EXCERPT: Most construction loans contemplate multiple advances or disbursements of funds at various stages of the construction project. The construction loan agreement will set forth the conditions that the borrower must satisfy to receive each advance of funds. Given that a construction loan concerns an active construction project, there is a risk that a lender could lose its lien priority in an advance (secured by the insured mortgage) to a mechanic’s lien. This post addresses how a title insurance policy and endorsements can insure against such a risk.
This issue arises due to the nature of mechanic’s liens. Specifically, if a contractor does not receive duly owed payment for furnished labor, services or materials, then the contractor may file a lien against the real property for the amount owed (in accordance with state law). In addition, in most states, the priority of the lien typically relates back to the date that the labor, services or materials were initially furnished by the contractor. During construction (and after the title insurance policy is issued), a lender could lose its lien priority in an advance to a mechanic’s lien if the contractor’s work began before the future advance is disbursed.
A lender can insure against such a loss of priority by negotiating with the title insurer to (i) include mechanic’s lien coverage in the title policy jacket or (ii) obtain certain endorsements to the title policy for such coverage. Those familiar with the American Land Title Association (ALTA) forms of title insurance policies and endorsements know that the standard covered risks include:
“The lack of priority of the lien of the Insured Mortgage upon the Title (a) as security for each and every advance of proceeds of the loan secured by the Insured Mortgage over any statutory lien for services, labor, or material arising from construction of an improvement or work related to the Land when the improvement or work is either (i) contracted for or commenced on or before Date of Policy; or (ii) contracted for, commenced, or continued after Date of Policy if the construction is financed, in whole or in part, by proceeds of the loan secured by the Insured Mortgage that the Insured has advanced or is obligated on Date of Policy to advance…” (Covered Risk 11(a), ALTA, Loan Policy, Adopted 6-7-06.)
As shown above, Covered Risk 11(a) offers coverage for mechanic’s liens arising before the Date of Policy, or after the Date of Policy if the insured must advance the proceeds under the loan agreement.
Nonetheless, title insurers exercise a great deal of caution when providing insurance coverage for mechanic’s liens vis-à-vis construction loans; this caution is principally due to the increased risk that a mechanic’s lien could be filed during the construction project. The title insurance policy for a construction loan will almost certainly include a Pending Disbursement Clause as an exception, limiting the scope of coverage offered by Covered Risk 11(a). Specifically, these clauses limit the insurance covered by the policy for loan proceeds actually disbursed. These Pending Disbursement Clauses come in many forms; however, one example is:
“Pending disbursement of the full proceeds of the loan secured by the Insured Mortgage, this Policy insures only to the extent of the amount actually disbursed, but increases as each disbursement is made in good faith and without Knowledge of any defects, liens or encumbrances on the Title, up to the face amount of the Policy. At the time of each disbursement of the proceeds of the loan, the title must be continued down to that time for defects, liens or encumbrances on the Title intervening or recorded between Date of Policy and the date of the disbursement.” (Stewart Title, PDCX02 ALTA.)
In order for a construction lender to receive additional coverage for each advance and insure against a potential loss of its lien priority, the lender must request a datedown endorsement at the time of each disbursement of funds. Other forms of Pending Disbursement Clauses often impose additional requirements, such as the provision of lien waivers by contractors and proof of paid bills by the owner, before a datedown endorsement is issued. Nonetheless, Covered Risk 11(a) and datedown endorsements (issued pursuant to the Pending Disbursement Clause) offer one approach to protect lenders against a potential loss of its lien priority in an advance to a mechanic’s lien suffered after the initial Date of Policy. Continues…