How to Protect Yourself Legally on Problem Construction Projects: Construction Liens and Lien Foreclosure
Join Marty Frenkel, head of Maddin Hauser’s Construction Practice Group, and his colleague Corinne Rockoff, as they share crucial information about construction liens, lien foreclosures, and other key operation risks for general contractors.
Transcript:
Marty Frenkel: [00:00:00] Hello, my name is Marty Frenkel. I am an executive committee member of Maddin Hauser and head of the Firm’s Construction Practice Group. I have with me my esteemed colleague, Corinne Rockoff.
Corinne Rockoff: Good morning everybody.
Marty Frenkel: Corinne and I have had the privilege of working with commercial general contractors for many, many years.
Marty Frenkel: In fact, our firm has served as outside general counsel for a significant commercial general contractor located in our area for over 25 years. One thing that we have learned in representing general contractors is that there is a lot of emphasis on. Construction lien foreclosures, which we will talk about, but not a lot of emphasis on other operational issues [00:01:00] that arise for general contractors and which pose significant risk.
Marty Frenkel: As such, we decided we were going to put together a video podcast taking a general contractor through some landmines that exist, uh, on the operations side. Specifically, we’re going to talk about construction lien foreclosures as mentioned, defending delay claims, dealing with failed subcontractors, and finally walking through a myriad of remedies, which should be in your sub subcontract with your subcontractor.
Corinne Rockoff: So to start us off, can you tell us a little bit about. Why construction liens are such a big deal in the industry.
Marty Frenkel: Sure. Construction liens are utilized by a general contractor to convert a claim for [00:02:00] money under a construction contract with an owner who’s not paying you into the real estate, into the property that you’re working on.
Marty Frenkel: So what do I mean by that? What happens is, is a construction lie. Gets recorded with the register or recorder of deeds in the county in which the project is located. Someone physically walks in a construction lane and delivers it to the county administration and it gets indexed. And what, what that means is in olden days, it actually used to be put in a physical book.
Marty Frenkel: It would be assigned a book and page number where one could go back and look and find that construction link. Now, everything is done on a digital basis, but it is still assigned a book and page number because that [00:03:00] determines the priority or order in which claims against real estate are determined.
Corinne Rockoff: And so to take it back a step for those of us who aren’t spending all of our free time hanging out at the register of Deed’s office like you and I do, of course.
Corinne Rockoff: Let’s talk about why exactly it’s important that it’s recorded. What is the purpose of something being recorded and officially longed with this office?
Marty Frenkel: So recording does something called perfect. It perfects the uh, a lien. It perfects an interest in real property. And the reason why that’s important. Is because in this digital book that maintains all of these claims of, of interest,
Corinne Rockoff: and in some counties still a physical, still a physical book,
Marty Frenkel: depend in some on rural counties in particular depend it that everyone in the world is charged with what we call constructive notice, uh, of what is in that book.
Corinne Rockoff: So you or I, at any point, could [00:04:00] walk into one of these offices. Look through that register and say, okay, I’m looking at the property on 1, 2, 3 Main Street. Maybe I’m gonna get involved as a contractor in a project that’s happening there, but I can take a look and see what’s the history of the interest in that property.
Corinne Rockoff: Has anyone else filed a lien? ’cause they didn’t get paid. Is there a mortgage? All these things are just public record, right?
Marty Frenkel: That that’s correct. And so what happens is, is the world is charged with. Notice of what’s in that book, even if they haven’t actually gone and looked in that book. Because that will be important if there ever is a lawsuit to foreclose that construction link.
Corinne Rockoff: So talk us through how we get from owners not paying. I’m unhappy to that point where you can have a lawsuit to foreclose the construction. What happens in the middle?
Marty Frenkel: Well, what happens in the middle is, is a mixture of two things. One is you have a general contract [00:05:00] with the owner, and that contract has a bunch of terms that determine how I’m supposed to be paid when I’m supposed to be paid.
