CONSTRUCTION LENDER BEWARE

A recent decision by the Appeals Court of Massachusetts produced a surprising result in a suit by a buyer of a new home against the construction lender. In this case a builder approached a bank for a construction loan after it had entered into a purchase and sale agreement with a buyer. After the loan closed, the builder and the buyer got into a dispute. The builder refused to finish construction and to sell the property to the buyer. Ultimately, the buyer took residence in the property with the consent of the seller and the building inspector and later filed suit to enforce their agreement.

The developer stopped making payments to the bank and the bank started foreclosure proceedings. The buyer then brought suit against the bank seeking a judgment that the mortgage was junior to the rights of the buyer under his purchase and sale agreement and asked that the bank be restrained from selling the property to anyone other than the buyer.

The buyer’s theory of recovery was that the purpose of the recording statutes is to protect bona fide purchasers for value who have recorded rights in their property in the appropriate registry of deeds. However, the recording statutes, specifically, General Laws, Chapter 183, Section 4 provides that the purpose of the recording statutes is to allow persons without actual knowledge to the contrary to rely on the registry records. The plaintiff took the position that the bank had actual knowledge of their purchase and sale agreement before they recorded their mortgage so, accordingly, they should be entitled to priority with respect to that property.

The issue of rights of parties in possession has always been a consideration in the context of leases to the end that in most lease forms there is a provision for a subordination of any of the lessee’s rights to any mortgage then or thereafter placed on the property. However, the issue has never been raised with respect to a mortgage.

The question posed by the court was did the bank have actual knowledge of the agreement prior to the recording of its mortgage and, if it did, did the buyer have the type of interest that should be given priority over the bank’s recorded mortgage. The court found that the bank did indeed know about the agreement and that the buyer should be given priority over the mortgage.

The court noted that the bank could have, but failed to, require a subordination by the buyer of their rights under the purchase and sale agreement to the mortgage. No doubt it never occurred to the bank to request such a thing since there are no cases which ever reached this peculiar result.

The case leaves us with a series of difficult unresolved questions such as, how does the bank foreclosure the mortgage? The obligation of the foreclosing mortgagee is to get the highest and best price for the owner and any junior lien holder. The bank cannot force the contractor to sell the property. If the bank forecloses, is it required to have only a one person buyer at the auction? What are the rights of the owner and junior lien holders who may not have had notice of the purchase and sale agreement?

Also unresolved is the question of if the balance of the bank’s mortgage is in excess of the purchase price is the bank forced to take a loss? The decision leaves in its wake a battleground for fights yet to be fought. The case is on appeal to the Supreme Judicial Court and, hopefully, they will review it and come to a different conclusion.

However, in the meantime, the lesson is that any purchase and sale agreement should have in it a clause subordinating the rights of the buyer to any existing or future mortgage thereafter placed on the property.

Thomas V. Bennett, Esq. (tvb@barronstad.com)

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