Mechanic’s Lien Process
The basic aim of the lien process is straightforward. To provide a form of security for the payment of money owed to persons such as contractors, subcontractors, workers and material suppliers who add value to a building that is under construction.
In providing this security, the lien process is sensitive to the need to accommodate the legitimate interests of the owner/developer, the construction lender and other participants in the project.
The lien process also aims to encourage the prompt payment of creditors throughout the project and ensure that money intended to finance the construction is, in fact, used for that purpose.
In 35 of the 50 states the mechanic’s lien process is a three step practice. The remaining 15 states and Washington D.C are “direct to lien” or two step states. Canada is a direct to lien country. In the 35 states where statutorily Notices or Owner (NTO) are required this first step is a prerequisite to taking subsequent steps, lien/bond claim, and foreclosure/suit against bond.
The fist step, the NTO, is designed to protect owners. The NTO, is created as an identifying process designed to protect the owner from double jeopardy. The theory is all down steam subcontractors and supplier identify themselves to the owner. The owner then has its check and balances, NTO’s and waivers of lien, to protect it self from paying twice.
The second and third steps were created for subcontractors and suppliers as reactive steps in the event they are unpaid.
The Anatomy of a Construction Project
To understand how the Mechanic’s Lien statutes operate it is necessary to understand the legal and economic environment that surrounds a major construction project.
Typically, large numbers of persons will contribute to the project and their relationships are defined by the "chains" of contracts that link them together. Pictorially, these relationships resemble a pyramid like the one set out in “The Pyamid”. This is sometimes referred to as "the construction pyramid" or "the ladder of supply".
At the top of the pyramid is the owner/developer along with the construction lender who provides financing for the project. At the next level down are persons engaged directly by the owner. This may include architects, engineers and the prime/general contractor. Further down, the pyramid broadens out with one or more layers of subcontractors and sub-subcontractors. Any of these persons may purchase building materials and hire workers in performing their part in the construction.
The various participants in the project are linked by chains of contract relationships that reach from the top of the pyramid to the bottom. The lien statues often use the word "engage" to indicate that two or more parties are in the same contract chain. One person is "engaged by" another when they contract directly with each other. When a person is "engaged under" another this means that they either have contracted directly or are linked through one or more intermediate parties. Sometimes, for greater certainty, the statutes use the expression "engaged by or under."
Apart from most lien statutes, two persons in the pyramid have legal rights against each other only when one of them is "engaged by" the other. They must have a direct contract relationship.
The Flow of Money and Credit
In the construction pyramid money flows from the top to the bottom. On a major project, the owner will normally finance it by borrowing from an outside lender whose interest is secured by a mortgage over the project. Typically, the mortgage money is advanced in stages (known as a "mortgage draw" or "progress payment"). These stages correspond with the various stages of completion of the project.
The mortgage draw is usually timed to coincide with the point at which the general contract entitles the contractor to receive a progress payment from the owner for the most recent work performed. On receiving a progress payment the prime/general contractor will use some or all of the payment to pay its workers, suppliers and subcontractors. The subcontractors will, in turn, pay the persons they have engaged. Thus, money flows from the top of the pyramid to the bottom.
In contrast, credit is extended from the bottom of the pyramid toward the top. It is an important characteristic of construction financing that payment is normally made only after work that it pays for has been performed. This applies at all levels of the pyramid.
The flow of money down the pyramid from the top to satisfy the credit extended at the bottom is the lifeblood of a construction project. Anything that stops or slows that flow or allows money to escape from the pyramid can have serious consequences for those at the bottom.
A basic aim of lien legislation is to provide a form of security for persons involved in a construction project. These persons may be directly engaged by the owner, such as the prime/general contractor, or they may be workers, subcontractors, and material suppliers who are not engaged directly by the owner.
The most primitive way of providing security is simply to give these persons a lien over the building under construction. This was the basic strategy of most state legislation for many years, but as the construction industry grew more complex it was seen to be flawed.
One problem was that construction projects were often fully mortgaged and, until it was almost complete, the owner had little equity in the project and a lien was of little value. Also, it was seen as unfair to make the owner's property liable for the payment of debts where the person actually in default was someone much lower in the pyramid over whom the owner had little or no control.
A result of introducing lien legislation was that a standard term came to be included in the general contract and in most subcontracts. The term was that the contractor or subcontractor promises the other party that the project would be kept "clear" of liens asserted by persons lower in the pyramid in the same branch of the chain of contracts.
A Single Retainage Scheme - Limiting the Owner's Liability
In response to the weaknesses of the "primitive" lien system, most state lien and prompt pay legislation was amended to require that the owner retain a certain percentage (usually 10 percent) of progress payments made to the prime contractor. The amount retained was known as the "retainage." Since only the owner was required to retain money, this came to be known as the "single retainage scheme." The owner's retainage also became an asset that was subject, in many states, to lien claims and it provided additional tangible security for their payment.
The single retainage scheme had an unintended result. The risk of financial loss associated with liens was transferred from the owner to the prime contractor. This occurred because the retainage, which is really the prime/general contractor's money, became in many states security for lien claims.
The reaction of contractors was to retain informal retainage from payments to their subcontractors so if it became necessary to clear liens claimed by persons lower in the pyramid, funds were available to do this. But if the contractor is to be fully protected these informal holdbacks must, in total, be much larger than the owner's holdback. This reflects the fact that the contractor's liability is not limited like the owner's in many states.