Mechanics’ Lien Enhancement Rule – Post-Cypress Creek

Section 16 of the mechanics lien statute (770 ILCS 60/17), which codifies the enhancement rule (please see prior post), was recently amended in the wake of 2011’s LaSalle National Bank v. Cypress Creek 1, LLP decision:

http://www.state.il.us/court/Opinions/SupremeCourt/2011/February/109954.pdf

In Cypress Creek, the Illinois Supreme Court severely diluted contractor’s lien rights by allowing a construction lender to trump contractors’ rights to sale proceeds.  The Court accomplished this by allowing the lender to take priority to the amount of property improvements it funded – even funds paid to contractors that didn’t record liens.  Essentially, as Justice Freeman said in his detailed dissent, the Court put lenders that fund property improvements on a par with contractor lien claimants and conferred lien creditor status on the lender by “judicial fiat”.  This resulted in the lender getting the lion’s share of sale proceeds while the contractors received only a  fraction of the monies. 

Another pro-lender, anti-contractor holding of the Cypress Creek was that lien claimants only took priority for the specific value of their individual improvements; as opposed to proportionally taking priority to the total value of all contractor improvements to the land. The result: banks and lenders were thrilled; contractors were furious.

After public outcry and warring legislative bills, the legislature passed H.B. 3636, and the bill was signed into law on February 11, 2013 as P.A. 97–1165.  It essentially reverses Cypress Creek and provides that a lender has priority only to the value of the land at the time of the owner-general prime contract and that lien claimants (contractors) take priority for the value of all improvements constructed after the prime contract (not just the specific improvements performed by an individual contractor).

770 ILCS 60/16 of the Act now reads:

When the proceeds of a sale are insufficient to satisfy the claims of both previous incumbrancers and lien creditors, the proceeds of the sale shall be distributed as follows: (i) any previous incumbrancers shall have a paramount lien in the portion of the proceeds attributable to the value of the land at the time of making of the contract for improvements; and (ii) any lien creditors shall have a paramount lien in the portion of the proceeds attributable to the value of all subsequent improvements made to the property.

 At this point it’s too early to tell what impact HB 3636 will have on construction lending and mechanics lien law in Illinois.  Stay tuned.

PBP

Illinois Contractor’s Lien Issues: The Enhancement Rule

The enhancement doctrine comes into play when liened property goes to foreclosure sale and the sale proceeds are insufficient to pay off both the lender and competing lien claimants. The lender, who often records its mortgage before the contractor’s lien attaches, will argue that its mortgage interest takes priority over the contractor’s lien and any property sale proceeds should go first to the lender. 

The contractor will counter that it’s unfair for his lien to get extinguished after he furnished valuable improvements to the property just because his lien happened to attach after the lender recorded its mortgage against the property.  Recall that in Illinois, the lien attaches on the date of the owner-general contractor contract and relates back to that prime contract date.

Enter the enhancement rule.  Codified at Section 16 of the Mechanics Lien Act, 770 ILCS 60/16, it allows a contractor whose lien attached after the mortgage was recorded to still take priority over the lender to the value of improvements furnished to the property.  The theory being that the contractor should be able to defeat or “prime” the prior mortgage in the amount the contractor improved or “enhanced” the value of the property.

To prove enhancement, a contractor must demonstrate that: (1) the work was authorized by the owner; (2) the contract price was reasonable; (3) he performed his obligations under the contract; and (4) the work constitutes a valuable and permanent improvement. Lyons Sav. v. Gash, 279 Ill.App.3d 742 (1st Dist. 1996); Erickson Brothers, Inc. v. Jenkins, 41 Ill.App.2d 180 (1963).

The question then arises as to how to prove enhancement.  Typically, the contractor will employ the market value approach.  This usually requires the contractor to provide expert testimony and appraisals to show the “before and after” value of the property – by comparing the property value before the contractor’s improvements vs. the value after the liened improvements.

However, in Gash, the court held that the market value approach was not the proper method to prove enhancement and instead found that the contract price was the proper measure of enhancement.  The basis for this holding was that the amount of the contractor’s improvements was minuscule compared to the Property’s value. Gash, 279 Ill.App.3d at 747.

In Gash, the contractors’ liens totaled $78,411.55 and the property sold for over $4 million at foreclosure sale.  Because the market value theory of enhancement contained a 10% margin of error or variance, and because the property value far exceeded the lien claims, the court held that the market value theory was improper and instead the contract price was the correct gauge of enhancement. Id. at 745-47.

This is a significant holding for contractors because it dispenses with the time, expense and burden (evidential and time-wise) of hiring an expert to testify concerning before and after property values.

Going forward, if you represent a contractor whose lien attached after a mortgage was recorded on the property, it’s critical that you prove that your client enhanced the property’s value. 

