Avoiding Construction Project Challenges

Today's post is a bit off topic but still has relevance to the commercial foreclosure area.  This is because construction problems can lead to mechanic's liens, which can lead to priority disputes between contractors and lenders/mortgagees.

Here is a PDF of Dinsmore's White Paper entitled:  Show Me the Money (Top-10-Considerations-in-Contract-Pre-Planning) 

My partners Rob Schein and Jim Boyers, and our associate David Patton, did great work preparing the article.

Prior posts on this topic:

• Indiana’s “Lender Exception” Applicable To Leasehold Mortgage In Priority Dispute With Mechanic’s Lien
• Indiana’s Remedy For Mechanic’s Lienholder On Property Subject To Mortgage Foreclosure Action
• Commercial Construction Mortgages Stand Tall Over Later-Recorded Mechanic’s Liens In Indiana
• Blog Post On Priority Of Commercial Construction Mortgages “Affirmed On Appeal”

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I represent lenders, as well as their mortgage loan servicers, entangled in lien priority disputes and contested foreclosures. If you need assistance with a similar matter, please call me at 317-639-6151 or email me at [email protected]. Also, don’t forget that you can follow me on Twitter @JohnDWaller or on LinkedIn, or you can subscribe to posts via RSS or email as noted on my home page.

 

 

     

Indiana’s “Lender Exception” Applicable To Leasehold Mortgage In Priority Dispute With Mechanic’s Lien

Lesson. A leasehold mortgage constitutes a valid mortgage lien and can be senior to a mechanic’s lien, if the facts otherwise meet the so-called “Lender Exception.”

Case cite. Kellam Excavating v. Community State Bank, 82 N.E.3d 928 (Ind. Ct. App. 2017)

Legal issue. Whether a leasehold mortgage or mechanic’s lien had priority in title.

Vital facts. A lessee of real estate and a contractor entered into a construction contract on 7/30/13 to build a fertilizer plant. Construction began on 10/25/13. Lessee later needed additional financing for the construction. On 5/16/14, the lessee granted a bank a leasehold mortgage as collateral for some financing the bank offered through a series of master leases between the bank and the lessee. The bank recorded its mortgage on 6/24/14. Following the lessee’s failure to pay the contractor in full, the contractor recorded a mechanic’s lien on 3/6/15. Collection and foreclosure litigation subsequently commenced against the lessee that included a lien priority dispute between the bank and the contractor.

Procedural history. The bank filed a motion for summary judgment claiming that its mortgage should receive priority over the contractor’s mechanic’s lien. The trial court granted the motion, and the contractor appealed.

Key rules.

    Three statutes: There are three Indiana statutes that govern priority between a mortgage and a mechanic’s lien: Indiana Code Sections 32-21-4-1(b), 32-28-3-2 and 32-28-3-5(d).

    Lender Exception: The Court in Kellam incorporated its prior decision in Harold McComb v. JP Morgan Chase that “discussed the interplay between the three relevant statutes and the question of mortgage lien priority versus a later-recorded mechanic’s lien as to improvements provided on commercial property.” That holding “is commonly referred to as the Lender Exception,” and I wrote about the McComb opinion on 9/6/08. In short, the Lender Exception provides:

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.

    Mortgage defined: The definition of a mortgage is a “conveyance of title to property that is given as security for the payment of a debt or the performance of a duty and that will become void upon payment or performance according to the stipulated terms” and as a “lien against property that is granted to secure an obligation (such as a debt) and that is extinguished upon payment or performance according to stipulated terms.”

Holding. The Indiana Court of Appeals affirmed the trial court’s summary judgment in favor of the bank/mortgagee. The Indiana Supreme Court denied transfer.

Policy/rationale. The heart of the Kellam dispute surrounded the nature of the financing. The contractor argued, among other things, that the lessee did not execute a promissory note and that the security agreement was not a qualifying mortgage because the document’s title was a “leasehold” mortgage. The Court, however, found that the agreement operated like a typical mortgage by granting a lien on the lessee’s property rights and by obligating the lessee to repay the bank for funds the bank expended. Moreover, there was no authority for the proposition that a promissory note is required for a valid mortgage.

In the final analysis, despite the unconventional (my term) nature of the financing arrangement, the Court in Kellam was convinced that the lessee sought a loan from the bank for construction of the facility and that the bank’s funds were used for that purpose. Since the Lender Exception applied, the bank’s mortgage was superior to the contractor’s mechanic’s lien.

Related posts. The Mechanic's Liens category to your right contains all of my posts about these kinds of priority disputes.
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I represent lenders, as well as their mortgage loan servicers, entangled in lien priority disputes and contested foreclosures. If you need assistance with a similar matter, please call me at 317-639-6151 or email me at [email protected]. Also, don’t forget that you can follow me on Twitter @JohnDWaller or on LinkedIn, or you can subscribe to posts via RSS or email as noted on my home page.

