Property development is no easy business. Even for real estate developers who have the system down-pat and can organize plans in their sleep – there are a thousand things that could go wrong on any given project. Perhaps the highest degree of risk comes with construction payment. That is, making sure that your contractor pays their sub, and that sub pays their subs and suppliers, and so on down the payment chain. Luckily, there are steps to reduce this risk.
Real Estate Developer’s Guide to Mechanics Liens
Let’s start with the payment chain itself. The typical structure starts at the top (with the real estate developer or their lender). Once payment is released to the project’s general contractor, the money begins to flow. The GC will then pay all their subcontractors and suppliers. Then, those parties will pay their subcontractors and suppliers – and so on, down the chain.
Seems simple, right? As long as everyone does the right thing, everyone gets paid. But the more parties that are present on a job, the more complicated things get. Each payment handoff must go flawlessly. Consequently, the money flows through numerous hands, and everyone is looking to protect themselves at the expense of others.
Knowing who is on the project, what they’re contributing, and maintaining an open channel of communication is vital to a project’s success. In the words of H.P. Lovecraft, “the oldest and strongest kind of fear, is fear of the unknown.” The more unknowns on the project, the more fear is instilled on all the project participants. This leads to the “protect yourself and gain leverage” mentality which leads to most of the problems a project will face.
Unfortunately, no matter how much planning and preparation is done, payment problems will still happen. When these payment disputes do occur, unpaid contractors and subs go into survival mode – and typically, the best chance at getting paid will be via a mechanics lien claim. To know how to approach the problem, real estate developers must first understand it.
The Mechanics Lien Problem
When a construction business or an individual furnishes labor or materials to improve property, they’ve got some tools available to make sure they get paid. Filing a mechanics lien is the strongest of these tools – and a lien filing will typically work better than going to collections or filing a lawsuit.
As long as they follow certain requirements and deadlines are followed, a contractor, sub, or supplier can file a lien on the project property. These parties are working on credit and floating their own business costs, getting paid as quickly as possible is their top priority!
For real estate developers, especially those heavily relying on financing, a mechanics lien might mean cardiac arrest for the project. One small lien filing can put the whole job in jeopardy, and that one filing will have a ripple effect far beyond the claimant themselves. Money stops flowing until the issue is resolved, schedules are delayed, contracts get breached, and relationships become soured. All the while, work on the job might come to a halt, putting the project behind schedule.
Further, the property itself is essentially frozen. A lien claim will “cloud the title,” meaning it will be tough to sell, refinance, or otherwise transfer the property until the title is clean. If left unchecked, the claimant can enforce the lien and potentially cause the foreclosure of the property to get paid what they’ve earned. Investors and lenders don’t like that.
Avoiding Mechanics Lien Liability in the Contract
There are some current tricks of the trade that real estate developers use to avoid lien claims while contracting. These tools aren’t always very fair, which is why every state disfavors them and some outright ban them. Rather than attack the underlying problem, these “solutions” put a bandaid on it and hope for the best.
No Lien Clauses
No lien clauses aren’t enforceable in most states. Basically, this is a provision in the contract where a contractor waives their right to file a mechanics lien on the property. The problem is that waiving statutory rights at the time of contracting is against public policy. For this reason, 20 states have outright banned these clauses and only 2 states formally allow them.
For More on No Lien Clauses: Forced to Give Up Lien Rights Before a Project Starts? It Can Happen
Indemnification clauses aren’t necessarily lien prevention measures, but more of a liability shift in case a lien is filed. This will usually contain language along the lines of “agree to indemnify, defend and hold harmless the owner from and against any and all actions, claims and demands.” This will require the contractor to compensate you for any losses or claims that arise. The term claims include mechanics liens.
Be cautious with being to overreaching with these clauses. Because of the potential for abuse of leverage involved with indemnity clauses, many states have enacted “anti-indemnity” statutes that void overly broad indemnification clauses.
For More on Indemnification Clauses: Construction Contracts: Explaining Indemnification Clauses
A subordination agreement is another provision that doesn’t necessarily provide protection against lien claims. Instead, a subordination agreement reduces any potential lien’s effectiveness. Subordination of a mechanics lien refers to the lien’s priority. If and when a lien is enforced, and the property is subsequently foreclosed, there are likely some other creditors that have a security interest in the property. Mechanics liens are typically given higher priority than most other interests. But, if your contract includes a lien subordination clause, a lien is knocked down a few rungs on the priority ladder – and the prospect of a lien claim is less scary for investors and lenders.
For More on Subordination Clauses: When Advance Waiver of Lien Not Allowed, Subordination by Contract Might Do the Same Thing
Minimizing Lien Claims Through Procedure
There are documents and procedures that, when properly utilized, will create a healthy project and help avoid disputes in the first place. These tend to be a little fairer than the contractual tools described above, and some of these procedures and documents are required by statute, depending on the state.
Preliminary notices (also known as pre-lien notices or notices to the owner) are hands down the best way to increase the visibility on your project and reduce the likelihood of a lien claim. Don’t fret when you receive these notices – they’re not a threat of a lien claim or even an indication that someone is more likely to lien! Instead, preliminary notices help higher tiered parties identify who all is providing work on a project, and they establish communication and transparency that will be valuable in the later stages of the project.
