When does a subordination agreement affect the priority of a mechanic’s lien?

Mechanics Lien

In re Manhattan W. Mechanic’s Lien Litig. (Nev. Supreme Ct. – Sep. 24, 2015)

The issue is whether a subordination agreement that subordinates a lien for original land financing to a new construction deed of trust affects the priority of a mechanic’s lien for work performed after the date of the original loan but before the date of the construction deed of trust.

Gemstone Apache, LLC (Apache), intended to develop a mixed-use property (Manhattan West) in Las Vegas. Real party in interest Scott Financial Corporation (SFC) made multiple loans to Apache for this purpose. The first three loans, which were recorded in July 2006, totaled $38 million (the Mezzanine Deeds of Trust) and financed the purchase of the property. In April 2007, petitioner APCO Construction (APC0),1the contractor hired by Apache, began construction on Manhattan West, setting the priority date for mechanic’s lien services. In May and October of 2007, the Mezzanine Deeds of Trust were amended to secure additional funds for the project.

In early 2008, Gemstone Development West, LLC (GDW), purchased Manhattan West from Apache, assuming Apache’s loan obligations. To obtain financing for construction, GDW borrowed an additional $110,000,000 from SFC (the Construction Deed of Trust), recording the deed of trust on February 7, 2008. As part of the overall transaction, SFC and GDW entered into a subordination agreement subordinating the Mezzanine Deeds of Trust to the Construction Deed of Trust. SFC indicated that its intent for the subordination agreement was for SFC to determine in what order SFC’s debts would be satisfied. The subordination agreement did not state whether the subordination was complete or partial, nor did it address the priority of any potential mechanics’ liens.

The relationship between APCO and GDW deteriorated. APCO stopped work on Manhattan West and filed suit against GDW, SFC, and others. SFC and APCO both moved for summary judgment on the issue of lien priority. SFC argued that the subordination agreement partially subordinated the Mezzanine Deeds of Trust to the Construction Deed of Trust, giving the Construction Deed of Trust senior priority for $38 million and leaving APCO’s mechanics’ liens unaffected. APCO argued that the subordination agreement completely subordinated the Mezzanine Deeds of Trust to the Construction Deed of Trust, prioritizing the Mezzanine Deeds of Trust after APCO’s mechanics’ liens and the Construction Deed of Trust. It further argued that NRS 108.225 precluded the Construction Deed of Trust from taking priority over APCO’s mechanics’ liens.

The district court initially granted summary judgment in favor of APCO, but, after SFC filed a motion for reconsideration, the district court granted summary judgment in favor of SFC. The district court determined that the subordination agreement only partially subordinated the Mezzanine Deeds of Trust to the Construction Deed of Trust and left the mechanics’ liens in the second-priority position. APCO petitioned for a writ of mandamus to compel the district court to vacate its order and recognize APCO’s mechanics’ liens as holding a first priority.

The Supreme Court of Nevada explained that in a complete subordination, the agreement subordinating the senior lien to a junior lien effectively also subordinates the senior lien to intervening liens. Here, for example, the Mezzanine Deeds of Trust would simply become junior to the Construction Deed of Trust, which would remain junior to the mechanics’ liens, thus moving the mechanics’ liens to first priority. In contrast, partial subordination gives a junior lien priority over a senior lien to the extent that it does not affect the priority of the intervening lien; thus, the junior lien only has priority over the intervening lien in the amount of the senior lien. In other words, in partial subordination, the priority of liens is contractually rearranged without affecting the position of any intervening lien. Here, the Construction Deed of Trust would partially subordinate the Mezzanine Deeds of Trust, giving the Construction Deed of Trust $38 million in first priority, leaving the mechanics’ liens in second priority, and placing the remainder of the Construction Deed of Trust in third priority over the Mezzanine Deeds of Trust.

At issue is whether the subordination agreement effected a complete subordination and whether Nevada caselaw and statutes preclude partial subordination.

Did the subordination agreement create a partial subordination?

APCO argued that the district court erred when, in granting summary judgment in favor of SFC, it determined that the subordination agreement was intended to create a partial subordination, not a complete subordination.

