Fullerton & Knowles | Attorneys - Virginia, Maryland
Table of Contents for Construction Law Survival Manual

Mechanic’s Lien Rights
and General Principles

This chapter presents a general discussion of important mechanics liens topics and consequently will help you understand mechanics liens generally. In the following chapters, we will provide detailed discussions of each state mechanic’s lien laws, pointing out differences between this general mechanic’s lien discussion and each specific state law.

THE IMPORTANCE OF SECURITY

Why are one-year adjustable mortgage rates 6%, while some credit cards charge 18% interest per annum? Each dollar costs the bank the same amount. How can it be cheaper to lend one dollar than the other? Security is the most important difference. Security increases the bank’s chances of preventing default and collecting its money within terms. In the event of default, the bank increases its chances of collecting faster and at lower cost.

What if the government required all lending to be at the rate of 10%, whether or not the bank had security? Which banks would make money and which would lose? What would determine profitability? The obvious answer again is security. The banks that could consistently get security for their 10% loans would obtain a windfall and become even more profitable. The banks that could not get security would lose money.

What if the market rate for all lending was 0%? What would determine which lenders were profitable? Guess what! The answer is still security. The market rate for lending in the construction industry is 0%. Anyone that pays within 30 days gets this 0% rate. Even if there is a credit application that discusses 18% or 24% per annum, anyone that pays within 60 to 90 days probably gets this 0% rate. If you are a 0% lender, security is critical to your profitability.

When you or your business owner compute the price you need to be profitable, risk factor is one of the components considered. In addition to the cost of materials, labor and overhead, the business owner must consider the risks of default and non-collection. If these risks are lowered or eliminated, the business can sell the same product for less without reducing profitability. They now are better able to compete. The good, paying customers will no longer have to pay for the damage caused by the non-paying customers. This is exactly how credit management policies can be sold to credit customers. If they are willing to provide security, the vendor can sell them products cheaper. The customer can be more competitive.

If the seller can decrease the risks of default and non-collection without lowering prices, they have simply increased profits. This is making more money in less time.

Why does security decrease the risk of non-collection? When you purchased your last home or automobile, the bank required you to sign at least two pieces of paper. One was your promissory note. This was your “contract” with the bank in which you agreed to make certain monthly payments. This is your “personal promise to pay.” This allows the bank to sue you personally in the event of default.

The other paper you signed was a mortgage, deed of trust or other “security agreement.” The security agreement provides the bank rights against the “security property.” In the event of default, the bank can foreclose upon the security property, whether it is a house, automobile or other property.

The secured creditor has a “bigger hammer” than the unsecured creditor. The secured creditor can cause more immediate problems for the debtor by taking away the house, equipment, accounts receivables or other security property. The debtor will work harder to stay current. The risk of default is lower to the secured creditor.

If the debtor is solvent, security is not as important. The lender will be able to go against the debtor on the “contract.” The lender will be able to obtain a personal judgment against the debtor and will then be able to attach all assets owned by the debtor.

If the debtor is insolvent or disappears, security becomes critical. The contract or promise to pay will be worthless if the debtor has no assets or cannot be found. If the lender has security, however, the lender will be able to sell the security property to obtain repayment on some or all of the loan. If there is default, the risk of noncollection is lower.

WHAT IS A MECHANIC’S LIEN?

If you supply labor and materials for the construction of improvements on real estate, the law provides security in the real estate, whether the debtor agrees to it or not. The mechanic’s lien works basically the same as a mortgage, deed of trust or other security agreement. If the contract debtor is insolvent or goes to Jamaica, the claimant will still be able to enforce this security interest in the real estate to obtain repayment of some or all of the debt.

When a contract debtor defaults, the claimant supplying labor or material can elect to sue the debtor on the promise to pay, to proceed against the property, or elect to do both at the same time. In the event of bankruptcy by the contract debtor, the claimant who proceeds against the property will be a “secured creditor” in bankruptcy and will have rights in the security property. It may even be possible to enforce security rights against the property while the contract debtor is still in bankruptcy and while all “unsecured creditors” are still waiting around to see whether there will be any distribution.

A construction contractor wants to make sure that the company has both a contract (promise to pay) and security rights. Smart contractors make sure they have a strong enforceable contract with a solvent debtor. Smart contractors also will make sure that good security rights exist and then take whatever steps are necessary to preserve those security rights. Preserving both avenues of recovery will dramatically decrease the chance of default and increase the chance of collecting. It is not necessary for the contract debtor to agree to a mechanic’s lien, but it is necessary to strictly comply with the procedures for preserving mechanic’s lien rights.

