The extent of the dire economic consequences of the COVID-19 pandemic remain to be determined. Executive Order 202.6 issued by New York State Governor Andrew M. Cuomo in March, which prohibits non-essential construction, has placed additional pressure on lenders as delays increase risk and deplete the capital of developers who have to carry costs for a longer timeline (taxes, debt service, insurance and other expenses). When work is permitted to commence again, these developers can expect to be faced with increased remobilization costs, as well as the additional time and expense of implementing worker distancing and other safety measures to mitigate against the risk of re-invigorating the spread of the virus. Developers can also expect increased costs of materials due to shortages in the supply chain. In turn, the timelines and budgets for construction increase, requiring the approval of the developers' lenders. Some projects may end up being scaled back and/or undergo changes to the planned use (in whole or in part).
These new budgets, longer timelines, changes in use and/or other material changes will be memorialized in modifications to the building loan agreements. This advisory assumes that the New York Lien Law (the "Lien Law") was properly adhered to by the lender in making and administering its building loan prior to entering into any modification. Under Section 22 of the Lien Law, any material modification to an existing building loan agreement must be reduced to writing and filed with the County Clerk within 10 days. The drastic consequence for lenders which fail to do so is that all advances made under the building loan will be subordinated to mechanic's liens filed against the property – this remains true whether the advances were made before or after the modification was made. In light of the severity of noncompliance, construction lenders are well-advised to file all modifications to best protect themselves in this volatile economic environment rather than hope no one challenges a modification they considered immaterial and/or that if challenged, the courts will agree that the modification was immaterial.
Moreover, despite the experience of lenders and developers in entering into building loan modifications, any number of these projects will end up in foreclosure, bankruptcy or both; in many instances, this will include claims for liens filed by contractors and material suppliers. Aggressive counsel for lienors may seek to challenge the priority of the lenders and the failure to timely file a modification may be the clearest path to doing so. At a minimum, such failure may give negotiating leverage to the lienors to the detriment of the lender. More and more projects will face challenges and the delta between the value of the project and the amounts owing to these lenders will shrink, making it more critical that construction lenders fully protect the mortgage lien priority status of their building loans.
From a practical standpoint, building loan title insurance policies provide that date down endorsements are available each time an advance is made. To obtain these endorsements, a title continuation search is run prior to making the advance to confirm no intervening liens were filed against the project. However, if a building loan is modified but the modification is not timely filed with the County Clerk, the title company will be unwilling to issue such endorsements unless it is convinced that the modification in question was not material (an unlikely scenario and easily avoided by timely filing). As of the writing of this advisory, many County Clerks offices have not been open for accepting the recording of liens or modifications, and our understanding from communicating with various title companies is that there is somewhat of a backlog of filings that were submitted to these clerks' offices prior to closures but which have not yet been filed of record. This has effectively rendered many title insurers unable to file any modifications until the clerks return to completing these filings or new legislation or an executive order is implemented to address this issue (or insure new building loans for that matter which also require the filing of the building loan agreement within 10 days of making a building loan).
ACTION ITEM: Construction lenders should consult with experienced counsel with a deep understanding of the Lien Law prior to entering into any building loan modifications. Should these loans thereafter fall into default, it will be critical that the modification properly reflects changes to the building loan and is filed with the County Clerk within 10 days of execution.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
