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"Who's On First?": Priority Issues Between Mortgages and Mechanic's Liens
Posted in Real Estate

Given the current economic climate, Indiana attorneys practicing in the areas of real estate and construction law have likely been faced with an increasing number of questions regarding foreclosures. For most clients on the creditor side, the bottom line question will be “How do I get paid?” The appropriate response to that question involves an analysis of lien priorities, especially if the particular real estate is encumbered by both a mortgage and a mechanic's lien. These issues are certainly not new under Indiana law, although the law on this issue continues to evolve.

Statutory Framework
There are several statutes relevant to the analysis of priorities between mortgages and mechanic's liens in Indiana. The general priority rule is contained in Indiana Code § 32-21-4-1(b), which states that "[a] conveyance, mortgage or lease takes priority according to the time of its filing." Thus, a mortgage that is recorded first typically has first priority. However, Indiana's Mechanic's Lien Statute provides that "[t]he recorded lien relates back to the date the mechanic or other person began to perform the labor or furnish the materials or machinery." Therefore, since the priority date for a mechanic's lien "relates back" to the first date labor or materials are provided to a project, a subsequently recorded mechanic's lien could potentially take priority over a previously recorded mortgage if any work on the project commenced before the mortgage was recorded.

Another section of Indiana's Mechanic's Lien Statute states that:

(a) The entire land upon which the building, erection or other improvement is situated, including the part of the land not occupied by the building, erection or improvement, is subject to a lien to the extent of the right, title, and interest of the owner for whose immediate use or benefit to labor was done or material furnished.

(b) If:

1. the owner has only a leasehold interest; or 2. the land is encumbered by a mortgage;

the lien so far as concerns the buildings erected by the lienholder is not impaired by forfeiture of the lease for rent or foreclosure of mortgage. The buildings may be sold to satisfy the lien and may be removed not later than ninety (90) days after the sale by the purchaser.

Thus, by the language of that provision, the mechanic's lien holder has an interest in the improvement that is apparently not subject to the foreclosure of a mortgage.

In 1999, the Indiana legislature added Indiana Code § 32-28-3-5(d) to the Mechanic's Lien Statute. That section states that, for commercial construction projects, "[t]he mortgage of a lender has priority over all liens created under this chapter that are recorded after the date the mortgage was recorded, to the extent of the funds actually owed to the lender for the specific project to which the lien rights relate." As discussed below, how to reconcile the provisions of I.C. § 32-28-3-5(d) with the other priority provisions set forth above has been the subject of recent cases.

Historical Indiana Case Law

The 1910 case of Ward v. Yarnelle, was one of the first reported decisions in Indiana to address the priority issues between mortgages and mechanic's liens. In Ward, the Indiana Supreme Court was asked to determine the priorities between the holder of a construction mortgage and multiple mechanic's lien claimants, some of whom began work before the mortgage was recorded, and some of whom began work afterwards. The Ward Court outlined four separate scenarios that the statutes in effect at the time addressed:

They may be stated, first, as cases where there is no building on the land when the improvement begins, and the land is unencumbered, and so remains. There the liens attach to both realty and the improvement, without distinction or priority among the materialmen or laborers. Second, cases where there is no building, but there is a leasehold or the land encumbered. There the existing encumbrances take priority on the land and the materialmen and labor claimant equally upon the building or improvement. Third, where some labor is performed, or material is furnished prior to the execution of a mortgage, in which event, upon notice being filed within the statutory period, though after the mortgage is given, the lien reaches back of the mortgage to the time when the work is begun or the material furnished, and gains priority both as to the land and the building. Fourth, where the improvement is made after the mortgage is executed, but under a prior contract for the improvement, but no work is done or material furnished until after the mortgage is executed or where the work is all done, and material furnished under the contract later than the mortgage becoming effective as a lien, in which case priority is given on the building alone.

Nevertheless, the particular scenario presented in that case was not among those directly addressed by the statutes. Ultimately, the Indiana Supreme Court concluded that because the mortgagee and the mechanic's lien claimants were engaged in a "common enterprise" of improving the property, their respective rights, equities and priorities should be equal.

Statutory Revisions and Recent Case Law
The state of the law remained relatively unchanged for almost 90 years after Ward, until the legislature enacted Indiana Code § 32-28-3-5(d) in 1999. The intent of this most recent statutory amendment appears to be to clarify the relative priorities between the holder of a construction mortgage and a mechanic's lien claimant on commercial projects. Since the enactment of that statute, two significant reported Court of Appeals' decisions have revisited the priority issue.

