General Contractors Beware of Subordination Clauses

Amy M. Anker, Esq. | Construction Chaos | December 10, 2014

In California, a general contractor can usually rest assured that in the event of nonpayment, it can rely upon the remedy of a mechanics lien, which remedy is, in fact, even a constitutional right. The priority rights accorded to mechanics liens are strong. For example, although California is a race-notice statute (meaning that priority is determined by notice and date of recordation), a mechanics’ lien, even if it is recorded after another encumbrance, and even if the mechanics lien claimant had notice of that earlier recorded encumbrance, takes priority over such earlier encumbrance for work performed prior to recordation of the earlier encumbrance. This means a general contractor can feel comfortable that notwithstanding an encumbrance recorded after its work has started, any mechanics lien it records for nonpayment of such work, even if the mechanics lien is recorded after a later encumbrance (which didn’t exist at the time work commenced), relates back to when work started and takes priority over such later encumbrance. Or so was the case before Moorefield Construction, Inc. v. Intervest-Mortgage Investment Company (September 12, 2014, No. D065464), in which the Fourth Appellate District Court held that a general contractor could waive its priority rights of a mechanics lien.

In 2006, general contractor Moorefield Construction, Inc. (“Moorefield”) entered into a construction contract to build a medical office building and commenced work at the property. About a month after work started, the owner of the property obtained a construction loan from Intervest-Mortgage Investment Company (“Intervest”), which loan was secured by a deed of trust on the property.  In connection with the loan, Intervest required Moorefield to subordinate its mechanics lien rights to Intervest’s deed of trust.

By the end of construction, the owner defaulted under the construction loan and failed to pay Moorefield outstanding payments totaling approximately $2.2 million. Moorefield timely recorded a mechanics lien and sued to foreclose on the mechanics lien in accordance with the statutory scheme specifically designed for this type of circumstance. Intervest filed a cross-complaint claiming that its deed of trust was senior to Moorefield’s mechanics lien given the subordination clause Moorefield agreed to.

The trial court found in favor of Moorefield and ordered the foreclosure and sale of the property to satisfy the mechanics lien. In doing so, the trial court held that the subordination clause was null, void and unenforceable largely for two reasons: first, the clause is void as a public policy matter because it would deprive Moorefield “of its mechanic’s lien priority right that is a guarantee to them (as a contractor) under the California Constitution,” and second, the clause is unenforceable since it did not substantially follow the statutory forms set forth in former California Civil Code § 3262(d) (now § 8122).

Intervest appealed and the Fourth Appellate District Court reversed, holding that Section 3262(d) does not protect general contractors, explaining that the plain language of Section 3262(a) allows a general contractor to waive its own rights. Section 3262(a) read as follows: “[n]either the owner nor original contractor by any term of a contract, or otherwise, shall waive, affect, or impair the claims and liens of other persons whether with or without notice except by their written consent…” The Court stated: “The clear implication is that the contractor may waive or release his own claim, when doing so does not affect or impair the claims or liens of other laborers or subcontractors.”

The beneficiary under the deed of trust foreclosed on the loan and took title to the property. Moorefield’s mechanics lien, as a subordinate lien, was extinguished. Without a lien, Moorefield lost any chance of recouping more than $2 million for unpaid work.

In light of this case, California general contractors should be very mindful of any documents they may be asked to execute in connection with a construction loan, especially anything containing a subordination clause, and should always have such documents reviewed by an attorney knowledgeable in the area.

via General Contractors Beware of Subordination Clauses « Ervin Cohen & Jessup LLP « It’s not a common practice..

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