Where the property value dwarfs the lien amount, the contract amount will be the presumed enhancement amount.  However, if it’s a closer call (there is not a huge gap between property value and lien amount), be prepared to hire an appraiser or similar opinion witness to testify concerning the value of the property before and after your client’s improvements.  Proving this amount will enable your client to trump a prior competing mortgage lien.

 

Illinois Mechanics Lien Basics

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The Statute: The Illinois Mechanics’ Lien Act, 770 ILCS 60/1 et seq.

Purpose: to provide a remedy to a contractor who provides valuable improvements to real estate by allowing him to lien the property (place a hold on the property to secure payment).

Once the lien is in place (or perfected), the lien clouds the property’s title and the contractor can sue to foreclose his lien and force a sale of the property.

Without this lien remedy, the contractor is at the mercy of the general contractor or owner.  If either runs out of money, the contractor gets nothing for his labor, materials, time and effort.

Cast of characters:

Owner = developer, person or entity that owns real estate

General Contractor (or Prime Contractor or Original Contractor or “GC”) = party that contracts with Owner

Subcontractor = party that contracts with General Contractor

Sub-subcontractor = party that contracts with Subcontractor

Lender (Mortgagee, Incumbrancer) = mortgage lender that funds construction activities on real estate

Notice and Timing Rules

General Contractor: “4 months/2 year rule”.  770 ILCS 60/7.  The GC must record lien within 4 months of last date of performance and must file suit to foreclose his mechanics’ lien within 2 years of last performance on the project.

Subcontractor: “90 days/4 months/2 years”.  770 ILCS 60/24.  The Subcontractor must serve notice to Owner within 90 days of last performance, must record its lien within 4 months of last performance, and must file suit to foreclose within 2 years of last performance.

Subcontractor on owner-occupied, single-family residential property: “60 days/90 days/4 months/2 years”.  770 ILCS 60/5.  A subcontractor on this type of property must serve notice on owner within 60 days of his commencement of work that he is a subcontractor on the property.  He then must serve notice on the owner of his intent to lien within 90 days of his last performance, record his lien in the Recorder’s offices within 4 months of last performance and file suit within 2 years of his last performance.

Venue (where to file): the lien is filed in the Recorder of Deeds for county where property is located (e.g. Chicago property = Cook County Recorder of Deeds; Waukegan property = Lake County Recorder of Deeds; Wheaton = DuPage County Recorder of Deeds).  770 ILCS 60/9.

Elements of a Mechanics Lien Claim (the Complaint):

A general contractor mechanic’s lien claimant must establish: (1) a valid contract; (2) with the owner of the property or someone authorized to contract on behalf of the owner; (3) for the furnishing of services or materials; and (4) performance of the contract or a valid excuse for non-performance.

A contractor can enforce a mechanic’s lien by proving that he substantially performed the contract in a workmanlike manner.

To perfect a mechanics lien, the subcontractor must serve the 90-day notice and record his lien within 4 months while  a general contractor must record his lien within 4 months of last performance.

A properly perfected lien will “relate back” and attach as of the date of the owner-general contractor prime contract.  This is important when the issue of priorities arises (e.g. when two liens are recorded against the same property, what takes priority?)

The general contractor does not have to serve a 90-day notice because he has contracted directly with the owner and so the owner presumably knows the general contractor’s identity.

Filing Suit to Foreclose the Lien

While recording the lien will certainly blemish the owner’s title and make it difficult to sell or refinance the property, to really go for the jugular, the contractor must file suit to foreclose his lien.  This sets in motion an eventual judicial sale of the property and provide sales proceeds from which to compensate the lien claimant.

To that end, a contractor suing to foreclose his lien must allege (a) a brief statement of the contract, (b) the date of the contract, (c) the date of last performance under the contract, (d) the amount unpaid, (e) a description of the premises, and (f) any other necessary facts.  770 ILCS 60/11(a).

The  contractor should name as defendants the owner, general, all other lien claimants and mortgage lenders on the property.  My experience is the vast majority of mechanics’ lien cases settle before trial.  However, the end-game is a foreclosure sale of the property with the court divvying up the sale proceeds among the various competing claimants (typically, the mortgage lender, general contractor, and at least one subcontractor).’

If You Didn’t Record the Lien On Time

If you fail to record a lien (such as in a situation where a client doesn’t tell you about its claim until more than 4 months have passed – it happens), you can still sue for breach of contract and alternatively for quantum meruit/unjust enrichment.  The limitations period for written contracts is 10 years (measured from the date of breach); for oral contracts, 4 years and for quantum meruit – 5 years.  Obviously, with these remedies, you run the risk of an insolvent or judgment-proof defendant.