Fall 2008 • Issue 30, page 4

Real Property Receivers Beware: Mechanics' Lien and Stop Notice Law May Subvert Your Sales!

By Griffin, Benjamin & Normandin, Tom Roddy*

(Many receivers are being asked these days to take possession of partially-completed real estate projects and liquidate same to preserve whatever value remains for the secured lender(s). A poorly-understood aspect of California law – the effect and relation-back features of California mechanics’ lien law – may add layers of unanticipated encumbrances senior to the secured lender. This article provides an overview of these laws and their effects in the marketplace. Ed.)

Social Policy Written Into Constitution and Statutory Scheme
The mechanics’ lien has existed in California for well over a hundred years. Its basis is in California’s Constitution, Article XIV, § 3 and Civil Code §3082 et seq., because California lawmakers have long believed in protecting licensed professionals (usually a contractor) who expend time and money improving real property. The policy is simply stated — in California (and other states as well) persons who have been hired to improve a property, through labor or materials, and do improve that property, should be paid for that work.

California law evidences the belief that the most assured way of ensuring such contractors are paid is to grant them a legal interest, or lien, on the property they improved, until the amount owing for goods and/or services has been paid. This legal mechanism—the mechanics’ lien—exists to protect the “little guy” (someone usually lacking major institutional resources) who improves a property but is not paid.

The argument is not entirely one-sided, however. A clash of interests becomes manifest when an owner, or lender who has financed the work of improvement, also believes that he or she should have senior secured status on the property in question to ensure repayment of sums invested or loaned. Many cases addressing this battle of interests are quite old but still relevant, and the modern interpretation reflects the major projects that now define California developments. California statutes and case law defining mechanics’ lien rights and stop notice laws are complex and contain both protections and pitfalls for owners, lenders, and contractors.

It is extremely important for all three that counsel be retained and used from the beginning of any development project to ensure and protect their respective rights and duties, rather than at the end, after problems have developed. The laws are complex and subject to judicial interpretation. Here is an overview.

Super-Priority of a Mechanics’ Lien
California’s mechanics’ lien laws are set out at Civil Code Sections 3109 through 3154, and warrant close scrutiny. The essence of California’s mechanics’ lien law is the fact that the recording of such a lien encumbers the subject real property (i.e. creates a “cloud on title”), and generally gives super-priority to the mechanics’ lien claimant for sums earned and owed.

This super-priority is dictated by California’s Civil Code § 3137(c), which states that a mechanics’ lien or other claimant (such as a Stop Notice claimant under Civil Code §3112) will have priority over other lien holders. This statutory grant of priority will generally give the claimant payment priority even over prior recorded instruments, encumbrances, deeds of trust, and other liens. There is a major exception to this grant of priority, however, which, notably, advances the interests of construction lenders regarding their security rights in the real property.

A Caution for Lenders – Dual Obligations
A construction lender’s priority is governed by California’s Civil Code §3137. This statute makes it clear that while a mechanics’ lien is normally first in priority, a Construction Lender will retain a senior position over the mechanics’ lienholders, when the lender: (a) records its Deed of Trust before “visible work” is commenced on the property, and (b) enters into a binding construction agreement, where the lender retains control of the funds, and promises to satisfy all lien claims in full (Schmitt v. Tri Counties Bank (1999) 70 Cal.App.4th 1234.). When fully complied with by the lender, this statutory scheme allocates to the lender seniority on the real estate pledged as collateral for the construction loan.

First Requirement - “No Visible Work”
The language “visible work” is loaded. Its precise meaning has often been debated. It has been roughly construed by California courts to mean any work that is “apparent and visible” and of a “permanent nature”. (See National Charity League, Inc. v. Los Angeles County (1958) 164 Cal.App.2d 241; and, Lambert Steel Co. v. Heller Financial, Inc. (1993) 16 Cal.App.4th 1034, 1043 [temporary fence does not constitute commencement].)

Before funding a construction loan, a careful lender will have its own representative or a title insurance company representative inspect the site to ensure that no work has commenced before the construction deed of trust is recorded. This precautionary step, combined with a binding agreement allowing the lender to control the construction funds (discussed below), will assure the lender’s priority lien position and even foreclose out junior lien holders should the project fail. See R-Ranch Markets #2, Inc. v. Old Stone Bank (1993) 16 Cal.App.4th 1323, 1328, Pacific Trust Co. TTE v. Fidelity Fed. Sav. & Loan Ass’n (1986) 184 Cal.App.3d 817, 825.

[Note that this article does not discuss the a lender’s liability to pay following service of bonded stop notices — this discussion pertains to the priority retained by a lender careful to protect its collateral.]

A lender that records its construction deed of trust after visible work has commenced will not enjoy a senior secured position on its collateral (but there are some alternatives for lenders, discussed below). A foreclosure sale by a construction lender whose deed of trust is junior to outstanding valid mechanics’ liens (whether by date of recording or operation of law) conveys title subject to these senior (mechanics) liens. The sale price will likely be discounted to reflect the outstanding liens.

Lenders concerned about their priority may look to title insurance companies for assurance. Title endorsements covering the risk of construction trust deed recordings after visible work has commenced are available. The CLTA Series 101 Endorsements expand the standard coverage of a CLTA policy regarding mechanics’ liens.

Second Requirement - “Binding Construction Agreement Promising to Pay Lien Claims”
This second requirement under Civil Code §3137 for the lender to retain priority requires the lender to have entered into a contract with the borrower/developer requiring (a) that the lender pay all outstanding claims before funding the borrower, and (b) that the lender retains control of the construction funds.

