Arizona Court of Appeals Gives Contractor the Edge over Certain Lenders in Mechanic’s Lien Foreclosure Lawsuit

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In lien foreclosure lawsuits involving lenders and contractors, priority is everything. Where you stand in terms of priority will not necessarily determine when you get paid, but rather will determine whether you get paid.

For many years, Arizona courts have sorted out competing interests among lenders and contractors by applying not only the mechanics’ and materialmen’s lien priority statute enacted by the legislature, A.R.S. § 33-992(A), but also the common law doctrine of “equitable subrogation,” which allows certain lenders to step into the shoes of another lender’s priority. However, in Weitz Co. v. Heith, the Arizona Court of Appeals recently upended this practice and held that the lien statute alone controls how priority is to be established. Essentially, the court held that A.R.S. § 33-992(A) means exactly what it says: but for one exception applicable to the original lender who provides funding, contractors’ liens have priority over “all [other] encumbrances upon the property attaching subsequent to the time the labor was commenced.” The court held that the subsequent lenders who provided funding after construction commenced could not piggyback off the original lender’s lien priority under the doctrine of “equitable subrogation,” but instead were behind the contractor who built the project. This result, according to the Weitz court, was mandated by the lien priority statute.

In the Weitz case, First National Bank of Arizona (FNB) had provided a $44,000,000 loan to build the Summit at Copper Square, a mixed-use commercial and residential condominium project in downtown Phoenix. Weitz Co. was hired as the general contractor. Summit began selling condo units while construction was still ongoing in order to begin paying off the construction loan to FNB. Most of those individual condo purchases were financed through mortgages by other lenders. At project completion, Weitz Co. was still owed nearly $4,000,000 and filed a lien foreclosure action to secure payment. FNB had priority because it recorded its deed of trust within 10 days after labor first commenced (the statutory exception mentioned above), but Weitz Co. claimed priority over all other subsequent encumbrances pursuant to A.R.S. § 33-992(A). In response, the condo lenders argued they were equitably subrogated to FNB’s first position and therefore had priority over Weitz Co., because their condo financing ultimately went towards satisfaction of FNB’s construction loan.

The equitable subrogation doctrine had long been recognized by Arizona courts, including in mechanics’ lien foreclosure cases. These previous Arizona cases indicated that the equitable subrogation doctrine was intended to maintain fairness in these actions: contractors would normally be junior to the original lender’s deed of trust, so when a subsequent lender extinguished that first position deed of trust by providing additional funding, the contractors who built the project during the intervening period should not be catapulted to first position priority. These previous Arizona cases held that the equitable subrogation doctrine allowed the subsequent lender to step into the original lender’s shoes in terms of priority, which trumped the contractors’ intervening lien interests.

The trial court in Weitz acknowledged the doctrine of equitable subrogation but held the condo lenders could not invoke it because they did not fully discharge the FNB loan, as not all condo units had been sold. The trial court ruled in Weitz Co.’s favor accordingly and the condo lenders appealed. The Court of Appeals also held for Weitz Co., but instead of adopting (or even addressing) the trial court’s conclusion that partial equitable subrogation was not permitted, the appellate court instead held that the equitable subrogation doctrine should have no applicability whatsoever in mechanics’ lien foreclosure actions, given the unambiguous statutory requirement in A.R.S. § 33-992(A) that contractors’ liens have priority over all subsequent encumbrances. The Court of Appeals had held otherwise for nearly 40 years, but in the Weitz case, the court held that the lien priority statute enacted by the legislature was clear, and therefore controlled.[1]

Of course, the Weitz decision does not necessarily represent a seismic shift in favor of contractors at the expense of lenders, given that it is somewhat rare for any subsequent lender to pump money in an ongoing construction project. But a few changes are likely. For example, it will probably be more difficult or expensive for the lender to obtain title insurance now. Furthermore, more lenders may require more projects to be bonded in order to avoid liens altogether, or may attempt to find a way around broken priority by (for example) taking an assignment of the original loan, although this latter strategy has not been tested in court. However, pending any further appeal to the Arizona Supreme Court, or perhaps a successful lobbying effort on behalf of lenders during the next legislative session, contractors appear to have the upper hand when threatening lien foreclosure—for now.

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Notes

[1] In so holding, Arizona joins the Nevada Supreme Court’s recent decision in In Re Fountainebleau Las Vegas Holdings, 289 P.3d 1199 (Nev. 2012), which likewise concluded that the doctrine of equitable subrogation cannot operate to supersede the requirement that mechanics’ and materialmen’s liens have priority over all subsequent encumbrances. See our previous legal alert at < http://www.swlaw.com/ publications/view/id/2044> (November 13, 2012).

Topics:  Construction Contracts, Contractors, Foreclosure, Mechanics Lien

Published In: General Business Updates, Construction Updates, Finance & Banking Updates, Commercial Real Estate Updates, Residential Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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