OP-ED: Addressing Risks of Mechanic’s Liens in Construction Financing
Daily Journal of Commerce
Construction financing typically involves complex projects, with many moving parts and different parties. Oftentimes, construction loans contemplate multiple advances or disbursals at various stages of the project. The multifaceted nature of the industry can lead to a broad range of risk points. Losing lien priority to a mechanic’s lien is one of those risks. Before the start of the busy construction “season,” I recommend that construction lenders review their practices and forms to ensure that they are adequately mitigating the risks associated with mechanic’s liens. The following two best practices are geared toward accomplishing that goal.
- Obtain a title insurance policy that covers mechanic’s liens and/or issue advances directly to the general contractor
First, construction lenders should make disbursements through a title company and obtain some type of mechanic’s lien coverage wherever possible. If mechanic’s lien coverage isn’t in the cards, lenders should pay the general contractor (GC) directly, rather than issuing disbursals to the borrower.
Both recommendations are geared toward addressing the lender’s risk of losing priority to a mechanic’s lien. In Oregon, construction contractors and suppliers have strong lien rights.
Mechanic’s liens provide a mechanism for folks who don’t receive payment for furnished labor, services or materials, to file a lien against the real property for the amount owed. Mechanic’s liens can come into play if the GC is not paid or if the GC doesn’t pay the subcontractors, laborers, material suppliers or equipment rental companies. Under those circumstances, the unpaid contractor or supplier has a statutory right to assert a lien against the property to secure payment. In Oregon, with certain exceptions, a mechanic’s lien takes priority over all prior liens, mortgages or other encumbrances on the land. (Note that other states treat the priority of mechanic’s liens differently, so I recommend consulting with an attorney on that issue.)
One effective way for a lender to protect itself against priority issues related to mechanic’s liens is to obtain a title policy that includes mechanic’s lien coverage in the title policy jacket or endorsements.
However, title insurers may be hesitant to issue coverage for mechanic’s liens with respect to construction loans, which usually involve active construction projects, due to the increased risk that a mechanic’s lien will be filed at some time before the project is complete.
Where title insurance isn’t possible, I recommend that lenders direct advances or disbursements directly to the general contractor and avoid paying the borrower directly for the entire construction advance. That is because issuing payment to the borrower increases risk that the general contractor won’t be paid, and thus increases the likelihood for mechanics liens. It’s important to note that paying the GC directly provides one layer of protection, but it does not mitigate the risk that the GC will fail to pay its subcontractors or suppliers, resulting in secondary mechanic’s liens. For that reason, I also recommend that construction lenders obtain appropriate lien waivers, as discussed next.
2. Use (and update) lien waivers that accomplish your goals
Construction lenders should obtain lien waivers tailored toward accomplishing their specific goals. A lien waiver is a formal, binding document signed by potential lien claimants (e.g., contractors, subcontractors and suppliers), stating that the claimant has received payment for the service or materials agreed upon and therefore waives any future statutory right to file a mechanic’s lien against the subject property.
Essentially, lien waivers serve as a “proof of payment.” Every time a payment is made on a construction project, there is a payor and a payee. When lien waivers are involved, the payee will execute a lien waiver acknowledging receipt of the payment and promising not to file a lien with respect to that amount.
There are two types of lien waivers: conditional and unconditional. Unconditional lien waivers are effective as soon as they are signed, no matter if payment was actually received or not. Conditional lien waivers, on the other hand, become effective only once a predetermined condition (usually actual receipt of payment by payee) occurs. Whereas conditional lien waivers are typically used for the current payment that is due and submitted with every contractor or vendor invoice, unconditional waivers are usually signed upon receipt of payment and apply to the cumulative amount that has been paid prior to the current advance request.
Construction lenders often use standard forms for both types of lien waivers. This is generally sufficient, but I advise consulting with an attorney to confirm that the wording of your form waivers is compliant with, and effective under, state law, which can vary significantly. For larger or more complicated projects, I recommend that lenders tailor the wording of their waivers to the specific demands of the project.
Because the terms of a lien waiver can vary significantly, I advise lenders against relying on lien waivers provided by the GC or borrower without careful review to ensure that the waiver complies with the lender’s objectives. For instance, some waivers require that change orders be in writing and fully executed by both parties in order to be covered by the waiver. Others cover all labor, services, equipment and materials furnished through a specific date. Waivers can also vary with respect to how they treat extra work. Some don’t cover extra work performed before the release date if the work does not rise to the level of a change order or if a change order is not reduced to writing and fully executed by both parties. Others don’t include these types of exclusions.
These types of variations can create risk of costs that are unaccounted for and may result in competing encumbrances on the property. To reduce that risk, I advise parties to develop and maintain form waivers that accomplish their goals and require contractors to use those forms.
The best way to assess and mitigate the risks associated with mechanic’s liens is to work with an attorney to assess your individual practices and forms in light of applicable state law.
Column first appeared in the Oregon Daily Journal of Commerce on February 14, 2020.