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Mechanics liens are a powerful way for construction participants to secure payment on their projects. Rather than relying costly remedy of hiring a lawyer to file suit for breach of contract, a mechanics lien “secures” the amount due by giving the claimant in interest in the property improved during the construction project itself.
Lien law is complicated, and making sure that the rules, requirements, and regulations are complied with in order to claim a valid lien can be a load to handle. Usually, a payment issue that results in the filing of a mechanics lien is the result of a breakdown somewhere in the payment chain (see illustration, right), whether due to a lack of visibility, a lack of communication, or something related. When there is a catastrophic breakdown, however, and there is a group of claimants all trying to grab a piece of a the same pie before it’s gone, your claim’s priority can determine whether or not you end up getting paid anything at all.
What Is Lien Priority?
Priority, as related to a secured claim, and as you may guess, refers to a party’s right to payment in reference to other creditors. When multiple parties go unpaid on a project and there may not be enough money to go around, the priority rules sort out the mess and determine who gets first crack at getting paid. A good way to think about it is to imagine a pile of money designated for a group of creditors. The priority rules determine which creditor gets to take from the pile first. Generally, all secured creditors get a chance at payment prior to any unsecured creditor, but the priority rules between secured creditors can be tricky. These rules can also vary significantly state to state, but most states use some iteration of a “first to file” rule.
When Does Lien Priority Matter?
Nobody starts a project expecting or hoping to file a mechanics lien. Even more, nobody wants to join a project on which multiple liens or secured claims are expected. If your company is thinking about signing on to a construction project where non-payment or some other payment issue is a strong possibility, it might be better to look for opportunities elsewhere. However, it’s a fact of the construction industry that payment problems arise, and these problems can be significant.
When a project falls through completely due to a bankruptcy, or other type of default by the owner, there can be multiple claims and not enough cash to go around. When this happens and there are multiple unpaid parties with secured debt, such as other lienholders or mortgagers, there must be some order to the process. And that’s where lien priority comes in.
Priority matters whenever there are multiple creditors and/or claimants wanting to get paid. The priority rules serve the function of determining how the pie will be split, and these rules help navigate scenarios where similarly situated creditors fight over that same pie to get paid.
What Are the General Rules for Lien Priority?
The most prominent way states sort out the priority mess is through the first to file or “first in time, first in right” rule. This essentially means the old stand-by, first come, first served, applies. When this rule is applied, whichever encumbrance on a property was filed first would be the first in line among creditors. While this may be a simple rule when looking at the big picture, it can get a little messy since there can be subordination agreements, or other contracts that make what would be a clear line of creditors a bit jumbled.
Unfortunately for mechanics lien holders, this rule tends to favor mortgage holders. Since (at least) the first mortgage on a property is typically recorded before projects are initiated or even contemplated, liens are often second in priority to mortgages – which, depending on the equity in the property, could mean mechanics lien holders get left holding the empty bag. When a mortgage or, more likely, a secondary mortgage is fixed on a property after the work on the construction project has begun, a mechanics lienholder would not have to defer to the mortgage holder.
Under the first to file method, a secondary creditor is paid only after the credit interest ahead of it is paid off. In the case of a mortgage saving first priority, there can be little money left over to fulfill other debts. There are a few instances where lienholders do receive some help, however.
In some states, the mechanics lien filing date relates back to the first day work was done on the project rather than when the lien was actually filed. And, in others, lien holders can actually be put before mortgagers even when the mortgage was filed first. It’s worth noting, however, that the government pretty much always gets paid – in almost every case, tax liens take priority over any other encumbrance to the property that’s held by a private entity.
What Is the Financial Impact of Lien Priority
Say an owner has a $400,000 mortgage, which the lending company dutifully recorded. Sometime after, the owner initiates a construction project on the property and hires a contractor. Due to unforeseen circumstances, the project falls through, but not before the contractor has racked up a $50,000 bill for their services to date. But the owner doesn’t have the cash to pay, leaving the contractor with unpaid invoices for $50,000 of work. As a result, the contractor files a lien on the property. Since the owner doesn’t have the money to pay, the contractor initiates a foreclosure action to recover the debt.
In a first to file state, the mortgage has priority to the mechanics lien. This means the contractor would only be able to enforce the lien to the extent possible once the amount remaining due on the mortgage has been paid in full. To keep the math simple in this example, let’s assume that the owner had paid off $10,000 of principal on the mortgage. If these parties were the only two creditors with an interest in the property, the division of the cash would work as follows: Should the property be sold for $410,000, the mortgage company would be entitled to the first $390,000, and the contractor would only be entitled to the remaining $20,000, despite having a secured claim for the total $50,000 owed.
Knowing how the priority rules operate in a particular project state is incredibly important to recovering amounts owed. It may make sense to be proactive on filing a lien to “get in line”‘ earlier if it looks like there may be money troubles. Once multiple parties have established secured credit interests, the merits of the claim may not matter – parties with good claims may not be able to recover just because of their place in line. At the end of the day, after dodging all of the procedural obstacles required to protect lien rights, priority could determine whether a claimant recovers.