Imagine this scenario. You are the developer for a new mixed-used facility as part of a city’s revitalization effort. Months went into clearing all of the zoning and financing hurdles. But now, everything is in place. All that remains is for the lender to finish the loan paperwork and get a security deed recorded. In the interim, you decide to visit the future project site to check on things. You notice that materials and equipment are already there. Some clearing has been completed and grading work begun. There appears to have been a miscommunication with the contractor, which directed its subcontractors to commence with project preparation. Is this merely a harmless scheduling hiccup, or have everyone’s lien rights been suddenly inverted?
This example illustrates what is known as “broken priority.” This occurs where construction work begins before a construction loan is finalized and recorded. Depending on what side of the table you are on, this can be potentially problematic or advantageous.
If you are an owner or developer, broken priority can make it difficult to actually close the construction loan. A bank may no longer wish to lend the funds, and a title company may not want to insure the loan. There is no longer certainty that the construction loan will be the senior lien on the property. Why? A materialman or mechanic’s lien may have just cut in front of the lender in the priority line.
Many jurisdictions enforce a “relation back” approach to materialman/mechanic’s liens. California’s lien priority statute is a good example of how these jurisdictions handle broken priority. Under California Civil Code §8450, “A lien under this chapter . . . has priority over a lien, mortgage, deed of trust, or other encumbrance on the work of improvement or the real property on which the work of improvement is situated, that (1) attaches after commencement of the work of improvement or (2) was unrecorded at the commencement of the work of improvement and of which the claimant had no notice.” This means that although a contractor or materialman may not have actually recorded a lien, its lien rights could still trump a security deed that the lender recorded after construction work began. That’s what makes the relation back doctrine a deep concern to banks and title insurers—even though there is no lien or encumbrance recorded on the public land records, a contractor or materialman could come back months later, record its lien, and have superior rights to the already-recorded security deed.
This broken priority situation can create headaches for owners and lenders. Project financing may be cancelled or delayed until lien waivers are obtained from each subcontractor and contractor on the job.
Assuming that you are a contractor, subcontractor, or material supplier, the relation-back doctrine potentially could be significant. If you are considering recording a lien, check the land records to see when the security deed for the construction loan was actually recorded. If you began work before that date, the construction loan could potentially be subject to your lien, allowing you to foreclose and be paid first from the proceeds, giving the contractor substantial bargaining power. Further, some jurisdictions, such as Missouri, employ a “first spade” rule. This rule is unique in that “a deed of trust recorded after the commencement of work on a project is inferior to any mechanic’s liens arising on the land from that work.” See Bob DeGeorge Assocs., Inc. v. Hawthorn Bank. This means that even if you are a contractor or material supplier who got involved later in the project, you could still take advantage of the first spade rule if any work commenced before the recordation of the construction loan security deed. Thus, under this rule, all mechanic’s lien claimants are on equal footing.
In short, the timing of a loan closing and the beginning of construction work is important. If you are a construction lender or title underwriter, make sure that no work has commenced before you lend the funds or issue a policy, or obtain a lien subordination agreement from the contractor that has already begun work. If you are a contractor, subcontractor, or material supplier, never assume that a security deed for a construction loan automatically has priority over your lien, except in those projects where the lender in fact obtained a subordination agreement from your company.