In February 2011 the Illinois Supreme Court issued its opinion in LaSalle Bank, N.A. v. Cypress Creek I, LP, announcing a new interpretation of the rules governing distribution of proceeds between a mortgage lender and mechanic lien claimants in a situation where 1) the mortgage was recorded before the construction contract was made; 2) the borrower defaults; 3) the lender elects to continue funding improvements from the construction loan; and 4) proceeds generated by foreclosure sale are insufficient to satisfy all claims.
Before Cypress Creek, the law was commonly understood as granting the mortgage lender a priority interest in that portion of the sale proceeds attributable to the value of the land before the construction contract was made, and granting the lien claimants priority in that portion of the proceeds attributable to the improvements they constructed pursuant to the contract. The court in Cypress Creek departed from the traditional analysis, holding that where a mortgage lender has funded a construction loan and paid for some of the improvements with that funding, the lender will: 1) continue to have priority in that portion of the sale proceeds attributable to the value of the land before improvements, and 2) in addition, will share priority with lien claimants in that portion of the proceeds attributable to improvements, proportionately to the value of the improvements it funded.
The Cypress Creek opinion effectively increased the lender’s share of the proceeds realized from a foreclosure sale, and decreased the share available to the lien claimants. Applied prospectively, Cypress Creek will operate to benefit construction lenders and to the detriment of unpaid mechanic lien claimants. As a result, the construction industry lobbied the Illinois General Assembly to enact legislation to overturn the Cypress Creek opinion while the banking industry lobbied to retain the Cypress Creek holding. The construction industry lobby prevailed and House Bill 3636 has been passed by the both the House and Senate, and was signed into law by Governor Quinn on February 11, 2013. It is now in effect.
HB 3636 will implement the following rules for determining priority of interests in proceeds of sale where the mortgage was recorded before the construction contract was made, and foreclosure sale proceeds are not sufficient to satisfy all claims:
- The mortgage lender with a previously recorded mortgage will take priority in that portion of the proceeds of sale attributable to the value of the land at the time that later construction contract was entered.
- Unpaid mechanic lien creditors will share priority in the portion of the proceeds attributable to the value of all subsequent improvements made to the property, pro-rata.
- The lender will not share in proceeds attributable to improvements made pursuant to the construction contract, even if the lender funds subsequent improvements from its construction loan.
Some observers have made dire warnings that passage of HB 3636 will discourage construction lending, since lenders will no longer enjoy the advantages announced in Cypress Creek.
This need not be the case. Construction lenders can structure loan documents and payout methods to preserve parity of interest with unpaid mechanic lien claimants, leading to a lender’s greater probability of enhanced recovery in distressed development projects.