In the current 2013-14 legislative session, the Pennsylvania House of Representatives passed House Bill 982, and the Pennsylvania Senate passed Senate Bill 145, with the stated purpose of preventing subcontractors from filing mechanic's liens on residential properties when the property owner has paid the general contractor.
Although this is the advertised purpose of the bills, the bills also quietly make construction lending easier on contractors, title companies and banks by fixing the nearly 2-year-old problem created by the Superior Court, in Commerce Bank/Harrisburg NA v. Kessler, by allowing funds from open-end mortgages to fund "soft" construction costs.
Title companies and banks always believed that "open-end mortgages," or mortgages where money was advanced post-closing, were entitled to priority over mechanic's liens. This proved untrue on May 9, 2012, when the Superior Court decided Commerce Bank/Harrisburg NA v. Kessler.
Kessler was a somewhat unusual case, because the borrower had already owned the real estate, meaning the bank's loan was not a purchase money loan, which would have ensured it was secured by a first-priority mortgage. When the borrower got the loan from Commerce (now Metro) Bank, it had already begun construction.
The Mechanic's Lien Act states that mechanic's liens are subordinate to purchase money mortgages and open-end mortgages where the proceeds are used to pay "all or part of the cost of completing erection, construction alteration or repair of the mortgages premises." It turns out that in Kessler, Metro Bank's loan also paid taxes, a prior mortgage, title insurance premiums and other soft costs. Therefore, it was subordinate to a pre-existing mechanic's lien and effectively worthless in the ensuing sheriff's sale that followed the mortgage foreclosure when the borrower failed to pay the bank and contractor.
Following Kessler, lenders have had to minimize risk by creating separate loans for hard and soft costs, or requiring developers to use equity to fund soft costs. Title companies have asked contractors to sign indemnity agreements and asked those signing to provide financial information to determine if those agreements were worth anything.
Almost immediately, banks, title companies and contractors realized this made construction more difficult and, in response, the Senate introduced Senate Bill 1495 in the previous legislation session. S.B. 1495, which was eventually tabled, would have given an open-end mortgage seniority to a mechanic's lien if at least 25 percent of the loan proceeds went toward "construction costs," which was defined broadly to include both soft and hard costs.
Therefore, if a bank extended a $1 million loan to a borrower secured by an open-end mortgage, $250,000 of the loan proceeds could go toward the soft and hard costs of renovating a building, while $750,000 was used to refinance existing debt encumbering the building, and the open-end mortgage would be entitled to priority of a mechanic's lien.
The same bill was reintroduced in 2013 as S.B. 145 and was eventually amended to require at least 60 percent of the loan proceeds to be used for eligible "construction costs." S.B. 145 was passed by the Senate on June 12, 2013, where on the Senate floor, the bill's sponsor, Sen. Kim Ward, stated the bill "had been worked on for two legislative Sessions and it has the support of the bankers, title insurers, mechanical contractors and the Realtors."
S.B. 145 is currently in the House Labor and Industry Committee. The House of Representatives passed its version of the bill, H.B. 982, on Nov. 12, 2013, and that bill is currently before the Senate Labor and Industry Committee.
Hopefully, agreement between the House and Senate can be struck on this issue and this legislation sent to the governor's desk, where it will ease construction lending by allowing open-end mortgages to fund hard costs, soft costs and refinance existing debt, with banks and title companies having the assurance their mortgages will receive their intended priority.
Derek Dissinger is an attorney with Barley Snyder, where he counsels his clients in a variety of real estate and finance & creditors' rights issues. He is also a licensed title agent.