Given current market conditions, a refresher on state law issues such as mechanics’ lien laws, which vary greatly from state to state and can adversely affect a lender’s lien priority, is appropriate. California, in particular, has lien laws generally unfavorable to lenders and worthy of discussion. This institutional preference is evident in that, among other things, there is no defense of payment under California law, so a property owner (and, indirectly, its lender) can be liable to subcontractors who can “lien-up” a property even after the general contractor is paid in full. Furthermore, California’s site improvement liens and “relation back theory” could trigger a series of losses of priority such that all of the work performed on a project could prime an improperly structured deed of trust. Lenders can protect themselves in many ways against such extreme results so long as they (and their counsel) have a working knowledge of local law risks inherent in making loans in California.

Statutory Lien Waivers. Payment to a general contractor is not a defense against mechanics’ lienors in California. A property owner (and its lender) can therefore find its property subject to mechanics’ liens after full payment of all construction work and materials is delivered to a general contractor if the general contractor never pays the subcontractors. The simplest method for lenders to protect themselves against this result is to retain, in the loan documents, the option of (i) requiring the general contractor to pay its subcontractors before the general contractor obtains reimbursement from the lender or owner, (ii) paying subcontractors directly or (iii) paying contractors and subcontractors by two-party checks.

Lenders should also require lien waivers prior to each disbursement of loan proceeds. Section 3262 of the California Civil Code provides for four different types of statutory lien waivers: (1) Conditional Waiver and Release Upon Progress Pament; (2) Uncondi-tional Waiver and Release Upon Progress Payment; (3) Conditional Waiver and Release Upon Final Payment; and (4) Unconditional Waiver and Release Upon Final Payment. These statutory forms of lien waivers are the only means under California law for a claimant to waive lien rights. The main difference between the “conditional” lien waivers and the “unconditional” lien waivers is that conditional lien waivers are not effective until the claimant receives payment on the check (i.e., if payment is never actually received, the waiver is ineffective). The unconditional lien waiver forms state that the claimant has actually already been paid (and claimants cannot reinstitute their claims even if they never actually received funds). The main difference between the “progress payment” lien waivers and the “final payment” lien waivers is that the progress payment lien waiver only covers the amount paid to the mechanic. A final lien waiver is a total waiver of the mechanics’ lien (subject to limited exceptions under California law).

Prior to receiving payment, contractors and subcontractors will generally only be willing to provide a conditional waiver, with unconditional releases provided only after the claimant is actually paid. Therefore, before making disbursements lenders should require, among other things: (1) invoices for the amount of the requested disbursement, (2) a Conditional Waiver and Release Upon Progress Payments signed by the contractor and by each subcontractor whose work is covered in such invoices, and (3) an Unconditional Waiver and Release Upon Progress Payment signed by the contractor and by each subcontractor with respect to the immediately preceding progress payment that was made (if applicable). For final payments upon completion of the work, lenders should also make sure the contractors and subcontractors are required to provide an Unconditional Waiver and Release Upon Final Payment. In this manner, the lender can help manage its exposure for unpaid work.

Site Improvement Liens. In California, a lender can record a deed of trust against real property before any work commences on the property and still lose priority to subsequently recorded site improvement liens. This concept is a significant departure from standard practice in most states and should be guarded against by lenders.

As a general note, California follows a “relation back” theory of mechanic lien priorities whereby the priority of each lien incurred in connection with a project “relates back” to the same date. In California, this date is the date work readily apparent to the public first commenced at the property. This is necessarily an amorphous standard, but for our purposes, it is sufficient to note that, unlike in some states, there is no recorded document putting lenders on notice of potential liens. Instead, a physical inspection of the property is needed to confirm that work has not commenced before a deed of trust is recorded.

One practical effect of California’s subscription to the relation back theory is that contractors providing labor in the first week of a project will have the same priority as contractors providing labor in the last week (e.g., a finishing carpenter will share lien priority with a foundation layer). Contractors providing finishing work could therefore potentially have priority relating back months before they first worked on a project. Lenders need to be cognizant of the potentially substantial effects on the lender’s lien priority resulting from this theory. For example, if $100 of work is performed on the day before a deed of trust is recorded, the lender’s lien can be subordinate not only to the $100 which came first in time, but also to the millions of dollars of work performed after the recording of the deed of trust .

