By S.H. Spencer Compton and Steven G. Rogers
In 2008, came the subprime mortgage loan crisis, the Lehman Brothers Chapter 11 bankruptcy filing and the financial meltdown. Numerous borrowers defaulted on commercial real estate financings, leaving many failed construction projects in their wake. As a result, title insurers have reevaluated the manner in which they underwrite mechanics’ lien risk.
This article will discuss current approaches to underwriting inchoate mechanics’ liens. An inchoate mechanic’s lien is one that has not yet been filed, but once it is filed, its priority date relates back in time to the date upon which the work performed or materials furnished first commenced.
An existing mechanics’ lien claim is illustrative of the kinds of tactics being employed today by certain indemnitors to evade their contractual liability.
A mixed use project consisting of three towers closed in April of 2007. The cost of construction was to be $124 million dollars, comprised of a $97 million dollar loan secured by an insured mortgage and $27 million dollars of borrower’s equity. Since construction had already started, the “broken priority” of the mortgage to be insured was a concern. “Broken Priority” means that any inchoate liens could prime (i.e. gain priority over) the lien of the mortgage securing the construction loan.
A title insurance company’s underwriters reviewed the borrower’s financial information and took an indemnity from the local developer (now in bankruptcy) and its principal, Mr. X, individually. Mr. X is a businessman who owns a large company. At closing, he had a purported net worth of $750 million dollars. Mr. X also gave the mortgage lender a personal guaranty on the loan for $44 million dollars. (As of this writing, the lender has already obtained a judgment against Mr. X for $40 million)-Guess where this is going….
In July, 2008, due to cost overruns and a market decline (no condo sales), construction stops. The first tower is complete. The second tower is framed with 2/3 of its outside skin in place and the third tower is excavated only. $25 million dollars in mechanics’ liens are promptly filed.
To date, the title insurer has spent $2 million in defense costs and will end up paying millions of dollars more to settle all of the claims.
The insurer is now suing Mr. X to honor his indemnity. He contends that 1) all of his assets are community property under state law and, since his wife did not sign the indemnity, the assets can’t be executed on, and 2) the indemnity may be invalid or void because the title insurer owed him a duty to disclose that there were liens or potential liens against the project at the time of closing (there were notices of commencement but no actual liens recorded) and that the insurer should have obtained subordination agreements from these potential lien claimants prior to closing.
The title insurance company has since discovered that the cost to construct may have been artificially low due to side profit sharing agreements with some of the subcontractors where the subs agreed to discount the amount they would charge for their work in exchange for which they would be repaid the discount plus an additional payment upon completion of the project.
The title insurer has a hearing scheduled to amend its complaint against Mr. X to include fraud/misrepresentation. Adding insult to injury, one of the largest liens against the project belongs to a company owned and/or controlled by Mr. X.
In light of such unsatisfactory indemnity experiences, how are title insurance companies modifying their underwriting practices to address today’s increased inchoate mechanic’s lien risk?
Nationwide, there are essentially three different types of statutory schemes governing the attachment and establishment of the priority of mechanics’ and construction liens:
- priority established by the date on which materials or labor are first provided (or the commencement date), so long as an inchoate lien is filed or recorded (“Type 1”) ;
- priority established by the date of filing of a notice of commencement or the lien itself(“Type 2”) ; or
- priority established by the initiation of judicial action (“Type 3”).
The majority of jurisdictions, including New York, fall within scheme Type 1. In these States, upon the commencement of the furnishing of materials or performance of labor, as set forth in the particular statute, the mechanics’ or construction lien is inchoate until the filing or recording of the notice of lien in the manner prescribed by statute.
Once perfected, the lien in these states attaches as of the date of the commencement, though not so in New York due to the lien clause required by Section 13 of New York’s lien law. In New York, a lienor has a period of eight months following the completion of the improvements or furnishing of materials (four months if a single family residential property) in which to file their notice of lien. Any conveyance instrument filed subsequent to the commencement of the improvement would be subject to the validly filed notice of lien unless it contains a covenant similar to the following:
AND the party of the first part, in compliance with Section 13 of the Lien Law, covenants that the party of the first part will receive the consideration for this conveyance and will hold the right to receive such consideration as a trust fund to be applied first for the purpose of paying the cost of the improvement and will apply the same first to the payment of the cost of the improvement before using any part of the total of the same for any other purpose.
