Advance with Caution: Construction Lending Complications on the Horizon

Real Estate and Finance Alert | May 11, 2012

Construction lending in Pennsylvania just became more complicated for lenders and title insurers due to a very troubling decision handed down on May 9, 2012 by the Pennsylvania Superior Court in Commerce Bank/Harrisburg, N.A. v. Kessler, 2012 WL 1610139 (Pa. Super. 2012).  The issue before the court was the lien priority of an open-end mortgage vis-a-vis a mechanics lien where work commenced prior to the recording of the mortgage.  In that decision, the court held that if even as little as one dollar were advanced under a construction loan for “soft costs” (i.e., interest reserve, architect’s fees, etc.), mechanics liens would have lien priority over ALL loan advances, and the priority of such mechanics liens would relate back to the date when work on the project first began on the ground.  In other words, the apparent protection that the Pennsylvania Mechanics’ Lien Law seemed to afford to open-end mortgages against mechanics liens has just been eliminated. 

Mechanics lien priority for erection and construction is set forth in Section 1508 of the Pennsylvania Mechanics’ Lien Law as follows:

The lien of a claim filed under this act shall take effect and have priority as follows:

(a)  Except as set forth in subsection (c), in the case of the erection or construction of an improvement, as of the date of the visible commencement upon the ground of the work of erecting or constructing the improvement.   

The heart of the issue before the court in Commerce Bank/Harrisburg, N.A. v. Kessler, 2012 WL 1610139 (Pa. Super. 2012) was the interpretation of the exception in subsection (c) of Section 1508 the Pennsylvania Mechanics Lien Law which states:

(c)  Any lien obtained under this act by a contractor or subcontractor shall be subordinate to the following:

(2)  An open-end mortgage as defined in 42 Pa. C.S. §8143(f) (relating to open-end mortgages), the proceeds of which are used to pay all or part of the cost of completing erection, construction, alteration or repair of the mortgaged premises secured by the open-end mortgage.  

The facts underlying the May 9 decision presented the “perfect storm” to test the interplay of these two sections of the Mechanics Lien Law and an open-end mortgage.  In October, 2006, the property owners contracted with the mechanics’ lien claimant to construct improvements on their property.  The contractor commenced work on October 18, 2006.  On January 12, 2007, the property owners obtained a loan secured by an open-end mortgage, which was recorded on January 24, 2007.  Advances were made under the loan for not only actual “hard” construction costs, but also for paying tax claims, closing costs, the pay-off of an existing mortgage and the payment of liens and judgments.

The court stated that because work commenced before the recording of the open-end mortgage, unless the exception in subsection (c) applied, the mechanics’ lien claim would have priority over the advances secured by the lender’s open-end mortgage.  More precisely, the court had to determine how the words “the proceeds of which are used to pay all or part of the cost of completing erection, construction, alteration or repair” should be construed.  If interpreted narrowly, the mechanics’ lien claimant would prevail.  If interpreted broadly, the lender would prevail.  The court, surprisingly, chose the narrow interpretation.

Based on its narrow interpretation of  Section 1508(c), the court held that in order for an open-end mortgage securing a construction loan to receive the protection of the Mechanics Lien Law, none of the proceeds of the loan could be used for costs other than actual costs of construction.   Because some of the proceeds of the loan in this case were used for such “soft costs,” the lender’s mortgage lost all priority over the mechanics lien claimant’s lien. 

Due to this decision, in situations in which work commenced before the recording of an open-end mortgage, the result is that only open-end mortgages securing nothing but funds for the erection or construction of improvements may have priority over the lien of an otherwise prior mechanics’ lien claim.  Advances for interest reserve, soft costs, developer’s fees, payment of a prior mortgage, purchase money advanced to acquire the property and the like, otherwise secured by an open-end mortgage, might now have the effect of tainting all advances, even those for construction, into a subordinate lien position.

We will continue to monitor the situation and provide updates on how the title insurance industry underwrites as a result of this decision, in particular whether, and to what extent, they will insure over potential mechanics’ lien claims. The answer may be a return to using “pending disbursement” provisions in loan title policies, with corresponding “bringdown searches” prior to each loan advance, until the Pennsylvania legislature or the Pennsylvania courts remedy this risky situation.  In the interim, construction lenders may want to explore creative solutions, such as: (i) bifurcating a construction loan into two loans with separate mortgages, one for the hard costs of construction and erection, and one for other costs, on a senior/subordinate structure or a pari passu structure; (ii) requiring bonds to obtain the benefit of contractor lien waivers in certain proscribed circumstances; or (iii) strict monitoring of the commencement of work and payments to those who have lien rights throughout the loan advance process. 

The bottom line is that construction financing has become more complicated and possibly more expensive, and one of the first questions a construction lender should ask its potential borrower is whether work has commenced.

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation with any specific legal question you may have.