Mechanics liens provide good protection against the risk of non-payment on construction projects. One of the reasons why is that mechanics liens encumber the improved property itself, and generally, have priority over other subsequent encumbrances on the property. This is especially helpful when severe financial distress at the top of the payment chain results in the necessity of foreclosing on the property. In some circumstances, the property may not be worth enough to cover all outstanding claims secured by an encumbrance; when this happens, the liens or encumbrances with the highest priority have the greatest likelihood of getting paid. A recent case decided by the Arizona Supreme Court muddies the waters of mechanics lien priority in some circumstances, and should give contractors some pause. In certain projects, mechanics liens may be significantly weakened if foreclosure is needed.
Weitz Co., LLC v. Heth
In Weitz Co. LLC v. Heth the Arizona Supreme Court examined lien priority in relation to the doctrine of equitable subrogation. Usually, lien priority is governed by the “first in time, first in right” rule. That is, liens or other encumbrances are given priority in the order in which they attached to the property. This is generally pretty good for a mechanics lien claimant, because mechanics liens unusually attach (for priority purposes) when the work on the property first starts (or when the lien claimant first began work), not when the lien was filed.
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Equitable subrogation is an exception to that general rule, and can apply in certain situations when equity (fairness) requires a result different than the one that would be reached using the general rule. Courts have noted that a party who:
1) pays off an encumbrance on real property (at the insistence of either the owner or the lien-holder);
2) with the understanding (either expressly stated or under circumstances by which the understanding is reasonably implied) that the payment was to be secured by a first-position lien on the property; and
3) the payment (creating a new security) is not a first-priority lien on the property; then
4) the holder of the new security may be subrogated to the rights of the prior encumbrancer.
In the case at issue, the court was asked to determine whether the Arizona mechanics lien priority statute precluded assignment by equitable subrogation of a lien that attached prior to work began on the project, and whether, when a single mortgage covers multiple parcels, if equitable subrogation may apply when the entire obligation has not been paid but a party has paid a pro rata amount of the total obligation, and obtained a full release of the parcel at issue.
The court determined that: 1) the statute does not preclude assignment by equitable subrogation of a lien that attached prior to work began on the project; and 2) equitable subrogation may apply when the entire obligation has not been paid but a party has paid a pro rata amount of the total obligation, and obtained a full release of the parcel at issue.
In Weitz, work was begun on the project prior to any of the units of the housing development were sold. In general circumstances, therefore, the mechanics lien enforcement suit would result in the foreclosure sale of the property to pay the debt (provided it wasn’t paid prior to that outcome). In Weitz, however, some of the properties had been sold after work began and some of the purchase money for these units was applied to the construction loan (that had priority over the mechanics liens). Because the owners of/lenders for the sold properties had paid off their pro rata share of the first-position obligation, they argued that they had priority over the mechanics lien (even though the entire obligation was not satisfied [which is usually required for equitable subrogation] and that they units weren’t sold until after the mechanics lien attached). The Supreme Court of Arizona agreed, and granted the owners/lenders of the sold properties priority over the mechanics lien for purposes of avoiding a foreclosure sale.
This result should be a little bit troubling for potential mechanics lien claimants in Arizona. The power of the mechanics lien has been potentially lessened slightly, and in a manner that may be hard for the lien claimant to see until non-payment is an issue.