A Mechanics’ Lien is Security for Work and Materials Provided
A contractor’s remedy for nonpayment is usually to sue the other contracting party for breach of contract or to foreclose a mechanics’ lien recorded against the property. Without a mechanics’ lien the party seeking payment is limited to a money judgment with no security to enforce payment. A lawsuit may be by the contractor against the owner or a subcontractor against the general contractor. A mechanics’ lien claim is always against the person who owns the property subject to the lien.
A mechanics’ lien recorded against property is a cloud against the title. Title companies will not issue title insurance unless any mechanics’ liens on title are cleared up. Or they will issue insurance “except for” the mechanics’ lien. When this happens the lender will not lend. This is because anyone that buys a property with a mechanics lien recorded against it takes the property subject to the lien and the possibility that the lien will be foreclosed. A loan that is recorded against property after a mechanics’ lien could be “wiped off” of the title if the mechanics’ lien is foreclosed. This is a risk no lender will make.
Priority of Loans and Liens is Critical
An important concept to understand when using a mechanics lien to foreclose on property is that earlier liens (senior liens), mortgages, or deeds of trust are superior to ones recorded later. If a senior lien forecloses the buyer at the foreclosure auction takes the property free of any junior liens. All junior liens are wiped off of the title and the creditors they represent lose their with the exception of property tax liens and assessments, which stay on title.
A mechanics’ lien that is timely recorded is considered to date back to the commencement of work for the purposes of establishing lien priority. That means if a lien is recorded on the last day of the job (if allowed) it will have priority to all liens recorded after the day work first started on the site. However, the construction loan will usually have a lien (deed of trust) recorded against the property before construction began. The loan that was used to buy the property will usually also be recorded before work began. Thus, if either of these loans goes into default and forecloses a contractor’s mechanics lien will be worthless. The buyer of the property at a foreclosure sale will take title without the lien.
In a Falling Market There is a Risk of Default on a Mortgage Senior to a Mechanics’ Lien
In today’s market there is a significant risk that a lender will foreclose on the project property either during the project or before the workers and suppliers are all paid. This is especially true on subdivisions and large projects. Large projects are so long in the making that the loans backing them were based on appraisals that are no longer valid. A project based on an old appraisal may not be worth the price of the land, the construction, and the financing combined. The developer is likely to make a business decision to just let the project go into default instead of continue to service a loan that is more than he can sell the property for. This is especially true if the whole project was done in the name of an “LLC” or corporation that has no assets of its own and is ripe for abandoning.
How Can a Contractor Protect Himself from Foreclosure?
What can a contractor due to protect himself? One thing that can be done is to stay informed. Before starting a job a contractor (including subcontractors and materialmen offering work and materials on credit) can record a “Notice of Request of Default.” This Notice requires lenders to mail a notice to the contractor that a loan which will be senior to a mechanics’ lien is in default. California Civil Code section 2924b specifically provides this right and provides the information that must be included in the Notice of Request. If the contractor gets such a notice of default then the contractor can then decide whether he should stop work or not. He might even put something in his contract that allows him to stop work if such an event occurs.
What Happens After the Owner Defaults?
If a contractor continues working after the owner has defaulted on a loan that was obtained before the commencement of work it is possible that the property will be sold at a foreclosure sale. Any recorded mechanics’ lien will be “wiped off” the title. When this happens the contractor has no security for the work he has provided. Civil Code section 3264 prohibits any action against the lender except where there is a contractual relationship. Since the contractor usually has no contract directly with the lender he cannot usually collect from the lender, even if there are still funds available in the loan. The contractor is limited to a breach of contract lawsuit against the owner or the general contractor. If the owner or general contractor has no money to pay then collection will be impossible and a lawsuit is a waste of money.
Investigate Whether the Lender Funded Optional Draws.
To try and avoid losing a mechanics’ lien in the event of a default by the owner on a mortgage one thing the contractor can do is investigate whether the lender gave draws on the construction project that were not required under the loan documents (like change orders that went beyond the original loan amount, or where the borrower defaulted and the lender had the option to cancel the loan). Any payments made after default are deemed to be later in time than the mechanics lien. Thus, a foreclosure would not wipe out the mechanics’ lien. Usually it is the lender that buys the property at a foreclosure sale. If so the contractor can assert rights against the lender by alleging facts that show the mechanics’ lien was not wiped out. The contractor could then move to foreclose on the banks’ title to the property.
Conclusion
It is important to understand the importance of priority of loans and liens against a property when deciding to advance your work and materials before getting paid. If there are already loans (mortgages) against a property when you sign a construction contract there is a risk that the owner will default and your security for being paid (the mechanics’ lien) will be wiped out. Proper precaution before signing onto a job can save your shirt somewhere down the line. This article summarized general points. There are other strategies that can be used to protect a contractor from losing his shirt on a project.
Great post! Thanks!