Plus, preliminary notices make it easy to determine who all should provide a lien waiver at the end of the job. Ideally, any party who’s provided labor or materials to the job will be providing a lien waiver. However, that doesn’t always happen – it’s hard for owners, developers, and even contractors to see who all is working on the project below the first few tiers. If everyone is encouraged to send a preliminary notice, it will be easier to collect lien waivers later on.
Notice of Commencement
A notice of commencement is a public announcement that work has begun on the project, and it contains all the necessary information of the project. Not only the property and project information, but also all of the contact information for the real estate developer, the general contractor, the lender, the surety and other stakeholders. This document is filed with the clerk’s office, posted at the project site, and provided to any contractors that request it.
By filing a notice of commencement, a real estate developer can create better transparency on their project and, in some cases, mandate the sending of preliminary notice. They aren’t available or required in every location, though. In fact, there are only 8 states where this is required or optional.
For More on Notice of Commencement: What is a Notice of Commencement?
Having a proper lien waiver procedure in place is an invaluable tool to prevent the possibility of a lien. Think of them as a receipt for payment. The contractor confirms that they have been paid x amount of dollars, and therefore waives x amount of dollars in lien rights. Some states, 12 to be exact, have statutory form requirements for these waivers. Collecting lien waivers along with every progress and final payment application is an easy way to keep your property lien free.
For More on Lien Waivers: The Ultimate Guide to Lien Waivers
Given the inherent difficulties with the construction payment chain, you can never be too sure that the money you’ve released is getting to the people who need it. A joint check agreement can help quell some of this anxiety. A joint check is one that is made payable to two or more individuals. Think about this the next time you cut a check for a contractor. If the check names both the contractor and their sub, it will require both signatures to cash out. This can help ensure that the lower tiered parties are being paid, so you don’t have to worry about any double payment problems.
For More on Joint Checks: What is a Joint Check Agreement?
Good practice for property developers is to include on their projects the use of a contractor’s affidavit. Before releasing final payment, you can require your GC to execute one of these. This is a sworn statement saying that they have paid their subcontractors and list any uncollected payments remaining. In the event a sub files a lien, you can use the contractor affidavit as evidence of payment.
What to Do if a Lien is Filed?
The worst thing you can do when confronted with a lien is to ignore the problem in hopes that it will go away. It won’t. It’s time to take action! Here are some potential responses to a mechanics lien filing on a development project. Every real estate developer is different, and each situation will call for a unique approach. Still, some themes ring true.
Related Reading: A Mechanics Lien Was Filed on My Property – What Do I Do Now?
Validate the Claim
Even if the lien is not executed properly, it will still be recorded. Remember a recorder’s office does just that, record. There is almost no verification process. The person at the county clerk’s office is not going to make sure the notice procedures were met or that it was filed in time. You would be surprised how many times liens are recorded, even though their deadline has long since passed. An improperly filed lien still needs to have an action filed in court to dissolve it. Before taking any action, have an attorney review the lien claim to be sure it’s valid.
If the lien claim is invalid, its time to send lien removal demand. Why? Well first off, some states actually require that you send a demand letter. But better than that? You are ensuring there is no miscommunication between you and the contractor. This formalizes the reasons you believe the lien is invalid and may be enough to induce them to remove the lien without having to file a lawsuit.
If the payment claim is legit, it may be time to negotiate. Even when it might result in double-payment, it might be worthwhile to keep the development moving. Plus, there’s always the possibility of going after the non-paying party once the dispute is resolved. Obviously, with large claims, it might not be feasible to just pay the claim outright. But, remember that it’s always an option on the table, and if a project delay would be a serious problem, it might be a good short-term solution.
Put Pressure on the Claimant’s Customer
Parties at the top of the payment chain hold the most leverage. That’s always been true. With this leverage in hand, real estate developers have the power to “persuade” a lien claimant’s customer to resolve whatever payment dispute is present on the job. Payment disputes regularly arise out of petty disagreements or simple misunderstandings. However, when the weight of the property developer is standing over the shoulder of a lien claimant’s nonpaying customer, that customer might be more willing to resolve whatever issues are present.
Bond-Off the Lien
Bonding off a lien claim can be beneficial to both a developer and a lien claimant. Clearly, real estate developers love this option because it prevents the property from being affected by the lien and potentially foreclosed upon. Further, when a lien claim is bonded off, a lien claimant can rest assured that there are actually funds at the end of the day to pay their claim (if it comes that far). When a lien is bonded off, a developer is able to buy time to resolve the dispute while also alleviating issues caused by the lien.
What’s more, because real estate developers hold quite a bit of leverage over their contractors – and a property developer could always force their general contractor to bond off the claim. Tons of development agreements actually require it under contract. When lien claims pop up, these contractual provisions will force a quick resolution to the lien claim by shifting liability from the property to the bond. That may sound like passing the buck, but where a developer has made all payments according to plan, holding a contractor accountable for resolving claims makes a lot of sense.
For More on Bonding Off a Lien: Primer on Mechanics Lien Bonds and Bonding Off a Lien
Fight the Lien in Court
If you and the contractor still can’t come to an agreement it may, unfortunately, be time to involve the courts. This can be initiated by you or the contractor. The contractor may file to foreclose on the lien, if successful, its time to pay up! You can attempt to avoid this by filing a lawsuit requesting the removal of the lien claim. At this point, your fate is in the judge’s hands.