Public-private partnership development projects, sometimes referred to as P3 projects, present some unique and somewhat unresolved issues on the relative claims and priorities of the construction mortgage lien and the liens of mechanics and materialmen who provide labor and materials to the project. As an example, First American Title Insurance Company recently was asked to insure the lender’s lien priority on a public-private project in New Mexico. The private developer was responsible for financing and building the project, located on land subject to a long-term ground lease with the public landowner. At issue were whether mechanic’s and materialman’s liens could attach to the project (or interests in the project), given that the land is publicly owned, and the liens’ relative priority vis-à-vis the construction mortgage securing the loan made to a private developer.
The law in this area is unsettled across the country. To the extent that these issues have been specifically addressed in some states, the result is not uniform. New Mexico law did not provide a definitive answer, but the title insurer ultimately came to a successful resolution with the developer-borrower.
P3 Partnerships in General
A public-private partnership describes a variety of different legal structures whereby a governmental entity and a private business interest invest together to develop an essentially public project or improvement, such as an airport, prison, government office building, toll road, high-speed railway, water facility, or sewer facility. There is no single model for how these projects are structured. The project’s financial and operational risk is allocated between the public entity and the private entity under the terms of their agreement. Structures may include both private and public financing and may include government contributions such as land or tax incentives.
Purely private projects and purely public projects have their own set of fairly clear rules controlling liens and how contractors get paid. Because P3 projects may contain elements of both a private and a public project, the applicable rules for attachment of liens and lien priority become muddy and to a large extent are not specifically addressed by current state laws. To understand and analyze the issues, one has to ascertain whether the project is private, public, or a combination of both, and understand how that characterization affects the ability of contractors (including subcontractors) to secure payment for their services and goods provided to the project. From the construction lender’s perspective, how do the lender and its title insurer try to establish the priority of the construction mortgage lien?
Let us first examine the basics of mechanic’s liens and similar rights on purely private or public projects.
Private Projects: Mechanic’s Liens
A mechanic’s lien is a security interest that attaches to the title to property for the benefit of those who have supplied labor or materials that improve the property. Other names for this type of lien include construction lien, materialman’s lien, supplier’s lien (when referring to those supplying materials), laborer’s lien (when referring to those supplying labor), and a design professional’s lien (when referring to architects or designers who contribute to a work of improvement). This article uses the term mechanic’s lien to encompass all of these types of liens.
Mechanic’s liens are purely creatures of state law. Generally, they are statutory, although in California and in Texas they have a state constitutional basis. Because they are state-law based, the process and priorities of mechanic’s liens vary widely from state to state. These statutes reflect a public policy to protect contractors and those who provide goods and services to contractors.
Most statutes create a specific and formalized process that must be followed precisely for the lien to attach to the real property and for the lienholder to enforce the lien. Because the lien attaches to the real property interests, the lien can encumber property of a person not contractually obligated to pay the obligation from which the lien arises (such as the buyer whose property becomes subject to a lien arising from the seller’s failure to pay for pre-closing repairs). The lien claimant’s ultimate remedy is the right to foreclose the lien, but because the mechanic’s lien is subject to any senior security interests, foreclosure of the mechanic’s lien may not be a particularly useful remedy. As a practical matter, most lien claimants are paid in a transaction in which a title company insures a loan because the lender will attempt to ensure that all known actual or potential lien claimants are paid.
Key issues in mechanic’s lien laws include who has the right to claim the lien (only the persons specifically enumerated in the statute), what type of work is covered (usually the work has to improve the property), how, where, and when the lien must be filed (with the public recorder within a relatively short time after labor or materials are provided to the project or on completion of the project), what type of notice must be given by the claimant and to whom (written notice to the owner), and what the process of enforcement is (commencement of a foreclosure action within the specified statutory time).
