Particularly in declining real estate markets, the priority of construction liens can be tricky. Generally, contractors in private construction who improve a property are, by law, provided lien rights in that property. The contractor’s lien priority date is the date the contractor first performs work on the project regardless of when the lien is actually filed. Financial institutions, which provide project financing, are also provided security interests in the property generally in the form of a deed of trust (“DOT”). The priority date of the DOT is the date the DOT is filed. Thus, in most instances because the financing precedes construction, the lien rights of the contractors, subcontractors, and vendors who build the project are “behind the bank” (i.e., junior to the bank). Then, when real estate bubbles burst, the loan amount may exceed the value of the property, and there are inadequate funds to satisfy both the DOT and contractor liens. In such instances the bank can foreclose on its loan (the DOT) and, if the equity in the property at that point is insufficient to satisfy the bank’s DOT, the contractor liens, which are “junior” to the DOT, are simply wiped out. The contractors, subcontractors, and vendors who built the project lose.
This situation becomes interesting, however, when more parties are introduced. For example, when an architect (architect professional services are accorded lien rights similar to contractors) commences work after a bank finances a project, but then a second bank steps in and refinances the project. Although the first bank had priority initially, the second bank removes the first bank from the picture. At this point, if the owner of the property defaults on its loan and fails to pay the architect, there will likely be a battle to determine whether the lien or DOT reigns supreme. Generally, when a second bank refinances a project (e.g., when the owner takes on a new debt in substitute for a former debt), the second bank is allowed to take the lien priority position of the first bank. This legal doctrine is called “equitable subrogation.” The Oregon Court of Appeals, however, recently held that equitable subrogation does not apply when there is an intervening lien unless the new debtor (second bank) proves that it was ignorant of the intervening lien and that its ignorance was not a result of inexcusable negligence.
In SERA Architects, Inc. v. Klahowya Condo. LLC,[i] the developer of a failed property development, Klahowya Condominium, LLC (“Klahowya”), found itself in the middle of a priority dispute by two of its creditors. In March 2006, after purchasing the property with a loan from Triangle Holdings II, LLC (“Triangle”), Klahowya entered into a contract with SERA Architects, Inc. (“SERA”) to provide architectural services for the development, which SERA began in March 2006. In November 2006, Shorebank Pacific Corp. (“Shorebank”) provided Klahowya with a line of credit in the amount of $1,462,000 to repay the loan from Triangle and secured the loan by a DOT on the property.
Klahowya eventually stopped making payments to SERA and, in June 2007, SERA recorded a professional services claim of lien on the property for $375,598, plus interest. In October 2007, SERA sued Klahowya and Shorebank to foreclose on its construction lien, claiming that its right to interest in the development property was superior to Shorebank’s DOT. Shorebank answered the complaint and asserted several affirmative defenses, including priority under Oregon’s lien statute and “equitable subrogation.” The trial court held that Shorebank had priority over SERA’s lien and gave Shorebank priority.
The Oregon Court of Appeals, however, reversed and remanded, holding that Oregon’s lien statute gives SERA’s lien priority over Shorebank’s lien, and equitable subrogation did not apply to Shorebank’s lien.
In interpreting Oregon’s lien statute, the Court found that ORS 87.025(7) provides that an architect’s lien relates back to the date of the commencement of the improvement (i.e., when Klahowya’s contractor began performance). Here, Klahowya’s contractor began improvements on the project in July 2006. Therefore, although Shorebank recorded and modified its deed of trust before SERA filed its claim of lien, SERA had priority because the improvements commenced (July 2006) before Shorebank recorded its deed of trust in November 2006.[ii]
Shorebank argued that the doctrine of equitable subrogation should apply to its deed of trust. The bank contended it should be afforded the original priority (i.e., as if it were Triangle) because its loan was substituted for Triangle’s. The Court, however, stated that equitable subrogation would not apply unless Shorebank proved that it was ignorant of the existence of the intervening lien (i.e., SERA’s lien) and that its ignorance was not a result of inexcusable negligence.
The Court found that Shorebank should have known of SERA’s lien before recording its first deed of trust. For example, the bank attended a workshop hosted by SERA in April 2006, at which site preparation plans were discussed and a timeline assembled, and Shorebank’s loan negotiations also included discussions of SERA’s work that occurred after site preparation had begun. Thus, Shorebank should have been aware of SERA’s potential lien rights before it refinanced the project. To the extent Shorebank was ignorant as to SERA’s lien rights, the Court held that its ignorance was attributable to a misunderstanding of the law, which was inexcusable negligence. Merely being unaware of the lien law did not excuse Shorebank. Therefore, even though Shorebank’s loan was a substitute for Triangle’s loan, SERA’s lien had priority over Shorebank’s deed of trust because Shorebank failed to prove excusable ignorance.
Comment: The same logic applies to a construction contractor’s lien. Even though the Shorebank loan (second bank) was a substitute for the Triangle loan (first bank), the court indicated it would only apply equitable subrogation if the second bank (Shorebank) carried the burden of proof that it was unaware of the architect’s intervening lien and its ignorance was not the result of inexcusable negligence. Although Shorebank believed they had superior lien rights, its misunderstanding of the lien law was inexcusable.
[i] 253 Or. App. 348 (2012).
[ii] A construction lien’s priority date relates back to the first day work is performed irrespective of when it is filed.