Contractors: Beware the Subordination Clause

Doberman

A bit of mechanics lien trivia.

What is the only state in the United States in which mechanics liens are a constitutional right?

If you answered California, ding, ding.

Article XIV of the California Constitution states:

Mechanics, persons furnishing materials, artisans, and laborers of every class, shall have a lien upon the property upon which they have bestowed labor or furnished material for the value of such labor done and materials furnished; and the Legislature shall provide, by law, for the speedy and efficient enforcement of such liens.

But how does that constitutional right stand up against contractual rights? Not so well it seems.

But, First, a Note About Race-Notice Recording and Mechanics Lien Priorities in California

In the United States most states employ a system of recording legal documents, such as the deed of trust accompanying your mortgage, as the means of documenting land titles and interests. States which use a recording system have recording statutes which fall into one of three categories:

Race Statutes

Under a race statute, whoever records first wins. Thus, if a seller sells real property to buyer A, and the next day sells the same property to buyer B, and B records the conveyance before A, B will be deemed to own the property, even if B knew about the prior sale to A. Only Delaware, North Carolina and Louisiana have race statutes.

Notice Statutes

Under a notice statute, a subsequent bona fide purchaser without notice wins. Thus, if a seller sells real property to buyer A, and the next day sells the same property to buyer B, and B records the conveyance before A, B will be deemed to own the property, but only if B did not have notice of the prior sale to A.

To put a bit of a finer point to it, if A records the conveyance before B’s purchase, A’s recordation will be deemed to give B constructive notice of the sale, and A will be deemed to own the property. But, if B purchases the property without notice of A’s purchase, and A then records the conveyance either before or after B records his conveyance, B will be deemed to own the property.

Alabama, Arizona, Connecticut, Florida, Illinois, Iowa, Kansas, Kentucky, Maine, Massachusetts, Missouri, New Mexico, Oklahoma, Rhode Island, South Carolina, Tennessee, Vermont, and West Virginia have notice statutes.

Race-Notice Statutes

Under a race-notice statute, a subsequent bona fide purchaser without notice and who records first wins. Thus, if a seller sells real property to buyer A, and the next day sells the same property to buyer B, and B records the conveyance before A, B will be deemed to own the property, but only if B did not have notice of the prior sale to A and recorded his conveyance before A.

California is a race-notice statute, as are the majority of other states including Alaska, Arkansas, Colorado, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Maryland, Michigan, Minnesota, Mississippi, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New York, North Dakota, Ohio (except with respect to mortgages in which Ohio follows race), Oregon, Pennsylvania (except with respect to mortgages in which Pennsylvania follows race), South Dakota, Texas, Utah, Washington, Wisconsin, and Wyoming.

Mechanics Liens and Priorities in California

Mechanics liens, however, are special. In California, a mechanics lien, even if it is recorded after another encumbrance such as a deed of trust has been recorded, and even if the mechanics lien claimant had notice of the earlier recorded encumbrance, takes priority over such earlier encumbrance for work performed before the earlier encumbrance is recorded (as well, of course, to unrecorded encumbrances which the mechanics lien claimant had no notice of per the general race-notice rules). Thus, Civil Code section 8450(a) provides:

A lien under this chapter, other than a lien provided for in Section 8402, has priority over a lien, mortgage, deed of trust, or other encumbrance on the work of improvement or the real property for which the work of improvement is situated, that (1) attaches after commencement of the work of improvement or (2) was unrecorded at the commencement of the work of improvement and of which the claimant had no notice.

This is what is called “relation back.” That is, that a mechanics lien, although recorded later, relates back to when construction first commenced.

Moorefield Construction v. Intervest-Mortgage

In Moorefield Construction, Inc. v. Intervest-Mortgage Investment Company, Case No. D065464 (September 30, 2014), the California Court of Appeals held that, despite the constitutional and priority rights accorded to mechanics liens, a general contractor could waive its mechanics lien rights through a subordination agreement with a construction lender.