All contractors should be thankful to the state legislature for providing this security interest and then be very careful to preserve these rights. Contractors must understand some important differences in mechanic’s lien rights from state to state. Will this be a difficult project to enforce mechanic’s lien rights? Will this mechanic’s lien have a high or low priority? Can they simply file a memorandum of mechanic’s lien to preserve rights in the short term, or must they go through an entire court procedure?

Contractors must understand the limitations of security rights. If security rights are weak, it is much more important to determine whether the customer is solvent or has a good track record. Weak security rights mean that the contractor must carefully evaluate the financial strength of the project and customer, carefully negotiate contract terms, consider requirements for alternate security and must watch the project much more carefully. If good and easy mechanic’s lien rights exist, the contractor may decide to take a chance on a riskier customer offering strong profit margins.

The contractor also must understand the varying mechanic’s lien statutes in different states to make sure that rights are preserved. Mechanic’s lien laws in various states are similar in some ways, but many contractors have lost much money assuming the rules are identical. It is important to be aware of the little differences in deadlines and the procedures to preserve mechanic’s lien rights.

PRESERVING SECURITY RIGHTS

The chapters in this book about state law in Virginia, Maryland, Pennsylvania and the District of Columbia should help.

In every state, correct project information is very important to assess security options, ensure mechanic’s lien accuracy, hold costs down and cut the time an attorney will need to prepare a lien claim.

The best practice is to collect project and customer information before your agreement to ship materials. It is always easier to collect such information while you are still friends with your customer. When a customer is more than 60 days past due, they are not likely to return phone calls or provide copies of documents. A contractor needs this information early, while they are determining risks of default and noncollection.

A site plan for the project and/or copy of the building permit are the single most important documents to have as the best source of information to identify the project and begin title search. A site plan also can be very important to solve allocation problems in the lien.

Prefiling Before Construction

In order to preserve mechanic’s lien rights, some states do require the contractor to give notice or file a paper before or soon after supplying materials. These “prenotices” sometimes involve a mailing to the owners or to a “mechanic’s lien agent.” Sometimes it is necessary to file a document with the court. These prefilings are often simpler than a full mechanic’s lien filing. A contractor is often able to send these notices without the help of an attorney. It is obviously important for a contractor to learn about these requirements before working in a particular state.

Lien after Work

A good rule of thumb is that bond and lien claims in most states must be made within 90 days of the last supply of labor or materials. Relying on this in any one state, however, could cost a lot of money.

Completion of the Project and Claimant’s Last Work

How do contractors know when a project has been completed? Does trivial work, warranty work or repair work extend the deadline for mechanic’s lien filing? The general rule is that any original contract work required to complete the contract will extend the deadline for filing a mechanic’s lien.

Minor work will normally extend a contractor’s mechanic’s lien rights, if it is a part of the original contract’s scope of work. The status of replacement items, repair work or warranty work is less certain. Suppose an electrician went back on a project to screw in one light bulb. If that light bulb was definitely part of the original contract and had never been there before, then this probably extends lien rights. If the light bulb had been broken or did not work properly, it is questionable whether lien rights can be extended.

Punch lists and other communications from the customer are helpful. If the contractor is required to complete the punch list item, then the contract is not complete. Lien rights do not begin to run until this punch list item is completed. It would be inconsistent later for the owner to argue that the contract had actually been finished earlier.

If there is more than one contract for the supply of labor or materials, then each contract may run its own deadline. Labor or materials supplied under the second contract may not extend the time to lien for money owed on the first contract. This is important when considering “change orders” or “extra work.” It may make a difference what you call this additional work. If work is a change order to the original contract, it will probably extend the time to lien for the original contract. If it is a separate extra work order or a new purchase order, it may not create more time.

Deadlines for Open Account Suppliers

When materials are furnished under separate contracts, the right to lien for each contract often dates from the time materials are furnished under each contract. Unless there is a “continuing contract” to furnish materials on the whole project, time limits may run from each separate order.

If there is a written or verbal contract for the entire project, then the deadline will normally count from the last day labor or material is furnished to the project as a whole.

