Case Study: Commerce Bank/Harrisburg, N.A. v. Kessler

July 2012Articles In the Zone

In May 2012, the Superior Court of Pennsylvania filed its decision in Commerce Bank/Harrisburg, N.A. v. Kessler. Its decision turned a commonly held belief among title companies — that the Mechanics’ Lien Law provides a lien priority “safe harbor” for all open-end construction mortgages — upside-down. As a result, property owners are likely to have a more difficult time removing exceptions for mechanics’ liens from title policies, especially for recently constructed or improved properties. Lenders should update their best practices to reflect a more complex lending landscape.

In Kessler, purchasers contracted with a builder to construct a luxury home, and soon thereafter the builder commenced excavation. Subsequently, the purchasers borrowed a construction loan of up to $435,000 with an open-ended mortgage. The purchasers used the loan for construction and other debts. Eventually, the purchasers failed to make their payments to the builder and defaulted on their mortgage. The bank, and later the builder, both obtained default judgments against the purchasers who filed for bankruptcy soon after.

The home was destined for a sheriff’s sale, but both the bank and builder filed a “Joint Emergency Motion to Stay Sheriff’s Sale and Adjudicate Lien Priority Dispute.” The trial court continued the sheriff’s sale and later entered an order holding that the builder’s judgment enjoyed priority over the bank’s. On appeal, the Superior Court affirmed the trial court’s judgment in favor of the builder, but on different grounds.

Section 1508 of the Mechanics’ Lien Law determines the priority of contractor’s mechanics’ liens and liens for construction financing. Prior to January 1, 2007, mechanics’ liens enjoyed priority over competing liens if the competing lien was filed after the date of visible commencement upon the ground of erecting or constructing improvements. Amendments to the Mechanics’ Lien Law took effect on January 1, 2007 and Section 1508(c)(2) created an exception to mechanics’ lien priority for “[a]n open-end mortgage … the proceeds of which are used to pay all or part of the cost of completing erection, construction, alteration or repair of the mortgaged premises secured by the open-end mortgage.” Until Kessler, title companies treated this exception as a “safe harbor” for all open-end construction mortgages.

The trial court found that the exception did not apply because the construction commenced prior to January 1, 2007. The appeals court rejected this analysis, finding that Section 1508’s clause, “[a]ny lien obtained under this act,” unequivocally applied to all liens obtained after January 1, 2007, regardless of when work had commenced.

The appeals court found in favor of the builder on other grounds. The court interpreted the use of the terms “the proceeds” in Section 1508(c)(2) to mean all of the proceeds of an open-end construction mortgage. Therefore, where work has already commenced, open-end construction mortgages only have priority over mechanics’ liens when all of the open-end construction mortgage’s proceeds are used for costs associated with erection, construction, alteration or repair of the mortgaged property. Because the purchaser’s open-end mortgage was used for other purposes, the exception did not apply, and the mechanics’ lien retained priority over the mortgage.

Title companies, stripped of their safe harbor, now determine on a case-by-case basis whether a mechanics’ lien exception can be removed from a loan policy when construction is involved. Some underwriters in states known to favor construction parties are moving toward providing no mechanics’ lien coverage at all.

However, since Kessler, there have not been significant changes in an owner’s ability to remove the mechanics’ lien exception from title insurance. The best position for an owner is still where no work has been performed on an existing property within the last six months and no mechanics’ liens have been filed. If work has commenced within the past six months, owners face an uphill, case-by-case battle. Some underwriters, however, may be willing to remove the mechanics’ lien exception for newly completed construction such as homes located in developments.

The bottom line for lenders is clear: open-end mortgages will not have priority over mechanics’ liens where work commences prior to recording the mortgage and any amount of the mortgage is used for costs other than erection, construction, alteration or repair of the mortgaged property. For these reasons, it is more important than ever that lenders implement or continue best practices, such as requiring an owner to disclose prior to closing whether work has been done and when it commenced. Lenders should review financial documents and construction contracts and monitor whether payments are current.

Lenders may mitigate risk by paying contractors directly or requiring mechanics’ lien waivers. Lenders should also consider whether to bifurcate loans and structure one portion to only be used for erection, construction, alteration or repair of the mortgaged property. In the event of default, under Kessler, this portion of the loan will enjoy priority.

Fox Rothschild will continue to monitor the Kessler decision to keep clients apprised of any subsequent appeals or legislative action.