Indiana Commercial Foreclosure Law

Mortgage Securing Residential Subdivision Development Primes Site Work Mechanic’s Liens

Today’s post follows up my July 3, 2007, July 7, 2007 and September 6, 2008 posts dealing with the priority of commercial construction mortgages over mechanic’s liens.  If you are struggling with lien priority questions related to the development of a residential subdivision, the Indiana Court of Appeals’ decision in Lincoln Bank v. Conwell Construction, 2009 Ind. App. LEXIS 1047 (Ind. Ct. App. 2009) (Lincoln.pdf) provides answers.

The interests.  Nichols Group owned real estate that it intended to develop into a residential subdivision.  Lincoln Bank gave a mortgage loan to Nichols Group to fund the development, and the bank recorded its mortgage in 2006.  General contractor, Conwell Construction, contracted with Nichols Group to develop the site (earth work, sewer, water, curbs and paving).  Conwell Construction, in turn, contracted with subcontractors Hedger (for curbs), Mitchell (for drains) and Grady (for paving).  The contractors only performed site development work.  They did not construct any houses, nor did they improve any specific lots.  Indeed no houses were ever built on the property.  Since the contractors didn’t get paid, they filed mechanic’s liens in 2007. 

The controversy.  The Court addressed the question of whether Lincoln Bank’s mortgage should have priority, as opposed to the bank and the four contractors sharing pro rata in any foreclosure proceeds.

Inventory of statutes.  Lincoln Bank, a thorough and logical opinion, addresses the applicable Indiana statutes:

 a. I.C. § 32-28-3-1 – Contractors may file mechanic’s liens for, among other
  things, the labor and materials at issue.

 b. I.C. § 32-28-3-5(c) – Mechanic’s liens are equal in priority to other
  mechanic’s liens.

 c. I.C. § 32-28-3-5(d) – Priority of construction mortgages (see also July 11, 2007
  and September 6, 2008 posts).

 d. I.C. § 32-28-3-5(d)(1-3) – Exceptions to general rule of construction mortgage
  priority for homes, improvements auxiliary to homes and utilities.

Section 5(d) and its three categories of exceptions.  The Court noted that a recorded mortgage has priority over a subsequently-recorded mechanic’s lien, per I.C. § 32-28-3-5(d), “to the extent of the funds actually owed to the lender for the specific project to which the lien rights relate.”  There was no dispute Lincoln Bank recorded its mortgage before the recordation of the mechanic’s liens, nor was there a dispute that Lincoln Bank’s mortgage “was for the specific project to which the lien rights relate.”  Therefore, if § 5(d) applied, Lincoln Bank’s mortgage would have priority over the mechanic’s liens.  The Lincoln Bank decision focused on the three stated carve outs in § 5(d) for construction (1) of houses, (2) of improvements auxiliary to houses and (3) on property controlled by a utility.  For those categories, Ward v. Yarnelle would control, meaning that there would be parity among the mortgage and the mechanic’s liens.

Exceptions not applicable.  Since the underlying site development work in Lincoln Bank related to the ultimate construction of houses, seemingly the door was open for the Court to apply one or more of the three exceptions to § 5(d)’s priority rule.  Instead, the Court viewed the work for what it was – construction, for a real estate investor, of a commercial project.  The work in question did not directly involve the building of an individual homeowner’s residence.  The closest call for the Court was § 5(d)(2), which governs the development or construction of “an improvement on the same real estate auxiliary to a Class 2 structure [house].”  Despite concluding that the contractors’ earth moving operations and asset installations were indeed “improvements,” the Court relied heavily on the fact that “no home had yet been constructed on the land” in concluding that § 5(d)(2) “does not apply to preparing land for the subsequent construction of houses.” 

Result.  The Court concluded, with regard to the foreclosure proceeds, that “the first priority is to satisfy Lincoln Bank’s mortgage.”  Thereafter, “the four mechanic’s liens are equal in priority.”  Lincoln Bank is particularly relevant today given recent failures of many residential subdivision development projects across Indiana.  These projects have, in certain instances, stalled before any houses were built or any specific lots were improved.  According to Lincoln Bank, where the general contractor or subcontractors have devoted resources only to subdivision site work, lenders holding a timely and perfected construction mortgage will not be forced to share equally with such contractors. 

