>Daily Development for Friday, August 15, 2008
>by: Patrick A. Randolph, Jr.
>Elmer F. Pierson Professor of Law
>UMKC School of Law
>Of Counsel: Husch Blackwell Sanders
>Kansas City, Missouri
>dirt@umkc.edu
>
>Here’s another great contribution from Dale Whitman:
>
>MORTGAGES; SUBROGATION; CONSTRUCTION LOANS:   A permanent mortgage may not claim subrogation to a construction mortgage in order to gain priority over an intervening mechanics lien.

>
>Lawson v. Brian Homes, Inc., 2008 WESTLAW 2780780 (Ala. Jul. 18, 2008) (not yet released for publication)
>
>This case presents a simple but challenging fact pattern. Brian Homes built houses in a subdivision, financing the work with a construction loan obtained in 2003 from New South Federal Savings Bank, whose mortgage was properly recorded. During the course of construction, Brian hired Lawson to perform work on the houses. Brain failed to pay Lawson for her work. In January 2004 the completed homes were sold, and the buyers all obtained “permanent” loans from other lenders. After these closings occurred, but within the time allowed by the Alabama mechanics lien statute, Lawson recorded a notice of mechanics lien.

>
>The Alabama mechanics lien statute gives mechanics liens a priority date as of the date work commences on the project, and provides that liens are subordinate to mortgages recorded before work commences. However, it states that mechanics liens have priority over mortgages created after work commences. Ala. Code 35-11-211.

>
>On the face of things, the permanent loans would appear to be subordinate to the mechanics liens, which is what Lawson argued. However, the permanent lenders claimed that they should be subrogated to the priority of the construction loan, which they had paid off, and hence gain priority over the liens. The Alabama Supreme Court ultimately rejected the subrogation argument and held that, under the statute, the liens had priority.

>
>The court employed three arguments in rejecting subrogation, each of which is discussed below:
>
>1. The “same debtor” argument. The court quoted prior Alabama case law that had held the first element of equitable subrogation was that “the money is advanced at the instance of the debtor in order to extinguish a prior incumbrance.” In the present case, the court observed that the money advanced by the permanent lenders was lent not at the request of the original debtor (Brian Homes) but at the request of the individual buyers who were purchasing the homes.

>
>This is a rather mechanistic argument, but it raises a genuine policy issue: should subrogation be available for a refinancing in connection with a purchase of the property, or only when there is a refinancing by the same owner? There is surprisingly little discussion of this issue in the cases. Several recent cases have granted subrogation in the context of a sale of the property and new financing by the new owner. See In re Project Homestead, Inc., 374 B.R. 193 (Bkrtcy.M.D.N.C. 2007); Ocwen Loan Servicing, LLC v. Williams, 305 Wis.2d 772, 741 N.W.2d 474 (Wis.App.2007); Decaro v. M. Felix, Inc., 371 Ill.App.3d 1103, 864 N.E.2d 890 (Il.App. 1 Dist.,2007). But none of these cases appear to recognize that the issue is controversial or attempt any serious discussion of it. I’m aware of only one case that does: E. Boston Sav. Bank v. Ogan, 701 N.E.2d 331 (Mass. 1998), where the court said:

>Because we find that the equities are substantially similar in refinancing and sales transactions, and that application of equitable subrogation to a sale is consistent with our precedent, we hold that equitable subrogation applies in this case. ... [T]he distinction between a sale and a refinancing exists, but subrogation arising out of either context yields the same result.

>
>For what it’s worth, the Restatement expressly includes sale transactions within its definition of subrogation; Rest. (Third) of Property (Mortgages) §7.6(b)(4) speaks of a payment of a mortgage “upon a request from the obligor or the obligor's successor to do so.” (italics added)

>
>The bottom line is that the Alabama court in Lawson applied the “same debtor” argument mechanically and without giving any reason that it ought to be the rule. In this respect, the opinion is weak and unconvincing.

>
>2. The lender must be ignorant of the intervening lien. The court held that subrogation will only be available where the refinancing lender lacks notice of the intervening lien. Prior Alabama case had held that anyone who buys a new building “has constructive notice that material used to build the structure may not be paid for,” and therefore has notice that there may be a mechanics lien filed on the property.

>Since this sort of notice always exists when the intervening lien is a mechanics lien, it is tantamount to saying that no lender can ever use subrogation to gain priority over a mechanics lien. Of course, the real culprit here is the basic structure of the lien law, which allows the lien claimant to file up to 6 months (for general contractors) or 4 months (for subcontractors and materials suppliers) after the last item of work on the project has been completed. (Ala. Code §35-11-215) Thus, for a period of up to 6 months, the impending lien can be secret, and impossible to find by any title search.

>
>This is, of course, outrageous in terms of public policy, but it is well-established in Alabama and many other states. Contractors, lumber yards, and others in the construction business love it. It has the effect of making buyers and their lenders responsible for the unpaid bills of the builders of newly-constructed real estate. There is no satisfactory way that buyers and their lenders can guard against this risk. Getting lien waivers is fine as far as it goes, but it’s impossible to be sure that all of the people who have supplied labor or materials have signed waivers. One might buy title insurance against the risk, but many title policies sold don’t cover it. Because some policies do, it is the largest single source of title insurance claims. It’s difficult to believe that a civilized society puts up with this sort of rule, but we do.

