Borrower beware: early construction and mechanic’s lien coverage

This article, written by attorney Kathleen O’Neill Burgener, was originally published by New England Biz Law Update and can be found here.

Construction loans are different from other mortgage loans in that the construction lender makes advances of loan funds to the borrower as work is completed in multiple (typically monthly) draws over the course of the loan term, rather than making a single advance to the borrower at closing.  This structure means that the construction lender will be particularly focused on the issue of mechanic’s liens and the possibility that such a lien will have priority over either their mortgage entirely or any monthly advance of loan proceeds.  Given the complicated nature of construction loan closings and timing constraints, borrowers sometimes start work before the loan closes.  While mechanic’s lien law varies by jurisdiction, there are a few solutions to the problem of early work commencing, which early work presents risks to the lender.

Before addressing the risks of a borrower starting work on a project prior to closing the construction loan that will fund the majority of the project, it is important to understand the protections provided by mechanic’s liens and the process by which these liens are created.  The protections provided by mechanic’s liens vary from state to state as there are states that are more favorable to contractors and others more favorable to owners and lenders.  In Massachusetts, unlike most jurisdictions, not only is this protection available to contractors and subcontractors, but design professionals and architects are entitled to file a mechanic’s lien, and while this article does not address the differences applicable to the category of person filing the lien, those exist and it is important that the statutory requirements are strictly followed.

At a high level, a contractor is at risk of not being paid as they provide the labor and supplies for the project.  If they are not paid, the mechanic’s lien against the underlying property usually has the effect of halting the project and resulting in payment of the claim or bonding over the lien.  In Massachusetts, in order to enforce a mechanic’s lien (the lien itself is effective as of the date of recording the notice of contract), certain steps must be taken, including the following: (i) entering a written contract, (ii) recording a notice of contract with the applicable registry of deeds in conformance with the timing outlined in MGL c. 254 §2 (for instance, within 90 days after labor or materials were last supplied by the contractor or subcontractor), (iii) filing a sworn statement of claim as to the amount owed, and (iv) filing a complaint in court.

In Massachusetts lenders typically run title at each advance to confirm continued priority, however, even when the mortgage is recorded before the notice of contract, the lender has exposure to a mechanic’s lien priming the mortgage with respect to subsequent loan advances.  This issue can be further complicated when work on the project is started prior to the construction loan closing and the recording of the mortgage.  If the borrower desires to start work prior to the loan closing, it is critical that the borrower work with the title company in a timely manner to determine what the title company’s requirements will be in order for the lender to receive a policy without an exception for mechanic’s liens.

In some states, if work has started prior to the mortgage being recording, the work must stop for a certain number of days in order to provide a clean title policy on this issue.  Other states may provide that if demolition work starts and that work is under a separate contract that is completed prior to loan closing that the title company may be comfortable and not take exception for mechanic’s liens.  In Massachusetts, title companies may require that a credit entity indemnify the title company for mechanic’s lien claims and the title company will need time to underwrite the indemnitor, so if required this is a lead time item.  In addition to an indemnity, the title company will want to receive executed lien waivers for all work completed up to the closing date.  It is essential that the form of lien waiver be reviewed and approved by the applicable parties (including the contractor) in advance of closing to avoid miscommunication, such as whether the title company will accept a partial lien waiver conditioned on receipt of payment by the contractor within a certain number of days or unconditional lien waivers for work completed up to and including the date of recording the mortgage.  Working out exactly what the title company will require for a lender to close a construction loan when work has started on the project is an important timing issue and impacts many parties to the transaction, so it is best to understand the requirements before starting work and well before the closing date.