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.
Tips for Lenders
If Senate Bill No. 145 is passed in Pennsylvania, then open-end mortgages will receive priority over a mechanics' lien only if more than 60.00% of the proceeds of the loan secured by the open-end mortgage are used to fund hard or soft construction costs. Until the bill is passed, lenders will need to find ways to ensure that their open-end mortgages receive a first priority lien whenever they are financing soft costs. Here are a few tips for lenders in light of the current developments stemming from Kessler.
Don’t Finance Soft Costs. The easiest solution to avoid the mistake made by Metro Bank in the Kessler case is to require the borrower to pay for soft costs out-of-pocket. Many borrowers are either going to be unable to pay these costs out-of-pocket, or are not going to be happy with the out-of-pocket costs because they are intending on having them financed with the loan. This may, however, be a good starting point in terms of setting the borrower's expectations and maintaining a good working relationship.
Fund Soft Costs With an Unsecured Loan. Metro Bank could have reduced the uncollectible portion of its loan in the Kessler case by funding the hard construction costs with an open-end first priority mortgage on the property and then funding soft costs with an unsecured loan. If this approach had been taken, then Metro Bank would have enjoyed a first priority lien on the property for a large portion of its exposure, but its unsecured loan for the soft costs would have still been subordinate to the mechanic’s lien (and thus, worthless). Using a loan to fund soft costs will be more attractive to some borrowers than paying for them out-of-pocket, although the financing will likely be more expensive than the loan secured by an open-end mortgage, as banks take higher risks with unsecured loans.
Use An Acquisition Loan Followed By a Construction Loan. In my opinion, the best option for lenders is using a purchase money facility and an open-end construction mortgage. The other exception to the priority of a mechanics' lien under the mechanics’ lien law, along with open-end mortgages, are purchase money mortgages. Unlike open-end mortgages, purchase money mortgages are eligible to finance closing costs. Therefore, a lender can extend to a borrower a purchase money mortgage to acquire the mortgaged property (where applicable) and use such loan to finance transaction costs. They can then issue a second priority open-end mortgage for construction. In this case, both mortgages would have priority over mechanic’s liens.
Until legislation is finalized, lenders will need to balance protection of their security interests with maintaining good working relationships with their borrowers. Pending legislation will go a long way towards easing fears regarding perfection and priority of security interests, but until that occurs lenders should ensure they are keeping Kessler in mind when extending construction loans.
Derek Dissinger is an attorney at Russell, Krafft & Gruber, LLP in Lancaster, Pennsylvania. He received his law degree from Duquesne University and practices in a variety of areas.