>
>Rant over! Alabama has made its choice on this point. And if buyers and their lenders are generally subject to intervening (and secret) mechanics liens, why should the doctrine of subrogation bail them out? That seems to be the court’s position: the statute says that later lenders are the losers, and by golly, they’re losers!

>
>3. Subrogation to a construction loan would be unfair to the intervening lienor. This third argument against subrogation was made only by the concurring opinion of Justice Lyons, but it may be the most persuasive. Everyone agrees that subrogation is proper only if it will (in the Restatement’s words) “not materially prejudice the holders of intervening interests.” If subrogation is granted, the mechanics lien claimant, who was previously subordinate only to a short-term construction loan, will now be subordinate to a 20-year or 30-year permanent loan. That sort of switch, the argument goes, is detrimental to the lien claimant. This argument makes some sense. If the construction loan had gone unpaid, it would likely have been foreclosed quickly. With a long-term loan as a substitute, it’s likely that the borrower will make the payments and no foreclosure by the senior lender will ever occur. The lien claimant can foreclose the lien, of course, but if it’s subject to a senior mortg

age for a large amount, maybe foreclosure of the lien will produce little or nothing to pay the lien.
>
>Reporter’s Comment 1:  Bob Harris, a very experienced Alabama lawyers who filed a brief in the case arguing against subrogation, made the following additional argument in an e-mail to me.

>
>It has long been my view that the dynamics of a construction loan mortgage situation are quite different from those involved in conventional permanent lending.  Typically the construction lender loans a lower percentage of the expected improvement value and the loan term is much shorter.  Also, typically an ongoing business relationship exists between a construction lender and a developer that does not exist where a lender makes a long term loan to a home buyer. Even threats of prosecution by unpaid contractors against a construction loan borrower frequently cause the developer to find funds and either pay the contractors or satisfy the construction lender so that a release of the property subject to a lien is given. These considerations are taken into account  by a material supplier when asked to extend credit to a developer; and while the supplier may be willing to extend credit subordinate to the construction loan mortgage that same supplier would not extend the credit as subo

rdinate to a mortgage given to a permanent mortgage lender.
>  
>Thus, I would argue that the Restatement Subrogation view should not be applicable to a "refinancing" by a permanent loan borrower of a debt secured by an earlier construction loan debtor, where there are intervening statutory liens. Indeed, I do not think the buyer of a new residence who gives a mortgage to secure funds with which to purchase a house, a part of which is paid to secure the release of a lot from a construction loan mortgage, can in any legitimate sense be regarded as "refinancing"  the construction loan debt.

>
>I’d be interested in whether DIRT readers find these argument convincing. If you represented a mechanics lien claimant, would you rather be subordinate to a construction loan than a long-term loan?

>
>Reporter’s Comment: 2: The court says that its position is approved by an illustration in the Restatement, but that’s not quite accurate. The illustration, which is in Restatement s7.6, comment f, involves a different fact pattern, one in which there is a delay of a few days between the satisfaction of the old construction mortgage and the recording of the new long-term mortgage, and the work of construction commences during that period of delay. The illustration says the court is justified in refusing to grant subrogation because it would unjust to the lien claimant to do so. That’s true, of course, because when the lien claimant commenced construction, the public records would have indicated that there was no prior mortgage on the property. But it’s quite different from Lawson, in which the lien claimant knew full well, when she did the work on the land, that there was a construction loan that would have priority over any lien that might be filed. In effect, Lawson holds that t

he lien claimant “lucked out” by virtue of the fact that the construction loan was replaced by a permanent loan.
>
>Editor’s Comment 1: This case illustrates a very important point that the editor, candidly, has lost sight of, assuming he ever knew it.  The subrogated position has the priority of the old loan, but the terms and conditions of the new loan, at least insofar as the equities are appropriate.  And if, as here (see the third argument above), the equities are inappropriate, subrogation is denied entirely. 

>
>The editor certainly, in his ruminations about this before, has speculated that the subrogating loan not only gets priority as to the original loan, but also the terms and conditions of that earlier loan.  Apparently, according to Dale, after research, this is not the situation.  The court will install the new loan (up to the amount paid to the earlier loan) on the new loan’s terms, so long as not equitably injurious.  Since the editor has researched the question of whether a mortgagor and mortgagee can modify a loan (even without a provision so permitting) and has generally concluded that they can, this is not a surprising result.  But what is interesting is that if the court should conclude that giving the new lender’s terms priority is not equitable, it apparently will not elect to give the new lender the old lender’s terms.  It will just deny subrogation entirely.

>
>In the instant case, where the construction loan probably had passed its due date and had been paid off by the individual mortgage loans to the purchasers, it would not have made any sense to grant subrogation to an expired loan on its terms.

>
>Editor’s Comment 2: The editor has always found inappropriate the granting of equitable relief to one who walks into the “inequitable situation” with eyes open.  Thus, the editor does not agree with the Restatement notion that parties can be subrogated to senior liens over intervening even when the party paying the senior lien is aware of the intervening liens. 

>
>The editor agrees further with Bob Harris that there are significant differences between the relationship of a construction lender to a developer and a permanent lender to a home buyer that makes it nearly impossible to conclude that the “equities are equal” in evaluating whether to grant subrogation. 

>
>
>
>The Reporter for this item was Dale Whitman of the Missouri, Columbia Law School, emeritus. 
>
>Readers are encouraged to respond to or criticize this posting.
>
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