Changes to Pennsylvania Mechanic’s Lien Code

For this week’s Guest Post Friday here at Musings, we welcome Jim Fullerton.  Jim is the President of the law firm of Fullerton & Knowles, P.C., which has attorneys licensed in Virginia, Maryland, Pennsylvania, and the District of Columbia, is a Martindale Hubbell Peer Rated Lawyer AV^® Preeminent.^™  The firm represents owners, lenders, design professionals, suppliers, subcontractors, general contractors and other members of the real estate and construction industries, filing mechanic’s liens, surety bond and other construction claims across all of the states in the Mid Atlantic region.  He also represents creditors in bankruptcy issues nationwide, particularly defense of bankruptcy preference claims; advises owners and lenders in real estate lending and acquisition transactions; on all real estate and construction law issues; contract formation and disputes. 

The firm’s Construction Law Survival Manual is well known and widely used by participants in the construction process.  The 550 page manual provides valuable information about construction contract litigation, mechanic’s liens, payment bond claims, bankruptcy and credit management and contains over 30 commonly used contract forms.  All of this information and recent construction law issues are constantly updated on the firm’s website.

There are two changes to the Pennsylvania Mechanic’s Lien Code that became effective September 2014. First, residential properties built by an owner for their own residence will now have a defense of payment to subcontractor mechanic’s liens. This protects homeowners from mechanic’s liens if they have paid their general contractors in full. Second, construction loan open end mortgages will have priority over mechanic’s liens, as long as at least sixty per cent (60%) of the loan proceeds are used for construction costs. This change was pushed by Pennsylvania lenders in response to a recent court case.

Under prior Pennsylvania law, there was no automatic defense of payment for any Pennsylvania project owner. That is, any owner might be required to pay for the project twice. Even if the owner had paid the general contractor in full, a subcontractor might be able to establish a lien and eventually foreclose on the property. The burden was always on the owner to make sure that all subcontractors were paid.

An owner can create a defense of payment by filing a copy of the general contract in the prothonotary’s (court clerk’s) office before commencing construction. This will limit each subcontractor to a pro rata share of money still owed the general contractor. In addition, general contractors can waive lien rights for lower tier subcontractors if the general contractor posts a payment bond to cover the value of the labor and materials provided. Lien waivers by a general contractor are made by filing a “Stipulation Against Liens” (“Stipulation”), often referred to as a “Stip.” Most commercial Pennsylvania project owners will continue to do one of these things. Most Pennsylvania construction lenders require it.

Beginning in 2014, most owners will have an automatic defense of payment to a subcontractor lien on owner occupied residential projects.  If the owner has paid the general contractor in full, all subcontractor liens will fail. For the defense of payment to apply, the property must be a residential single townhouse or a building consisting of one or two dwelling units.   The property must be used or intended to be used as the residence of the owner or a tenant of the owner subsequent to occupation by the owner. It seems that a tenant would not have a defense of payment for any construction unless the property was previously occupied by the owner. This would also seem to rule out any builder or developer owned residential properties. Professional residential builders must still file a copy of the general contract in the prothonotary’s (clerk’s) office before commencing construction or give the subcontractor written notice of the contract payment provisions to create a defense of payment.

The statute says that “a subcontractor does not have the right to a lien with respect to an improvement to a residential property” if all of these conditions are met. However, subcontractors would normally have no way to know whether the owner had paid the general contractor or whether the owner intended to use the property for their own residence. Accordingly, it appears that subcontractors can and should file their lien claims if they are not paid. The statute seems to recognize this, stating that a court can issue an order discharging the lien against the property in response to a petition or motion to the court by the owner or a party in interest, when the owner or tenant has paid the full contract price to the general contractor. It is up to the owner to contest the lien. It is not clear who has the burden of proof on each condition. However, a subcontractor would not be in possession of evidence regarding payments by the owner or the intended use of the property, so the owner should have the burden.

An owner can also have a partial defense of payment. Where the owner or tenant has paid the contractor less than the full contract price, a court can also reduce the lien to the amount of the unpaid contract price owed.

The second big change (or clarification) in the Pennsylvania Mechanic’s Lien Code concerns the priority of mechanic’s liens compared to construction loan open end mortgages. The priority of any type of lien can be extremely important. Priority can determine whether or not the lienholder gets paid upon foreclosure. In a mechanic’s lien or foreclosure situation, by definition there is not enough money to pay all debts. A lien with low priority can easily be worthless.

It does seem like the Pennsylvania legislature tried to give open-end mortgages (construction loans) priority over mechanic’s liens in the 2007 amendments. This was a significant change in the Pennsylvania Mechanic’s Lien Code. However, the Superior Court decided in Commerce Bank/Harrisburg, N.A. v. Kessler in 2012 that the construction loan lender did not have priority unless ALL of the proceeds off the loan were used for the hard costs of “completing erection, construction, alteration or repair of the mortgaged premises.” In response to this decision, Pennsylvania lenders successfully lobbied for a change or clarification.

Starting in September 2014, a construction loan (open-end mortgage) will have priority over any type of mechanic’s lien, whenever at least sixty percent (60%) of the mortgage proceeds are intended to pay or are used to pay all or part of the costs of construction. Costs of construction are defined to include all costs for erection, construction, alteration, repair, mandated off-site improvements, government impact fees and other construction-related costs, including, but not limited to taxes, insurance, bonding, inspections, surveys, testing, permits, legal fees, architect fees, engineering fees, consulting fees, accounting fees, management fees, utility fees, tenant improvements, leasing commissions, payment of prior filed or recorded liens or mortgages, including mechanics liens, municipal claims, mortgage origination fees and commissions, finance costs, closing fees, recording fees, title insurance or escrow fees.

Accordingly almost any construction soft costs will count as construction costs and the construction loan (open-end mortgage) will have priority over any type of mechanic’s lien, if at least sixty percent (60%) of the mortgage proceeds are used to pay those costs of construction. Construction loans, therefore, will almost always have priority over mechanic’s lien in the future.

For cites to some of these changes, check out the full newsletter at the Fullerton & Knowles website.

As always, Jim and I welcome your comments below.  Please subscribe to keep up with this and other Guest Post Fridays at Construction Law Musings.