Marty Frenkel: And as a result, if the owner fails in its obligations, is the owner in default under that contract? The owner is in default under that contract I als. I then have a remedy. By law under a statute, most if not all states have a statute that governs construction or mechanics liens and says, if you general contractor, subcontractor, supplier, laborer, follow the requirements of the statute, you have the right to a lien for the amount owed under that contract.
Corinne Rockoff: And just a side note as well, is there actually a substantive difference between a construction lien and a mechanics lien, or are those interchangeable? Depending on
Marty Frenkel: they, they are interchangeable. A [00:06:00] mechanics lien is a bit more of an archaic term used, you know, before the 1980s. Some states still utilize that term, but they are one and the same.
Corinne Rockoff: So what is it that’s specific about construction as an area that made the legislators say, Hey, there’s something different here. We need to have a particular statute about this. Why? Why are we here at all?
Marty Frenkel: Well, there is a public policy behind construction liens that if a general contractor, subcontractor labor or or supplier has provided equipment labor.
Marty Frenkel: Materials for improvement of real estate. The legislature in every state has said we want those individuals to be able to claim an interest in the property itself and the real property because normally liens don’t arise by a law necessarily. They arise [00:07:00] by an agreement. So for example, I go ahead and, um, buy a commercial building and I need a mortgage.
Marty Frenkel: A mortgage is a type of lien, and that mortgage is granted by agreement between me and the bank. In this case, for construction liens. The legislature has said, we don’t need an agreement to have a lien against property by law. We’re gonna allow one to arise.
Corinne Rockoff: And there’s, there’s another feature about construction as.
Corinne Rockoff: Um, a part of the economy that’s a little different from anything else because if, for example, you buy a big piece of equipment and you don’t pay for it, the person who sold it to you can come and physically take that back away. But if you are pouring a concrete parking deck, for example, you can’t exactly come and take back your concrete and reuse it on another project.
Corinne Rockoff: It becomes attached and the same value doesn’t come back out of it. So I think there’s a core difference there as well about what attaches to the [00:08:00] land and becomes part of it. And that’s part of the difference between what it means to just be improvement versus placing something on the land. It has to have that attachment and you’ll see that come up in a lot of cases
Marty Frenkel: that that is correct, Corinne, you can’t sever, for example, improvements that have been incorporated into a building in order to go ahead and recover the value.
Marty Frenkel: Of the four story parking structure attached to your to a building is to foreclose and liquidate the entire building and parking structure and make it turn it into money to satisfy the construction.
Corinne Rockoff: So usually if you’re on a project and something goes wrong, it’s pretty unlikely that there’s only one thing that’s going wrong, and so that leads to situations.
Corinne Rockoff: Where multiple folks working on a project may each have their own lien claim, and there might be multiple competing liens on a project. What do you do in that situation? How do we figure out who gets paid?
Marty Frenkel: Typically, the [00:09:00] statute at play will say that all of those construction liens have equal priority.
Marty Frenkel: So for example, I may have an excavator that has a lien against the property. I may have the general contractor that has a lien against the property. I may have a painter at the end of the job that has a lien against the property. They all all have equal priority, and they will either be paid in full if there’s enough equity in the property once it’s sold to, uh, uh, and foreclosure of those liens, or they will be paid probably in proportion to the amount of their liens versus the amount of equity that is in the property.
Corinne Rockoff: Now if something has gone wrong previously on the job, or even if nothing has gone wrong and maybe there’s just a mortgage on the property where the project is happening, right? How, how are determinations made about the order of payoffs between pre-existing liens or between mortgages or other things that came [00:10:00] first?
Marty Frenkel: So as we talked about earlier, there is this book. That is maintained by the register of deeds. That creates an order of priority of interest in real estate, and some states do allow for construction liens as a matter of law to acquire super priority, which means by virtue of having done work on the on the project, that even if a mortgage appears in that book prior to the construction lane, the construction lane will have priority over the mortgage.
Marty Frenkel: That’s not the majority of states. The majority of states say, okay. If the mortgage was recorded, for example, on June the first, and a construction lien is recorded on August the first, the mortgage is gonna be senior or prior to the construction lane. Why is that important? It’s [00:11:00] important for a few reasons.