Alternatively, a statement as simple as, “subject to the trust fund provisions of section thirteen of the lien law” may be used.
The party taking delivery of the instrument containing this covenant can rely upon the record in determining the status of title and those matters that affect it. They are not vulnerable to an inchoate lien being filed following the conveyance which springs into priority ahead of the interest conveyed to them. It adds an element of predictability for the purchaser not found in the other States that make use of scheme Type 1.
As a result of the Lien Law § 13(5) trust fund, the underwriting practices of title insurers of New York property in connection with inchoate mechanics’ liens are somewhat different from those of title underwriters of property located in other States. So long as the instruments of conveyance contain the lien clause, inchoate mechanics’ liens need not be addressed since the purchaser and/or lender will be conveyed their interests free of the same for the reasons set forth above.
Generally, the only mechanics’ liens of concern are those duly filed in the county clerk’s office that should be disclosed during a search of the clerk’s records. Nor are inchoate liens a concern in those States that follow scheme Types 2 or 3. This is not the case, however, in the majority of jurisdictions.
When real property located in any States with scheme Type 1 (other than New York) is to be conveyed, the issue of inchoate liens is always of concern, especially in the case of commercial properties such as shopping centers or office buildings that are constantly undergoing repairs and renovation. It is often difficult to accurately pinpoint just what labor or materials may have been provided to the premises prior to closing.
When closing a transaction involving a property in one of these jurisdictions, the issue is addressed by furnishing the title insurer with affidavits and/or indemnities. The owner of the premises will generally provide an affidavit which states that the improvements on the real estate were completed, and that no new construction or major repair work has been performed thereon for at least the period within which the inchoate lien could be filed in the particular jurisdiction.
Further, the affidavit will state that the owner of the premises has not contracted for any labor or materials to be furnished that might become the subject of a lien or that such labor or materials, if furnished, has been paid for in full. If the owner cannot make those representations, then an indemnity in favor of the title insurer will be necessary in order for a title insurance policy to be issued without raising an exception to coverage with regard to inchoate liens which may take priority over the interest insured.
What other approaches are title insurance underwriters taking to get comfortable with inchoate mechanics’ lien risks today? To the extent such a risk is a quantifiable dollar amount, an escrow account funded with some multiple of that amount may be required. Alternatively a bond or a letter of credit could be posted. Given the prohibitive cost of any of these solutions, a borrower’s initial approach to the underwriter’s concerns should be proactive cooperation with the underwriter’s diligence efforts to accurately quantify the risk in question. Often what first may appear to be open-ended risk can be reduced to a tolerable contingency by a thorough and transparent presentation of the facts. Additionally, title insurers routinely are declining to insure mechanics’ lien risks arising after the date of the title insurance policy by only issuing the FA 61 endorsement, which provides affirmative coverage against mechanics liens only up to the date of the policy.
Just as lenders reeling from their losses today have adopted more conservative lending standards, so title insurers are more cautious in light of recent history.
S.H. Spencer Compton is a vice-president and special counsel with the New York office of First American Title Insurance Company’s national commercial services division.
Steven G. Rogers is senior vice president and managing director, Northeast region, for that division.
Reprinted with permission from the November 22, 2011 edition of the
New York Law Journal (c) 2011 ALM Media Properties, LLC. All rights reserved.
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“Type 1” States: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Montana, Nevada, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, Washington, West Virginia, Wisconsin
“Type 2” States: Florida, Kentucky, Louisiana, Maine, Massachusetts, Mississippi, Nebraska, New Jersey, Rhode Island, South Carolina
“Type 3” States: Maryland, New Hampshire
Lien Law § 10
Lien Law §13(5)
Standard N.Y.B.T.U. Form 8002
Lien Law §13(5)