On October 25, 2012, the Nevada Supreme Court, in a case of first impression, held that equitable subrogation cannot be used as a method to repair broken priority over mechanics' liens, but left the door open to the potential for a contractual subordination alternative in its decision In re: Fontainebleau Las Vegas Holdings, LLC, 128 Nev. Adv. Op. 53 (Oct. 25, 2012).

Prior to this decision, two contradicting arguments were generally made: A lender with broken priority argued that either (1) a prior lender’s mortgage superiority could be inherited by a subsequent lender through the doctrine of equitable subrogation or (2) mechanics’ lien claimants could prospectively subordinate their rights and the priority of their liens through a subordination agreement. Mechanics’ lien claimants, in contrast, argued that equitable subrogation was contrary to the express priority hierarchy established in NRS 108.225 and that the anti-waiver provisions of NRS 108.2457 disallowed even a knowing and intended subordination of a mechanics' lien priority. With the impact of the Great Recession, the resolution of these arguments held potentially significant ramifications for lenders, developers, contractors and title insurers.

In Fontainebleau, a lender loaned a developer $150 million in 2005 to acquire a parcel of land and secured the note by recording a deed of trust against the land in a first priority position. After the developer commenced construction in 2007, the lender provided a construction loan of $1.85 billion, re-conveyed the existing deed of trust and placed a new deed of trust on the property to secure the new loan. Additionally, the lender required various construction companies to enter contractual subordination agreements of their mechanics' liens to the new deed of trust. Upon recordation, the lender began disbursing loan proceeds for the payment of construction and various operating expenses of the developer. In 2008, with the downturn of the economy, the lender declared a default of the loan and began foreclosure of the property under construction. The contractors working on the project recorded mechanics' liens to secure their unpaid work. The developer was forced to file bankruptcy. In the bankruptcy proceeding, the property was sold to a third party with the mechanics’ liens and the deed of trust attaching to the proceeds of the sale. The lender and the mechanics' lien claimants each claimed priority to the funds under the arguments described above. The Bankruptcy Court certified questions summarizing the disputed legal arguments to the Nevada Supreme Court.

The Court holds that the doctrine of equitable subrogation cannot be applied to mechanics' lien claimants.

In responding to those questions, the Court noted that it had not previously applied equitable subrogation in the mechanics lien context and began its analysis of the doctrine's applicability by reviewing past Nevada applications of the doctrine. Finding the application of equitable subrogation in the context of mechanics’ liens contrary to the public policy considerations of the Nevada legislature and the plain language of NRS 108.225, the Court held equitable subrogation to be inapplicable. In doing so, the Court noted that the lender had “ample means to minimize its financial risk through the proper channels of contractual subordination.” Fontainebleau, 128 Nev.Adv.Op. 53, at fn 13, pg. 29.

The Court holds that subordination agreements that purport to subordinate liens prospectively are unenforceable.

Next, in analyzing the effects of a contractual subordination agreement, the Court reviewed the specific circumstances in which mechanics' lien claimants can waive their rights and the priority of their liens under NRS 108.2453 and 108.2457. The lender, arguing that the lack of a specific statutory provision renders prospective subordination agreements enforceable, asserted that the general proscriptions against waiving or modifying lien rights did not prevent lenders from protecting their superiority through subordination. In disagreement, however, the Court held that NRS 108.2453 and 108.2457 unambiguously prohibit contractual waivers of mechanics' lien claimants’ priority position; prospective waivers of any type were intended to be prohibited, but under circumstances set out in NRS 108.2457, non-prospective agreements could be enforceable.

The decision lends mechanics' lien claimants comfort as they undertake and perform on construction contracts, but ultimately changes little in the analysis of lien priority.

While the Fontainebleau decision has answered two previously unaddressed questions of Nevada law, the impact on lenders and title companies is not necessarily game-changing. A plain reading of the statutes, enacted in 2003, supports the holdings of this case, which should have been anticipated. Mechanics' lien claimants can now rely on the fact that their mechanics' liens have priority over any deed of trust recorded after the commencement of construction. Nonetheless, the decision does not change the priority of loans acquired and secured before work has begun. Lenders who seek to take out pre-existing acquisition loans after commencement of construction need to consider other ways to retain the acquisition deed of trust priority.

The law remains murky on exactly how a subsequent lender can create an effective non-prospective subordination agreement that complies with the provisions of NRS 108.2457. The language of NRS 108.2457 would appear to restrict its effect on mechanics' lien rights to release upon payment only. Subordination of priority is not mentioned. Since the Court did not provide any guidance here, a lender’s best chance of regaining broken priority may be to convince the Nevada legislature to amend NRS 108.225 to specifically provide for contractual subordination of priority.