The Court explained that different courts have reached different conclusions about whether a general subordination agreement effects complete or partial subordination. The minority view concludes that a general subordination agreement results in complete subordination. Relying on Black’s Law Dictionary’s definition of “subordination agreement,” this view contends that”by definition, subordination contemplates a reduction in priority. Nothing in the definition contemplates raising a lower priority lienholder up to the position of the subordinating party. Thus, the Court noted that this view holds that lienholders can only step into the shoes of another lienholder when the agreement explicitly indicates that there is a transfer of priority rights.

In contrast, in Caterpillar Fin. Servs. Corp. v. Peoples Nat’l Bank, N.A., 710 F.3d 691 (7th Cir. 2013), the United States Court of Appeals for the Seventh Circuit adopted the majority approach and held in favor of partial subordination when the subordination agreement was silent on the issue. This approach holds that nonparties are unaffected by the subordination agreement and simply swaps the priorities of the parties to the subordination agreement. The Caterpillar court reasoned that the party agreeing to subordinate its higher-priority lien surely wants the subsequent loan to occur so that the debtor would be strengthened, but that complete subordination would drop the subordinating creditor to the bottom of the priority ladder, thus benefiting a nonparty to the subordination agreement. Therefore, as a practical matter, the Caterpillar court could not think why the subordinating party would have insisted on complete subordination.

The Court agreed with the reasoning in Caterpillar. The Court explained that in the instant case, complete subordination would move APCO’s mechanics’ liens (nonparties to the subordination agreement) into the first-priority position and leave SFC’s liens junior to all mechanics’ liens. Partial subordination, however, would leave $38,000,000 of the Construction Deed of Trust in first priority and the mechanics’ liens in the same position they were in prior to the subordination agreement. The Court could not determine any reason SFC would have intended to completely subordinate the Mezzanine Deeds of Trust, only for APCO’s mechanics’ liens to then take the first-priority position. Moreover, this aligned with SFC’s claimed intent for the subordination agreement—that it should be allowed to freely contract the order of payment as between itself. The subordination agreement neither stated it intended to create complete subordination nor mentioned the mechanic’s lien. Absent this clear intent, the Court concluded that a common-sense approach weighs in favor of partial subordination.

Does NRS 108.225 preclude partial subordination?

APCO argued that, while parties may contractually subordinate the priorities of their liens, NRS 108.225 did not permit partial subordination, only complete subordination; specifically, APCO asserted that NRS 108.225 prevented SFC from partially subordinating the Mezzanine Deeds of Trust in favor of the Construction Deed of Trust. That statute, which protects the right to payment for those who have worked to improve property, states, in pertinent part, that mechanics’ and materialmen’s liens are senior to any lien, mortgage or other encumbrance which may have attached to the property after the commencement of construction of a work of improvement. SFC argued that NRS 108.225 did not preclude other lienholders from contracting for a partial subordination with respect to their lien priorities.

The Court noted that the statute gives priority to mechanics’ liens over liens that attach after the commencement of the work of improvement. It does not, however, address subordination agreements between other lienholders. The Court explained that it does not fill in alleged legislative omissions based on conjecture as to what the legislature would or should have done. Therefore, the Court concluded that NRS 108.225 did not prohibit negotiations between lienholders with priority over mechanics’ liens and those with lesser priority in situations where the mechanics’ liens will be left in exactly the same position as if the subordination agreement had never occurred. In other words, the statute does not preclude partial subordination.

The Court noted that when APCO began work on Manhattan West, it did so with notice of SFC’s Mezzanine Deeds of Trust and knowledge that its mechanics’ liens would be in second priority to those liens. Crucially, nothing about the subordination agreement altered the amount of debt that APCO was junior to, and thus, the subordination agreement did not violate NRS 108.225. The Court explained that to read the statute in a way that would grant APCO first priority even though the subordination agreement did not prejudice APCO’s lien position—or change APCO’s status whatsoever—would be an over-reading of the statute.

Accordingly, the Court denied APCO’s petition for a writ of mandamus and prohibition.

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