Priority in Liens Magnified as Property Values Fall

By John Mrowiec

A private-project owner might default under its loan agreement and also fail to pay the construction contractor. The lender and contractor could record liens against the real estate and improvements.

If, as is happening more frequently, the real estate and improvements are not sufficiently valuable to pay all the liens in full, who bears the shortfall, the lender/mortgagee or the contractor/lien claimant?

The answer depends on state priority laws where the construction occurs, the timing of various events and, in some states, even the type of mortgage or deed of trust. The rules can be arcane. On similar facts, the result in one state might differ from another.

An Indiana court recently addressed two Indiana statutes that, at first reading, seemed to reach contrary priority results in Harold McComb & Son, Inc. v. American Renovations of Indiana, Inc., 2008 Ind. App. LEXIS 1995 (Ct. App., Sept. 3, 2008).

Owner Defaults, Liens Recorded

In Harold McComb & Son, Inc., two contractors, McComb and ARI, were involved in the renovation of apartment buildings for seniors and related civil work. The owner entered into a construction loan agreement. The first contractor’s contract predated lender’s recording of its mortgage.

The owner defaulted in payment to the lender and to the contractors, who recorded mechanic’s lien claims. All sought to foreclose their liens.

The trial court ruled that the lender’s mortgage lien had priority over the liens of the mechanics lien claimants. A foreclosure sale was held but rendered proceeds of nearly $1 million less than the mortgage indebtedness. That left no proceeds to pay mechanic’s lien claimants.

The mechanics-lien claimants appealed. They argued that an Indiana statute, Indiana Code §32-28-3-2, gave mechanic’s lien claimants priority.

That section, read alone, gives priority to a mechanic’s lien holder “with regard to new improvements even if the mortgage is recorded before the mechanic’s lien is recorded and before the mechanic’s lienholder begins its work or furnishes any materials,” Harold McComb & Son, Inc., 2008 Ind. App. LEXIS 1995, *11.

The mortgagee argued a separate statute, Indiana Code subsection 32-28-3-5(d), gave priority to mortgagees. Subsection (d) applies to “commercial property” including commercial residential property.

That subsection provides “[t]he mortgage of a lender has priority over all liens created under this [mechanics lien] chapter that are recorded after the date the mortgage was recorded, to the extent of the funds actually owed to lender for the specific project to which the lien rights relate,” Harold McComb & Son, Inc., 2008 Ind. App. LEXIS 1995, *12-13 quoting Ind. Code 32-28-3-5(d).

The Harold McComb & Son, Inc. appellate court traced the caselaw and statutory history to find that Subsection (d) was a legislative response to a gap in prior statutes discovered by a court decision in the context of construction loans, was the more specific and would govern in the factual context of commercial property with a construction loan.

The McComb & Son, Inc. court announced this Indiana rule of priority:

“With regard to commercial property, where the funds from the loan secured by the mortgage are for the specific project that gave rise to the mechanic’s lien, the mortgage lien has priority over the mechanic’s lien recorded after the mortgage,” McComb & Son, Inc., 2008 Ind. App. LEXIS 1995, *22.

Applied to the facts, because lender’s mortgage lien was recorded before recording of the mechanic’s liens and the loan was for construction of the specific project, the mortgage took priority to the extent of unpaid indebtedness related to that project, Id.

The result in McComb & Son, Inc. was based on Indiana law and the specific facts of the case. The result would be different under the statutes of other states or if the facts were different.