The following article highlights a few of the ways for lenders, investors and sponsors to protect against the risk of losses due to a mechanic’s lien.
Overview of Mechanics Liens
Each state has a statute under which a contractor, subcontractor or supplier has an automatic right to a lien on a project for the value of the contractor’s work until the contractor is paid. To enforce a lien, a contractor generally must record notice of the lien in the county where the project is located within a certain period of time.
Unlike a UCC Article 9 lien or a deed of trust, a mechanic’s lien does not require a security agreement or pledge by the project company, or even an agreement between the project company and the party asserting a lien. While priority of UCC liens and mortgages is generally determined by the “first to file” rule, a mechanic's lien has priority over a lender's mortgage if work began before the lender's filing (i.e., lien priority relates back to the first day of work).
Lien laws vary by state and are subject to change. Such differences could significantly affect the scope of liens and the losses that may result from unpaid subcontractors. Some states cut off the lien rights of lower-tier subcontractors; for example, in Arizona lien rights apply only to persons who have an agreement with the owner or with a contractor that has an agreement with the owner. In addition, some states, such as New York and Texas, limit the value of a subcontractor’s lien to the remaining amount that has not been paid to the general contractor.
Key Protections Against Mechanic's Liens
- File notices or other instruments prior to the start of work in order to (1) protect against the risk of a mechanic’s lien from an unknown subcontractor and/or (2) limit liability for subcontractor’s liens. In several states, including North Carolina and Ohio, the owner of a project records a notice or designates a lien agent prior to commencement of the work; to be protected by lien laws, any subcontractor must notify the owner and lender (or agent) that it is working on the project at the outset of work. Once subcontractors are identified, the owner/lender can protect itself by obtaining lien waivers from those subcontractors. In Colorado, if a memorandum of the prime contract is filed in the county, subcontractors’ liens are limited to the unpaid amount under the prime contract; if the prime contract is not filed in the county, the value of the subcontractor’s lien may exceed the amount that remains owed to the general contractor.
- File deed of trust prior to start of construction(for purposes of establishing priority of lien). As noted above, given that the priority of a mechanic’s lien relates back to when work began, lenders should ensure that a deed of trust is filed prior to start of construction. Where construction has already commenced, lenders may require a contractor to enter subordination agreements, subordinating the contractor’s lien rights to those of the lender. However, Nevada courts have ruled that such subordination agreements are not enforceable.
- Require payment bonds as security for subcontractor liens. In many states, including Texas, an owner may require a contractor to post a “statutory” bond, which is recorded in the county; subcontractors then must look to the bond as security for the contractor’s failure to pay the subcontractor. Given the expense of such bonds, most creditworthy, reputable contractors resist providing bonds.
- Require liens waiver as a condition of funding. Each invoice from the contractor should attach: (a) a conditional lien waiver, waiving liens through the invoice date upon receipt of payment, and (b) an unconditional lien waiver, waiving liens through the date of the previous invoice for which payments have been received. In several states, a lien waiver must comply with a form prescribed by the applicable state.
- Lender's Title Insurance. Extended mechanic’s lien coverage under a lenders’ title policy is available in many states, subject to the title company receiving an affidavit from the owner and lien waivers. Without extended coverage, a title policy has an exception for unfiled mechanic’s liens.
- Representations and indemnities from the sponsor. Transaction agreements include representations from the sponsor regarding the absence of liens, other than mechanic's liens of contractors for amounts that are not then due and payable.
Mechanic’s liens are a state-specific area of law, requiring close coordination with title companies and, if applicable, local counsel. In financing transactions, negotiated protections against mechanic’s liens depend on, among other factors, the reputation of the contractor, availability of title insurance coverage in the state, and the unique features of the applicable state’s lien statute.