As between recorded mechanic’s liens and recorded construction loan mortgages, in most states the first one recorded may not have the priority right because of “broken priority.” Under some state laws, broken priority occurs when construction commences before recordation of the construction mortgage. This means that all providers of labor and materials to the construction project can claim lien priority to the date of commencement of construction, in effect putting the construction mortgage at the end of the priority line. Because construction mortgage lenders require that title companies insure the priority of the mortgage over mechanic’s liens, broken priority issues pose a large risk for title companies. Accordingly, title companies are especially careful when insuring construction loans to try to make sure that there is no broken priority. If there is broken priority, the title insurance company may choose not to insure the lien of the mortgage against unrecorded mechanic’s liens, or it may choose to insure only on satisfaction of underwriting conditions (such as indemnities from the borrower and the general contractor) and on the payment of extra hazard premiums.
Public Projects: Payment and Performance Bonds
Mechanic’s liens generally cannot attach to government-owned or publicly owned real property because of the government’s sovereign immunity. As such, the mechanic’s lien remedy is generally not available to contractors and materials suppliers working on projects located on publicly owned land. In the public realm, both federal and state law require prime contractors on certain government construction contracts to post both performance and payment bonds for the benefit of those providing labor or materials to the public project.
A performance bond is issued by a surety company, and it is designed to cover the government’s (owner’s) cost of obtaining substitute performance of the original contractor’s contract. The underwriting necessary to the bonding process helps ensure that only responsible contractors can get bonded, and the surety’s right of indemnification against the original bonded contractor helps deter nonperformance of the contract. A payment bond is issued by a surety company to insure the payment of subcontractors and materials suppliers.
Federal projects are subject to the Miller Act, Pub. L. No. 74-321, ch. 642, §§ 1−3, 49 Stat. 793, 794, codified as amended at 40 U.S.C. §§ 3131–3134 (formerly 40 U.S.C. §§ 270a–270d). The Miller Act generally applies to federal contracts in excess of $150,000. The contractor must post a performance bond in an amount deemed adequate by the federal contracting officer and a payment bond generally equal to the amounts payable under the contract. Then an unpaid subcontractor or materials supplier who has not been paid within 90 days after the day on which he last furnished labor or materials can bring a civil action on the payment bond against the surety within the one-year limitations period. There are special rules for those who only have a direct contractual relationship with a subcontractor, and the right to pursue a claim on bond can be waived in writing and after the labor or material is supplied.
All states have what are called “Little Miller Acts.” See Little Miller Act Statutes, Zlien (last visited Apr. 8, 2013), www.zlien.com/miller-acts/ (providing links to statutes of all 50 states). These state statutes essentially mimic the federal Miller Act and apply to state-funded construction contracts. Each Little Miller Act has its own particular requirements, but conceptually they operate much like the federal Miller Act.
How do these two different schemes interact in the public-private project arena? Because P3 projects may involve a combination of private financing, private contracting, and private property interests on which a mechanic’s lien might attach, it is necessary to evaluate the enabling legislation, financing, contracts, and property rights to determine whether there is a private real property interest subject to a mechanic’s lien. If a mechanic’s lien can attach, then the general rules of priority under the private project regime will apply, and the lien priorities will be evaluated as if the deal were purely a private project. If the mechanic’s lien cannot attach, then the priority of the mortgage lien is not affected by any claims of the mechanics and materialmen, and such contractors and suppliers are limited to their remedies against the payment bonds and not against the insured property itself.
Case Studies of P3 Projects
The following examples from several states demonstrate the variability of results for P3 projects. In California, the courts have analyzed the precise property interests that were subjected to lien claims to determine whether a lien could attach. In North Bay Constr., Inc. v. City of Petaluma, 49 Cal. Rptr. 3d 455 (Ct. App. 2006), the city leased public land to a developer for the purpose of constructing a sports complex. The developer entered into a construction contract. When the contractor was not fully paid, it sought to enforce a mechanic’s lien against the city’s land. The trial court sustained a demurrer by the city on grounds that a mechanic’s lien cannot be enforced against public property. The court of appeal affirmed.
Whether the contractor could enforce a lien against the developer’s leasehold interest was not before the court in North Bay but arose four years later in South Bay Expressway v. Otay River Constructors, 434 B.R. 589 (Bankr. S.D. Cal. 2010). South Bay involved a toll road project in which the California Department of Transportation (Caltrans) issued a franchise agreement to a private developer to construct a toll road and granted the developer a 35-year lease to collect tolls and operate the public road. In turn, the developer entered into private contracts with a general contractor to design and build the improvements. After the general contractor completed the project, it recorded mechanic’s liens on the developer’s leasehold interest in the toll road, but did not seek to lien public property. The general contractor then filed an action to foreclose the liens. Meanwhile, the developer filed bankruptcy and asserted the liens were invalid because they were placed on public property.