In Provident Bank v. Tri-County Southside Asphalt, Inc., the dispute involved the priorities of two mortgages and a mechanic's lien claimant. The evidence showed that both mortgages were recorded before the mechanic's lien, and that the mechanic's lien did not relate back in time to before when the mortgages were recorded. Both the first mortgage holder and the mechanic's lien clamant filed motions for summary judgment with respect to priority. The trial court ordered that the mechanic's lien had priority over the mortgages. On appeal, the Court of Appeals cited to Indiana Code § 32-21-4-1(b) in holding that the mortgages had priority as to the real estate because they were recorded first. However, the Provident Bank court further held that, pursuant to Indiana Code § 32-28-3-2, the mechanic's lienholder had priority as to the improvements on the real estate. While acknowledging the practical difficulty that may be associated with a mechanic's lien claimant removing its particular improvement in order to obtain its remedy, the court reasoned that its decision effected legislative intent, with Indiana Code § 32-28-3-2(b) protecting the lien claimant's interest in its work.

Judge Sharpnack wrote a strong dissent in the Provident Bank case, focusing on the priority as to the improvement that is the subject of the mechanic's lien. Relying on Ward, Judge Sharpnack asserted that the legislative history of the Mechanic's Lien Statute showed an intent to favor laborers and to provide them with a return for the work done. Notably, Indiana Code § 32-28-3-5(d) did not apply because the mortgages at issue were not construction mortgages. However, Judge Sharpnack noted that the very fact that the legislature found it necessary to enact Indiana Code § 32-28-3-5(d) showed, by implication, that a mechanic's lien would otherwise have priority over a prior mortgage as to the improvements. Judge Sharpnack argued that the mechanic's lien claimant should have priority to the proceeds of a foreclosure sale up to the amount of its lien claim, and should not have to resort to removing its improvement to obtain a remedy.

More recently, the Court of Appeals had the opportunity to apply Indiana Code § 32-28-3-5(d) in Harold McComb & Son, Inc. v. JP Morgan Chase Bank. In McComb, the contractor was hired to build an apartment complex. Subsequently, the owner entered into a construction loan agreement. The bank recorded its mortgage on July 11, 2003, and second mortgage was recorded on December 14, 2004. Thereafter, the contractors recorded mechanic's liens in February of 2005. The mechanic's lienholders sued to foreclose their mechanic's liens in April 2005. The bank filed suit to foreclose its mortgages in March 2006. The cases were ultimately consolidated, and the bank filed a motion for partial summary judgment on the issue of priority which was granted, with the trial court holding that the bank's mortgage liens were superior to the mechanic's liens.

On appeal, the mechanic's lien claimants argued that they had priority as to the improvements that they constructed, pursuant to Indiana Code § 32-28-3-2. The mechanic's lien claimants argued that Indiana Code § 32-28-3-2 should be recognized as an exception to the more recently enacted Indiana Code § 32-28-3-5(d). The bank argued to the contrary, that Indiana Code § 32-28-3-5(d) creates a "super priority" in favor of a construction mortgage lender. The Court of Appeals held that neither the mechanic's lien holders nor the bank were completely correct, but that the bank's reading of Indiana Code § 32-28-3-5(d) was likely more consistent with the legislature's intent. Tracking the language of the statute, the Court of Appeals noted that the priority granted by Indiana Code § 32-28-3-5(d) is not absolute, but that it exists to the extent of funds owed to the lender for the project to which the mechanic's liens related. Thus, the Court of Appeals rationalized that the intent of Indiana Code § 32-28-3-5(d) was to fill the void recognized in the Ward decision, where there are both a construction mortgage and mechanic's liens recorded by those who provided the labor and supplies necessary to complete the improvements. In reconciling Indiana Code § 32-28-3-2 with Indiana Code § 32-28-3-5(d), the Court of Appeals stated that Indiana Code § 32-28-3-2 provides the general rule that a mechanic's lienholder shall have priority to the improvement for which he provided labor and materials, as set forth in the Provident Bank case, and that Indiana Code § 32-28-3-5(d) provides the more specific rule with respect to a construction mortgage's priority over improvements on commercial property, where the mortgage is recorded before the mechanic's lien. Thus, the Indiana Court of Appeals held that "where the funds from the loan secured by the mortgage or 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."

Conclusion
Determining the relative priorities between mortgages and mechanic's liens is not as simple as looking merely at which was recorded first. While the McComb decision appears to clarify the application of Indiana Code § 32-28-3-5(d), that opinion still does not address all of the priority issues that may arise under the Mechanic's Lien statute. For instance, the McComb decision does not specifically address how to reconcile the construction lender's priority under Indiana Code § 32-28-3-5(d) with the "relation back" provision contained in Indiana Code § 32-28-3-5(b). Questions may also still arise as to whether a construction mortgage holder, with notice of a recorded mechanic's lien, can attempt to further diminish the mechanic's lien claimant's position by continuing to advance funds. These types of priority issues will undoubtedly continue to be litigated and Indiana law will continue to develop in this area.

  • Partner

    Grant is the chair of the firm’s Real Estate Litigation Team. He concentrates his practice on representing clients in real estate and construction matters, including contract disputes, mortgage foreclosures, mechanic’s ...

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