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Commercial Construction Mortgages Stand Tall Over Later-Recorded Mechanic’s Liens In Indiana

The law is well settled in Indiana concerning the priority of mechanic’s liens and commercial construction mortgages.  The 2011 opinion of City Savings Bank v. Eby Construction, 954 N.E.2d 459 (Ind. Ct. App. 2011) reaffirmed the Court’s 2008 decision in McComb & Son v. JPMorgan Chase, about which I have written.  Construction mortgages prime mechanic’s liens on commercial projects, assuming the lender recorded its mortgage before the contractor recorded its mechanic’s lien.

The usual suspects.  The facts in City Savings were undisputed and not terribly unique.  The case involved a real estate owner/borrower, a lender/mortgagee and a subcontractor/mechanic’s lien holder.  In 2005 and again in 2007, the lender made two construction loans to the owner and contemporaneously filed two mortgages.  The funds from the lender’s mortgage loans were for the specific commercial project that gave rise to the subcontractor’s mechanic’s lien.  In 2008, after failing to get paid, the subcontractor recorded a mechanic’s lien. 

The litigation context.  At the trial court level of the City Savings foreclosure case, both the subcontractor and lender claimed their respective lien had priority over the other.  Despite the McComb precedent in favor of the lender, the trial court gave the mechanic’s lien priority based upon laws of equity.  (Black’s Law Dictionary defines “equity” as “justice administered according to fairness as contrasted with the strictly formulated rules of common law.”)  On appeal, after citing to McComb and the three operative statutes (Ind. Code §§ 32-21-4-1(b), 32-28-3-2 and, most importantly, 32-28-3-5(d)), the Court reversed the trial court in favor of the lender.

Unclean hands.  What distinguishes City Savings from McComb is the Court’s analysis of the subcontractor’s equity-based arguments around Section 5(d).  The subcontractor asserted the equitable doctrine of “unclean hands.”  In Indiana, that doctrine “provides that one who seeks relief in a court of equity – [foreclosure actions are essentially equitable in nature] – must be free of wrongdoing in the matter before the court.”  The subcontractor, Eby, contended:

[Lender] supplied the [owner] with proceeds from a third promissory note to pay a subcontractor, Vendramini, for its improvements to the Real Estate knowing full well that Eby remained unpaid by the [owner] for Eby’s improvements.  The payments to Vendramini occurred after Eby had already recorded its mechanic’s lien and after Eby had filed its complaint to foreclose to which [lender] was made a party.  The trial court frowned upon the fact that [lender] “essentially authorized the payment of a third contractor before the second contractor.”  As [lender] was on notice of Eby’s mechanic’s lien before it disbursed those funds on behalf of the [owner], the trial court concluded that [lender] was in the best position to avoid a loss in this case. 

Equity vs. law.  The Court did not condone the owner’s decision to pay Vendramini when it had not yet paid Eby.  But the Court did not view such a decision as unclean hands on the part of the lender, which was under no obligation to control its borrower’s decisions.  Moreover, the Court did not believe that the owner’s decision to put the lender in a better position than Eby should negate the lender’s statutory priority status.  In a pro-lender, pro-legislature statement, the Court said:

The Real Estate was clearly encumbered by [lender’s] first recorded mortgage at the time Eby contracted with the [owner] to provide improvements.  Eby knew that the Real Estate was commercial property, that it was encumbered by a mortgage, and that the loans secured by the mortgage were for the specific construction project that gave rise to Eby’s mechanic’s lien.  Eby was in the best position to avoid a loss because, at the time of contracting, Eby knew exactly what kind of lien it would be getting regarding its improvements to the Real Estate:  an inferior one.

A separate equitable doctrine in Indiana provides that “equity follows the law.”  In City Savings, principles of equity could not overcome the clear application of the statutory law in favor of the lender.  There was no evidence that substantial justice could not be accomplished by following the law.  Since Indiana’s priority statutes governed the parties’ actions, “equity must follow the law.”