Many open account sales, however, will still be in a gray area. Even without an explicit contract for the whole project, the material supplier will be entitled to count the deadline from the last delivery if there was a “continuing” agreement to furnish materials and the parties “contemplated” that a certain supplier would furnish through the end of the project. It may be important to a supplier to quote an entire project, or at least have information on hand about the entire project, for this purpose.

Tickle Systems

Tickle systems are very important to track aging accounts. Such a system must be linked to the last day labor or materials are supplied and not linked to the date of invoice. Most computer programs and accounting procedures run from the last date of invoice. This will not work for companies in the construction or public procurement businesses. These procedures or programs must be modified.

The best practice is to start the rotating tickle system when the major portion of your work ends. It should be the duty of the project or production manager to inform the accounts receivable department when shipment has been made or your construction crew is pulling off the job. This may give you an additional cushion because a punch list may add additional time to your lien rights.

Material suppliers should have a company policy of dating all invoices with the date of delivery, even if the invoice is physically printed another day. Then when a credit manager is looking at an accounts aging summary, they know how much time has passed since the last delivery. Mechanic’s lien or bond rights are often lost, because clients are looking at the invoice dates and not the delivery dates.

Labor and material contractors must normally use a different tickle system. They are usually billing monthly and may be on the project doing punch list long after the job has been billed in full. Someone in the company must have the responsibility to recognize when the project is substantially complete and then track the date to make sure lien or bond rights do not expire. It is often helpful and cheap to buy an account system like Quick Books to generate an artificial internal “invoice” when you have substantially completed your work. The credit manager can then track this artificial invoice in a conventional aging summary.

All suppliers and contractors must remember that each project or parcel of land will normally run its own mechanic’s lien deadline. It is not sufficient to know whether the customer is late on the invoices generally. You must know whether 90 days have passed since your last delivery of labor or material on any particular piece of real estate. For this purpose, aging summaries should show more than just the customer name and the age of that customer’s invoices. The summary should show each project as a separate line item. This is discussed in greater detail in the mechanic’s lien portions of this book.

Tracing and Allocation

In order to have lien rights in most states, you must be able to trace labor or materials and show the type and dollar value of labor or materials used in each piece of real estate. A lien may be invalid if it “overburdens” by claiming more than the materials that actually went into that parcel. An “over-inclusive” lien also may be invalid, because it includes too much property and claims lien rights against property that did not receive labor or materials.

As evidence, delivery tickets for material suppliers are normally sufficient, but they must make sure those tickets show exactly how to allocate the materials between each parcel of land. This is especially difficult in townhouse developments. Both the builder and the supplier plan shipments by “building.” If that building has eight townhouse units, however, there are eight different pieces of real estate for allocation purposes. Counter sale or bulk sale suppliers must require this information at the point of sale. Computer programs should not permit a sale until the customer has provided information on the allocation of these materials. It also is possible to do a materials take-off from a set of plans.

Many states have special rules for subdivision and utility improvements that make tracing and allocation easier. Contractors that supply labor or materials for roads, water systems or sewer systems want to be familiar with these lien rights in each market state.

SERVICE OF LIEN NOTICE

In addition to filing a mechanic’s lien in the land records, subcontractors and suppliers must usually provide notice of the mechanic’s lien to the owner. For a general contractor lien, the law usually assumes that the owner is aware that the general contractor has not been paid. No notice to the owner is necessary.

Because the owner is not aware of the status of accounts between the general contractor and its subcontractors, the law normally requires that a subcontractor send notice of the lien so that the owner can protect itself. The notice must usually be sent by certified or registered mail or served by the sheriff.

Defense of Payment:
Owner’s Responsibility for Payment to Subcontractors

Money flows down the payment chain from the lender to the owner to the general contractor to the subcontractor to the supplier. One bit of information to collect on default is “who has the money” within this payment chain. If the debtor received the money 90 days ago and is now 60 days past due, the claimant is in serious trouble. If the money is still held by someone up the payment chain and the claimant can contact them, the claimant will normally be in better shape. They may have the practical ability to “jam-up” the money to keep it away from the debtor. Everyone also has an opportunity to solve the problem without “hurting” anyone. This also may be important to preserve security rights.

In some states, the validity of the mechanic’s lien will depend on the status of accounts between the debtor and the contractors further upstream. Mechanic’s lien statutes in New York and Virginia, for example, have a “defense of payment” where the owner or general contractor is required to pay for the project only once. If the owner or general contractor can show payment in full, they have established a defense to any mechanics liens filed. This is the “defense of payment.”

