The Pennsylvania Superior Court has created a new potential problem for construction lenders in Pennsylvania. In Commerce Bank/Harrisburg, N.A., v. Kessler, the court held that an open-end mortgage does not have priority over a mechanics’ lien filed after the mortgage is recorded if:
- work on the property began prior to the recording of the mortgage; and
- any portion of the loan proceeds are used to fund something other than the “cost of completing erection, construction, alteration or repair of the mortgaged premises secured by the open-end mortgage.”
This decision has serious implications for construction lending in Pennsylvania.
Section 1508(a) of the Pennsylvania Mechanics Lien Law of 1963, as amended (the Lien Law), provides that a lien filed under the Lien Law has priority “[e]xcept 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.” Section 1508(c) of the Lien Law then provides that any lien obtained under the Lien Law shall be subordinate to “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 a part of the cost of completing erection, construction, alteration or repair of the mortgaged premises secured by the open-end mortgage” (emphasis added).
The relevant facts in the Commerce Bank case are as follows:
- On Oct. 18, 2006, the contractor began excavation on the Kesslers’ property.
- On Jan. 12, 2007, the Kesslers closed a construction loan with Commerce Bank.
- On Jan. 24, 2007, the mortgage securing the Commerce Bank loan was recorded.
- On May 22, 2008, as a result of a payment default, Commerce Bank foreclosed on the mortgage.
- On Feb. 24, 2009, the contractor obtained a default judgment against the Kesslers arising from the Kesslers’ failure to pay the contractor.
When the property went to sheriff’s sale, Commerce Bank and the contractor filed a joint motion to stay the sheriff’s sale so they could litigate a dispute over which of them had lien priority. The trial court found that the contractor’s lien had priority over the bank’s lien, and Commerce Bank appealed to the Pennsylvania Superior Court.
In this case, neither party disputed that work had commenced on the property prior to the recording of the mortgage. Thus, the issue the court ultimately determined was whether the mortgage in favor of Commerce Bank fit within the exception enumerated in Section 1508(c) of the Lien Law. The court found it significant that the parties had stipulated in the underlying proceedings that, in addition to construction funding, portions of the proceeds of the loan were used for purposes such as payment of tax claims, closing costs, satisfaction of an existing mortgage and payment of judgments and other liens. As this was the case, and applying a very narrow interpretation of Section 1508(c), the court held that the Commerce Bank mortgage did not fit within the exception and, therefore, Commerce Bank’s lien was subject to the mechanics’ lien in favor of the contractor. In explaining its decision, the court said, among other things, “we agree with [the contractor] that any other interpretation of the [Lien Law] would permit lenders and owners to improperly manipulate the system to defeat lien rights.”
Construction lenders are now in a precarious position in any transaction in which work has commenced prior to the recording of the mortgage. It is quite often the case that the proceeds of a construction loan are used to, among other things, satisfy existing debt secured by the property, fund the acquisition of the property, pay soft costs (such as fees to architects or engineers), pay closing costs (including commitment fees and the bank’s attorneys’ fees), and fund interest reserves. As a result of the Commerce Bank decision, all advances under that construction loan, even those used for “erection, construction, alteration or repair,” may be reduced to a subordinate lien position if work has commenced prior to recording the related open-end mortgage and a contractor later files a lien under the Lien Law.
We are monitoring developments in the case, especially to see whether Commerce Bank will appeal the decision to the Pennsylvania Supreme Court, and we will advise regarding further developments. Likewise, we will be monitoring whether there is a legislative response to the decision. In the meantime, there are steps lenders can take to protect themselves. At closing, a lender should get representations and warranties regarding the commencement of work prior to closing and, if applicable, do a deeper dive to determine what work has been done, whether payments are current, etc. A lender also should adjust its construction monitoring process to ensure that all potential lien claimants are being paid timely. If not its current practice, the lender is advised to require that the borrower provide a title bring-down at the time of each draw request. Finally, a lender should consider whether to pay contractors directly and require mechanics’ lien waivers from the contractor and material subcontractors at the time of each draw.
Should you have any questions regarding the Commerce Bank decision and how it may affect you, please contact Christopher Rosenbleeth at crosenbleeth@stradley.com or 215.564.8051.
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