Marty Frenkel: I knew you were gonna ask me that. Um, it’s important because when one goes to foreclose, senior liens get paid first. So for example, if I have a hundred million dollars multifamily housing project and there is a mortgage on that property in the amount of a hundred million dollars from Wall Street lender, general contractor.
Marty Frenkel: Is coming to the end of the job and realizes that at the end of the job, they’re owed their last draw of $5 million. Project owner says, I don’t have any money to pay you if the construction lien is recorded by the general contractor and foreclosed the general contractor unless that property has greater value.
Marty Frenkel: Then a hundred million dollars is not going to receive [00:12:00] anything by virtue of foreclosure of that lien.
Corinne Rockoff: So essentially the way that it works in, in the practical timeline is that if that’s a $100 million property and it’s already got a hundred million dollars of debt on it, there’s essentially a queue at the end of the foreclosure process where everybody lines up in order to see when they’re gonna get paid.
Corinne Rockoff: And when the money runs out from the sale of that property, the money runs out. So. That’s part of why, thinking back to the physical book, right, you wanna be aware of what’s in that physical book of what other interests are involved in your property if you’re joining a project. Because if there’s a big, long queue of folks that have maybe a hundred, $150 million on a project, that’s worth, worth less than that, the odds that the last person in line getting paid.
Corinne Rockoff: Are not looking so good anymore.
Marty Frenkel: That, that’s correct. And there is even a, a, a bit of a nuance on that. Practicality. So let’s go back to my example of that a hundred million dollars multifamily [00:13:00] project, let’s say after the general contractor has completed its work, that by virtue of the improvements that property appraises at $104 million.
Marty Frenkel: So there’s a little bit of equity. The problem is, is that when one goes ahead and takes into account that you are going to need to find a buyer for that property that is willing to pay $104 million. There are very few buyers that are in that market, that $4 million delta between the mortgage and the equity.
Marty Frenkel: Will be depleted by, uh, foreclosure costs, attorney fees, brokerage fees, transfer taxes. So ultimately it shrinks to the point where, as a practical matter, the ability to actually liquidate the property to obtain any money [00:14:00] is small.
Corinne Rockoff: You don’t wanna be calculating to the scent and be the last person squeezing it in line.
Corinne Rockoff: You wanna make sure that you’re leaving a healthy cushion there and that you understand the real. Broader financial landscape of a project, but I know there’s a complicating factor that comes up sometimes where the owner that you think you’re working with isn’t always technically the same owner of the property.
Corinne Rockoff: So can you talk us through what happens in those situations?
Marty Frenkel: Sure. So most uh, general contractors that we know, they enter into a relationship with a project owner, developer. The project owner developer in my hypothetical is Wall Street Mega Corp. Mega Corp developer,
Corinne Rockoff: my favorite.
Marty Frenkel: They tell you they’re a billion dollar company.
Marty Frenkel: You research them. They are in fact, uh, a billion dollar company. They have significant assets. General contractor concludes I will be paid. [00:15:00] They then get to the closing table and sign the construction contract. And you look at the paperwork and the construction contract is not with Megacorp developer, it’s with Megacorp developer 1 2 3 LLC.
Corinne Rockoff: A little suspicious. What’s the deal?
Marty Frenkel: What is Megacorp Developer 1, 2 3 LLC? It is what it is called a single purpose or single asset entity. And what what these companies and developers will do is they will take that one particular project. And put the land in this entity and have the construction contract also held by that entity have the loan that they obtain from Wall Street Hedge fund to, to develop the property in the name of that entity as well.
Marty Frenkel: And so
Corinne Rockoff: you, you think you’re looking at. An entire portfolio of [00:16:00] 10, 15, 20 different properties that are all owned by the same large developer. But in reality, they’ve created just a single tiny business that contains nothing but this project, which means there’s nothing to fall back on.
Marty Frenkel: Yeah, you’re essentially contracting with an entity that has nothing.
Corinne Rockoff: So when a GC encounters something like this. Is there anything they can do to help protect themselves and give themselves a little bit of security when they’re working with a, a small SPE like this?
