Construction financing: The lender’s role & priority under the construction act
Construction Financing: The Lender’s Role & Priority Under the Construction Act (Part 1)
When a property owner sets out to begin a construction project on their property, the owner arranges new mortgage to finance the construction and pay for the work completed on the project. This type of mortgage is referred to as a “building mortgage” or a “construction mortgage”. A construction mortgage in Ontario is advanced in stages and each mortgage draw depends on the progress made in the project. Each advance triggers a unique obligation on the mortgage lender under the Construction Act (the “Act”).
The goal of the Act is to protect the general contractor, subcontractors, and suppliers of a construction project that supply services or materials against the default, insolvency, or bankruptcy of others above them in the construction pyramid. This protection is given by allowing contractors, subcontractors, and suppliers to register a construction lien against the property to which they provided services or materials. A construction lien is essentially a right that a person has in a property which is created when they provide materials and/or services to that property that are “lienable” under the Act. This lien right is much like a bank registering a mortgage (also known as a charge) on title to the property. Below is an example of a construction pyramid and the different members that can form the pyramid in a construction project.
The Act attempts to lessen the impact of the abandonment of a project or of bankruptcy by establishing a fund for the members of the pyramid. The fund is created with a mechanism called a “holdback”. The holdback fund works a bit like insurance and a construction lien forms a charge on the holdback funds.
The members of the pyramid, including the owner, contractor, and subcontractors, are required to holdback funds from any payments made under the project. Under sections 22 and 24 of the Act, the owner is required to hold back from the payments due to the general contractor at least 10% of the value of the work completed at that time. The 10% holdback is referred to as a “statutory” holdback and it can only be released once the contractor’s lien rights have expired.
The lender in a construction mortgage plays an important role in maintaining the holdback. Before an advance can be made in a construction mortgage, the lender must be vigilant in verifying the owner’s/borrower’s construction activities. The lender must first obtain an architect’s or engineer’s certificate before advancing funds to verify the value of the work completed and ensure they are not advancing more than that value. Next, construction lenders need to be concerned not only with whether a lien arose or was registered on title, but with whether the proper holdbacks were retained by the owner under the Act. As a result, the lender is usually directly involved in the holdback process itself, by deducting 10% of the amount to be advanced under the mortgage loan.
If the mortgage is a construction mortgage, and is therefore directly tied to the construction project, the Act imposes a special priority regime. This priority regime will be explored further in part 2 of this article.