Thus the court held in Schmitt v. Tri Counties Bank (1999) 70 Cal.App.4th 1234, 1244 that “[The lender] was required to do more than secure a binding agreement which referenced the borrower’s obligations and hold the loan funds in good faith... the lender is required to control the loan proceeds until all the liens are paid.”(emphasis added.).

In Schmitt a subcontractor installed site improvements (asphalt) at a subdivision and was not paid for the work. The subcontractor sued the developer and the bank for breach of contract and foreclosure of the mechanics’ lien. While the subcontractor settled with the developer, the lawsuit continued as to the bank and the property, regarding the mechanics’ lien. The Appellate Court affirmed the Trial Court’s decision and findings that plaintiff’s mechanics’ lien took priority over the bank’s prior recorded deed of trust under Civil Code § 3137 because the bank did not have a binding construction loan agreement for site improvements within the meaning of Civ. Code, § 3137.

However, the lender can make “obligatory advances” required on the construction loan funds to preserve its seniority under §3136 in certain circumstances. Rheem Mfg. Co. v. U.S. (1962) 57Cal.2d 621.

Remember - Subcontractors Can “Jump Ahead” of Other Lienors: Their Liens Can “Relate Back” to the Beginning for Payment Priority
A key feature of the mechanics’ lien statutory scheme is that once “visible work” is done on a property or project by a licensed contractor, all of the subsequent licensed subcontractors that later work on that same project and record a lien will “jump ahead” in priority.

In other words, the later subcontractors’ liens “relate back” to the priority date of the first subcontractor that performed visible work on the property. (See Civil Code §3134, and Kodiak v. Ellis (1986) 185 Cal.App.3d 75, 82, Westfour Corp. v. California First Bank (1992) 3 Cal.App.4th 1554, 1562-1563, Santa Clara Land Title Co. v. Nowack & Associates, Inc. (1991) 226 Cal.App.3d 1558, 1565, further discussed in Miller and Starr’s California Real Estate 3D §11:121.)

For example, if a subcontractor (like a painter) records a lien on the property during the middle of the project build-out, the subcontractor will be entitled to priority for his mechanics’ lien equal to that of the grader or surveyor who first provided work / improvement at the beginning of the project.

Construction Lender Payment Bond Alternative
As briefly alluded to, the lenders in California have also an influence on the social policy and statutes that protect the contractors. Lenders are, by nature, concerned about protecting their senior interests on the projects that they lend on. One avenue that will ensure that a lender is protected is Civil Code §3138. In summary, it states that when a holder of any mortgage or deed of trust which is subordinate to a mechanics’ lien procures and records a payment bond in an amount not less than 75% of the principal amount of the mortgage or deed of trust, that mortgage or deed of trust will be preferred to all liens for materials and labor furnished after recording. On major projects the cost of such a payment bond may not make this an easy alternative, however.

Cessation of Building May Sever Claimant’s Rights
A final step in the Mechanics’ Lien/Stop Notice process, as it involves project completion and the Lender is the statutory deadline when the stop notice or mechanics’ lien must be filed or recorded. California’s Civil Code §3116 is instructive on this point. A stop notice and mechanics’ lien must be filed after the claimant ceases the furnishing of labor, services, or materials and within (a) 90 days after completion of the work of improvement if no Notice of Completion has been recorded, or (b) 30 days after recording a Notice of Completion. (Civil Code §3116.)

Of particular note in a down economy, the law specifies that after work has commenced on a project, a cessation of labor for a continuous period of 60 days will cause it to be considered legally complete, even though the construction is not actually finished. Civil Code §3086(c). Sunset Lumber Co. v. Bachelder, (1914) 167 Cal. 512, 516. Therefore, when the 60 days of cessation is added to the 90 days after completion (assuming that no Notice of Completion has been recorded), then there is a total of 150 days following last work on a project for a contractor to record a mechanics’ lien claim or file a stop notice. M. Arthur Gensler, Jr., & Associates, Inc. v. Larry Barrett, Inc., (1972) 7 Cal. 3d 695, 706.

It appears that following the expiration of the time to record a lien, any subcontractor that has not recorded a claim will be legally barred. This is the case even when a project starts up again, as the time to file is not extended. W. F. Hayward Co. v. Transamerica Ins. Co., (1993) 16 Cal. App. 4th 1101. See further discussion in Miller and Starr’s California Real Estate 3D §28:52.

Following timely recordation of the mechanics’ lien, a recorded mechanics’ lien claim automatically becomes void if the claimant fails to foreclose within 90 days after recording of the lien claim. Civil Code §3144(b). See Coast Cent. Credit Union v. Superior Court, 209 Cal.App.3d 703 (1989). Finally, because of the deadlines involved, the time to file a mechanics’ lien is important to consider. If a lender is attempting to complete a project that the builder/developer has walked away from, it is incumbent on the lender to immediately record a Notice of Cessation to commence the deadline for new mechanics’ lien claimants. This will set in motion the period during which new claimants must record a mechanics’ lien or be barred. Civil Code §3116 (a)

To sum up, a construction lender must be cognizant of the mechanics’ lien and Stop Notice laws and issues, as they become a major factor in today’s down economy. Compliance with these laws are a must, or lenders will find themselves with problems of priority when seeking to protect their interests.

*Benjamin K. Griffin is a litigation associate with the Santa Ana firm Prenovost, Normandin, Bergh & Dawe, APC. Mr. Griffin’s practice includes the representation of banks as well as contractors in the mechanics’ lien and stop notice areas.

*Tom R. Normandin is a principal with Prenovost, Normandin, Bergh & Dawe, APC, a law firm in Santa Ana, CA, with over 25 years of experience specializing in business and commercial litigation, and has worked with receivership issues in various contexts in representing banks and construction lenders.