Blog Post On Priority Of Commercial Construction Mortgages “Affirmed On Appeal”

My July 3, 2007 blog post entitled “Construction Mortgage v. Mechanic’s Lien:  Win, Lose or Draw?” addressed Indiana’s rules applicable to a hypothetical priority dispute between a construction mortgage lender and a contractor in a commercial project.  Based upon my research and analysis at that time, my theory was:

2007: Lender Wins.  At least as to a standard commercial project, therefore, the Ward doctrine of parity seems to be a thing of the past.  The lender, in the scenario presented to me, shouldn’t be forced to share equally with any contractors that started construction before the developer closed the deal.  Instead, the lender should hold a superior lien, assuming the lender records his mortgage before a contractor records a notice of mechanic’s lien.  In other words, if the project goes south, the lender should get paid first.  Having done all the research and reasonably assured myself of the answer to the question, therefore, I believe my lender contact can relax.  Minimal delays with the closing should not adversely affect his bank’s mortgage lien.  But, he should make sure he records the mortgage sooner rather than later, and certainly before any of the contractors record a notice of mechanic’s lien.

This past Wednesday, in a case of first impression in Indiana, the Court of Appeals in McComb & Son v. JPMorgan Chase, Case Number 02A04-0802-CV-60 (McComb.pdf), reached the same conclusion I did.

The situation.  The parties involved in McComb & Son were two general contractors (McComb and ARI), who had entered into a construction agreement with the property owner (Indian Village) to develop an apartment complex.  Lender JPMorgan Chase Bank (Chase) extended an $850,000 line of credit and a $2,650,000 construction loan to Indian Village.  Indian Village failed to pay McComb/ARI and also defaulted on its construction loan with Chase.  Significantly, Chase had recorded its mortgages before McComb/ARI recorded their mechanic’s lien notices.

The statutes.  Indiana law is well-settled that Chase had priority over McComb/ARI with regard to the land and the pre-existing buildings.  The only issue in McComb & Son was whether McComb/ARI had priority as to the improvements they constructed.  The Court outlined the three operative statutes and the corresponding rules/exceptions:   

1.  Generally, a purchase money mortgage is superior to a mechanic’s lien “if the mortgage was recorded before the mechanic’s work was begun or materials furnished.”  Provident Bank v. Tri-County South Side Asphalt, Inc., 804 N.E.2d 161, 163 (Ind. Ct. App. 2004); I.C. § 32-21-4-1(b).

2.  But, a mechanic’s lien holder has priority “as to the improvement for which he provided the labor and materials.”  Provident Bank, 804 N.E.2d at 164; I.C. § 32-28-3-2.  “The holder of a mechanic’s lien may sell the improvements to satisfy the lien and remove them within ninety days of the sale date.”  Thus a mechanic’s lien has priority over a purchase money mortgage with regard to “new improvements” even if the mortgage was recorded before the mechanic’s lien notice was recorded and even if the mortgage was recorded before the mechanic’s lien holder began its work or furnished any materials.

3.  On the other hand, as to commercial property (including apartment complexes), the mortgage of a lender has priority over all liens recorded after the date the mortgage was recorded, “to the extent of the funds actually owed to the lender for the specific project to which the lien rights relate.”  I.C. § 32-28-3-5(d) . 

For the first time, McComb & Son conclusively tells us what Section 5(d) means.  The Court talked about Ward v. Yarnelle, 91 N.E.7 (Ind. 1910) and its doctrine of parity, as well as the dissenting opinion in the Provident Bank case, both of which I addressed in July of 2007.  According to McComb & Son, the Ward doctrine of parity does not apply to commercial construction projects.  The critical rule announced in McComb & Son was: 

With regard to commercial property, where the funds from the loan secured by the mortgage are for the specific project that gave rise to the mechanic’s lien, the mortgage lien has priority over the mechanic’s lien recorded after the mortgage.

The conclusion.  Chase’s mortgages had priority over McComb/ARI’s mechanic’s liens because:

There is no dispute that [Chase’s] mortgages were recorded before the Lienholders’ mechanic’s liens or that the property in question is commercial in nature.  In addition, the trial court … concluded that the funds from [Chase’s] loan were for the specific project that gave rise to the Lienholders’ mechanic’s liens. 

Although McComb/ARI may seek transfer of the case to the Indiana Supreme Court, for now a lender’s construction mortgage lien will prime a mechanic’s lien, if the lender records its mortgage before any contractor records its notice of mechanic’s lien and if the construction project was commercial in nature. 

