The Tennessee Court of Appeals recently decided a classic case involving lien priority and whether an individual or entity not holding title can create a valid security interest in real property. Anchor Pipe Co., Inc. v. Sweeney-Bronze Dev., LLC, No. M2011-02248-COA-R3-CV (Tenn. Ct. App. Aug. 2, 2012).
The issues involved in the case arose during the development of a residential subdivision located in Gallatin, Tennessee. In February 2007, the owner engaged Anchor Pipe Company (“Anchor”) to promptly commence work on the property. As of May 2007, record fee simple title to the property was held by Sweeney-Bronze Development, LLC (“SBD”). On July 24, 2007, the construction lender recorded a Deed of Trust from Sweeney-Bronze Holdings (“SB Holdings”), not SBD. On June 27, 2008, Anchor was told that it was not going to get paid for any more work on the property. During July 2008. Anchor recorded two materialmen’s liens against the property. On November 12, 2008, a deed of conveyance was recorded transferring title from SBD to SB Holdings. On the same date, the construction lender recorded an amended and restated deed of trust, which correctly listed SB Holdings as the grantor. Anchor recorded an amended lien for the total amount owed on June 10, 2009. A week later, Anchor filed a complaint for amounts due under its construction contract with SBD. The trial court held that Anchor agreed to subordinate its lien to the bank’s lien rights and that Anchor’s lien did not have priority over the bank’s deed of trust. Anchor appealed to the Court of Appeals.
Under real property law, priority (first in time–first in right) determines the order in which lienholders are permitted to satisfy their liens from a security interest held in real property. Tennessee has a race-notice recording statute (TCA § 66-26-101). Under a race-notice recording statute, a lienholder who records his lien first without knowledge of a prior unrecorded instrument has priority over the prior unrecorded lien or instrument. Under Tennessee law, “[n]o person shall agree to buy, or to bargain or sell any pretended right or title in lands or tenements, or any interest in such pretended right or title.” TCA § 66-4-201. If the grantor of a deed of trust has no legal interest in the property to be conveyed, the deed of trust may be completely invalidated.
In the Anchor case, the bank cited the case of Wilkins v. Reed, 300 S.W. 588 (Tenn. 1927) to argue that the defect in the deed of trust (that the grantor was incorrect) should not deprive the bank of its lien priority because its 2007 deed of trust was properly recorded and put Anchor on notice of the bank’s financial interest in the property. However, the Tennessee Court of Appeals did not agree with this argument. The Court of Appeals found that the bank’s deed of trust itself was defective because the grantor was an entity that did not have an interest in the property to convey in the deed of trust. The recording of a deed of trust that does not convey an interest in the property cannot result in a perfected security interest. Interestingly, in a footnote, the Court of Appeals indicated that it would be less likely to overlook a recording error made by a bank, noting that no “entities are better situated to properly perfect interest in land than banks, whose purposes are to maximize profit derived from lending money and to ensure the repayment of their loans by taking an interest in the borrower’s collateral. Courts can not underwrite [banks’] business risks under the guise of equity when [banks] themselves failed to take minimal steps to ensure their interests were properly protected.”
The Court of Appeals determined that the bank’s 2007 deed of trust did not perfect its security interest.
A few practice pointers to remember based on the lessons learned from this case:
- Lenders should always (no exceptions) have a title examination performed before making loans secured by commercial real estate. A title exam is the only way that one knows with 100% certainty who holds record fee simple title to a piece of real property. Additionally, lenders should always obtain a loan policy of title insurance to protect its security interest. In this case, the bank would have been protected against Anchor’s lien if it had a loan policy. In fact, I suspect the lender had a loan policy and made a claim against its title insurer when its security interest was called into question by the lien.
- Lender’s should always require a Borrower’s Affidavit at the closing of a loan secured by real property. The Borrower’s Affidavit should specifically state that the title insurer and lender intend to rely on the affidavit for purposes of issuing a title policy and/or making the loan. In the Borrower’s Affidavit, among other things, the Borrower must swear that “no work has been performed at the property during the previous 95 days.” The number of days will vary by state based on lien laws. By requiring the Borrower to swear to the title insurer that no work has been performed during the previous period of time, the risk of loss from lien is shifted to the title insurer from the lender.
- Lenders should make sure that the proper entities are listed as the grantors and grantees on their deeds of trust and other recorded documents. It appears that Tennessee courts are not showing a willingness to correct these types of errors in the interest of equity, especially if the error was made by a bank. This is real estate 101 and applies to all types of real estate transactions.
- Lastly, always obtain full lien waivers from any materialmen or contractors as they are paid for a project from construction draws. This is a second means of eliminating the risk of a materialmens’ lien having priority over your lien.