Indiana’s Remedy For Mechanic’s Lienholder On Property Subject To Mortgage Foreclosure Action

Lesson.  In Indiana lien priority disputes, a purchase money mortgage fares better than a subsequent mechanic’s lien.  Contractors beware. 

Case cite.  Wells Fargo v. Rieth-Riley, 38 N.E.3d 666 (Ind. Ct. App. 2015) .

Legal issue.  As between a mortgagee and a mechanic’s lienholder, whose lien has priority?  And, how does Indiana view each party’s remedy vis a vi the real estate?  Note this case did not involve a construction mortgage (see posts below), which the law treats differently.

Vital facts.  Wells Fargo involved a shopping center.  Lender refinanced the purchase of the subject real estate and held a mortgage, which lender recorded on the real estate in January of 2008.  In 2011, the center’s owner hired contractor to pave the shopping center’s parking lot.  After failing to receive payment, contractor recorded a mechanic’s lien on the real estate.  Neither lender nor contractor got paid, so a foreclosure lawsuit ensued against the center’s owner. 

Procedural history.  The case mainly dealt with the dispute between lender and contractor as to which party’s lien had priority, together with their respective remedies.  The trial court entered a complicated summary judgment spelling out the treatment of the parties’ interests in the real estate.  Lender appealed.

Key rules.  A mortgage takes priority according to the time of its filing.  Ind. Code 32-21-4-1(b).  The effective date of a mechanic’s lien relates back to the date the contractor began work.  I.C. 32-28-3-5.  A mortgage generally takes priority over a mechanic’s lien if the mortgage was recorded before the contractor began its work. 

In instances of a purchase money mortgage, the exception to the general rule arose out of the Provident Bank v. Tri-County Southside Asphalt case decided by the Court of Appeals in 2004 (and discussed in a post below).  That case established that Indiana’s mechanic’s lien statute at I.C. 32-28-3-2 protects contractors by providing priority over a purchase money mortgage “as to the improvement for which he provided the labor and materials.”  Provident Bank went on to hold that the contractor “may sell the improvements to satisfy the lien and remove them” following the sale.  Provident Bank, not unlike Wells Fargo, surrounded paving work (a driveway).  The contractor had a senior lien over the driveway (only) and, as absurd as it seemed, the Court concluded that the contractor could sell and remove the driveway to satisfy its lien. 

Holding.  The Indiana Court of Appeals in Wells Fargo first held that, generally, lender’s mortgage had priority over the contractor’s lien for the simple reason that the lender recorded its mortgage earlier.  Contractor was not entitled to a pro-rata share of the proceeds from the sale of the real estate, as contractor had contended and as other states, such as Illinois, allow. 

The more complicated aspect of the case surrounded contractor’s right to remove and sell the parking lot to satisfy its lien.  Lender asserted that contractor should not be permitted to remove the parking lot because removal would impair the value of the land.  On that issue, the Court remanded the case back to the trial court to determine whether removal of the lot was “practical” and, if so, to allow contractor to exercise its option.  “Otherwise, [contractor’s] lien is junior to [lender’s] mortgage lien, and [contractor] is entitled to proceeds from the sale … only after [lender’s] mortgage has been satisfied.”

Policy/rationale.  Indiana public policy in these cases places the risk of loss on the party best able to avoid the loss.  “A mechanic performing work on property encumbered by a mortgage may easily determine whether the property upon which he will work is encumbered before deciding whether to perform the work.”  Someone has to lose, and Indiana favors lenders.  In my view, the absurdity of the “improvement removal” remedy for contractors serves to force the parties to settle the case. 

Further, I should note that Wells Fargo is a novel decision in that it extends the Provident Bank analysis to mandate a trial court determination of whether removal of the subject improvement is “practical,” which in Wells Fargo meant “that its removal will not substantially impair the value of the land beyond that which it would have been had the parking lot never have been paved.”  Absent a “practical” removal, the mechanic’s lien will be fully primed by the purchase money mortgage. 

Related posts. 

• Construction Mortgage vs. Mechanic’s Lien: Win, Lose or Draw?
• Lien Priority Follow-Up: The Operative Statutes
• Blog Post On Priority Of Commercial Construction Mortgages “Affirmed On Appeal”
• Mortgage Securing Residential Subdivision Development Primes Site Work Mechanic’s Liens
  Lender’s Preservation Expenses Prime Mechanic’s Lien
• Commercial Construction Mortgages Stand Tall Over Later-Recorded Mechanic’s Liens In Indiana

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.”   

Lender’s Preservation Expenses Prime Mechanic’s Lien

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.

Chronology.

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.

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.