On May 9, 2012, the Superior Court of Pennsylvania published its decision in Commerce Bank/Harrisburg, N.A. v. Kessler, which now requires lenders to proceed cautiously with open-end construction mortgages. The Pennsylvania Mechanics’ Lien Law establishes the priority of contractors’ mechanics’ liens relative to competing liens, such as open-end construction mortgages. Under Section 1508 of the Mechanics’ Lien Law, open-end mortgages were given a super-priority (commonly called a “safe harbor”) over mechanics’ lien where the proceeds of the loan were used to pay all or part of the costs of construction.
Prior to the Superior Court’s decision in Kessler, banks enjoyed this “safe harbor” for open-end construction mortgages. The Superior Court in Kessler held that an open-end mortgage only has priority over a prior-in-time mechanics’ lien, where all of the proceeds of the mortgage are used to pay the costs of completing erection, construction, alteration, or repair of the mortgaged premises. Where a portion of the proceeds of the open-end mortgage is used to pay for non-construction items (such as tax claims, closing costs, the satisfaction of an existing mortgage, or payment of other judgments and liens on the property), the Superior Court insisted that the “safe harbor” protection of the open-end construction mortgage does not apply.
In Kessler, the borrowers contracted with a builder to construct a luxury home in the Harrisburg, Pennsylvania area. Excavation on the borrowers’ lot began in October, 2006. In January 2007, Commerce Bank of Harrisburg, N.A. extended a construction loan of up to $435,000, secured by an open-end mortgage, recorded on January 24, 2007, after the amendments to the Mechanics’ Lien Law went into effect. The purpose of the loan was not only for construction, but also for satisfaction of other debts and closing costs. By mid-2008, the borrowers defaulted on the construction loan and also failed to make timely payments to the builder. The bank sought to foreclose on the property, while concurrently, the builder sought to enforce its mechanics’ lien. Both the bank and the builder obtained a default judgment, and the property was slated to be sold at Sheriff’s Sale. Prior to the Sheriff’s Sale, both the bank and the builder asked the trial court to stay the Sheriff Sale and determine the priority of their competing liens. In February, 2011, the trial court found that the builder’s mechanics’ lien had priority over the mortgage lien because the builder’s contract was executed prior to the amendment to Section 1508, and therefore the open-end mortgage safe harbor did not apply. The bank appealed to the Superior Court, which agreed with the trial court as to the result, but not the reasoning.
The Superior Court’s analysis focused on the portion of the statute that provides the “safe harbor” to open-end mortgages where, “… the proceeds of which are used to pay all or part of the cost of completing erection, construction, alteration, or repair of the premises secured by the open-end mortgage.” The Superior Court found that an open-end mortgage will maintain priority over mechanics’ liens that are first in time only if all of the proceeds of the construction loan are used to pay the construction costs. In essence, no part of a construction loan may be used for a purpose that is not construction-related. Because some of the mortgage proceeds in Kessler were used to pay for costs such as tax claims, closing costs, satisfaction of an existing mortgage on the property, and payment of other judgments and liens, the bank’s lien was not protected.
At this stage, this decision may very well be appealed again to the Supreme Court of Pennsylvania; but, until then, Kessler stands to define the nature of lien priority for open-end construction mortgages. Lenders should take steps to protect their priority by looking at the execution and use of proceeds from a construction mortgage more proactively – such as paying the contractors themselves, requiring bonds from the general contractor sufficient to cover the invoices of the subcontractors and materialmen, and in conjunction therewith, obtaining waivers of mechanics’ liens, obtaining a certificate from the borrower that construction has not commenced as of the loan’s closing and mortgage filing date, doing site inspections periodically and reviewing project financials to ensure that all contractors are being paid. In the alternative, a lender could bifurcate its loans so that non-construction costs are separately covered by another mortgage, thereby retaining super-priority status for the construction costs. It may be best practices for lenders to have their security instruments, in particular their open-end construction mortgages, reviewed by counsel to ensure that they retain the expected priority under the Mechanics’ Lien Law in light of the Kessler decision.
** For questions, please feel free to call Vish Petigara, Joanne Murray, Don Veix or Susan Maslow at Antheil Maslow & MacMinn, LLP, 215-230-7500 **