project, and similar considerations. Ideally, these terms will be addressed in the applicable construction contract prior to starting the project. If not addressed in the construction contract, the parties should provide the lender with a separate written agreement that defines the treatment of retainage on the project. In the absence of the parties providing an agreement, lenders may consider providing a standardized form or inserting language in loan documents that is consistent with construction loan agreements. A written agreement can provide much-needed clarity about terms not addressed in the statute and minimize the risk of future conflict among all the impacted parties. Since HB 2415 does not regulate financial institutions, lenders can properly pass these requirements onto owners or contractors who wish to use the lender’s services for their construction project.

 

Insisting on a written agreement can also provide the lender with an opportunity to protect its position and preserve its rights and interests. Lenders should consider whether to include release and disclaimer language in the escrow agreement, as well as authorization for the lender to recover the retention in certain situations. For example, a situation may arise where the borrower defaults on its loan after the disbursement of retainage but before the retention is due to be released to the contractor. Appropriate language in an escrow agreement regarding an event of default may permit the lender to retain the disbursed funds that would otherwise be due to the contractor. Related, because HB 2415 is silent on what constitutes an escrow account, the parties might agree on the use of a deposit account as an escrow account depending on the level of risk an institution wishes to assume.

 

Given the reach of HB 2415, lenders may be concerned about potential risks and liability for noncompliance. Nothing in HB 2415 provides for a penalty or related consequence for a financial institution that fails to comply with the provisions of this statute. In fact, HB 2415 does not contain any penalties, fines, or other adverse consequences for any party that fails to deposit the retainage funds into an escrow account, accrue interest on the funds, or otherwise follow the statute. As a result, to date, the industry has been slow to address the impacts of the law. Nonetheless, lenders should be wary of other potential claims that may arise out of the prompt payment laws.

 

Ultimately, while HB 2415 imposes new requirements related to the treatment of retainage, the legislation does not clarify the practical application of these requirements. Unfortunately, the law does not address several important issues and there is uncertainty surrounding the implementation of HB 2415. The Oregon legislature may revisit the statute in an upcoming session to resolve the unanswered questions and issues unraveling this gordian knot. However, until that happens, we expect there to be inconsistent, and perhaps non-compliant, application of HB 2415 throughout the construction industry. Lenders should be prepared to address this uncertainty and define internal best practices concerning the treatment of retainage on impacted construction projects.

 

Erich Paesch is a partner in the Creditor’s Rights and Bankruptcy Practice Group and chair of the Financial Services Industry Group. Daniel Reynolds is an attorney in the Litigation practice group and chair of the Construction Industry Group. The information in this article is not intended to provide legal advice. For professional consultation, please contact Erich or Daniel at Saalfeld Griggs PC.  503.399.1070.  © 2020 Saalfeld Griggs PC