The Pennsylvania Supreme Court sent shockwaves through the lending world in May 2012 when it issued its opinion in Commerce Bank/Harrisburg v. Kessler. In the case, the Court held that a bank's open-end mortgage was subordinate to a mechanics’ lien because part of the mortgage proceeds were used to fund soft costs like taxes and certain fees.
The Open-End Mortgage Exception
Kessler stands for the basic proposition that "all means all" in Pennsylvania's open-end mortgage statute, with “all” referring to the amount of the loan proceeds that must go directly toward construction costs in order for an open-end mortgage to fall under the exception to Pennsylvania’s Mechanics' Lien Law. While typically a mechanics’ lien has priority under the law, the exception allows an open-end mortgage to have priority over a mechanics’ lien when the proceeds of the loan secured by the open-end mortgage fund “all or part of the costs of completing erection, construction, alteration or repair of the mortgaged premises." In order to obtain this priority, the Pennsylvania Supreme Court decided that all of the proceeds of an open-end mortgage must be applied to hard costs, which greatly impacts lenders in Pennsylvania.
New Legislation Following Kessler
This year, new legislation was introduced which seeks to remedy this problem for lenders in two ways. First, the open-end mortgage statute would be amended to specifically allow proceeds to be used to fund soft costs, such as title insurance, transfer taxes, legal fees, engineering fees, accounting fees, architectural fees and management fees. Second, a mortgage will qualify as an open-end mortgage if at least 60.00% of the loan proceeds are used for these eligible costs. Metro Bank would have prevailed in Kessler if either one of those provisions were included in the statute at the time.
If Senate Bill No. 145 is passed, Pennsylvania lenders will be better protected with respect to their lien priority for construction loans. Until then, there are some steps that can be taken to protect those security interests.Continue Reading...