Mortgage and Mechanics Lien Priorities and the Section 13 Trust Fund

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PART II OF A SERIES:
Commercial Real Estate Finance in New York

In this series, Robert Riva navigates the nuanced and often confusing world of commercial real estate finances in New York, with practical guidance on challenges and considerations.

States struggle to strike the right balance between assuring payments to a contractor who improves real property and a lender whose financing helps make those improvements possible in the first place.

It’s here that New York provides lenders with a unique protection, but one that’s almost as universally unnoticed as it is ubiquitous: the Section 13 Trust Fund – a bedrock facet of New York’s attempt to balance the potentially competing interests of contractor and lender.

WHAT IS A SECTION 13 TRUST FUND?

• At its core, the Section 13 Trust Fund is a covenant that a borrower makes in a mortgage – an agreement to receive loan advances in trust, and to apply those advances to the payment of the cost of improvement before using any part of those funds for any other purpose.
• Including the covenant in a properly filed mortgage can help protect the lien priority of the mortgage over competing mechanics liens, even if those mechanics liens relate back to work that was performed before the mortgage was filed.
• The covenant isn’t limited to mortgages only – but it finds its most powerful expression there.

HOW DOES THE SECTION 13 TRUST FUND WORK?

• The covenant legally transforms loan advances into trust funds.
• Importantly, the lender isn’t obligated to see to the proper application of those trust funds.
• That obligation lies with the borrower: the borrower is statutorily obligated to use those trust funds to pay contractors first.

WHAT IF A MORTGAGE DOESN’T HAVE THE SECTION 13 TRUST FUND COVENANT?

• Quite simply, not including the Section 13 Trust Fund covenant in a mortgage will result in the mortgage not having the benefit the covenant provides.
• The consequences are potentially so harsh for a lender that the New York Lien Law even provides a simplified statutory form of the covenant that can be used in lieu of the full covenant.
• As a result, virtually all New York mortgages include a Section 13 Trust Fund covenant, whether the mortgage is fully funded at closing or whether the mortgage secures construction financing that will be advanced over time.

Not surprisingly, the strongest protection a Section 13 Trust Fund covenant provides is in the case of a mortgage that’s fully funded at closing with no mechanics liens of record at the time the mortgage is filed.

When construction is contemplated, however, the matter becomes much more complex.

We delve into some of those complexities and how to deal with them in upcoming installments of this series.