by Richard E Danley, Jr. and Rick Carlton
Title insurance companies in Utah and much of the nation changed their coverage regarding mechanics’ liens in 2010, in particular their coverage of broken lien priority. In a complete reversal of their prior practice, virtually all major title companies stopped insuring construction lenders as holding a first lien position when there is broken lien priority. Broken lien priority occurs when work on the property is commenced or materials are furnished prior to the recording of the deed of trust or mortgage. Previously, for established lenders and experienced, financially strong developers, it was normal and expected to have the title company insure over the broken lien priority. When a mechanics’ lien claimant filed a lien or construction commenced prior to the recording of the construction lender’s lien, it was common for most title companies to insure the lender as holding a first lien position, with no exception taken for the mechanics’ lien claims. Suddenly in 2010 for lenders, contractors, and developers, the world changed. As mechanics’ lien claims mounted in the recession, title companies refused to insure over mechanic-lien claims and title coverage was more limited, with careful underwriting of the project and a serious evaluation of the borrower’s financial capacity. But what was most alarming for many contractors and developers, was that without first-lien-title coverage many construction lenders simply refused to fund projects involving broken lien priority, demanding an insured first lien for the loan.
This reversal of historic practice, even if well justified and sensible, created an immediate problem for a significant number of projects in Utah. Projects with broken lien priority required an innovative change in the mechanics’ lien laws. The refusal to issue first-lien coverage on projects with broken lien priority became an entrenched and immovable position among title insurers. As reported by Representative David R. Clark of the Utah House of Representatives,
In Utah title companies generated roughly 1% of policy revenues for title companies but were responsible for 11% of all losses and legal expenses from mechanics’ lien claims. Title companies’ refusal to insure with title insurance on broken lien priority issues raised the bar for everybody, including the contractors, suppliers and lenders. If we hadn’t fixed it by statute then construction projects would have ground to a halt for two or three years until it corrected itself, which was not an option anybody wanted to face.
Telephone Interview with David R. Clark, Member of Utah House of Representatives (July 15, 2011); see also ALTA Statement for the year 2010, Schedule T-Exhibit of Premiums Written, http://www.alta.org/industry/financial.cfm (stating that premiums earned by title companies in 2010 were $9,442,719,439.00 of which $167,865,731.00 was attributable to Utah or .017%).
This viewpoint of Representative Clark and the need for a solution spurred representatives from the legislature, contractors, suppliers, lenders, and the title industry to find a solution. The result is House Bill 260 (“HB 260”), sponsored by Representative Clark. HB 260 represents a far-reaching and innovative approach to the problem. HB 260 was passed by the legislature and signed into law by Governor Gary R. Herbert on March 25, 2011. On August 1, 2011, HB 260 went into effect amending Utah Code Sections 14-2-5, 38-1-5, -27, -31, -32, -33. See Utah Code Ann. §§ 14-2-5, 38-1-5, -27, -31, -32, -33, (Supp. 2010, 2005); enacting Utah Code Sections 38-1-30.5, -31.5, -32.5 and 32.7; and, repealing Utah Code Section § 38-1-37. The new mechanics’ lien revisions, according to Representative Clark,
provide priority between construction loans and mechanics’ liens; modify the indexing of information by the State Construction Registry [“Registry”]; require each notice or document submitted for inclusion in the Registry to contain specific information; modify the filing to require preliminary notices; require construction lenders to file with the Registry; and, modify the relation back and priority of liens.
Telephone Interview with David R. Clark, Member of Utah House of Representatives (July 15, 2011).
Utah law recognizes that the first to record is the first in right and time and holds priority over subsequent liens. However, the priority of the first to record has some significant exceptions, particularly with respect to mechanics’ liens. Under Utah Code Section 38-1-5 (prior to HB 260), see Utah Code Ann. § 38-1-5 (2005), Utah recognized that the priority for a mechanics’ lien claim is determined under the relation-back test using the date when the first observable work commenced or the first observable materials were delivered to the project and not the date when the individual mechanics’ lien was recorded. See EDSA/Cloward, L.L.C. v. Klibanoff, 2005 UT App 367, ¶ 19, 122 P.3d 646. This test has often been called the first shovel in the ground test, and refers to the collective priority of all mechanics’ liens for a project being tied to the date the first observable work commences on the project or materials delivered. It permits all mechanics’ liens for the project to relate back to the same date when work commences. Historically, the Utah Supreme Court (for the Territory of Utah) in Morrison v. Carey-Lombard Co., 33 P. 238 (Utah 1893), found the intent of these provisions was to augment, and not abridge, the rights of the laborer. The Morrison court explained,
It is evident from a deliberate consideration of the whole act that the legislature intended to have the lien of subcontractors attach on the date of their commencing to do work or to furnish materials. The owner must be presumed to observe the presence of the subcontractors and others on his property when they commence to labor or to furnish materials.