Marty Frenkel: Sure. Um, there are some things that can be done. So one is at least under a standard a in a document, there is a provision that allows the general contractor at the beginning of the contract.
Marty Frenkel: To ask the owner to examine the owner’s financial records, records to determine it’s it’s wherewithal, it’s financial wherewithal. So in this example, if I went to the developer and said, please provide me [00:17:00] with the financial information for Mega Corp 1, 2 3 LLC, and they did, and we determined that it in fact has no real assets to pay.
Marty Frenkel: We could. In theory, ask Mega Corp developer to guarantee performance of the contract. In addition, as a practical matter, knowing when I’m representing a general contractor, knowing that I am dealing with a single purpose entity, knowing that there is a big bank that holds a, a significant mortgage on the property.
Marty Frenkel: I at least encourage my clients not to allow the developer to get too far ahead of them in terms of payments. At least if I’m getting very timely and regular payments, I am reducing my risk at the back end. And finally when things really, really go wrong, [00:18:00] you know, as I, Corinne and I were, were talking about this, I’ve never in 30 years.
Marty Frenkel: Had a general contractor come in, go to the closing table, sign the general contract, be all smiles and say to me, you know what Marty? I can’t wait till this project goes down the toilet. Everyone always thinks things are going to work out well, and the majority of the time they do work out well, but sometimes they don’t.
Marty Frenkel: And so we as lawyers have to help our clients prepare for the what if things don’t work out well. And so one of the things that we will look at when and when things are not going well is, remember we talked about that book held by the register of deeds that determines priority in certain circumstances.
Marty Frenkel: There can be an argument. [00:19:00] That the general contractor, even though its lien is recorded later on after the mortgage actually is senior to the mortgage,
Corinne Rockoff: how is it possible that a construction lien that’s recorded after a mortgage can come back around and prime a mortgage?
Marty Frenkel: That’s a great question.
Marty Frenkel: Oftentimes it surrounds when a physical improvement was made to the real estate. So let me give a, a real world example that we’ve had. You have a vacant piece of land that developer is going to develop into a shopping center, and a mortgage is recorded on August 15th for development of the shopping center.
Marty Frenkel: August 15th should be the priority date for that mortgage. And everything that is recorded after it should go [00:20:00] ahead and be junior to that mortgage. However, in certain scenarios, developers and lenders are not as careful as they should be. So in my hypothetical, and we have seen this on many occasions.
Marty Frenkel: The project owner was telling our client, get out there, get out there. Get out there. We’re gonna fall behind schedule. Our closing has been delayed and in, uh, this case, the general contractor puts silt fencing up around the property demonstrating that it is going to begin construction. We also have an excavator out there, pulls out a couple of trees.
Marty Frenkel: That is all done on August 10th. Under that type of factual scenario, the general contractor, and by the way, all of its subcontractors may be senior to the bank’s mortgage, [00:21:00] and in the cases that we’ve had or that’s been the case, I can assure you the bank is not happy when it finds out that it’s a hundred million dollars mortgage.
Marty Frenkel: Is not first in line, but the general contractor’s claim for $5 million is,
Corinne Rockoff: and that’s one of those situations just like how at the core of the purpose of construction liens and why they’re different from other types of liens or other types of debt, is that actual physical improvement to the property.
Corinne Rockoff: Because once that excavator’s out there and it pulls a tree out, you can’t just put the tree back and undo the work. You can’t get the time back for the labor. That’s particular way of going about things that. Can’t be undone and that makes construction and thus construction lean different from other types of debt and sometimes can give us the opportunity to get the jump even on a big Wall Street bank and their mortgage to the advantage of our clients in some cases
Marty Frenkel: that, that’s, that’s correct.
Marty Frenkel: [00:22:00] And we would just tell our audience, we know we don’t wanna think about when things go wrong, but please, please, at the outset. While everyone is all handshakes and smiles, think about how you’re going to protect yourself as you go through a project.
Corinne Rockoff: It’s a lot more fun to think about it now than it might be in the future if you didn’t have the conversation in the beginning.