The Pennsylvania Superior Court’s recent decision in Commerce Bank v. Kessler, 2012 WL 1610139 (Pa. Super. Ct. May 9, 2012), raises concerns for construction lenders regarding the lien priority of an open-end mortgage relative to a mechanic's lien in situations where lienable work commenced prior to recordation of the mortgage.

In the case in question, the Kesslers engaged a third-party contractor to build a luxury home on their property. Excavation commenced on October 16, 2006. Thereafter, the Kesslers entered into a construction loan with Commerce Bank of Harrisburg, N.A. (now Metro Bank), secured by an open-end mortgage which was recorded on January 24, 2007. Advances were made under the loan not only for the payment of “hard” construction costs, but also for the payment of “soft” costs, such as closing costs, interest, architect’s fees and the satisfaction of an existing mortgage. The Kesslers defaulted under the construction loan and the construction contract. In the foreclosure of the open-end construction mortgage, a question arose as to which lien, the bank’s mortgage or the contractor’s mechanic’s lien, had priority.

The case in question held that the mechanic’s lien had priority over the lien of the mortgage due to the fact that the proceeds of the loan secured by the mortgage were not used solely for payment of “hard” construction costs, but also for the payment of “soft” costs.

Section 1508(a) of the Pennsylvania Mechanics’ Lien Law provides that a mechanic’s lien shall take effect and have priority as of the date of the visible commencement of the work1, except in certain situations specified in the statutes. One of the exceptions to the general rule of Section 1508(a) is an 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.”

Because work commenced on the Kesslers' property prior to the date of recordation of the open-end mortgage, the court stated that unless the exception for the open-end mortgage applied, the contractor’s mechanic’s lien would have priority.

The court held that the open-end mortgage exception only applied to the lien of open-end mortgages where all proceeds of the loan secured by the mortgage are used to pay for “hard” construction costs. Because a portion of the proceeds of the Metro Bank mortgage paid for costs other than “hard” construction costs, the court determined that the mortgage did not fall under the exception and, thus, did not have priority over the contractor’s mechanic’s lien.

As a result of the court’s holding, lenders must be cautious where work has commenced prior to the recording of the construction loan open-end mortgage if the mortgage secures advances of loan proceeds used for things other than the payment of “hard” costs of construction. The court’s reasoning goes so far as to suggest that if even as little as one dollar is advanced under a construction loan for soft costs, mechanic’s lien claims, where work has commenced prior to the recording of the mortgage, would have lien priority over all loan advances.

Construction lenders are advised to explore alternate approaches in situations where construction has commenced prior to the recording of the mortgage, including: (i) requiring all contractors to execute lien waivers; (ii) bifurcating a construction loan into two loans with separate mortgages, one for the hard costs of construction, and one for soft costs; (iii) requiring contractors to subordinate all claims and liens, in a recordable subordination agreement, to the lien of the mortgage and all advances of proceeds thereunder (regardless of what the proceeds are used for); (iv) requiring payment bonds with lien stipulation filings; (v) filing the actual construction contract stating the unpaid contract balance so as to limit a subcontractor’s right to claim an amount in excess of that balance; and (vi) requiring borrowers to fund soft costs as equity with hard cost draws contingent upon the borrower’s funding of all soft costs.

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1 As a threshold matter, lenders should consider when such “visible commencement” of work has occurred. Although what constitutes “visible commencement” is determined on a case-by-case basis, Pennsylvania law suggests that “visible commencement” requires the commencement, on the ground, of erecting or constructing an improvement. Such construction, however, including related grading, excavation and demolition work, must be done in connection with the actual erection of the building or improvement in order to have lien priority.