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Contractors are often faced with a conflict that businesses of all kinds frequently see: Should I follow the advice of my attorneys or my business development managers? Ideally, these parties would advise the same course of action. Unfortunately, that does not always happen. One area where a contractor is likely to hear divergent views: mechanic’s liens.
An attorney advises a contractor who performs work improving real estate to file a mechanic’s lien if they have not been paid. Liens provide excellent leverage in helping contractors get paid because once a lien is recorded against an owner’s property, it becomes a mar on the owner’s title. As an encumbrance on real property, a mechanic’s lien has an adverse effect on prospective sales, transfers or refinancings by an owner. As a result, liens are a bane of an owner’s existence.
A business manager understands that an owner hates liens. As a result, he advises the contractor that if the contractor ever hopes to work on another project for that owner again, the contractor had better not file a lien. Indeed, there may be no more efficient way to burn a business bridge than to walk into a clerk’s office, plunk down the minimal filing fee, and hand the clerk a piece of paper (i.e., a lien) that has the potential to screw up an owner’s business interests.
As a result of this tension, a savvy owner does whatever he can at the contracting stage to avoid having his property encumbered by a mechanic’s lien. One tactic employed to achieve this goal is contractual subordination. In this column, we take a close look at contractual subordination — what it is and how a contractor should deal with it in the event an owner asks for it.
What is subordination?
Simply stated, contractual subordination is where a contracting firm agrees (usually by way of a term in a written contract) to subordinate its lien rights to the rights of another party. An owner may require a contractor to agree that if the contractor files a mechanic’s lien claim in the future, the contractor’s lien will be subordinate (or of lower priority) than, for example, a bank mortgage — even if the lien was recorded before the mortgage.
Under this scenario, if there is ever a foreclosure, the mortgagee would get paid ahead of the lien claimant — even if the lien claimant otherwise had a superior position as a matter of law. By getting paid first, the mortgagee has a greater likelihood than the lien claimant of recovering all the money it is owed.
After reading about contractual subordination, one has to wonder: Is this allowed under the law? May an owner require a contractor to subordinate its lien rights in the parties’ agreement? The answer to these questions is a lawyer’s favorite response: “It depends.”
More specifically, it depends on the law of the jurisdiction that governs the parties’ contract. In some states, it is against public policy to require a prospective lien claimant to waive or otherwise impair its lien rights. Other jurisdictions follow the “freedom of contract” principle — if sophisticated business people wish to enter into such an agreement when they enter into their construction contract, then they should be allowed to do so.
In the case of In re Fontainebleau Law Vegas Holdings, LLC, 289 P.3d 1199 (Nev. 2012), the Supreme Court of Nevada looked at this precise issue in light of the legislative history behind Nevada’s lien statute. In that case, the court held that “subordination agreements that purport to subordinate [mechanic’s] liens prospectively are unenforceable ….” Id. at 1212.
Finding that the language of Nevada’s lien statute was unclear on the issue, the court looked to the legislative history. The court found that this history “illuminates the Legislature’s intent that prospective waivers of mechanic’s liens are unenforceable.” Id. at 1213.
In testimony before the Senate Judiciary Committee, a lobbyist for one of the bill’s sponsors addressed the issue head on: “The purpose of this bill is to prohibit the prospective waiver of a lien claimant’s rights, and to confirm, clarify, and standardize the procedures and forms required for a waiver and release upon payment.” Id. This legislative history was sufficient for Nevada’s highest court to find that lien subordination agreements are unenforceable.
If a contractor (or subcontractor or design professional, for that matter) is confronted with a contract requiring a subordination of lien rights in favor of another party’s interest, such as a mortgage, the contracting or designer firm must ask their lawyers a few questions.
First, how does this jurisdiction treat such subordination agreements? Are they enforceable as written, or are they void as against public policy?
Second, assuming contract provisions subordinating liens are enforceable, the contractor needs to make a business decision. Is it worth it? Am I willing to take a risk if the subordination provision is enforceable? If the project is lucrative and the contractor needs or wants the business, then he may decide to gamble on the possibility that the company will never need to file a lien.
And if it does file a lien, it will have to hope that there is not a superior encumbrance, such as a mortgage, that would take priority over its claim.
These decisions are not legal ones. Rather, they are practical business decisions that any contractor being asked to subordinate its lien needs to make before entering into a construction contract.