By Thomas S. Babel, Ward and Smith, P.A.

Editor’s Note: Thomas S. Babel is a member of the Business, Litigation, Construction, and Intellectual Property Practice Groups at Ward and Smith, P.A. This is the second of two articles.

Last week, this article focused on the basics of the North Carolina laws giving contractors a "hidden lien" on real property which is causing havoc in the current economy in which many builders, property owners, and general contractors are unable to pay their debts.

An Example of a Contractor’s "Hidden Lien"

A developer of an office complex of ten lots ("Owner") owns a lot in the complex ("Lot 1") and contracts with a general contractor ("General Contractor") to construct a building on Lot 1. On Day One, the General Contractor moves its bulldozers onto Lot 1 and begins to clear it. On Day Ten, the General Contractor hires a plumber ("Subcontractor") to provide the plumbing for the building being constructed on Lot 1. For five months, the General Contractor works on the building and the Subcontractor installs the plumbing. Every 30 days, the General Contractor gets a "draw" from the Owner equal to 90% of the expenses incurred by the General Contractor for the preceding month, including the amount the General Contractor is to pay the Subcontractor, which may well be 90% of the amount due to the Subcontractor for that month. The 10% "held back" by the Owner from the total due to the General Contractor and the 10% "held back" by the General Contractor from the total due to the Subcontractor, are called "retainages," which are amounts withheld until the end of the project to provide an incentive for the General Contractor and the Subcontractor to do good and timely jobs.

On Day 150, the building is completed when the Subcontractor hooks the water and sewer lines for the building to the public facilities. The Subcontractor comes to the General Contractor for payment of what the Subcontractor is due for the last month of work on Lot 1 plus the 10% retainage that has been held back. In turn, the General Contractor goes to the Owner for payment of what the General Contractor is due for the last month of work on Lot 1 plus the 10% retainage that has been held back. However, the Owner says that money is a "little tight" this month, but not to worry; there is a buyer for the building on Lot 1 ("You") who is looking to close in 30 days, and the Owner will have plenty of money then.

Sure enough, 30 days later the Owner sells Lot 1 to You, and promptly uses the money to pay off debts the Owner has owed for a year on Lot 9. You are picking out drapes and assigning office space while the General Contractor is not getting return calls from the Owner.

You move into the new building on Lot 1 and all is wonderful. But three months later, on Day 270, a stranger appears at your door. The General Contractor, having been ignored by the Owner long enough, files its Claim of Lien on Real Property in the amount it is owed for the last month of construction and the 10% retainage held back. After consulting an attorney, You are stunned to learn that, in addition to what You paid for Lot 1 (and still owe on Lot 1), if You don’t come up with the amount of the Claim of Lien on Real Property, You may lose Lot 1 because the General Contractor’s lien "relates back" to Day One, long before You had any rights in the property!

In addition, since the Subcontractor has not been paid by the General Contractor for the Subcontractor’s work on Lot 1, the Subcontractor under certain circumstances can claim of lien on Lot 1 by subrogation. This means that the Subcontractor steps into the shoes of the General Contractor and can assert all of the General Contractor’s lien rights, including the ability, if available, to file a Claim of Lien Upon Real Property on Lot 1. However, if the owner has fully paid the General Contractor, then there are no lien rights to which the Subcontractor can be subrogated.

Furthermore, the Subcontractor also may have a lien on Lot 1 in its own right. When it did not receive payment from the General Contractor, the Subcontractor could, by service on the owner of a Claim of Lien Upon Funds, claim a lien against any funds still owed by the owner to the General Contractor. The Claim of Lien Upon Funds warned the owner to withhold from the General Contractor funds equal to the amount claimed. If, however, the owner fails to withhold funds and pays the General Contractor, the owner becomes personally liable to the Subcontractor for the amount the owner paid to the General Contractor, and the Subcontractor now can file its own Claim of Lien on Real Property on Lot 1.

Safeguarding Your New Property

There are steps you, as a buyer of recently improved property, can take to protect your interest in the property:

• Purchase Title Insurance. First, and most importantly, you should purchase an owner’s title insurance policy which insures you against any loss as a result of a subsequently filed Claim of Lien on Real Property by a contractor. Almost universally, if you obtain a loan to purchase the property, your lender is going to require you to pay for title insurance protecting the lender. While you may be benefited indirectly by the lender’s title insurance in that the lender may pay off any Claim of Lien on Real Property to protect the lender, you will have no right to enforce this indirect benefit. In North Carolina, it generally does not cost any additional money for you to get an owner’s title policy if there is a lender’s policy, and one should be obtained. Even if you do not have a lender demanding coverage, you should purchase an owner’s policy that includes coverage against a contractor’s "hidden lien."

• Lien Waivers or Releases. While in the "good ol’ days," buyers and title insurance companies were satisfied with lien affidavits from the seller and the General Contractor that the General Contractor and all Subcontractors had been paid, that is no longer a safe option. Title insurance companies, who have suffered considerable losses in the past couple of years due to Claims of Lien on Real Property, now demand lien waivers and releases or lien subordinations before they will insure against such Liens. A lien subordination may help the lender and the lender’s title insurance company, but only a waiver or release by the General Contractor will help you as the new owner. Since, in most circumstances, the rights of Subcontractors in a Claim of Lien on Real Property is by way of subrogation to the General Contractor’s Claim of Lien on Real Property, if the General Contractor "waives or releases" its Claim of Lien on Real Property, there is no longer a lien to which a subcontractor can be subrogated.
Alternatively, you can request, or require in your purchase contract with the seller, that if there has been construction on, or improvement to, the property within 120 days prior to closing, the General Contractor provide lien waivers or releases from each Subcontractor that provided labor or materials to the property. If there are only a few Subcontractors, this may be feasible. It there are many Subcontractors, it can get to be cumbersome and time-consuming to get waivers or releases from each.

• List of all Subcontractors. In addition to a lien waiver or release, you also should request, or require in your purchase contract with the seller, that the General Contractor provide a list of every Subcontractor (by trade, contract amount, and the date the work of each Subcontractor was completed) that provided work or materials to the property. You then can contact the Subcontractors before the closing to ensure that each was paid in full.

• Obtain Financial Information. You also can require in your purchase contract that you be provided with detailed financial information from the General Contractor to ensure its financial viability in case there is a post closing problem. Certification from the General Contractor’s primary lender or a credit check is suggested. However, because of volatility in the economy, this option does not provide very much security because the financial viability of a General Contractor can change day to day.

Conclusion

Buying property free of any title problems has become a riskier proposition in today’s economic climate because of the "hidden lien" contractors have on property improved by them. Therefore, new owners of real property should beware before purchasing property on which recent improvements have been made. The last thing you want is to find the "stranger at your door."

© 2009, Ward and Smith, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Thomas S. Babel practices in the Business, Litigation, Construction, and Intellectual Property Practice Groups, where he represents clients in all aspects of business and property disputes. Comments or questions may be sent to tsb@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.