Construction lenders beware of California Civil Code section 3137(c), which provides that a mechanic’s lien for “site improvements” has priority over a trust deed recorded before commencement of the site improvement work in certain circumstances.

That provision has several subparts, but one trap for the unsuspecting lender and title insurance company is this if the loan proceeds secured by the trust deed are solely or primarily to pay for the construction of the site improvements, then a mechanic’s lien for those site improvements would have priority over the prior-recorded trust deed. Period.

When is a construction loan trust deed “primarily” for site improvements when other items are to be paid for from the loan proceeds?  What if the only items paid for, in part, are some site improvements and the balance of the loan funds are never disbursed due to a default and foreclosure?  Would a court look solely to the loan documents and budget at inception of the loan?  Or, would it look to see how the funds were actually used in the particular case?  Given California’s stated public policy favoring payment to contractors who have completed the work and have complied with the law, the latter scenario may be a real possibility, thereby exposing lenders and title insurers to unanticipated risk of loss.

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