Moving further beyond the relation back theory, California provides for a subset of mechanics’ liens called site improvement liens which permit a complete reversal of priority. California Civil Code Section 3137(c) provides that liens for “site improvement” work have priority over previously recorded deeds of trust. Site improvement work includes most work performed in connection with preparing a site for future “vertical” construction such as demolition, grading, clearing land, and installing roads or sidewalks or in-ground utilities. You will note that the commencement of some types of site improvement work may be hard to notice on a physical inspection of the property. It is therefore prudent to receive a borrower certification as to all construction contracts relating to the property and to confirm whether site improvement work has commenced.

While lenders should be concerned about losing lien priority to contractors providing site improvement labor, the site improvement lien priority rules, in combination with the relation back doctrine present a larger issue. Namely, in the event the site improvement work and vertical construction work are not clearly delineated, the date of commencement for all mechanics’ lien claims at a project (not just the site improvement work) could relate back to the date of priority attributed to the site improvement work. Therefore, instead of a lender’s lien becoming subordinated to just the site improvement work, the lender’s lien could also become subordinated to the work performed in connection with the vertical construction.

The simplest means of avoiding these decidedly lender unfriendly priority rules is to procure and record a payment bond in a face amount not less than 50 percent of the principal amount secured by the deed of trust (See, e.g., Cal. Civil Code Section 3139). While this option provides the deed of trust with priority over all site improvement liens, it is expensive (with the premium on the bond typically running between 1% and 5% of the face value of the bond, depending upon the financial position of the developer) and requires the developer to post an indemnification agreement with the bond provider. This option is unpopular with borrowers for obvious reasons. As such it is not frequently utilized.

A more cost-effective means of protecting the lender’s priority is by following safe harbors in the California Civil Code. In the event the lender finds itself funding site improvement work, it should require loan document provisions which (i) give the lender strict control of the proceeds, including authority to disburse directly to lien claimants, and (ii) include a recitation of the requirements of Section 3137(c) of the California Civil Code. Going forward, the lender must prohibit disbursements of funds to the borrower until all site improvement claims are paid and/or the time for recording such liens has expired with no liens recorded. Disbursing funds prior to such time puts lender at risk of losing priority.

Absent the safe harbors, there are other steps lenders can take to protect their lien priority. In the event site improvement work has commenced prior to the recording of a construction deed of trust, lenders should first look to the title company to bear the risk. The lender will also insist upon separate contracts between the property owner and contractors with respect to site improvement work and general construction work. This can help ensure that all site improvement work is governed by contracts separate and distinct from contracts governing general construction work. The lender should also ensure that construction loan funds are not utilized for paying for site improvement work or materials. Such bifurcation will help the lender protect against later arguments that all mechanics’ liens date back to the commencement of site improvement work for priority purposes. In all events, lenders should make sure the borrower has adequate funds for payment of site improvement work and that sufficient safeguards relating to the disbursement of such funds exist so funds will be available when necessary.

Current Practice Tips Relating to Site Improvement Liens. As a result of changing market conditions, companies issuing title insurance policies in California have become more conservative in offering mechanics’ liens coverage in general and to site improvement liens in particular. Indeed, we have anecdotal evidence that at least one major title company is refusing to write over site improvement lien risks. Such a movement by title insurance companies can drastically impact whether a development project can go forward. We have seen and heard of deals where a developer seeking construction financing after site improvement work has started, as is a common practice, has not been able to obtain financing after a title company was unwilling or unable to provide coverage with respect to site improvement liens.

Other title companies are still providing coverage over site improvement liens, but are becoming much more conservative in doing so. In the harsher scrutiny being applied to lien issues by title companies, the financial wherewithal of the developer, the market location and nature of the project have become much more important in the underwriting analysis. All else being equal, an apartment construction project in Silicon Valley may be deemed an acceptable underwriting risk while the same project may not receive insurance if located to the Inland Empire area of Southern California.

Developers can protect themselves from such a harsh result in several ways. Future projects can be structured so as to provide for different contractors for the site improvement work and the subsequent vertical construction. By clearly delineating where the site improvement work finishes and the vertical construction begins, the developer protects the title company and lender from the risk of the vertical construction lien priority relating back to the site improvement lien priority. If site improvement work has commenced and one title company refuses to provide coverage, another might (but the end result may mean more expensive title costs for the developer or that the developer may have to provide the title company with indemnities or other credit enhancements).

Conclusion. There are specific legal risks to lenders inherent in California law which should be taken into consideration when making loans with construction components and secured by real property in California. These risks can be managed; however, an awareness of the subtleties of California law is needed on the part of prudent lenders and their counsel to spot these issues preferably while the loan is initially being structured.