United States: What's Your Priority? An Open-Ended Examination Of Pennsylvania's Mechanics' Lien Law

On July 9, 2014, then Pennsylvania Governor Tom Corbett approved an amendment to Pennsylvania's Mechanics' Lien Law of 1963¹ (the "Lien Law") by signing into law Senate Bill 145. Officially named Act 117 of 2014² ("Act 117"), this new law effectively overturned the holding by the Superior Court of Pennsylvania in Commerce Bank/Harrisburg, N.A. v. Kessler³—and mercifully ended a two-year period of confusion and anxiety for construction lenders and title insurers doing business throughout the Commonwealth.

An Overview of the Law Pre-Kessler

In their most basic form, mechanics' liens are designed to allow aggrieved contractors and subcontractors to file a lien against real property as security for the payment by owners (in the case of contractors) or by contractors (in the case of subcontractors). While mechanics' liens are a legitimate tool for claimants who have spent money and/ or time in good faith reliance on future compensation, their practical application is often wrought with uncertainty. Mechanics' liens do not have a common law history in Pennsylvania, and lawmakers have struggled to find a version of the Lien Law that fairly accounts for the divergent interests of owners, contractors, and construction lenders, yet still provides the concrete certainty that is necessary for a fully efficient credit market.

Generally, the priority of a lien is determined by the date on which the lien was filed. Uncompensated contractors, however, often times do not have a claim until long after the lien of a construction mortgage has been placed on record. The Lien Law recognizes this inequity and provides certain exceptions in favor of contractors that allow the priority of the mechanics' lien to relate back to the date of "visible commencement" of the contractors' work. In the case of ground-up construction, this means that if any visible work on the property predates the recording of a mortgage, the mechanics' lien has a chance to jump to the front of the priority line as if the lien had been filed on the date that visible work initially began (even if the actual initial work has been completed and paid for in full).

In 2007, the priority pendulum was shifted, as the "relate back" exception was softened by an amendment to the Lien Law.⁴ Among other things, the 2007 amendment carved out certain open-end mortgages from the exception, thereby creating an exception to the exception. The open-end mortgage carve-out, however, was limited to loans where the "proceeds... 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." In effect, so long as the loan proceeds were used to pay for so-called "hard costs" of construction, lenders and their title insurers could be confident that the lien of an open-end mortgage would maintain priority over any mechanics' liens filed after the date that the mortgage was recorded, regardless of the date of visible commencement of work on the property.

The Kessler Effect

In Kessler, the Superior Court of Pennsylvania obliterated the commonly held belief that open-end mortgages enjoyed a type of super-priority over mechanics' liens. The following is a brief summary of the facts in Kessler, presented in chronological order: (i) a contractor was hired to build a home for Stephen and Lisa Kessler and shortly thereafter began excavation on the lot; (ii) the Kesslers received a construction loan for $435,000, and used a portion of the proceeds to cover their closing costs; (iii) an open-end mortgage was recorded pursuant to the construction loan; (iv) the contractor completed construction; (v) the Kesslers defaulted on their mortgage and failed to make payments to the contractor; (vi) both the lender and the contractor obtained default judgments against the Kesslers; and (vii) great uncertainty ensued. The substantive issue before the court was whether, under the Lien Law, an open-end mortgage whose loan proceeds were used to cover both hard and soft costs related to the project should be subordinated to a statutory mechanics' lien by relating back the effective date of the mechanics' lien to commencement of the contractor's work. At the time, the common interpretation of the Lien Law would have provided a quick and easy "no." With a jaw-dropping interpretation of a seemingly innocuous phrase in the Lien Law, the court held that the contractor should indeed get paid.

Expressing concern that potentially unscrupulous lenders might take advantage of the open-end mortgage carve-out from §1508(c)(2), the court interpreted the phrase "the proceeds" to mean "all of the proceeds."⁵ To add a touch of salt to the wounds of all lenders throughout the Commonwealth, the court further narrowed the carve-out by expressly excluding protection for open-end mortgage loans where anything less than "all" of the proceeds were used for the precise purposes set forth in §1508(c) (2): "Completing erection, construction, alteration or repair of the mortgaged premises."⁶ In the wake of Kessler, previously impervious construction lenders and exception-slashing title insurers were left to rely on a statute that would refuse to safely harbor their loans if even one dollar of the proceeds was used for soft costs. Predictably, the effects were not limited to the "unscrupulous lenders" that the Kessler holding envisioned; developers' access to construction financing came into question as the industry was forced to invent techniques, inefficient as they were, which allowed borrowers to use loan proceeds for certain project related soft costs without completely stripping lenders of required title insurance coverage against mechanics' liens. Unless a borrower was willing and able to use its own equity to fund the acquisition, closing fees, satisfaction of existing liens, insurance premiums, and other soft costs that were commonly covered by construction loan proceeds in the pre-Kessler era, lenders had to enforce cumbersome safeguards such as bifurcating loan structures or requiring multiple lien waivers. Combined with a sluggish economic recovery after the 2008 recession, this suddenly impaired credit market provided the perfect storm for a potentially protracted period of stagnated development in Pennsylvania.

