Division of foreclosure proceeds under Cypress Creek
Amendment
Post-amendment era
Comment


Illinois law was already more favourable to contractors and subcontractors than that of most other states, but the Illinois legislature recently gave them a greater edge against lenders in failed construction projects.

Division of foreclosure proceeds under Cypress Creek

Like most other states, in Illinois contractors and others that provide work and materials in connection with certain construction activities are entitled to a 'mechanics' lien on the real estate that is the subject of the construction activities. If the work or materials in question are entitled to the benefit of the lien then, to the extent that the contractor is not paid, the lien may be foreclosed. Issues often arise with respect to the relative priorities of the mechanics lien and a mortgage that may encumber the same real estate in connection with any such foreclosure or in connection with the foreclosure of such mortgage.

Until recently, if a foreclosure sale did not generate enough proceeds to cover what was owed to the mortgage lender and contractors holding valid and enforceable mechanics liens, the lender and contractors had a 'relative priority' (unless the contractors signed their contracts before the mortgage was recorded, in which case they would have absolute priority). Under that relative priority, the lender and the mechanic lienors would generally share sale proceeds pro rata – the lender's percentage was based on the value of the land and existing improvements at the time of a lienor's contract, and the lienor's percentage was based on the value of the improvements added after its contract date. However, the lender's share would increase if it funded draw requests because it would receive credit for the improvements it funded.

The relative priority model was illustrated and approved by the Illinois Supreme Court in LaSalle Bank NA v Cypress Creek 1, LP (242 Ill 2d 231 (2011)). In that case, LaSalle Bank made a loan to Cypress Creek, LLP for the development of raw land into apartments and the loan was secured by a mortgage. Construction began and LaSalle funded eight draw requests before it became clear that there would not be sufficient funds to complete the project. Shortly after that realisation, LaSalle filed a foreclosure action and five contractors recorded mechanics liens. The trial court was faced with limited foreclosure proceeds to distribute $1.3 million in foreclosure sale proceeds, minus $747,786 in receiver and sale fees, leaving just $552,214 in remaining proceeds.

After determining the total value of the property, the trial court found that about 40% of the value ($1.36 million) was attributable to the land before any improvements were made, and about 60% ($2.07 million) was attributable to the improvements. Based on these figures, the trial court calculated the following division of proceeds:

  • $215,100 – proceeds attributable to land; and
  • $331,328 – proceeds attributable to improvements.

However, in addition to the $215,100 attributable to the land, LaSalle was subrogated to the costs it paid through loan disbursements. The court calculated each party's pro rata share by dividing the value of their individual claims by the total value of the improvements:

  • 3% – Contractor 1;
  • 15% – Contractor 2;
  • 5.8% – Contractors 3, 4 and 5; and
  • 76% – LaSalle (subrogated to amounts that it paid through draw requests).

Ultimately, LaSalle received a total of $471,614 and two of the contractors appealed. The appellate court reversed, but the Illinois Supreme Court agreed with the trial court's calculations, holding that "the value of the property attributable to improvements paid for with proceeds of a mortgage and construction loan should be attributed toward the satisfaction of the mortgage". Anything else would result in unjust enrichment.

Amendment

Earlier this year, the Illinois legislature amended Section 16 of the Illinois Mechanics Lien Act in what some say effectively reversed Cypress Creek. Seemingly in response to the Illinois Supreme Court's interpretation of Section 16 as "clearly and unambiguously prioritiz[ing] lien creditors only to the value of their improvements and the prior inbumbrancer to the value of the land at the time the contract with the lien holder was made", the legislature amended Section 16 to reflect a different intention. Now Section 16 reads, in part:

"[A]ll previous incumbrances shall be preferred only to the extent of the value of the land at the time of making of the contract for improvements, but shall not be preferred to the value of any subsequent improvements, and each lien creditor shall be preferred to the value of all the subsequent improvements erected on said premises, whether or not provided by the lien creditor...[A]ny lien creditors shall have a paramount lien in the portion of the proceeds attributable to the value of all subsequent improvements made to the property." (770 ILCS 60/16, emphasis added.)

Under the amendment, contractors which are unpaid on a project now have priority on the value of the entire improvement – even the value paid for by the lender – and are not limited to the value that they themselves supplied. Thus, under the new law, as the lender funds draw requests, it does not gain a relative priority against mechanic liens, but merely sets up a fund for their satisfaction.

Post-amendment era

Amended Section 16 could have a potentially dramatic effect on lenders. To illustrate, if the Cypress Creek case had applied amended Section 16, the outcome would have been very different:

  • Rather than the $471,614 that LaSalle received, it would have received only the $215,100 attributable to the value of the land before any improvements; and
  • Rather than the approximately $80,000 that the contractors received, they would have received the entire $331,328 attributable to improvements.

Comment

Only time will tell what the actual impact of the revised statute will be and how it will be applied by the courts, including whether it will be applied retroactively. For now, it is at least an additional consideration for lenders that make loans in Illinois when deciding if they will fund draw requests.

For further information on this topic please contact Jennifer C Ryan or Timothy J Patenode at Katten Muchin Rosenman LLP by telephone (+1 312 902 5200), fax (+1 312 902 1061) or email (jennifer.ryan@kattenlaw.com or timothy.patenode@kattenlaw.com).

 

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