Friday, 28 June 2013 08:00
By Mary Leigh Pirtle
In one case, a lender’s mortgage was deemed to have priority over a number of subcontractors’ mechanic’s liens due to a flow down clause in the subcontractors’ contracts. This resulted in a $9 million loss for the subcontractors on a commercial construction project in Ohio.
The lender loaned the owner approximately $90 million in funding for the project under a construction loan, which required approval before any draws were made. After nearly $45 million had been approved and disbursed to the general contractor and subcontractors, the lender became concerned with the financial viability of the owner and chose not to approve any additional draws on the construction loan. Unaware that the lender had pulled funding, the subcontractors continued work on the project and racked up $9 million in unpaid labor and materials before the owner advised them to suspend all work. As a result of the unpaid labor and materials, the subcontractors filed mechanics liens.
Mechanic’s Liens vs. Mortgages
Soon after, the lender filed a complaint to foreclose the mortgage and appoint a receiver. In response, the subcontractors claimed the mechanic’s liens had priority status over the lender’s mortgage. The lender argued that the subcontractors contractually agreed to subordinate any lien claims to the lender’s construction mortgage, so they had waived any claim to priority. The lender based its argument on contracts executed between the owner and the general contract. These contracts included subordination clauses that stated the contractor and subcontractors agreed to subordinate any and all security interests and liens. The subcontractors argued that the general nature of the subordination clauses were not binding because they did not contain specific language incorporating the contracts into the subcontracts. In essence, they argued their contracts did not contain a flow down clause so they never agreed to subordinate any of their liens.
Flow down clause determines priority
However, after reviewing the subcontracts, the court noted that the specific language was not needed in the subordination provisions because the subcontracts contained a flow down clause. The court reasoned that when a flow down clause is used in a subcontract, the subcontract is not required to contain additional specific language of incorporation in order to impose a general contractor’s duties onto a subcontractor. The court noted these flow down provisions are routinely used in construction subcontracts to create obligations between the subcontractor and the general contractor consistent with the obligations between the contractor and the project owner.
After analyzing the contract provisions, the court determined that the flow down clause was clear and unambiguous and was drafted broadly enough to bind the subcontractors to the subordination provisions included in the contract between the general contractor and the owner. Basically, the court held that the flow down provision should be read to place the subcontractor in the same position in relation to the general contractor as the general contractor was to the owner. Therefore, the general contractor’s agreement to subordinate any of his potential liens bound the subcontractors to the same provision, which meant the subcontractors were not entitled to the $9 million in unpaid labor and materials until the lender received its fair share from the owner.
This case underscores the importance and impact of flow down clauses in construction contracts. Regardless of the size of the project, it is necessary to thoroughly review all other contracts and related materials that impose additional obligations through such a clause.