|October 12, 2012|
Previously published on October 9, 2012
In what then seemed to be a victory for construction lenders, amendments to Pennsylvania’s mechanics’ lien law were made effective January 1, 2007 giving lenders a perceived advantage over mechanics’ lien claimants. Specifically, the new law gave lenders apparent priority to the lenders’ purchase-money mortgages and construction mortgages over a mechanics’ lien filed later in time. This was all good news for lenders because, until the amendments, the law allowed contractors with mechanics’ liens to "leap frog" over a lender’s mortgage on the same property to the date that construction first began on the property. You may recall that pre-2007, this resulted in lenders taking all sorts of precautions to ensure that no construction began until after the lender’s mortgage was recorded -- including visiting and photographing the worksite the day of closing to confirm no construction has started. Most of these precautions had since ceased, given the 2007 amendments.
Unfortunately, however, a recent Superior Court case, Commerce Bank/Harrisburg, N. A., v. Stephen F. Kessler and Lisa K. Kessler, and Michael Kevin Ricker v. Metro Bank, F. K. A. Commerce Bank of Harrisburg N. A., 2012 WL 1610139, may now require lenders to start taking these precautions again, as this new case seemingly takes away the advantages lenders thought they had and has the potential to overhaul the way in which lender’s make construction-related loans going forward.
At first glance, it appeared that the primary issue the Superior Court had to decide in the case was the "straddling issue" of how to treat projects under the mechanics’ lien law that started prior to the effective date of the 2007 amendments. Therefore, the apparent question in the case seemed to be whether a contractor, who began work in October 2006, could avail itself of lien priority over a bank that filed a mortgage on the same property in January 2007. The lower court granted the contractor priority -- refusing to apply the amendments retroactively. On this issue, the Superior Court reversed the lower court’s decision and found the amended law did apply retroactively. But then the Superior Court went one step further -- it went on to interpret the law as requiring all of the proceeds of the bank’s mortgage loan to be applied to construction costs (i.e., "hard costs") in order for the bank to avail itself of priority if construction started before the mortgage is recorded. It was on this basis that the contractor retained lien priority, since some of the proceeds from the loan went to the "soft costs".
The contractor’s winning argument was based on the Court’s very strict reading of the exception set forth in Section 1508 c-2 of the Pennsylvania Mechanics’ Lien Law -- which gives priority to an open-ended mortgage loan filed subsequent to the commencement of a contractor’s work only if "...the proceeds...are used to pay all or part of the cost of completing erection, construction, alteration or repair of the mortgaged premises...". The contractor argued that the bank failed to qualify for the exception since approximately $95,000 of the mortgage loan proceeds paid for expenses other than the "completing, erection, construction, alteration or repair of the mortgaged premises". Since this fact was stipulated and agreed to by the parties, the Court was left solely with the task of determining whether all proceeds were required by the law to use for construction, repair or alteration, in order for the bank to have priority over the contractor that began construction before the loan was made.
The Court determined that the proceeds of the mortgage loan can only be used for actual construction costs to qualify for the exception. It took the position that the term "proceeds" means all of the proceeds -- agreeing with the contractor’s argument that even if $1.00 of the proceeds were used for "soft cost" purposes (i.e., closing costs, back taxes or satisfying an outstanding mortgage), then the mortgage would not qualify for the exception and would lose priority to the mechanics’ lien.
Lenders must consider that this decision, coupled with the remaining provisions of the law that were changed by the 2007 amendments but unchanged by this case (i.e., expanded period of time to file mechanics’ lien, additional layer of potential lien claimants, and the elimination of "stips" in commercial projects unless bonded), will increase the chances that a mechanics’ lien could gain priority over the lender’s mortgage. As a result, we expect that lenders are considering immediate changes in the manner in which purchase money and construction loans are made. For instance, it now becomes important again to determine if construction has started before extending credit. If a lender advances loan proceeds after a contractor has started, the lender now must be aware that the contractor may have priority if any proceeds of the mortgage loan are used for any purpose unrelated to construction, modification or repair of the mortgaged property, including "soft costs". This decision will also likely impact title insurance coverage, as it is expected that insurers will no longer simply delete the mechanics’ lien exception to lender’s policies.