Problems with construction mortgage loan defaults can be compounded by deterioration in the collateral when contractors stop working due to non-payment. In certain cases, a lender might utilize a formal receivership to finish the project during the pendency of a foreclosure case. In other cases, the expense of a receivership may not be warranted, or the lender may have no interest in funding the completion of the job. Sometimes, only short-term repairs such as winterization are needed. Does a lender’s claim for such direct advancements have priority over a mechanic’s lien claim? Robert Neises Construction v. Kentland Bank, 2010 Ind. App. LEXIS 2449 (Ind. Ct. App. 2010) addressed that issue.
05/13/08 The borrower executed promissory note in favor of the bank in the amount of $193,000 and simultaneously delivered a mortgage against the subject real estate. The $193,000 was to be used to construct a single-family residence.
04/2008 The borrower hired a contractor to construct the residence, and work began.
07/07/08 The bank recorded its mortgage.
07/14/08 The contractor filed a mechanic’s lien against the subject real estate in the amount of $22,369.
10/21/08 The contractor filed a complaint to foreclose its mechanic’s lien and named the bank.
12/11/08 The bank filed a counterclaim, crossclaim and third-party claim seeking to foreclose its mortgage on the subject real estate.
12/23/08 The bank filed an emergency motion to access the subject real estate and asserted that, pursuant to the terms of its mortgage, the bank had a right to preserve and protect the subject real estate. The bank alleged that the contractor had stopped construction and had left the property in jeopardy of being destroyed or damaged due to weather. Subsequently, the bank paid a separate contractor $20,188.91 to install a roof on the subject real estate and protect the structure from the elements.
Preservation expense super priority lien? The question was whether the bank’s expenditures to protect the subject real estate from damage during the foreclosure case had priority over the mechanic’s lien. There was no Indiana precedent or any specific statute providing the basis for the “preservation expenses” to be a super priority. The Court in Neises Construction relied on the general principle that trial courts in Indiana mortgage foreclosure actions have “full discretion to fashion equitable remedies that are complete and fair to all parties involved.”
Ruling. Here is how the Court ruled:
It is undisputed, then, that [the bank] paid for the installation of a roof and other protective measures meant to preserve the integrity of the unfinished house, which benefited each of the lienholders. There is no suggestion that the expenses were unreasonable or that the protective measures were otherwise ill-conceived. Indeed, [the contractor] never objected to [the bank’s] emergency motion, so it cannot now complain. Because [the bank], [the contractor] and the other lienholders were engaged in a common enterprise, and each benefited from the protective measures for which [the bank] bore the full expense, the trial court properly exercised its equitable powers to give [the bank] priority for preservation expenses over [the contractor] and the others in its distribution of the proceeds from the sheriff’s sale.
In short, since the bank’s “new money” helped everyone, the lien for the preservation expenses was senior.
Parity scenario. The Court noted that, in Indiana, a mortgage for construction of a house has the same priority as a mechanic’s lien where the mortgagee and the mechanic’s lien holder are engaged “in a common enterprise and neither of them is in a position to claim priority.” Pursuant to Ward v. Yarnell, about which I have discussed previously, the bank’s and the contractor’s underlying liens were held in parity, but the bank’s preservation expense advancement maintained a separate and distinct senior status. The contractor felt that even the new money to winterize the house should fall into the parity calculation, but the Court rejected the argument. (Had Neises Construction been a commercial project, there would have been no dispute because parity wouldn’t enter the equation. Pursuant to a separate statutory provision, the lender’s mortgage lien would be senior. Since Neises Construction involved a residential project, Ward’s parity rule applied and thus created the opening for the contractor to at least fashion an argument.)
In similar situations, and assuming a mortgage provision supports it, lenders involved in failed construction projects in Indiana can be assured that preservation expenses they advance will hold super priority status, generally superior to most all other liens except for delinquent real estate taxes. Neises Construction also illustrates that a formal receivership isn’t always necessary to preserve and protect the property during foreclosure.