Daily Development forWednesday, December 1, 1999

Daily Development for Tuesday, December 7, 1999

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

Thanks to H.E. Peterson for the tip on this one, too.

MECHANIC'S LIENS; PRIORITY: New York provision requiring that a construction lender file an affidavit indicating "net sums available for construction" and that developer agree to hold such funds in trust for costs of acquisition and construction is satisfied when the affidavit sets forth a lump sum without indicating that over onethird of the monies will be disbursed immediately to developer to reimburse for monies expended on site improvements prior to funding of loan.

In re Elm Ridge Associates, (S.D.N.Y. 12/1/99) http://www.nylj.com/decisions/99/12/120199bb.htm

Developers formed three entites, with virtually identical ownership, for the development of three parcels that Developers had under contract. The plan was that as each parcel became ripe for development, the developers would acquire title and a enter into a construction loan for that parcel. It became evident, however, that it would be best to perform infrastructure improvements on Parcel Three even while the developers were still working on Parcel Two and before the developers had acquired title to Parcel Three.

The developers entered into an agreement with the construction lender that they would advance their own funds to carry out infrastructure improvements on Parcel Three and would be reimbursed from construction loan funds secured by a mortgage on Parcel Three after they acquired title to Parcel Three. In fact, this plan was carried out. The developers did close on Parcel Three, the construction lender funded a loan, and paid $4.16 million to Developers to reimburse them for monies advanced to carry out infrastructure improvements.

Under New York law, construction lenders must file an affidavit setting forth funds available for construction. Here is the relevant text of the two statutes: A building loan contract either with or without the sale of land, and any modification thereof, must be in writing and duly acknowledged, and must contain a true statement under oath, verified by the borrower, showing the consideration paid, or to be paid, for the loan described therein, and showing all other expenses, if any, incurred, or to be incurred in connection therewith, and the net sum available to the borrower for the improvement, and, on or before the date of recording the building loan mortgage made pursuant thereto, to be filed in the office of the clerk of the county in which any part of the land is situated, ... No such building loan contract or any modification thereof shall be filed in the register's office of any county. If not so filed the interest of each party to such contract in the real property affected thereby, is subject to the lien and claim of a person who shall thereafter file a notice of lien under this chapter.

Every such building loan mortgage and every mortgage recorded subsequent to the commencement of the improvement and before the expiration of the period specified in section ten of this chapter for filing of notice of lien after the completion of the improvement shall contain a covenant by the mortgagor that he will receive the advances secured thereby and will hold the right to receive such advances as a trust fund to be applied first for the purpose of paying the cost of improvement, and that he will apply the same first to the payment of the cost of improvement before using any part of the total of the same for any other purpose . . .

The lender filed several affidavits as it advanced additional construction funds, including schedules of expenditures for hard and soft costs. It indicated that over $7 million was available for costs of construction, but the schedules never indicated that over $4 million was committed to reimbursement of the Developer for improvements carried out prior to funding of the loan. Subsequently the Developer went bankrupt and had outstanding approximately $14 million on the construction loan and over $300,000 in upaid accounts to the mechanic's lien creditor involved in this action.

The Bankruptcy Court concluded that the affidavit did not meet the statutory requirement and consequently applied the statutory requirement, permitting the mechanic's lien creditor to prime the construction loan entirely as an equitable subordination under the Bankruptcy Code.

On appeal, held: reversed. In the critical ruling as to the meaning of the statute, the District Court, citing two lower appeals court cases in New York, concluded that the statute permitted construction lenders to indicate that funds were available for construction even though they were committed to pay the costs of prefunding activities. It noted that the lender is not required to alter the affidavit of funds available every time that it makes a construction loan advance, and that parties interested in the information concerning funds available necessarily take their chances that the funds are not expended. The court notes that the New York Court of Appeals has not construed this language.

The District Court also construes specifically the language of the New York statute on a number of points involving this issue, but the above holding appears to be more an interpretation of the intent of the legislature than a clear cut parcing of statutory language.

Comment 1: If the purpose of the statute is to provide knowledge to parties evaluating whether it would be wise to advance construction credit for the involved property, then the court's conclusion seems questionable. Although, of course, it is always true that additional monies will be paid to other contractors, if the party studying the affidavit is aware of the proposed project and the funds available, the party can make a judgment about whether the funds available are sufficient to pay all the costs. It is difficult, if not impossible, to make this judgment when the construction loan monies are committed to others through an undisclosed contract.

Comment 2: Does it matter that the reimbursement for the prefunding costs was already required by contract when the lender entered into the construction loan for this property? There is no question that these monies were precommitted, and that it would have been a small thing for the lender to disclose the committment in its affidavit. This may distinguish this case from the New York precedent the court cites.

Comment 3: This is the first statute of this type that the editor has confronted. The editor offers the case on the chance that other jurisdicitons have similar disclosure requirements.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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