The survival of the Provident Bank rule (#2 above).  McComb/ARI argued for application of the Provident Bank rule, but Provident Bank did not involve a construction loan but rather a purchase money mortgage.  As such, I.C. § 32-28-3-5(d) did not apply.  Significantly, however, the Court explicitly stated that I.C. § 32-28-3-2 “still provides the general rule” in cases where the funds from the loan secured by the mortgage were not for the construction of the improvement. 

LIEN PRIORITY FOLLOW-UP: The Operative Statutes

Following-up my July 3 post concerning a potential priority dispute between a construction lender and a contractor, I thought it might be beneficial to set out the key statutes in full.  Here are the provisions, both of which are in Indiana's mechanic's lien statute.   

IC 32-28-3-2
"Extent of lien; leased or mortgaged land"
    Sec 2. (a) The entire land upon which the building, erection, or other improvement is situated, including the part of the land not occupied by the building, erection, or improvement, is subject to a lien to the extent of the right, title, and interest of the owner for whose immediate use of benefit the labor was done or material furnished.
    (b) If:
        (1) the owner has only a leasehold interest; or
        (2) the land is encumbered by mortgage;
the lien, so far as concerns the buildings erected by the lienholder, is not impaired by forfeiture of the lease for rent or foreclosure of mortgage. The buildings may be sold to satisfy the lien and may be removed not later than ninety (90) days after the sale by the purchaser.

IC 32-28-3-5
"Recording notice; priority of lien"
    Sec. 5. (a) As used in this section, "lender" refers to:
        (1) an individual;
        (2) a supervised financial organization (as defined in IC 24-4.5-1-301);
        (3) an insurance company or a pension fund; or
        (4) any other entity that has the authority to make loans.
    (b) The recorder shall record the statement and notice of intention to hold a lien when presented under section 3 of this chapter in the miscellaneous record book. The recorder shall charge a fee for recording the statement and notice in accordance with IC 36-2-7-10. When the statement and notice of intention to hold a lien is recorded, the lien is created. The recorded lien relates back to the date the mechanic or other person began to perform the labor or furnish the materials or machinery. Except as provided in subsections (c) and (d), a lien created under this chapter has priority over a lien created after it.
    (c) The lien of a mechanic or materialman does not have priority over the lien of another mechanic or materialman.
    (d) The mortgage of a lender has priority over all liens created under this chapter that are recorded after the date the mortgage was recorded, to the extent of the funds actually owed to the lender for the specific project to which the lien rights relate. This subsection does not apply to a lien that relates to a construction contract for the development, construction, alteration, or repair of the following:
        (1) A Class 2 structure (as defined in IC 22-12-1-5).
        (2) An improvement on the same real estate auxiliary to a Class 2 structure (as defined in IC 22-12-1-5).
        (3) Property that is:
            (A) owned, operated, managed, or controlled by:
                (i) a public utility (as defined in IC 8-1-2-1);
                (ii) a municipally owned utility (as defined in IC 8-1-2-1);
                (iii) a joint agency (as defined in IC 8-1-2.2-2);
                (iv) a rural electric membership corporation formed under IC 8-1-13-4;
                (v) a rural telephone cooperative corporation formed under IC 8-1-17; or
                (vi) a not-for-profit utility (as defined in IC 8-1-2-125);
            regulated under IC 8; and
            (B) intended to be used and useful for the production, transmission, delivery, or furnishing of heat, light, water, telecommunications services, or power to the public.

(Remember that, as to mortgages, Indiana is a "first to file" state.  I.C. 32-21-4-1(b) provides that a "mortgage ... takes priority according to the time of its filing" in the recorder's office.)

My partner Tom Hanahan, who often represents lenders on the front end of construction deals, informs me that title companies in Indiana usually will not insure absolute priority over mechanic's liens, where construction has commenced before recording of the mortgage, without securing indemnity from the principals of the borrower.  In speaking with Tom, I gather that the title lawyers have noted the potentially-inconsistent language in Ind. Code 32-28-3-5 and 32-28-3-2, about which I discussed in my prior post.  I highlighted the areas of potential conflict.  Judge for yourself. 

CONSTRUCTION MORTGAGE VS. MECHANIC’S LIEN: Win, Lose or Draw?

Recently, I met with a commercial lender who mentioned a problem with one of his projects.  Construction had started, but the developer hadn’t closed the construction loan.  Thus the lender’s mortgage hadn’t been recorded, but likely would be soon.  He wondered how the delay might affect the priority of his bank’s mortgage lien.  Secured lenders involved in real estate development in Indiana probably should be aware of some of the rules governing these situations.      

