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.