United States: Construction Lien Vs. Mortgage — The Claim Priority War

Last Updated: February 2 2014
Article by Vicki Harding

After the owner of a newly constructed hotel filed bankruptcy, the assignee of the construction mortgage sought a declaration that the mortgage had priority over the general contractor's mechanic's lien. The general contractor contended that its mechanic's lien had priority, and filed a dozen counterclaims for good measure. After losing before the bankruptcy court and district court, the general contractor appealed to the First Circuit.

The history of the project is as follows:

  • December 2006: Debtor signed a contract with the general contractor (ROK) to build the hotel.
  • April 2007: ROK terminated the contract based on the debtor's failure to pay approximately $1.6 million.
  • June 2007: The debtor signed a commitment letter with a lender for a loan of up to $8.7 million to fund continuation of construction.
  • September 2007: ROK signed a new construction agreement with the debtor.
  • October 2007: The debtor signed a construction financing agreement and executed a mortgage, which the lender recorded. At that time the lender paid ROK more than $1.8 million to settle the amount due under the original 2006 agreement.
  • May 2008: ROK signed a final waiver acknowledging past payments from the lender of approximately $5.7 million for work under the 2007 agreement, and lists a balance due of about $950,000. The waiver provided that in consideration of the amounts paid together with the amounts currently due, it waived all mechanic's liens for work done to and including the payment date.

The lender decided to stop payments due to the debtor's failure to secure additional financing, as required under its loan agreement. The lender did not advise ROK of this decision, and ROK performed additional work, unaware that it would not be paid. ROK received an additional $680,000 from the lender for a total of about $6.4 million for work under the 2007 contract. However, it contended it was still owed about $2.5 million that was secured by a mechanic's lien.

The lender's parent bank failed, and the lender assigned the construction mortgage loan to the Federal Deposit Insurance Corporation, as receiver, which assigned it to 2010-1 SFG Venture LLC. Soon after, the debtor filed bankruptcy.

SFG initiated a proceeding seeking a declaration that the $6.4 million construction mortgage loan was senior to ROK's mechanic's lien. ROK responded with a dozen counterclaims. The bankruptcy court dismissed ROK's secondary claims and granted SFG's summary judgment on the issue of the seniority of its claim. The district court affirmed, and ROK appealed to the First Circuit.

The lender's position was that to the extent that it paid ROK for its work, the mortgage was senior to any remaining mechanic's lien. In response, ROK argued that because it began work before the mortgage was recorded, any lien arising out of work remained senior.

The court analyzed priority under state law. It began with the concept that the first party to record without notice of a prior party's claim has priority. Further, an instrument must be recorded to be effective against a bona fide purchaser for value.

In this case the mortgage was recorded before the work that gave rise to the remaining lien. However there is an exception to the "race-notice rule" for mechanic's liens. A mechanic's lien has priority over a construction mortgage, except to the extent that the mortgagee shows that the proceeds were disbursed to pay construction invoices.

ROK attempted to make a counter argument based on a couple of cases from the 1800s. However, in those cases, the mortgagee did not pay for any work.

"In this case, by contrast, payment was in fact 'previously made' to ROK by [the lender]. Therefore, the lien for that paid work expired, leaving ROK with only a lien for later work. ... And [the lender], unlike the mortgagee in [the 1800s cases], even obtained a written lien waiver, to boot."

Thus, the court held that the mortgage was senior to ROK's mechanic's lien to the extent of the roughly $6.4 million it disbursed to ROK.

Among the various counterclaims, ROK asserted claims based on an implied contract (e.g., an agreement that arises from the conduct of the parties) and promissory estoppel (e.g., promisor reasonably expects a promisee to rely, and a promisee in fact does rely, so that courts can enforce the promise to avoid injustice).

The court's response was that even if the lender would have been subject to claims for an implied contract or promissory estoppel, there was no basis for holding SFG, as assignee, liable for the lender's actions.

There was nothing in the loan assignment that could be read to transfer the lender's liability to ROK when SFG accepted the assignment. While acknowledging that Section 328 of the Restatement (Second) of Contracts (1981) provides that a general assignment of all rights results in a delegation of duties under the contract, the court noted that even if this section was applicable to a mortgage loan assignment, ROK's claims related to a separate contract between the lender and ROK, as opposed to the assigned loan agreements.

ROK made a final attempt to assert a claim based on unjust enrichment. The court acknowledged that state law might require restitution by a party even if it was not involved in any wrongful acts. However, there were no allegations supporting a claim that it would be unconscionable for SFG to retain mortgage payments.

Litigation is certainly no surprise in a failed project where there is not enough money to go around. Given that the law on construction liens is very state-specific, mortgagees and contractors would be well-advised to make sure that their house is in order under applicable state rules in order to adequately protect their respective positions.

This article was published in Law360 on January 29, 2014. © Copyright 2014, Portfolio Media, Inc., publisher of Law360.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki Harding
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