One outgrowth of the increasing failure of commercial development projects is the rising tide of priority battles between banks and contractors. Ohio’s Mechanic’s Lien law provides contractors with an extraordinary security for their work in the form of the modern Mechanic’s Lien—what courts often refer to as a “derogation of common law.” When a project implodes, we are left with creditors battling over sheriff’s sale proceeds that often are not enough to cover all of the outstanding claims against those sale proceeds.
Generally, a mortgage is subordinate to mechanics’ liens that have an effective date prior to the date on which the mortgage is recorded. As such, lenders used to shudder at the prospect of lending money after construction had commenced on a project for fear of losing their first priority position to the intervening contractor. As one court explained, “With an inability to obtain priority over subsequently filed mechanics’ liens, lenders were often unwilling to advance the funds necessary for the completion of already commenced construction projects.”
Rather than watch Ohio’s construction industry grind to a halt, the Ohio Legislature devised a solution for the banks in Ohio Revised Code Section 1311.14. There—as explained in a bankruptcy proceeding—the Legislature “meant to prevent the stopping of building operations that was often caused by the priority granted to mechanics’ lien holders under prior law.”
In essence, if you follow the rules set forth in RC 1311.14, you can maintain your priority position over contractors that have performed work on the project. Unlike the service and filing requirements of Ohio’s Mechanics’ lien statutes which are interpreted strictly and require actual compliance, RC §1311.14(C) sets a significantly lower hurdle for banks loaning money in this instance: “This section, as to mortgages contemplated by this section, controls over all other sections of the Revised Code relating to...all liens that can be had under this chapter..” And, the statute compels that ORC 1311.14 “shall be liberally construed in favor of such mortgagees, a substantial compliance by such mortgagees being sufficient.” ORC §1311.14(C). In other words, the bank must substantially comply with the legal requirements and any interpretation of the statute by the courts should be in favor of the bank having priority.
The statute’s requirements—in summary—are that your mortgage must:
- Be given to improve real estate; or, pay off former encumbrances; or both; and
- Contain the correct name and address of the borrower; and
- Contain a “covenant”—agreement or promises—between the lender and borrower authorizing the lender to do all things they are required to do under the statute.
The gravamen of the bank’s requirements in ORC §1311.14 is found in section (B) of the statute. There, the legislature provided for the order in which money from the mortgage must be distributed. The first distribution, and any time after, is to pay off the prior encumbrance or withhold the amount of the prior mortgage for that purpose.
The good news is that to the extent you distribute the funds as required in the statute, you maintain priority. Because the first payment is usually to satisfy the existing mortgage, coupled with the low sale prices, that credit is often enough to wipe out the other claims. Distributing the money out of order—not in compliance with the statute—can be costly.
Lest I be accused of creating a false sense of security, I offer the following warning. While the statute may be reasonably clear when compared to some others, the Mechanic’s lien law and priority are very difficult legal concepts for most. The facts of the cases that spawn these types of issues often involve multiple parties, phases, agreements and various types of financing and security. Courts having to sift through the morass of a case like this will be looking to you to show that you have done things in a manner that preserves your priority. The further you stray from the confines of the statute, the harder it will be to get the relief you seek. A little homework up front will save you a ton of pain at the end.