Tag: priority

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.

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.