Id. at 241. Utah case law has consistently recognized the priority for a mechanics’ lien claim against property is determined under the relation-back test and recognizes few exceptions. See Calder Bros. Co. v. Anderson, 652 P.2d 922, 924 (Utah 1982) (finding work must have been performed in connection with what is essentially a single project performed under a common plan prosecuted with reasonable promptness and without material abandonment). As such, for any trust deed or mortgage to hold priority over any mechanics’ lien on the project the trust deed or mortgage had to be recorded on or before the commencement of the work. Any lender which recorded its lien after the date that observable work commences or deliveries commence runs the risk of having all construction liens for unpaid work or materials holding priority over the lender’s lien.
The foregoing describes why construction lenders require the assurance of a first lien position under their title policy. As noted above, until recently the title industry met the requirement of construction lenders for first lien coverage, even on projects with broken lien priority. However, the practice of insuring lenders a first lien when there is broken lien priority potentially opens the insurer to significant liability. It encourages developers and contractors to start construction prior to the construction financing being in place and the lender’s lien recorded and can be a risky practice. Reacting to their severe losses, the industry as a whole sought legislative assistance from the 2011 legislature and stopped the practice of insuring over broken lien priority. See ALTA Statement for the year 2010, Schedule T-Exhibit of Premiums Written, http://www.alta.org/industry/financial.cfm (stating that direct losses and allocated loss adjustment expenses incurred by title companies in 2010 were $1,074,415,616 or .107% of the premiums earned).
Representative Clark states
the title industry from Washington County and UTLA requested a revision of the mechanics’ lien laws for many reasons, but the three most prevalent reasons were: first, the title industry was hemorrhaging uncontrollably due to the economic downturn compounded by mechanics’ liens claims and lawsuits; second, the application of mechanics’ lien laws could not be practically applied to the commencement of work standard; and third, national title companies modified their coverage on broken priority lien coverage.
Telephone Interview with David R. Clark, Member of Utah House of Representatives (July 15, 2011). As the 2011 legislature sought to address the requested revisions to the lien laws surrounding broken lien priority, the relation-back test and commencement of work provisions, which have been Utah law since 1890 when the first version of the mechanics’ lien law passed in Session Laws 1890, p. 25, c. 30, § 19, they recognized that HB 260 would be the biggest change in Utah lien laws in 121 years.
One of the many benefits of HB 260 was the decision of the drafters to use the Registry to create a bright line test. In 2004, House Bill 136 was passed and put into law. It modified the mechanics’ lien statute by requiring the development of a standardized-statewide system for the filing of notices and created an online bulletin board providing an electronic registry for providers of goods and services to a construction project. See http://scr.utah.gov . The Registry provided the 2011 legislature with an alternative means for lien priority to be established without reliance on the “commencement of construction” test. The legislature used the Registry to give notice of all work on a project through the tax identification number of the property, set the date lien rights arise, and establish the procedure for all lien claimants to file and create their right to file a mechanics’ lien. In this process, HB 260’s revisions made the Registry an essential tool, tried to make it more efficient and productive, made the Registry the only means for the claimant to obtain a lien for work done, and made the Registry the means by which the First Preliminary Notice is filed and set the date by which all subsequent lien claims relate back for priority to the First Preliminary Notice by filing. The Registry became the exclusive system for filing and managing notices (preliminary for private projects and notices of commencement for public projects) and set a bright-line-filing date in an automated manner for the priority of all mechanics’ lien claims. As Representative Clark correctly notes, “now every entity involved in the construction project can file its notice using a common link to tie all lien claims to the project, i.e., tax serial numbers that are universally used by the title industry and mechanics’ lien claimants to properly lien or locate a lien on a property.” Telephone Interview with David R. Clark, Member of Utah House of Representatives (July 15, 2011).
In the opinion of the authors, the two most important changes coming out of HB 260 are (1) the complete rejection of the “commencement of work” test as the standard for determining mechanic lien priority and the date to which all future lien claims relate back and (2) the ability of the construction lender to cure broken lien priority by obtaining the first-lien position (in effect permitting the lender to buy its way to the front of the line) when the superior lien claimants voluntarily accept payment in full for their lien claims and file a withdrawal of their respective claim in the manner required.
With respect to the rejection of the commencement of work standard, the change creates a bright line test for lien commencement and removes the vagueness surrounding the commencement of work test. The commencement of work standard was from its inception an attempt to create equity at the expense of certainty and clarity. Absent full mobilization of work crews and active work on the site, it was almost impossible for the lender or the title insurer to determine if work had commenced or materials delivered to the site, particularly if an owner or contractor intentionally sought to conceal the commencement of work on a site with no vertical improvements. Under Utah Code Section 14-1-20 as revised by HB 260, any person furnishing labor or services, equipment, or material for which a payment bond claim may be made “shall provide a preliminary notice to the designated agent as prescribed by Section 38-1-32.5, Utah Code Ann.” In addition, Utah Code Section 38-1-32.5 further provides that a person performing work on a private project shall file a preliminary notice with the Registry by the later of twenty days after commencing work or after the filing of a notice of commencement if the work commences prior to the filing of the first notice of commencement, which is effective as to all labor, service, equipment, and material furnished to the project. If the preliminary notice is not filed within the period specified then the claimant is precluded under Utah Code Section 38-1-32.5(5) from maintaining any claim before five days after the late filing of the preliminary notice. Moreover, Utah Code Section 14-1-20(2) specifies that no person who fails to file the preliminary notice within the required period may make a payment bond claim. Filing in the Registry in this manner creates a clear electronic record and date which is a bright line as to when the lien claim arises.
