Jeffrey C. Stone, Inc. v. Central & Monroe, L.L.C. (In re Mortgages Ltd.)

Citation: 482 B.R. 298Docket: Bankruptcy No. 2:08-bk-07465-RJH; Adversary No. 2:09-ap-00424-RJH

Court: United States Bankruptcy Court, D. Arizona; September 27, 2012; Us Bankruptcy; United States Bankruptcy Court

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The legal opinion addresses the priority of mechanics’ lien claimants in relation to a construction deed of trust recorded in May 2007. Mechanics’ lien claimants assert priority from the start of construction in October 2005. In contrast, the lender, Mortgages, Ltd., argues that a mechanics’ lien's priority is tied to the general contract for the work performed, citing the separate contracts doctrine. Additionally, Mortgages claims entitlement to equitable subrogation to a prior, paid-off deed of trust.

The background involves a construction project at Hotel Monroe, initially financed through a $3.2 million loan from First Commonwealth Mortgage Trust in May 2002. This loan was refinanced in July 2005 with an $8.5 million loan from Mortgages Ltd., which was secured by a deed of trust. A significant portion of this loan paid off the First Commonwealth debt. In December 2006, a new loan from Choice Bank for $9.3 million was secured by another deed of trust, with proceeds used to release the Mortgages Ltd. deed of trust.

Construction work began under a general contract with Contractors Abatement Services, Inc. (CASI) in October 2005, followed by a contract with KGM Builders, Inc. (KGM) in October 2006. KGM’s principal also served as the owner’s representative. As the project progressed, it became clear that a larger contractor, Jeffrey C. Stone, Inc. (Summit), was needed, and they began work in October 2007. The formal contract with Summit was finalized in April 2008.

In May 2007, Mortgages Ltd. refinanced the Choice Bank debt with a $75.6 million loan, securing a new deed of trust. Mortgages was aware that the construction was already in progress when it recorded its deed of trust, thus it took preventive measures to protect its interests through indemnity agreements and assignments from the owner.

Mortgages did not secure subordination agreements from general or subcontractors involved in the project. Lacking the necessary $75.6 million for a loan to Central and Monroe, Mortgages struggled to raise funds from investors as early as May 2007. Upon closing the loan on May 16, 2007, Mortgages withdrew over $5.4 million for various fees and agreed to a delayed funding arrangement with the owner, intending to fund approximately $44.7 million to a Construction Impound account by October 2008 and an additional $9.4 million for interest reserves shortly thereafter. Initial funding occurred on July 13, 2007, but by November 2007, Mortgages needed to withdraw $2.5 million from the Construction Impound account, promising to replace the funds within specified timeframes. However, when the owner requested the first replacement of $1 million, Mortgages failed to comply, ceased funding, and diverted over $1.3 million from the account. The owner tacitly accepted these diversions as some funds were redirected to other projects. By spring 2008, the account could not cover construction costs, leading to the owner covering Summit’s initial draws. After a $1.6 million deposit in May, the account was empty by June, despite Mortgages approving over $10 million in draws. Mortgages’ principal committed suicide on June 2, 2008, and the company faced involuntary bankruptcy on June 23, 2008.

The litigation began in Maricopa County Superior Court and was removed to federal court due to Mortgages’ bankruptcy. Parties agreed to remand the adversary proceeding post-resolution of lien priority, leading to a court ruling on September 10, 2009. Following extensive pretrial proceedings, the priority issue was tried in August 2012. Summit asserts it had a separate contract with the owner starting December 2007 for the same project initially worked on by CASI and KGM since 2005 and 2006, respectively, and entered into a subcontract with CASI for ongoing demolition and abatement work.

Mortgages argues that under Arizona's mechanics' lien priority statute (A.R.S. 33-992(A)), a mechanics' lien cannot have a priority date earlier than the general contract date. When multiple general contracts exist, each establishes a new priority date for subsequent work by the general contractor and subcontractors. The statute, unchanged since 1901, states that liens are preferred to any encumbrances attaching after labor commencement. Mortgages asserts that multiple commencement dates may arise from successive general contracts or direct labor hired by the owner. It cites case law, including a 1932 Arizona Supreme Court decision in Wylie, which supports the notion of equal footing for all liens under a general contract, as well as later cases confirming this interpretation. However, the court has previously analyzed and rejected Mortgages’ motion for summary judgment. The statute indicates only one priority date for labor commencement, regardless of multiple contracts, implying that all related work shares the same priority date. The Wylie case emphasized that all liens under a general contract have equal priority, and the dictum from Wylie suggests that separate direct contracts with the owner do not share this priority date. Unlike California law, Arizona does not require construction contracts to be recorded, which impacts the classification of liens.