This may create a practical deadline for mechanic’s lien filing that is much sooner than 90 days. The contractor must send notice of the mechanic’s lien to the owner and upstream contractors before payments “flow downstream” to the debtor. THIS IS THE REAL DEADLINE FOR FILING A MECHANIC’S LIEN for subcontractors and suppliers in states with a defense of payment. It also is important to contractors to make sure they have the names and addresses of all owners and upstream contractors before shipment. Additionally, contractors should then keep track of the status of payments after shipment. Informal notices will often stop owners or general contractors from making further payments. By definition, general contractors do not need to worry about a defense of payment in filing a mechanic’s lien. The issue is simply whether the owner owes them any money.

In some states, there is no “defense of payment” for the project owner. The owner can be required to pay for the project twice. Even if the owner has paid the general contractor in full, a subcontractor will still be able to establish a lien and eventually foreclose on the property. The burden is on the owner to make sure that all subcontractors are paid. The owner receives the ultimate benefit of services and materials and, as a practical matter, controls the cash. This type of mechanic’s lien law was designed to make property owners a source of payment for subcontractors, in addition to the general contractor.

Remote Subcontractor and Supplier Liens

In some states, contractors and suppliers will have lien rights only if they dealt directly with the owner or general contractor. In other states, anyone who supplied labor or materials to a project has lien rights no matter how remote they are from the property owner. This difference is critical to suppliers, who are usually more remote. The supplier dealing with a subcontractor may have no possibility of mechanic’s lien rights and will always be an unsecured creditor.

PRIORITY

Various types of liens can be placed on a piece of real estate. Some liens are placed on the property purposefully by the property owner, such as a mortgage. Other liens are “involuntary” or “judicial,” including judgment liens and mechanics’ liens.

The general rule is that all liens have priority in the order that they are filed in the land records. The term “first mortgage” or “first trust” means that this was the first in time to be filed in the land records. A “second mortgage” is the second in time to be recorded in the land records on that property. If the property is foreclosed, the first lien holder has a “higher priority” to the proceeds of sale and will receive all of the proceeds of sale until paid in full. If there are any sales proceeds left, they go to the second mortgage holder, until the second mortgage holder is paid in full, and so on. The priority of any type of lien is extremely important and will often determine whether or not the lienholder gets paid. A lien with low priority can easily be worthless.

There are very few exceptions to this “first in time, first in right” general rule. One exception is tax liens. Another exception is a mechanic’s lien that is “inchoate” (in-ko-ate) as are mechanics’ liens in Pennsylvania, Virginia and the District of Columbia (but not Maryland). If a mechanic’s lien is inchoate, this means that the lien “relates back” to the time when work began on the property, even if the lien claim is not filed with the court until a later time. The lien exists from the moment labor or material is supplied to the property, as long as the claimant eventually perfects the lien by following the procedures in that state.

In a state without an inchoate lien, such as Maryland, a sale of the property or a bankruptcy may cut off lien rights.

Sale or Foreclosure of Property

A sale or foreclosure of a construction project will not defeat an inchoate mechanic’s lien. Any real estate purchaser must be aware that inchoate mechanics liens might be filed after they purchase the property, if the prior owner fails to pay. Because the lien existed on the property since the time the claimant supplied the labor and materials, the purchaser took the property “subject to” the lien, even though there was no notice of the lien. For this reason, real estate purchasers and title insurance companies always insist that the real estate seller sign an affidavit stating that no labor and materials have been supplied to the property in the last 90 days or that payment has been made for all such labor and materials.

The priorities of various liens on real property also determine whether or not the liens survive foreclosure. If the first mortgage holder forecloses, then the second and third mortgage holders are eliminated. These inferior lien holders have no security interest in the property after foreclosure. All liens that are “inferior” to the foreclosing lien holder are eliminated, but liens that are “prior” will survive the foreclosure. If a second mortgage holder forecloses, the first mortgage holder would be unaffected. The foreclosure purchaser now owns the property “subject to” the prior first mortgage lien.

If a mechanic’s lien is “inchoate,” it is prior to most other liens. The inchoate lien survives most foreclosures and can often be filed after foreclosure. A lender may foreclose on a property, only to see a mechanic’s lien filed afterwards. The mechanic’s lien claimant must be certain to name the new property owner in the mechanic’s lien, but otherwise lien rights still exist.