As basic as the foregoing change is from the prior procedure, it is amazing that almost no one objected after it was agreed to (a) use the Registry as the filing procedure to establish the lien date and (b) use the tax identification parcel number to act as the universal number and identification procedure to specify the property on which work is performed and each mechanic lien is claimed. These procedures enable both the claimants and the title industry to identify the property in the same way with the tax identification number and permits the title industry to search and identify all the lien claimants.
In contrast to the use of the Registry being the most practical result of HB 260, the real innovation and genius of the Act is the right under Utah Code Section 38-1-32(8) to fix the problems under broken lien priority. Utah Code Section 38-1-32(8)(a) permits the construction lien claimant to withdraw and re-file its preliminary notice; and, for the construction lender to buy its way to the front of the line and overcome the historical nightmare of broken-lien priority. Representative Clark expressly notes “a lot of the credit for the innovative change comes from the construction industry that suggested this change and played a central part in drafting the language.” Telephone Interview with David R. Clark, Member of Utah House of Representatives (July 15, 2011). This compromise under HB 260 allows the statute to work for both the lien claimant and the construction lender. However, the compromise was a surprise and unexpected because all prior proposals to allow the construction lender to buy the mechanic lien claimants’ position or to move to the front of the line had repeatedly been rejected by the construction lobby. Interestingly, as part of the compromise, HB 260 keeps the prior relation-back concept that all mechanic liens relate back to the first mechanic-lien claim; but in lieu of relating back to the first date work commenced, it relates back to the date the first preliminary notice for work was filed in the Registry. Utah Code Section 38-1-5(2) provides that a lien under this chapter relates back to and takes effect as of the first preliminary notice filing.
In the negotiations of HB 260 no contractor, supplier, or materialman would give up the existing seniority of any construction lien claim which predates the recording of the lender’s lien, even though the title insurance industry was refusing to insure broken lien priority, and construction lenders would not fund projects where the lender’s lien was not the insured first lien. In this regard, however, all parties reached an amazing compromise, i.e., Utah Code Section 38-1-36(3)(b), whereby the construction lender can in effect buy the first lien position by the lien claimants’ accepting payment in full of their lien claims and withdrawing their filed preliminary notices. A claimant who (1) files a preliminary notice in accordance with Utah Code Section 38-1-32, (2) accepts payment in full for labor, service, equipment, and material furnished prior to the recording of the construction lender’s lien, and (3) withdraws the claimant’s preliminary notice by filing a notice of withdrawal under Utah Code Section 38-1-32(8), theoretically retains control of the process and is not required to remove its lien claim. However, acceptance of the payment and withdrawal of the lien claimant’s preliminary notice effectively allows the construction lender to cancel their lien claims and obtain a first lien on the property. See Utah Code Ann. § 38-1-5(3)(b) (Supp. 2010). This result occurs because upon a lien claimant’s withdrawal of its preliminary notice, any future preliminary notice claimant cannot relate back to the date of the withdrawn lien. See id. § 38-1-5(a).
Perhaps the material difference between the initial positions under HB 260 that were repeatedly rejected and the final accepted compromise is that under the approved compromise the lien claimant’s withdrawal of the preliminary notice requires (1) all preliminary notice claims filed prior to the recording of the construction lender’s lien to be paid in full in order to permit the construction lender to get to the front of the line and (2) the voluntary consent of the lien claimant to accept the payment and file the withdrawal. While, as noted, this process leaves the lien claimant in control (not the lender), in effect, lenders can now determine the total amount of the lien claims and the number and identity of the claimants (something that was quite impossible under the old statute). Also, the construction lender never before could know how many liens and future potential claims were senior in right and time and relate back to the commencement of work; but with the clear line imposed by the Registry and the filing of the preliminary notices that is no longer the case and all parties know the risks and costs, and have the means at hand to resolve the broken-lien priority. The only open issue when the economics make sense is the lien claimants’ willingness to cooperate.
In the experience of the authors, the give and take of the legislative process is often not the best forum for innovation and practical workable solutions. However, in the case of HB 260, the process appears to have worked well and produced an ingenious and practical solution that protects the interests of the mechanics’ lien claimants and the construction lender. HB 260 allows both the lender and the mechanics’ lien claimant to assess the risk of any project and, if it makes sense, to cooperate with each other, to permit a project with broken lien priority to move forward and to correct the priority of the broken-construction lien.