A construction lender lends funds to an owner. The owner acts as its own general contractor and hires subcontractors to build a building on the owner’s property. For whatever reason (e.g. mismanagement, embezzlement, bad luck), the owner does not pay the subs. The subs stop work and file mechanic’s liens. Neither the lender nor the subcontractors are at fault. There is not sufficient equity in the property to cover both the construction loan and the mechanic’s liens. Which liens take priority, the subcontractors’ mechanic’s liens or the construction lender’s deed of trust?
In May 2000, the Colorado Court of Appeals resolved this type of disputes in the case of 1st Choice Bank v. Fisher Mechanical Contractors, Inc. The result in Fisher Mechanical conflicts with the conventional understanding of mechanic’s lien priorities. The holding should serve as a warning to the construction industry, and suggests practices for construction lenders to enhance the likelihood that construction loans will take priority over mechanic’s liens.
In Fisher Mechanical, “Bank” made a loan to “Owner” allowing Owner to purchase the “Property.” Through a first deed of trust, Owner pledged the Property as collateral for this purchase money loan.
Later, Owner obtained a construction loan from Bank. The Bank recorded the “Second Deed of Trust” securing the construction loan. This Second Deed of Trust mentioned that the purpose of the loan was to finance the construction of a “spec home” on the Property.
Owner hired subcontractors who provided labor and materials for the construction of the speculation home. The subcontractors were not paid and filed mechanic’s liens against the Property and the spec home. The Bank had recorded the Second Deed of Trust prior to the time when the lien claimants started work on the project.
In Fisher Mechanical, the parties acknowledged that the first deed of trust was senior to the mechanic’s liens. They disagreed about which lien took priority in the spec home: the Second Deed of Trust or the mechanic’s liens.
In discussing the dispute, the Court of Appeals first made the point that, regarding the land, the Second Deed of Trust took priority. The Court went on to discuss the priority of the two liens on theimprovements. Relying on CRS § 38-22-103(2), the court acknowledged the general rule that in situations where an entirely new building is being constructed, mechanic’s liens have priority over a previously recorded deed of trust. The Court summarized this general rule stating that “a properly filed mechanic’s’ lien becomes the prior lien upon the new structure, while an existing deed of trust remains the prior lien upon the land.” [Emphasis added.]
Relying, however, on a case from 1903, the Fisher Mechanical court stated an exception to this rule in situations where: (a) the deed of trust securing the construction loan was expressly intended to be a construction loan; (b) the deed of trust is recorded prior to the attachment of the mechanic’s liens (i.e. the deed of trust is recorded prior to the time that the first work was commenced upon the property); and (c) the loan proceeds are actually used for construction purposes. The Fisher Mechanical court determined that these three factors were met and concluded that the Second Deed of Trust had a lien priority senior to the mechanic’s liens.
Often, the first work done on a construction project is initiated prior to the recording of the deed of trust which secures the construction loan. Generally, construction loans are not made without the borrower providing plans and specifications to the construction lender. Usually the design work is done by contractors hired by owners such as engineers, surveyors, and/or architects. Fisher Mechanical is a frustrating case to study because the court’s decision does not indicate whether such design professionals were involved, nor does the opinion address the relative timing between the recording of the construction deed of trust and any work done by these design professionals.
Fisher Mechanical, as it currently stands, is one precedent where construction loan took precedence over mechanic’s liens. This contradicts the conventional understanding in most cases were the mechanic’s lien priorities relate back to the point in time at which the design work was done, a point in time which usually precedes the recording of the construction deed of trust.
Generally, Fisher Mechanical is a case which is favorable to lenders and title insurance companies; it hurts the construction trades. In response to Fisher Mechanical, contractors and suppliers providing substantial services and/or materials to projects should consider having a title search done prior to providing material or services to a project. If a title search reveals a previously recorded construction deed of trust, the contractor should consider obtaining a subordination agreement from the lender prior to providing goods or services to the project.
Fisher Mechanical teaches lenders that all construction loans should be secured by deeds of trust which referenced that the loan is financing new construction.
A version of this article appeared in the Colorado REALTOR® News, the monthly publication of the Colorado Association of REALTORS®.