In 2006, DBN Parkside, LLC (“DBN”) purchased unimproved property in San Jacinto, California with the intent of constructing a medical office complex. DBN had Moorefield Construction, Inc. (“Moorefield”), with whom it had worked on prior projects, erect a temporary chain link fence and clear and grub the property.

In the interim, DBN obtained a construction loan secured by a deed of trust on the property from Intervest-Mortgage Investment Company (“Intervest”). The loan agreement was entered, and deed of trust recorded, approximately a month after the DBN-Moorefield construction contract was signed.

In connection with the loan, Intervest required DBN to assign its rights and remedies under the construction contract to Intervest, and required Moorefield to subordinate its mechanics lien rights under the loan. Under the terms of the agreement, Moorfield:

[A]gree[d] and acknowledge[d] that any any and all payments made or payable to it pursuant to the [construction] Contract shall remain subordinate to the Loan at all times during the term of the foregoing assignment, and that any and all liens for labor done and materials and services furnished pursuant to the [construction] Contract or otherwise shall be subordinate to the lien of the Deed of Trust.

During the course of the project, Moorefield submitted and was paid approximately $7.2 million for its work on the project. By the end of the project, Moorefield had submitted and was owed approximately $2.2 million. However, about that same time, DBN defaulted on its construction loan and failed to pay Moorefield.

Moorefield later recorded a mechanics lien and filed suit to foreclose on the mechanics lien and Intervest filed cross-complant on the ground that its deed of trust was superior to Moorefield’s mechanics lien under the terms of the subordination agreement. At trial, the court found in favor of Moorefield, holding that the subordination agreement was void as to public policy because it deprived Moorefield “of its mechanics’ lien priority right that is a guarantee to them under the California Constitution.

Intervest appealed.

The Court of Appeal Decision

On appeal, the Court of Appeal, while noting that the constitutional rights accorded to mechanics lien claimants “strongly supports the preservation of laws which gives the laborer and material man security for their claims,” is also for the protection of owners, and “place[s] limits on the ability of certain persons to waive or otherwise impair mechanic’s lien rights.”

Thus, explained the court, Civil Code section 3262(a) (now Civil Code section 8122), provides that “[n]either the owner nor original contractor by any term of a contract, or otherwise, shall waive, affect, or impair the claims and liens of other persons whether with or without notice except by their written consent, and any term of the contract to that effect shall be null and void. . . unless and until the claimant executes a waiver and release.”

Note: The waiver and release referred to in Section 3262 refers to California’s statutory waivers and releases of which there are four types: (1) conditional waiver and release upon progress payment; (2) unconditional waiver and release upon progress payment; (3) conditional waiver and release upon final payment; and (4) unconditional waiver and release upon final payment. Copies of these waivers and releases can be found under the Toolbox menu.

However, explained the court, Civil Code 3262(a) states only that an “owner” or “original contractor,” not a construction lender, cannot by any term of a contract waive, affect or impair the claims and liens of other persons. “By its terms this section limits the ability of the original contractor to waive or impair the claims and liens of other persons. The clear implication is that the contractor may waive or release his own claim, when doing so does not affect or impair the claims or liens of other laborers or subcontractors.”

 Conclusion

I’m wringing my hands on this one. While I think the case was properly decided, I can’t help but feel for the contractor. The contractor did the work and when it wasn’t paid, it recorded a mechanics lien, and then filed suit to foreclose on its mechanics. That’s how it’s supposed to happen.

One thing the general contractor could have done though is file a stop payment notice. Although, as a general rule, general contractors are not allowed to serve stop payment notices, on lender financed projects, general contractors can serve a stop payment notice on the construction lender.

The general contractor could have also insisted that the owner post a large project security bond under Civil Code sections 8700 et seq. since the contract price was greater than $5 million.

But hindsight is always 20:20, isn’t it?

4 Responses to “Contractors: Beware the Subordination Clause”

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