Mechanics Lien Trumps Prior Mortgage in ‘Lien Strip’ Bankruptcy Dispute Involving Residential Property

Priority disputes happen a lot in mechanics’ lien litigation.  Typically, a mortgage lender claims that its first-filed mortgage trumps a later-filed mechanics lien.  The “trumps” part is activated if and when the property is sold and there aren’t enough proceeds to pay both the lender and contractor.  If the lender’s mortgage has priority, it gets first dibs on the sale proceeds, leaving the contractor with little or nothing.

Section 16 of the Mechanics’ Lien Act (770 ILCS 60/16) governs the lien priority issue.  This section provides that (i) prior lien claimants have lien priority up to the value of the land at the time of making of the construction contract; and (ii) mechanics’ lien claimants have a paramount lien to the value of all improvements made to the property after the construction contract is signed.

In re Thigpen, 2014 WL 1246116 examines the mortgage lender-versus-contractor priority question through the lens of a bankruptcy adversary case where the debtors attempt to strip away a mechanics’ lien recorded against their homeresidence.

The debtors filed for Chapter 13 bankruptcy protection and later filed an adversary proceeding to extinguish the lien a contractor recorded against the home. 

The debtors claimed that since there was a prior mortgage on the home and the home’s value had dropped to a sum less than the lien amount, the lien should be removed.

In bankruptcy parlance, this is called “lien stripping” and applies where a mechanics lien lacks collateral; usually because of plummeting property values. 

The contractor argued that its lien took priority to the value of the improvements/enhancements and moved for summary judgment.

Held: Contractor’s summary judgment motion granted.

Q: Why?

A: Applying Section 16 of the Act, the Court held that where proceeds of a property sale are insufficient to pay competing lienholders, a mechanics’ lien claimant takes priority over a lender up to the value the contractor added to the property.

The Court wrote: “the Illinois Supreme Court has expressly recognized that Section 16 of the Act confers first priority, not something less, on mechanic’s lien holders, and that they trump pre-existing mortgages to the extent of the value of the improvements.”  (*2).

While the court found that the contractor’s lien trumped the prior mortgage, the Court did not decide the specific monetary amount of the improvements relative to the home’s value. 

The holding is still significant because now the contractor has a secured claim (as opposed to an unsecured one) against the debtors’ estate which must be paid over the life of the Chapter 13 plan. 

If the debtors default, the contractor can liquidate the collateral –  by forcing a sale of the home – and get paid via the proceeds.  An unsecured creditor, by contrast, has no assets securing its claim.  It must hope that the debtors have unattached assets (e.g. paycheck, bank accounts, accounts receivable) with which to pay the debt.  (Good luck with that!)

Take-away: A big win for the contractor.  Instead of having an unsecured claim (with no collateral tied to the claim), its mechanics’ lien claim is secured.  This means the contractor’s lien attaches to the debtors’ house. 

If the debtor defaults under the plan, the contractor can foreclose its lien and force a sale of the home and take priority to the sale proceeds up to the amount of the improvements (here, about $200,000).  

The case’s unanswered question is how does the contractor prove the dollar amount of his improvements?  The contractor will likely have to produce expert witness testimony or documents to establish the dollar value of the contractor’s time, labor and materials  furnished to the debtors’ home.

Illinois Guaranty Law: Increasing Guarantor’ Risk or Changing the Terms = Discharged Guaranty

In Southern Wine and Spirits of Illinois, Inc. v. Steiner, 2014 IL App (1st) 123435, the First District outlined and applied the rules governing the interpretation and enforcement of written guaranty agreements in Illinois.

The plaintiff wine distributor purchased the assets of another distributor that had previously entered into a contract with a liquor store company; a contract personally guaranteed by the individual liquor store owners.

The year after the asset purchase, the plaintiff began supplying wine to the defendants’ liquor store on account.  But neither the plaintiff nor the purchased distributor informed the guarantors of the asset purchase.  Because of this, the guarantors had no idea that the assets of the distributor were sold to the plaintiff.  The defendants also didn’t know that the plaintiff now held the guaranty given by the liquor store owners to purchased distributor.

When the liquor store defaulted on about $20,000 worth of merchandise, the plaintiff sued under the guaranty signed by the liquor store owners.

The defendants moved to dismiss on the basis that the personal guaranty wasn’t assignable to the plaintiff since defendants didn’t know they were guaranteeing the liquor store’s contract obligations to the plaintiff.  The trial court agreed and plaintiff appealed.

Result: Trial court affirmed.

Rules/Reasoning:

In Illinois, a guaranty is simply a contract where a guarantor promises to pay the debts of a “principal” (the main debtor) to a third party creditor.

A guaranty is construed like any other contract and a guarantor is given the benefit of any doubts that may arise from the language of a guaranty.  A guarantor’s liability can’t exceed the scope of what he has agreed to accept and guaranties are strictly construed in favor of the guarantor; especially when the creditor drafted the guaranty.  ¶ 16. 

Guaranty agreements are generally not assignable but a guaranty can be assigned where the essentials of the original contract are not changed and the performance required under the guaranty isn’t materially different from what was originally contemplated. 

