Nevada Supreme Court Rules on Broken Priority Issues Affecting Deeds of Trust

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[authors: Stephen B. Yoken and Patricia J. Curtis]

The Nevada Supreme Court issued an important decision on the relative priority of deeds of trust and mechanics' liens in cases of "broken priority." In re: Fontainebleau Las Vegas Holdings, LLC, 128 Nev. Adv. Op. 53 (Oct. 25, 2012). With the impact of the great recession, the resolution of these questions holds potentially significant ramifications for lenders, developers, contractors and title insurers.

Facts

In Fontainebleau, a lender made a land loan in the amount of $150 million in 2005 to finance the acquisition of land on the Las Vegas Strip, and secured the note by recording a deed of trust against the land in a first priority position. After the developer commenced construction of the Fontainebleau Hotel in 2007, the lender provided a construction loan of $1.85 billion, reconveyed the existing deed of trust and placed a new deed of trust on the property to secure the construction loan. Additionally, the lender required various construction companies to enter into contractual subordination agreements of their mechanics' liens to the new deed of trust.

The lender disbursed proceeds of the construction loan for the payment of construction and various operating expenses of the developer. In 2008, with the downturn of the economy, the lender declared a default of the loan and began foreclosure on the partially completed hotel. The contractors working on the project recorded mechanics' liens to secure their unpaid work. The developer filed a Chapter 11 bankruptcy. In the bankruptcy case, the property was sold to a third party, with the mechanics' liens and the deed of trust attaching to the proceeds of the sale. The lender and the mechanics' lien claimants each claimed priority to the funds. The Bankruptcy Court asked the Nevada Supreme Court to rule on the priority issues under Nevada state law.

Legal Issues

Under Nevada law, mechanics' liens generally have priority as of the first date that any construction is commenced or materials delivered to the property, while deeds of trust have priority as of the date the deed of trust is recorded. A situation like this, in which the construction deed of trust was recorded after the commencement of construction on the property, is commonly referred to as "broken priority."

The mechanics' lien claimants argued that, since broken priority existed, the liens were senior to the construction deed of trust. The lender argued that either (1) the priority of the land loan deed of trust could be enforced by the holder of the construction deed of trust through the doctrine of equitable subrogation or (2) mechanics' lien claimants could subordinate their rights and the priority of their liens through a subordination agreement. The mechanics' lien claimants countered by arguing that equitable subrogation was contrary to the express priority hierarchy established in NRS 108.225 and that the anti-waiver provisions of NRS 108.2457 disallowed even a knowing and intended waiver of a mechanics' lien priority.

The Court holds that the doctrine of equitable subrogation cannot be applied to mechanics' lien claimants.

Ruling on these issues, the Nevada Supreme Court noted that it had not previously applied equitable subrogation in the mechanics' lien context, and began its analysis of the doctrine's applicability by reviewing past Nevada applications of the doctrine. Finding the application of equitable subrogation in the context of mechanics' liens contrary to the public policy considerations of the Nevada legislature and the plain language of NRS 108.225, the Court held equitable subrogation to be inapplicable. In doing so, the Court noted that the lender had "ample means to minimize its financial risk through the proper channels of contractual subordination." Fontainebleau, 128 Nev.Adv.Op. 53 at fn 13, pg. 29.

The Court holds that subordination agreements that purport to subordinate liens prospectively are unenforceable.

Next, in analyzing the effects of a contractual subordination agreement, the Court reviewed the specific circumstances in which a mechanics' lien claimant can waive its rights and the priority of its lien under NRS 108.2453 and 108.2457. The lender, arguing that the lack of a specific statement that prospective subordination agreements are unenforceable, asserted that the general proscriptions against waiving or modifying lien rights did not prevent lenders from protecting their superiority through subordination. The Court disagreed and held that NRS 108.2453 and 108.2457 unambiguously prohibit contractual waivers of mechanics' lien claimants' priority positions; prospective waivers of any type were intended to be prohibited, but under circumstances set out in NRS 108.2457, non-prospective agreements could be enforceable.

The decision offers mechanics' lien claimants comfort as they undertake and perform on construction contracts, but ultimately changes little in the analysis of lien priority.

While the Fontainebleau decision has answered two previously unaddressed questions of Nevada law, the impact on lenders and title companies is not necessarily game-changing. A plain reading of the statutes in question disclosed this outcome when enacted in 2003. Mechanics' lien claimants can now rely on the fact that their mechanics' liens have priority over any deed of trust recorded after the commencement of construction. Nonetheless, the decision does not change the priority of loans secured by deeds of trust recorded before work has begun.

From the perspective of a lender, the Fontainebleau case highlights the necessity of obtaining title insurance against mechanics' liens for all construction loans. Unfortunately, title company requirements for providing such insurance, especially in cases of broken priority, have become far more stringent and it may be difficult even to obtain such insurance in some cases. Lenders who seek to refinance pre-existing acquisition loans after commencement of construction need to consider different ways to retain the acquisition deed of trust priority. An alternative that a lender could consider would be to take an assignment of an existing land loan, with construction funds to be categorized as additional advances under the land loan.

Published In: General Business Updates, Construction Updates, Finance & Banking Updates, Insurance 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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