1910: A Draw.  The Indiana Supreme Court’s 1910 decision in Ward v. Yarnelle, 91 N.E.7 (Ind. 1910) is the landmark opinion on this subject.  At the time, Indiana’s mechanic’s lien statute “failed to address the lien priority between a [construction mortgage] and the mechanic’s liens of those who [completed] the construction.”  In Re Venture, 139 B.R. 890, 895 (N.D. Ind. 1990).  The Court therefore announced the equitable “doctrine of parity” in which a “real estate mortgage executed while a building was in the process of construction was entitled to equal priority with the claims of [contractors that] worked after [recordation] of the mortgage and with full knowledge of its purpose and effect.”  Beneficial Finance v. Wegmiller Bender, 402 N.E.2d 41, 47 (Ind. Ct. App. 1980) (no parity because contractor completed its work before lender recorded its mortgage); Brenneman Mechanical v. First Nat. Bank, 495 N.E.2d 233, 242 (Ind. Ct. App. 1986) (parity because contractors had knowledge of loan, which helped pay them). 

Whether the contractor had knowledge of the construction mortgage was critical to the Ward analysis.  In such instances, the Court felt that lenders and contractors were in a kind of “common enterprise.”  Ward, 91 N.E. at 15.  Under Ward, if funds derived from the mortgage were used in the construction project and if the contractors had knowledge of the loan when they performed their work, then the mortgage and the mechanic’s lien had equal priority.  Conversely, if the loan was not for purposes of construction or if the contractors worked without knowledge of the purpose of the loan, then the mortgage had priority over mechanic’s liens for work performed after recordation of the mortgage.  Venture, 139 B.R. at 896

1999: Statutory Amendments.  Ind Code §32-28-3-5 is the pivotal statute.  Subsection (b) provides that a mechanic’s lien is “created” when the lien notice is recorded.  But the recorded lien relates back to the date the work began, which could pre-date a mortgage.  In 1999, Indiana’s legislature added the language now in subsection (d) that says construction mortgages have priority over mechanic’s liens if the mortgage is recorded before the notice of mechanic’s lien is recorded (not created).  My reading is that subsection (d) disposes of Ward’s doctrine of parity, at least as to commercial and industrial projects.  (Note that section 5(d)(1)-(3) has carve-outs for certain residential and utility projects.)  Accordingly, Indiana courts should focus on relative filing dates, and not on work dates or contractor knowledge.   

Post-1999: One Case.  The meaning of section 5(d) has not been tested on appeal, however, and I.C. §32-28-3-2(b)(2) priority, which favors contractors, may to some extent conflict with section 5(d) priority, which favors lenders.  Section 2(b) might permit contractors to argue that, despite section 5(d), they have priority as to their specific improvement.  Provident Bank v. Tri-County Southside, 804 N.E.2d 161, reh’g granted, 806 N.E.2d 802 (Ind. Ct. App. 2004) gives some insight into the potential statutory inconsistency.  Provident Bank dealt with a contractor’s improvement (installation of a driveway) at a residence long after a purchase money mortgage had been recorded.  Believe it or not, the majority opinion held that the contractor’s statutory remedy was to remove and sell the driveway.  Anyway, the dissenting opinion toyed with Ward and the new I.C. §32-28-3-5.  “In 1999, our legislature amended I.C. §32-28-3-5 and specifically addressed the situation before our supreme court in Ward and again discussed by the bankruptcy court in Venture.”  Id. at 168.  As an aside, the dissent concluded that I.C. §32-28-3-5(d) applies “where funds from the loan secured by the mortgage are for the project which gave rise to the mechanic’s lien.  In such an instance, the mortgage lien has priority over the mechanic’s liens recorded after the mortgage.”  Id. at 169

2007: Lender Wins.  At least as to a standard commercial project, therefore, the Ward doctrine of parity seems to be a thing of the past.  The lender, in the scenario presented to me, shouldn’t be forced to share equally with any contractors that started construction before the developer closed the deal.  Instead, the lender should hold a superior lien, assuming the lender records his mortgage before a contractor records a notice of mechanic’s lien.  In other words, if the project goes south, the lender should get paid first.  Having done all the research and reasonably assured myself of the answer to the question, therefore, I believe my lender contact can relax.  Minimal delays with the closing should not adversely affect his bank’s mortgage lien.  But, he should make sure he records the mortgage sooner rather than later, and certainly before any of the contractors record a notice of mechanic’s lien.