As most contractors know, if they are not paid for their work, they are entitled to file a mechanic’s lien against the property where the work was performed. While the main purpose of a mechanic’s lien is to provide security for the debt, it can be a powerful tool in helping contractors receive payment. However, the reasons why filing a mechanic’s lien can result in a contractor receiving payment are not widely understood, and, for that reason, contractors may inadvertently waive all or some of their rights.
A mechanic’s lien is an attachment to “real property,” which is similar to but not exactly the same as a mortgage. Like a mortgage, a mechanic’s lien is recorded on the land records. Unlike a mortgage, however, a mechanic’s lien’s “priority” may not be based upon the date it is recorded. Thus, a property owner may need to discharge a mechanic’s lien to refinance, to avoid a default on its mortgage and/or to convert a construction loan into a regular mortgage. Therefore, an owner’s potential need to obtain a lien discharge may result in a contractor receiving payment.
Generally speaking, mortgages and liens (other than mechanic’s liens) take effect on or have “priority” from the date they are recorded. In other words, the date a lien or mortgage is recorded usually determines the order in which these different attachments are paid after a foreclosure sale. That order is very important when there is insufficient equity in the property to cover the total value of all the attachments.
In light of the foregoing, prior to issuing a new loan, which will be secured by a mortgage, the bank wants to know it will be first in line to be paid in case of a foreclosure. In most cases, a bank can determine the priority of any new mortgage that it may issue by performing a title search. The potential problem that mechanic’s liens create is that, depending upon the jurisdiction, a mechanic’s lien may have priority from the first day the contractor works on the site, which could be months or years before the contractor’s mechanic’s lien is recorded. Thus, a new lender may believe that a property has clear title only to find out after it issues a loan that a contractor is able to subsequently record a mechanic’s lien that has priority over its mortgage.
In order to avoid the potential nightmare scenario of finding itself in line before a contractor’s mechanic’s lien, lenders generally require the loan applicants to have subordination agreements and/or lien waivers signed by the contractor(s) working on the property. Subordination agreements are essentially a bank’s way of having a contractor allow the bank to step in front of the contractor in line for payment in the case of a foreclosure sale. These subordination agreements state that the contractor “subordinates”, i.e., relinquishes the priority of, its lien rights to the rights of the mortgage issued by the lender. After the execution of a subordination agreement, a lender will be in line to be paid ahead of a contractor even if the contractor started working on the property long before the lender’s mortgage was recorded.
With regard to lien waivers, it is a standard practice for owners to require contractors to sign lien waivers prior to receiving a payment. As discussed elsewhere in this blog, these lien waivers are often waivers of claim, but their main purpose is for a contractor to relinquish its lien rights to the extent that it is being paid for its work.
Subordination agreements are generally enforceable. However, any waiver of a right has to be knowing and intentional. For that reason, subordination agreements are normally separate documents that are clearly identified as such. As a result, a problem can arise when a contractor refuses to sign a subordination agreement because that will likely prevent the owner from receiving financing, which may lead to the cancellation of the project or the owner not having any way to pay the contractor for its work. Thus, it is typically in the contractor’s best interest to sign such agreements, but, depending upon the situation, a contractor may want to negotiate payment procedures that provide it with certain assurances in exchange for subordinating its lien rights.
The issues with lien waivers are slightly more complicated. First, any waiver that requires a contractor to prospectively give up its mechanic’s lien rights will probably be unenforceable (depending upon the jurisdiction). In most places, the law will protect contractors who are forced to sign documents which require them to give up their lien rights before they start performing work. Second, most owners and/or lenders require partial lien waivers covering the work for which payment is being made, but these lien waivers are often required to be submitted by the contractor before the contractor receives payment. This procedure can be problematic for the lender, owner and/or the contractor. In some jurisdictions, lien waivers provided before payment is tendered are unenforceable. However, some lien waivers are “unconditional” and effectively release a contractor’s lien rights once signed even if the contractor never receives the required payment.
Subordination agreements and lien waivers have important legal consequences that can impact your rights and your ability to get paid for your work. If you should have any questions regarding these issues, please give me a call.