Where (1) a guarantor’s risk is increased or (2) performance is materially changed by the assignment of a guaranty or a merger involving the plaintiff-creditor, the guarantor’s obligations can be discharged. ( ¶ 18).

The Court held that because the defendants didn’t know that the guaranty was assigned to the plaintiff and because the amount owed the plaintiff fluctuated from month-to-month (in contrast to the  fixed amount the guarantors owed the original distributor), the defendants’ risk under the guaranty was materially increased by the assignment to plaintiff.

This was deemed a material change in the terms of the agreement that defendants entered into with plaintiff’s predecessor and changed defendants’ risk from known to completely unknown.  (¶¶ 21-22).

The Court also held that the trial court properly struck key parts of the plaintiff’s affidavit filed in response to defendants’ motion to dismiss.

The plaintiff filed the affidavit of its credit manager who testified that she reviewed the payment history involving the purchased distributor and the guarantors’ liquor store business.  The credit manager attached about two years’ worth of invoices and a payment ledger to her affidavit.

But the invoices didn’t  reference the prior wine distributor and only identified the guarantors’ liquor store.  The Court found that because the affidavit attachments failed to link the plaintiff directly to either the guarantor defendants or their liquor business, the plaintiff failed to lay an adequate foundation for the invoices as business records.

Take-aways:

– A guaranty agreement should specify whether or not it’s assignable and enforceable by third parties;

– Where a guaranty is assigned to a third party, the original creditor and assignee should both notify the guarantor and make it clear that the assignee creditor plans to hold the guarantor to the terms of the guaranty;

– Where an assigned or sold guaranty either changes the guarantor’s performance or materially increases his risk, for example by increasing the payment terms or frequency, the guaranty will likely not be enforceable by a third party/assignee.

Commercial Frustration and the Impossibility Defense: The Case of the Missing Bentley

Illinois agency rules, consumer fraud law and the commercial frustration doctrine are the focal points of Tahir v. DMI, 2014 WL 985351 (N.D. Ill. 2014), a case involving the purchase of an undelivered Bentley.

The plaintiff sued multiple car dealer defendants for breach of contract and consumer fraud after he paid over $100,000 for a car he never received.  The companies and individuals involved in the sale of the car operated a complex web of interconnected business entities that made it difficult to properly identify the selling defendants. 

The defendants all moved for summary judgment.

Result: Judgment for plaintiff on breach of contract claim against the dealership; Judgment for management company on plaintiff’s consumer fraud count.  

Basis/Reasoning:

The Court found for the plaintiff on its breach of contract claim versus the dealership based on Illinois agency principles governing liability to third parties. 

The test for agency is whether the principal can control the manner and method of the agent’s work such that the agent can affect the principal’s legal relationship.  (*5). 

Where a principal’s identity is disclosed to a third party, the disclosed principal is liable to the third party for a breach of contract while the agent is not.

Where an agent enters into a contract for an undisclosed principal, the agent is personally liable on the contract. 

Where a plaintiff gets a money judgment against an agent and an undisclosed principal, the plaintiff must choose which party to take the judgment against. (*5-6).

Here, both undisclosed and disclosed principal rules applied.  The dealership was managed by another entity under a written management agreement.  That agreement was cryptic concerning each parties’ duties in relation to the other. 

Based on the agreement’s wording, it was equally plausible that the car dealer controlled the manager and vice versa.

Because of this uncertainty, the Court found the dealer was liable under the car purchase contract as either a disclosed principal of the manager or as an agent for an undisclosed principal – also the manager.  Either way, plaintiff stated a breach of contract claim against the dealer. (*5).

The Court rejected the dealer defendant’s impossibility and commercial frustration defenses that blamed another dealer for not delivering the car. 

The impossibility defense applies where the (1) the impossibility was not and could not have been anticipated by the contracting parties, (2) the party claiming impossibility didn’t contribute to it, and (3) exhausted all possible alternatives to permit performance. 

Commercial frustration applies where (1) the frustrating  event wasn’t foreseeable and (2) the value of performance has been practically destroyed by the frustrating event.  (*6).  

Rejecting the defenses, the Court found that the manager’s default under the management agreement was clearly foreseeable as the agreement specified respective default and remedy provisions. 

The dealership also failed to show it exhausted all attempts at performance, such as by buying the car itself. The dealership offered no evidence that it lacked the resources to buy and deliver the car to the plaintiff. (*6).

The Court ruled against plaintiff on its consumer fraud claim against the manager.  An Illinois consumer fraud plaintiff must show (1) a deceptive act or practice, (2) defendant’s intent that the plaintiff rely on the deception, and (3) occurrence of the deception in trade or commerce.  (*8). 

The Court found that the plaintiff failed to demonstrate a deceptive act by the manager such as its intent to take plaintiff’s money without delivering the car.  At most, the Court ruled, the plaintiff alleged a breach of contract claim; not consumer fraud.  (*8).

Take-aways:

Many businesses operate through a byzantine web of corporate parents, subsidiaries, holding companies, trade names and “d/b/a”s (doing business as).  The plaintiff wisely named all possible entity permutations as defendants and let them sort out the responsible parties through motion practice.

The case also shows how difficult it is to prevail on an impossibility or commercial frustration defense – especially where the parties are sophisticated commercial entities.