Arizona law does not provide a framework for categorizing mechanics liens into distinct classes. The Wylie Court explicitly refrained from ruling on whether the same priority date applies to liens arising from direct contracts with property owners, noting that all lien claimants in the case were linked through a general contractor. Consequently, the court did not address priority rules for liens derived from different contracts or direct engagements with the owner. The ruling established that the rights of material suppliers, except Ray Lumber, relate back to the date prior to mortgage recording when materials were delivered to the contractor.

The Wahl case invoked the relation-back rule from Wylie, discussing potential priority differences for contracts directly with the owner but ultimately did not resolve this issue, as the materials were provided to the contractor. Wooldridge similarly applied the relation-back principle to earthwork performed under a general contract but emphasized that it too was not determining priority for work under independent contracts with the owner.

Without statutory provisions distinguishing between liens from contracts with the owner and those associated with a contractor, no basis exists under A.R.S. 33-992(A) to assign varying priority dates. Mortgages acknowledged that California had eliminated its separate contracts doctrine in 1981, aligning priority dates with the start of work. Mortgages argued that two Arizona cases supported its separate contracts theory, but neither interpreted A.R.S. 33-992(A) or justified differing priority dates based on contractual relationships with the owner.

In Allied Contract, the lien-holder sought priority from the start of construction on four duplexes despite work on water mains commencing later, with no evidence linking the two projects. The Mayer Central case similarly failed to interpret the statute or provide a rationale for its conclusions. The strongest guidance on mechanics lien priority in Arizona is found in the Court of Appeals’ opinion in United California Bank, which addresses the complexities of priority in the context of broken priority.

The legal dispute involved a $25 million financing issue concerning the Hyatt Regency Hotel, characterized by intense and thorough litigation. The core of the issue was a "broken priority" problem stemming from the owner-developer commencing construction with personal funds before securing interim financing. Under A.R.S. 33-992, mechanics' and material-men's liens have priority based on the construction commencement date, not the filing date, which affects their standing against later recorded deeds of trust.

The opinion emphasized that mechanics' lien priority issues arise primarily when there is only one general contract and no direct work done for the owner. Although the opinion noted the lack of definitive authority supporting the separate contracts theory after its repeal in California in 1931, it pointed out that Arizona's legislature indicated that this theory does not generally apply, except for specific site preparation circumstances. 

The 1998 amendment to the mechanics' lien statute added a provision (paragraph E) that allows separate site preparation work, not included in a general construction contract, to have its own priority. However, all parties agreed that the work on the Hotel Monroe did not qualify as site preparation under this provision. 

The analysis concluded that the existence of paragraph E confirms that no separate contracts doctrine applies to vertical construction contracts. It argued that defining site preparation as a separate work implies that the priority of mechanics’ liens is governed by the nature of the work, not the number of contracts. The legislature's creation of a specific provision for site preparation work indicates that such a rule does not extend to separate renovation contracts, reinforcing the principle that statutes should not be interpreted to render parts redundant or meaningless.

Priority for liens on improvements is determined by the commencement of labor, not by the contracts governing the work. New paragraph E clarifies that even for separate site preparation work not specified in a general construction contract, each improvement's lien will have distinct priority. The lien attaches to the property when labor begins, aligning with the contract between the owner and the original contractor for that improvement. This principle mirrors the longstanding rule in paragraph A, emphasizing a work-by-work basis rather than a contract-by-contract basis. If all work pertains to a single improvement, it shares the same priority, irrespective of the number of general contracts involved.

The Arizona Supreme Court’s ruling in S.K. Drywall established that the timeline for perfecting a lien is based on the completion of the overall improvement, rather than individual buildings or contracts. This ruling led to legislative changes in A.R.S. 33.993(B) in 1998, which specified that separate residential buildings are treated as distinct works, regardless of the contractual arrangements. However, this legislative change reinforced the principle that lien priority is determined by the nature of the work rather than the existence of separate contracts.

There is no statutory basis for applying different priority dates based on separate contracts, as Arizona law emphasizes a singular priority date linked to the commencement of labor, with the exception of separate site preparation contracts. Evidence from the trial indicates that multiple contractors were engaged in a single renovation project at the Hotel Monroe from October 2005 until the cessation of funding in summer 2008, confirming the unified nature of the improvement.

A single renovation project evolved over time without a shift in species focus from Neanderthal to Homo Sapiens. CASI's asbestos abatement work was part of this renovation, initiated in October 2005, which the Court deemed the sole commencement date for labor under A.R.S. 33-992(A). Mortgages' deed of trust, recorded in May 2007, is junior to mechanics' liens established in October 2005. Mortgages seeks equitable subrogation to gain priority over these liens based on payments from its May 2007 loan that released an earlier deed of trust held by Choice Bank, recorded in December 2006. However, this does not confer priority over the mechanics' liens due to their earlier date. 

