A recent decision from the Minnesota Court of Appeals has held that a construction company may not receive full payment from a city for the company's work on a completed construction project. The dispute arose out of a failed residential subdivision project, a scenario likely to be repeated in the wake of the housing boom and bust. The decision therefore may have important implications for construction law and commercial real estate.
In early 2007, Percheron Properties, a developer, received approval from the City of Avon, Minnesota, to build a new housing subdivision. Percheron owned the land on which the subdivision was to take place. As a part of the project, the City of Avon was responsible for public improvements such as water and sewer extensions, streets, and sidewalks. Percheron agreed that special assessments would be assessed against the property to finance the public improvements, that Percheron would pay the assessments as they came due, and that Percheron would post collateral equal to 50% of the total cost of the improvements to secure its obligation to pay the assessments as they came due.
Nodland Construction submitted the winning bid, of approximately $4.5 million, to complete the public improvements for the City of Avon. The contract between Nodland and the City of Avon stated that the city would retain five percent of its progress payments until final acceptance of Nodland's work. However, because Percheron could not provide the required collateral to secure future payment of the special assessments, the entire project was in danger of being cancelled, including Nodland's contract. As a result, Nodland entered into a separate agreement to allow the retainage to be increased from 5% to 10%, with the 10% retainage being treated as security for the assessments.
However, there was a disagreement between the various contract documents as to how the additional 5% retainage was to be handled. The development agreement stated that if Nodland challenged the City of Avon's right to use the retained funds as assessment security, "this form of security shall no longer be approved" and Percheron must immediately substitute other security.
Nodland completed its work on the project, and the work was approved by the City of Avon. In January 2009, Nodland requested final payment, including the 10% retained amount. However, while the project was progressing, Percheron had experienced financial difficulties (due, at least in part, to the decline in real estate values between planning of the project and inception of construction), and had fallen behind in its payments of the special assessments to the City of Avon. As a result, the City of Avon refused to turn over the 10% retainage to Nodland.
In response, Nodland objected to and challenged the City of Avon's use of the retained amount as assessment security. The City of Avon then demanded that Percheron provide substitute security, but Percheron failed to do so.
Percheron ultimately went out of business. As a result, Nodland essentially was left paying for assessments owed to the City of Avon by Percheron.
Nodland ultimately sued the City of Avon to compel release of the retainage. Nodland was successful at the trial court level. The City of Avon appealed that result.
Court of Appeals Decision
The Minnesota Court of Appeals reversed the trial court, holding that the City of Avon could treat the retainage as an absolute guaranty by Nodland of Percheron's obligations to pay the special assessments. If Percheron were to provide substitute security, the City of Avon would then have to release the retainage. But because Percheron had defaulted, the City was not obligated to release the retainage to Nodland. And, as a result, while Nodland may have a claim against Percheron for default, Nodland could not recover against the City of Avon.
The Court of Appeals thus directed Nodland to seek damages from Percheron, not the City of Avon. But Percheron is out of business, and Nodland has little or no chance of ever recovering any money from Percheron. Thus, even though Nodland performed its work properly, it could suffer a loss of more than $450,000 on the project.
Implications of the Decision
The dispute between Nodland and the City of Avon highlights the risks associated with large development projects, and especially with municipal projects. The insolvency of Percheron has led to large losses by both the City of Avon and Nodland, innocent parties to the development. The City of Avon may be able to recover some or most of its special assessments from future purchasers of property in the subdivision, but it is unlikely that Nodland will ever be paid any of its retainage. The specific "moral" of the story may be to beware of ever guaranteeing or securing payments by another party. But the larger lesson to be taken away from Nodland's misfortune is that one should always make certain that all important contracts are reviewed by counsel before execution.
If you are involved in a real estate development dispute, contact an attorney experienced in construction law and business litigation to discuss your legal options.