The bankruptcy court found that the mechanic’s liens could attach to the private leasehold and franchise interests of the developer. In doing so, the court examined the enabling legislation and found that the toll road would be constructed by a private entity, but owned by the state. After examining the Caltrans franchise and lease agreements, the court found that the developer held a “private interest” in public property in the form of a long-term possessory interest in the leasehold and a franchise right to collect tolls. Caltrans granted the developer a right to privately develop and finance the construction of the toll road, and Caltrans did not directly contract with the general contractor for construction of the improvement. The court held that the toll road was a private work and that mechanic’s liens could attach to the developer’s distinct private property interests in the toll road, despite the fact that the toll road was owned in fee by Caltrans.
A New York court took the opposite approach when considering whether a lien could attach to a leasehold of public land. In In re Paerdegat Boat & Racquet Club, Inc., 443 N.E.2d 477 (N.Y. 1982) , the court concluded that, because a mechanic’s lien could not attach to city-owned real property or to improvements constructed thereon, the private owner’s leasehold interest in the city-owned land was also similarly exempt. Subsequently, however, New York Lien Law § 2(7) was amended in 1992 to allow certain liens against public property used for private purposes.
At least one state has tried to address this issue by statute. Effective July 1, 2012, Oklahoma’s Little Miller Act was amended to apply to private construction projects performed on public land. The amendment requires the furnishing of a bond for any “contract exceeding Fifty Thousand Dollars ($50,000.00) for construction or repair of a public or private building, structure, or improvement on public real property. . . .” Okla. Stat. tit. 61, § 1(A) (2012) (emphasis added).
This brings the discussion back to First American’s original problem on the New Mexico transaction in question. The construction lender was taking a mortgage on the leasehold interest and there was an issue of broken lien priority. In evaluating the potential risk associated with the broken priority, First American determined that the mechanic’s liens could attach to the developer’s leasehold interest in the publicly owned land and could therefore trump the priority of the construction mortgage that was being insured. The private developer took the position that the mechanic’s liens could not attach to the leasehold because the underlying land was public.
Under New Mexico law it is clear that a mechanic’s lien can attach to a lessee’s leasehold interest. In Furr’s Supermarkets, Inc. v. Richardson & Richardson, Inc., 315 B.R. 776 (D.N.M. 2004), the bankruptcy court analyzed certain 1991 amendments to the real property laws that specifically provided that leaseholds were “real estate.” After examining the purposes of the state’s mechanic’s lien laws, the bankruptcy court concluded that a leasehold interest in private real property was itself real estate to which a mechanic’s lien could attach.
This case, however, did not specifically address the question of whether a leasehold interest in public property would constitute real estate for purposes of the mechanic’s lien laws. Unlike Oklahoma, New Mexico’s Little Miller Act, N.M. Stat. Ann. § 13-4-18, does not contemplate public-private projects. Because First American was being asked to insure the lien priority of the leasehold mortgage, which in and of itself was premised on the view that the mortgage lien would attach to the leasehold interest, First American did not accept the developer’s argument that the mechanic’s liens would not attach to the leasehold interest. As such, First American required the developer-borrower to satisfy certain requirements to provide the requested title coverage for the lender.
For a comprehensive review of this and related issues, please see the excellent work of Scott Wolfe Jr., on his blog, www.zlien.com.
Ultimately, there is no one solution to the issues presented by P3 partnerships, and most states have not even addressed them. Like so many things, the answer will depend on the applicable state’s laws. Fundamentally, one has to understand the nature of the interest against which the mechanic’s or materialman’s lien may attach. If it is considered a private property interest, then the lien will attach, and lien priority and title insurance coverages will be evaluated as in any other private project. If it is considered a public property interest, the liens will not attach, and the materials and labor suppliers will rely on the payment bonds.