Recent changes in Arizona's equitable subrogation law, particularly as clarified in Sourcecorp, allow subrogation without an agreement if it prevents unjust enrichment. The Arizona Supreme Court restricted the application of equitable subrogation to prevent unjust enrichment and emphasized that its availability depends on specific case facts. In this instance, evidence demonstrated that Mortgages acted inequitably, contributing to financial losses and priority conflicts with contractors, and could have issued notice to protect contractors’ interests. Additionally, applying equitable subrogation would unjustly enrich Mortgages rather than address the contractors' claims.

Mortgages was aware that it was making a broken priority loan in May 2007, knowing that renovations for the Hotel Monroe had already begun, thus giving contractors and subcontractors lien rights that took priority over its deed of trust. Despite obtaining title insurance and indemnity agreements, Mortgages failed to notify these subcontractors of its intention to assert a priority claim via subrogation. Mortgages' defense rests on Arizona court precedents which state that obtaining insurance does not negate the possibility of equitable subrogation and that notice of intervening liens is not mandatory. However, these precedents do not absolve Mortgages, which had actual knowledge of the subcontractors' claims and the ongoing work that increased the value of the property. 

The testimony indicated that it is common practice for lenders to request subordinations from contractors, a step Mortgages did not take. Additionally, Mortgages did not provide public notice when recording its mortgage or releasing the prior Choice Bank deed of trust, despite being aware of the issues at hand. Mortgages was the only party that understood it did not have the funds it committed for construction, while others relied on the public record showing a $75 million deed of trust. Although KGM and Summit did not check the public record, they knew of Mortgages' financing. Furthermore, Mortgages did not notify any parties when it foreclosed its deed of trust, which also impacted its rights under earlier deeds of trust. This lack of notice is particularly significant as, unlike typical equitable subrogation cases where funds are already disbursed, the contractors continued to incur debt and improve the property while believing they had priority over Mortgages. They could have taken measures to protect themselves, such as requiring a payment bond or ensuring the construction draw account was fully funded and accessible to them.

Mortgages' failure to fund its promised loan ultimately harmed the contractors who relied on this commitment. The contractors could have mitigated their losses had Mortgages disclosed its financial inability to fulfill the loan agreement. According to Arizona law, delays in asserting subrogation claims can result in denial of such claims when it would lead to injustice. The evidence indicates that the contractors would have been fully paid if Mortgages had honored its loan commitment, as there was no indication of increased construction costs. Denying equitable subrogation would leave the contractors undercompensated, despite Mortgages having already benefited unjustly by over $9 million due to its breach. Mortgages argued against claims of unjust enrichment by stating that the contractors had no direct contract with it; however, unjust enrichment law is designed to address such scenarios. Furthermore, Mortgages must demonstrate that granting equitable subrogation is necessary to prevent contractor unjust enrichment, which is challenging given its prior enrichment. Mortgages also contended that its investors had no obligation to the contractors, but this is irrelevant, as the investors hold no greater rights than Mortgages itself in this context.

Equitable subrogation is deemed unnecessary to prevent unjust enrichment for contractors and subcontractors, who will receive less than what they justly deserve for their work. It is considered just for Mortgages to absorb a significant portion of their loss, as it holds a substantial equitable responsibility. Consequently, contractors and subcontractors are awarded lien priority from October 2005, while Mortgages holds priority only from its deed of trust recorded on May 16, 2007. The dispute over lien priority is resolved, and the matter is remanded to Maricopa County Superior Court as per the court's order from September 10, 2009. Various case law is cited to support these conclusions, including precedents that affirm the principle of mechanics' liens and the interpretation of statutory provisions relevant to the matter. The legal interpretation emphasizes the necessity to give meaning to all parts of a statute, avoiding any redundancy or triviality.

The 1998 amendments to the statute extended the lien filing period from sixty days to one hundred twenty days. If a notice of completion is recorded, a claimant must file their lien within sixty days of this recordation. The lien is established by recording a notice and serving it to the property owner, when possible. Notably, there is no requirement for a party seeking subrogation to lack notice to obtain equitable relief, as denying subrogation due to a party's diligence in acquiring title insurance would be unreasonable. After fulfilling the owner's obligation to Choice Bank, the subrogee, Mortgages, can request a formal assignment of these rights to be recorded publicly, which aids in asserting their claims. Subrogation aims to prevent unjust enrichment but can be denied if it would result in injustice, particularly if delays occur in recording the mortgage or asserting subrogation. Such delays can lead to prejudicial actions by holders of intervening interests, impacting the priority of claims. The excerpt references the principle that an assignee of a note and deed of trust inherits only the rights and remedies of the assignor.