The priority of construction loan advances is particularly touchy for mechanic’s lien claimants. The construction loan documents may be filed in the land records before any work began on the property, but the bank did not actually advance money until each loan draw after the labor and materials were supplied. Is the mechanic’s lien in this case prior or inferior to the loan advance? This seemingly minor issue can easily determine whether a mechanic’s lien claimant gets paid. If a project goes belly up part way through construction, someone must spend a lot of money to finish the project. The unfinished project will not be worth what the bank has advanced. Even in states with inchoate liens, the rules vary on the relative priority of mechanics liens and construction loan advances.

It is very important to understand that mechanics’ liens in some states, such as Maryland, are not inchoate at all. The claimant has no mechanic’s lien unless and until the Court establishes a lien after a court proceeding. It is as if the claimant walked into the courthouse the day of the court hearing and filed the lien, instead of getting the lien back on the day labor or materials were supplied. This court hearing could be months after labor and materials were supplied. Any new mortgages or judgments during that time will have priority. A sale of the property during this time will defeat lien rights.

Bankruptcy

The “automatic stay” of the United States Bankruptcy Code does not stay the perfection (filing in the land records) of the inchoate mechanic’s lien. The lien filing is not a “preference” because the claimant always had the mechanic’s lien from the moment labor and materials were supplied. The lien filing just gives public notice of this fact. This means that if the owner on the project files bankruptcy, a general contractor or subcontractor can still file their mechanic’s lien, and they will be secured creditors in the bankruptcy. If a general contractor files bankruptcy, a subcontractor can still file its mechanic’s lien.

In states that do not have an “inchoate” lien, the claimant is an unsecured creditor, until the court establishes a lien. The creditor is not allowed to bring court action to establish the lien, because this would improve the creditor’s position. The claimant will remain an unsecured creditor and will have to share with other general unsecured creditors in whatever assets the Debtor has left after all secured creditors have been paid. As a practical matter, this usually means the lien claimant will receive nothing.

If a property owner files bankruptcy within 90 days after a non-inchoate lien is established by a court, then the lien may be a preference that can be avoided (set aside) by the bankruptcy court. This is a radical difference between a lien that is inchoate and one that is not. With an inchoate mechanic’s lien, a claimant is a secured creditor from the moment labor and materials are supplied to the property. The mechanic’s lien claimant will retain secured status even though lien enforcement proceedings are filed long after bankruptcy.

Mechanic’s Lien Waivers

All types of waivers must be “clearly and unambiguously expressed.” Persons should not be able to accidentally waive legal rights.

This general rule on waivers also applies to waiver of lien rights in most states. A waiver of lien rights must be clear and unambiguous. If there is doubt whether a waiver was intended, then the claimant will likely retain lien rights. In addition to this general rule, some states have created laws that further prevent waiver of mechanic’s lien rights.

Some states do not allow mechanic’s lien waivers in the construction contract. Contract clauses stating that subcontractors “hereby waive all rights to lien” are “void as against public policy.”

It is still possible to waive mechanic’s lien or bond rights in a document separate from the construction contract. Subcontractors may be required to provide releases in exchange for partial payment. These releases can waive future lien rights for future deliveries. These problems in waivers are discussed in greater detail in the chapter on Contracts and Preserving Rights.

In some states a general contractor can waive a subcontractor’s right to a mechanic’s lien. If the law allows this, most sophisticated owners and almost all construction lenders will require the general contractor to waive lien rights for itself and any subcontractor. This reduces the effectiveness and importance of the mechanic’s lien law in these states. Subcontractors and suppliers should always be aware of these types of waivers in determining whether to supply labor and materials to a project, at what price and whether to require some form of alternative consensual security.

Conclusion

Construction contractors and suppliers are fortunate to have special forms of judicial security. The most important are mechanic’s lien and payment bond rights. The security rights in each state warrant special attention and will be discussed in greater detail in separate chapters of this book. For example, while Virginia law provides a relatively powerful mechanic’s lien that will not be lost in bankruptcy, Maryland has a lower priority mechanic’s lien that will be lost in bankruptcy. You must understand these differences to be able to assess the security and risks you have in each transaction.

James D. Fullerton, Esq.
Clifton, VA
703-818-2600
www.FullertonLaw.com
COPYRIGHT (1997,2008)   James D. Fullerton (703) 818-2600    

Footnotes