Watch out for lien subordination
Thursday, May 19, 2016
Lien waivers are important in construction payment. The parties in control of the money want the project to proceed free of lien claims, for several reasons.
While not an exhaustive list by any means, mechanics liens can potentially force double payment, cloud the property title, and negatively impact bonding capacity and cash-flow. Any of these problems can lead to the job falling behind schedule, running over budget or not being completed.
The strong desire to avoid lien claims, coupled with the hard truth that obtaining full protection via lien waivers can be difficult, can result in trying other means to avoid lien exposure.
The difficulties with lien waivers
As noted above, one way to manage and control lien exposure is to obtain lien waivers from all of the lower-tiered parties. This process, when functioning as designed, is fair and works to the benefit of all parties. The lower-tier parties get paid, and in return the top-tier parties get a waiver of the corresponding lien rights — everybody's happy, and the project keeps moving.
Unfortunately, however, obtaining lien waivers from all parties can be difficult. This is especially true when parties on the project are unknown to the party tasked with collecting the waivers.
If the project is to be completely free of the risk of liens associated with a particular payment, lien waivers must be obtained from every party on the project — subs, sub-subs, suppliers, etc. — whether the owner or GC has particular knowledge that each of those parties had performed work or not.
The sheer number of participants on some projects can make collecting all the waivers a challenge. Because of this, top-tier parties have, throughout history, resorted to other measures in an attempt to avoid liens. "No-lien" clauses or other provisions designed to eliminate the risk of liens by contract without dependence on piece-meal lien waivers are sometimes used.
While no-lien clauses are generally looked upon with disfavor by courts and legislatures, and have been expressly outlawed by many states, that doesn't mean these clauses, or their progeny, are not still used. It is a fact that no-lien clauses, or other methods by which a right to file a lien is extinguished preemptively, are contained within contracts or presented at another time prior to work being performed.
In general, the attempt to extinguish the right to file a lien preemptively is looked upon with disfavor by courts and legislatures, and many states have disallowed their inclusion in contracts, and their enforcement, by statute or through court decisions.
A "no-lien clause" is a clause within a construction contract (or a lien waiver signed and provided prior to furnishing work) whereby a party waives its right to later file a mechanics lien on the project. The practical result of this is that the providing party is unsecured for the work performed or materials furnished to the project — they no longer have the ability to file a mechanics lien to protect against nonpayment.
As noted above, as a general rule, these types of agreements are not enforceable. However, that's not the end of the story. Despite the general prohibition of no-lien clauses as against public policy, there are other mechanisms that may cause the same result.
One of these alternate mechanisms involves the subordination of a lien right, to some other right. Even in some states where the advance waiver of mechanics lien rights is disallowed, the subordination by contract of the mechanics lien to some other security interest is perfectly fine — the lien is only practically waived, not actually or technically.
The subordination of a mechanics lien relates to the priority of that lien. While that may not sound like much (just wait a bit longer to get paid), a lien's priority is what may ultimately determine who gets paid and who doesn't in the event there's not enough money to go around.
Subordination of a mechanics lien moves a lien and places it behind some other interest in the property. Often times, these subordination clauses are contained within lending agreements, so the lenders can claim priority for their deed of trust over mechanics lien claims that may have otherwise had priority.
This means the interest that was originally lower on the priority ladder now has the first bite at the apple, and the mechanics lien claimant can be left out of payment altogether. In effect, this can sometimes work as a back-door no-lien clause. If the party who would file a mechanics lien allows every other claim to have priority, the benefits of the lien are greatly reduced, if not eliminated.
Clearly, then, it is important to examine contracts for lien subordination clauses, to protect against the no-lien clause that was otherwise hidden in plain sight.
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