Act 117, to the Rescue

Officially approved by Governor Corbett on July 9, 2014 (which was made effective September 7, 2014), Act 117 further amended the Lien Law and, in effect, legislatively overturned the controversial Kessler holding.

Pursuant to Act 117, instead of the all-or-nothing prerequisite imposed by the Kessler holding, the Lien Law now limits the availability of the open-end mortgage carve-out from §1508(c)(2) to transactions "where at least sixty percent (60%) of the proceeds are intended to pay or are used to pay all or part of the costs of construction."⁷ This compromise accounts for the practical reality that an efficient financing market relies on the borrowers' ability to use a portion of construction loan proceeds for various costs other than those strictly attributable to erection, construction, alteration, or repair, while still addressing the concerns from the Kessler holding's hypothetical where an unchecked lender and owner might collude "to defeat lien rights by using as little as $1.00"⁸ of the proceeds towards hard construction costs.

In what appears to be a direct response to Kessler, Act 117 further clarifies the open-end mortgage carve-out by providing a definition of "costs of construction." The phrase is defined as "all costs, expenses and reimbursements pertaining to erection, construction, alteration, repair, mandated off-site improvements, government impact fees and other construction-related costs."⁹ The definition goes on to provide various examples of costs that would qualify as "other construction- related costs." The statutory construction indicates that the list is provided by way of example and not limitation, thereby providing additional flexibility with respect to items not specifically contemplated by Act 117. To fully understand how Act 117 interprets "costs of construction," the entire definition is as follows:

"all costs, expenses and reimbursements pertaining to erection, construction, alteration, repair, mandated off-site improvements, government impact fees and other construction-related costs, including, but not limited to, costs, expenses and reimbursements in the nature of taxes, insurance, bonding, inspections, surveys, testing, permits, legal fees, architect fees, engineering fees, consulting fees, accounting fees, management fees, utility fees, tenant improvements, leasing commissions, payment of prior filed or recorded liens or mortgages, including mechanics' liens, municipal claims, mortgage origination fees and commissions, finance costs, closing fees, recording fees, title insurance or escrow fees, or any similar or comparable costs, expenses or reimbursements related to an improvement, made or intended to be made, to the property."

Conclusion

While Act 117 was undoubtedly celebrated by lenders and title companies in every county of the Commonwealth, it would be imprudent to judge the worthiness of this amendment without at least a cursory consideration of the underlying logic and history that necessitated it. Taken as a whole, the Lien Law, as amended by Act 117, recalibrates the scale of lien priority by allowing construction loan proceeds to be earmarked for expenses other than hard construction costs without destroying the open-end mortgage lien, but imposes a reasonable threshold to deter unfair efforts to side step a contractor's legitimate expectation of timely payment. As of the date of this article, Pennsylvania courts have yet to publish an opinion interpreting the newly amended law. Any future Kessler-like surprises notwithstanding, this adjustment should achieve the legislature's presumed purpose of balancing the varying, and sometimes competing, interests of all parties to a construction loan transaction. In turn, construction lending is now more available—and that should make everyone happy, irrespective of where they may fall on the balance sheet.

Footnotes

1. 49 P.S. § 1101 et seq.

2. Senate Bill 145, Printer's No 2208 (Approved as Act 117 of 2014 on July 9, 2014)

(full text available at www.legis.state.pa.us).

3. Commerce Bank/Harrisburg, N.A. v. Kessler, 46 A.3d 724 (2012), appeal denied

per curiam, 62 A.3d 380 (2013).

4. House Bill 1637, Printer's No 4229 (Approved as Act 52 on June 29, 2006) (full

text available at www.legis.state.pa.us).

5. Kessler, 46 A.3d at 734

6. Id.

7. 49 P.S. §1508(c)(2)

8. Kessler, 46 A.3d at 733

9. 49 P.S. § 1201(15)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.