Mechanics' Lien Law Update: Expanded Safe Harbor for Lenders is Good News for Commercial Borrowers

Your business is growing, and you are running out of space.  You prudently save up about a quarter of the cost of expanding your facilities.  Confident that your bank will lend you the rest, you get the project rolling, hire the general contractor, and break ground.  A few months later, your equity contribution is almost gone, so you sit down with the bank to formalize your construction loan.  Up until last September, you would have been in big trouble.  Assuming that your lender wants a mortgage on your facilities, the specter of the mechanics' lien would have reared its ugly head, and your financing would have been in jeopardy.

What is the Mechanics' Lien Law

Pennsylvania's Mechanics' Lien Law provides contractors, their subcontractors and suppliers with the right to file a lien against your real property for unpaid construction costs.  Subcontractors and suppliers are entitled to the lien even if you have paid the general contractor.  The right to file the lien even extends to subcontractors and suppliers to a subcontractor.

Prior to 2006, the lien could be avoided if you and your general contractor filed a mechanics' lien waiver before construction began.  Such waivers are now only available for residential construction. In most cases, the lien can be filed for up to six months after the completion of construction, yet its effectiveness relates back to the day the work began, thereby jumping over the lien of your construction mortgage---a risk most lenders are unwilling to take.

Safe Harbor

The 2006 amendments to the Mechanics' Lien Law, while taking away the ability to file prospective lien waivers in commercial situations, did create a safe harbor for construction lenders.  The safe harbor subordinates after-filed mechanics' lien claims to the lien of open-end mortgages "the proceeds of which are used to pay all or part of the cost of completing erection, construction, alteration or repair of the mortgaged premises."  The safe harbor was effective even if the mortgage was recorded after construction began.  However, the Pennsylvania courts construed this provision very narrowly, basically limiting its applicability to situations where 100 percent of the loan proceeds were expended on hard construction costs.

Banks, borrowers and title insurance companies worked hard to come up with creative responses to this interpretation, but none were really satisfactory to address to address the issue.  In response, effective September 7, 2014, the Pennsylvania Legislature adopted Act 117 of 2014, which amended the Mechanics' Lien Law in two major respects.  First, Act 117 makes the safe harbor applicable where 60 percent or more of the loan proceeds are spent on costs of construction.

So, it is now possible to include land acquisition costs or even operating capital funds under the umbrella of a single mortgage along with your construction costs.  Second, Act 117 greatly expanded the definition of "costs of construction" to include many types of expenses beyond hard costs, including reimbursements, taxes, insurance, bonds, inspections, testing, surveys, permits, professional fees, leasing commissions, tenant improvements, payment of prior liens and mortgages, finance costs, closing fees, lender fees, and title insurance fees.

Proceeding With Caution

Although the title industry is proceeding cautiously to fully embrace the expanded safe harbor, it is likely that you will now be able to obtain your financing even though you began construction before your mortgage was recorded.  However, it is important to note that there is no similar protection for you as an owner.

In order to avoid mechanics' lien claims, it is critical for the owner to monitor the application of each payment to the general contractor to make certain that it is, in fact, being used to pay the subcontractors and suppliers.  This is best done by requiring the general contractor to obtain partial lien releases from the subcontractors and suppliers at each draw, confirming that they have been paid in full for all work performed and/or materials supplied up to the end of the period covered by the disbursement.  Otherwise, although your lender will protected, you will still be at risk.

For more information about the Mechanics' Lien Law Update, contact attorney Jay Alberstadt at 814-870-7750 or jalberstadt@mijb.com.