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Material Modifications of Building Loans

Even seasoned real estate finance practitioners can be stumped by New York's Lien Law, specifically Section 22, a provision that is intended to balance protections ensuring payment of available funds to materialmen and laborers with lien priority for mortgage lenders providing financing to the project. Construction lenders to a New York project may maintain lien priority for periodic loan advances over intervening liens of contractors for any portion of the loan which is advanced for hard costs and certain statutorily permitted soft costs in strict accordance with the lender's public disclosure of available loan amounts and intended uses made at the initial closing of the particular loan.

Such disclosure, known as a "Section 22 affidavit," reveals the consideration paid for the loan and all related expenses incurred or to be incurred in connection with the loan as well as, most importantly for purposes of this article, the net sum available to the owner for the cost of the improvements. The sworn statement, which accompanies the statutorily required building loan contract, must be filed in the office of the county clerk where the property is located prior to or simultaneously with the recording of the building loan mortgage.

The public filing permits contractors to determine the amount of loan proceeds that will be made available to the owner for the cost of improvements so that the contractors can determine, prior to their engagement, whether there will be sufficient funds for them to be paid out of such loan proceeds. Lender's failure to make such filing or advance the loan in accordance with the intended uses disclosed therein could result in the lender's mortgage lien being subordinated to mechanics' and/or materialmen's lien for work or materials provided in connection with the construction of the related improvement.

Among the significant challenges facing a construction lender in originating and administering a New York construction loan, many of which are outside the scope of this article, is how to document changes in deal terms that are prompted by construction delays, change orders and other market pressures. By statute, modifications to a building loan agreement must be filed within 10 days after execution or, if not so filed, the lender may be subject to subordination to mechanics' and/or materialmen's liens since the contractors' expectations concerning the availability of loan funds may be upset by the changed terms.1

While best practice suggests that every modification should be documented with a public filing, some courts have ruled that only "essential" or "material" modifications that serve to change the circumstances upon which a contractor may have previously relied, needs to be filed.2 This article seeks to remind practitioners to be cautious when representing lenders that modify building loans.

Fact-Driven Inquiries

Generally, the modification of a building loan contract will be deemed material if it alters the rights and liabilities between the borrower and lender or enlarges, restricts or impairs rights of contractors and materialmen.3 Although courts seem to agree that modifications relating to consideration paid for the loan, expenses incurred in connection therewith, and the net sum of proceeds available therefrom are considered material,4 the courts' inquiries in each case have been very fact driven. For example, where a building loan agreement required that the borrower obtain surety bonds prior to the lender making advances of funds, the court found that the lender's waiver of such condition was a material modification requiring the filing of an amendment.5 The court reasoned that because surety bonds provide a direct source of payment to contractors over and above the loan proceeds, the lender's waiver impaired their rights. However, by contrast, when the building loan contract provided that the lender may require surety bonds prior to making loan advances in the lender's discretion, the court held that the lender's decision to advance proceeds without requiring such bonds did not constitute a material modification and was therefore not actionable by lienors.6 In short, the lender's waiver of a requirement for surety bonds would be deemed material while a waiver of the lender's right to require such bonds would not be deemed material.

Similarly, a court reasoned that if a building loan contract requires a borrower to fund a certain amount of equity into the project prior to the lender making loan advances, but the contract does not contain a manifest requirement that such funds would be applied to payment of mechanics' and/or materialmen's claims, then such equity requirement does not establish a source of direct payment for contractors and materialmen. Accordingly, the waiver of such equity requirement, absent additional circumstances, would not constitute a material modification.7 If however, the building loan contract provided for the use of borrower equity to pay contractors, then the waiver of the equity requirement by the lender would likely be considered material.

Issues to Consider

We have sought to apply some of these principles to concerns our clients may encounter when servicing their loan portfolio. For instance, few construction projects face as many market pressures as residential condominium construction loans and, therefore, lenders regularly see the need for loan document modifications in this context. Certainly, changes that reduce available loan proceeds would be prejudicial to contractors and may result in subordination to the lender. However, changes that do not on their face affect amounts available to contractors should still be made the subject of a modification to the building loan agreement since it will generally help the lender's case in the event of a challenge by contractors engaged after such modification.

For example, the building loan contract for such a project normally permits the release of a unit from the lien of the lender's mortgage when such unit is sold so long as the borrower is able to realize enough proceeds from the sale of a unit, allowing a minimum release price (agreed to in the building loan agreement) to be paid over to the lender and applied to the outstanding principal balance of the loan. Would it be a material modification, requiring the filing of an amendment to the building loan agreement, if the lender agreed to release a unit for less than the minimum release price and the amount of available loan dollars were not reduced? If the building loan contract provides for the payment of all such proceeds to the lender, then contractors probably could not reasonably argue that they were relying on the sales proceeds as a source of funds and, therefore, such modification should not be deemed material based on the principles discussed above.

The answer to this question is beyond the scope of this article, but this hypothetical illustrates the types of issues a lender must consider when modifying or waiving any provisions of a building loan contract and further emphasizes the need to file written documentation of any such modifications.

It is imperative, when representing construction lenders, that attorneys consider the ramifications of any action, or inaction, by their clients during the term of a building loan. As the provisions of the Lien Law can seem rather arcane, even to experienced practitioners, caution is always recommended, and consultation with a seasoned professional at the title company is always a well advised.


1. New York Lien Law 22.

2. See N.Y. Sav. Bank v. Wendell Apartments, 41 Misc. 2d 527 (Sup. Ct., Nassau Co. 1963) (stating that "essential" modifications with respect to amount or manner of payment of advances require filing of modification agreement, but distinguishing a mere extension, which was not deemed "essential" enough to require filing of the modification); see also Howard Sav. Bank v. Lefcon P'ship, 209 A.D. 2d 473 (2d Dept. 1994) (stating that "notice is required only with respect to 'material' modifications of the agreement" (citing HNC Realty v. Bay View Towers Apartments, 64 A.D. 2d 417 (2d Dept. 1978))).

3. See Howard Sav. Bank v. Lefcon P'ship, 209 A.D. 2d 473 (2d Dept. 1994) (clarifying that "[a] modification of a building loan agreement is 'material' if it: (1) alters the rights and liabilities otherwise existing between the parties to the agreement or (2) enlarges, restricts or impairs the rights of any third-party beneficiary." (citing HNC Realty v. Bay View Towers Apartments, 64 A.D. 2d 417 (2d Dept. 1978))).

4. See In re: Admiral's Walk, 134 B.R. 105 (W.D.N.Y. 1991).

5. See HNC Realty v. Bay View Towers Apartments, 64 A.D. 2d 417 (2d Dept. 1978); see also Yankee Bank for Fin. and Sav., FSB v. Task Assocs., 731 F. Supp. 64 (N.D.N.Y. 1990).

6. See In re: Grossinger's Assocs., 115 B.R. 449 (S.D.N.Y. 1990)

7. See In re: Admiral's Walk, 134 B.R. 105 (W.D.N.Y. 1991).