Imagine this scenario. You are the developer for a new mixed-used facility. 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 record a security deed. However, upon visiting the site, 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. What is the effect, if any, on the priority of lien rights?
When construction work begins before a mortgage or deed securing the construction loan is finalized and recorded, the situation is sometimes referred to as “broken priority.” Broken priority can occur in jurisdictions that have adopted a “relation back” approach to materialman/mechanic’s liens. As an example, in California, “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” (Cal. Civ. Code § 8450). Under the “relation back” approach, a contractor or materialman may not have actually recorded a lien, but its lien rights could trump a security deed that the lender recorded after construction work began. Thus, even though there is no recorded lien or encumbrance that pre-dates the lender’s mortgage or deed, a contractor or materialman could record its lien months later and have superior lien rights to the lender.
Depending on what side of the table you are on, broken priority can be a significant issue. For owners or developers, broken priority can make it difficult to actually close the construction loan. The bank may not lend the funds, and the title company may not insure the loan because there is no longer certainty that the construction loan will be the senior lien on the property. A materialman or mechanic’s lien could cut in front of the lender in the priority line. Until lien waivers are obtained from each contractor that has performed work and each supplier that has provided materials, project financing may be cancelled or delayed.
For contractors, subcontractors, or material suppliers, the “relation back” doctrine can actually boost lien priority. A contractor considering recording a lien should check the land records to see when the security deed for the construction loan was actually recorded. If work began before that date, the contractor’s lien may trump the lender’s lien and allow the contractor to be paid first from the proceeds of a foreclosure.
Other 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.” Thus, even contractors or material suppliers that got involved later in the project can take advantage of the “first spade” rule if any work commenced before the recordation of the deed or mortgage securing the construction loan. Under this rule, all mechanic’s lien claimants are on equal footing.
Due to the potential consequences of broken priority, construction lenders and title underwriters should (1) try to confirm that no work has commenced before lending funds or issuing a policy, or (2) obtain lien subordination agreements from any contractor or materialman that has already begun work or provided supplies, or (3) do both. Conversely, contractors, subcontractors, or material suppliers, should never assume that a security deed for a construction loan is automatically superior, except where they have signed a subordination agreement. In short, construction loan closing and the beginning of construction work are critical dates for determining lien priority that all parties should carefully monitor.