Mechanics’ Liens: Part 2. Reallocating credit risk in construction projects


[Note: This one of a series of six posts regarding mechanics’ liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

In part 1 of this series, we discussed a hypothetical situation with a company that hired an ad agency, with the ad agency subcontracting some work to a production company and purchasing advertising time on a television station. The production company bore the ad agency’s credit risk because its contract was with the ad agency, and when the ad agency went out of business the production company faced the possibility of not being paid. In contrast, the television station did not bear the ad agency’s credit risk because its contract with directly with the ad agency’s client. The ad agency’s client faced the possibility of having to pay for the television air time twice – once to the ad agency and a second time directly to the television station when the ad agency failed to pay for the air time on the client’s behalf.

Now let’s look at the credit risks associated with a construction project in which the owner of a construction project hires a general contractor to complete the entire project on a time-and-materials basis, which means that the price paid by the owner is equal to the amount the general contractor pays for the labor (i.e., the “time”) and materials required to do the construction, plus a markup to cover overhead and profit. The general contractor does some of the work with its own employees and subcontracts some of the work, including the installation of the electrical wiring, to another contractor.

The electrical subcontractor completes its work and submits its invoice to the general contractor. The general contractor adds its markup to the amount of the subcontractor’s invoice and submits its own invoice to the owner. The owner pays the general contractor, but before the general contractor pays the subcontractor, the general contractor goes into bankruptcy. As we saw before, the subcontractor faces the possibility of not being paid for its work; in other words, the subcontractor bears the credit risk of the general contractor. The subcontractor has no claim against the owner because there’s no contractual relationship directly between the owner and the subcontractor.

Or at least that would be the case if it were not for the subcontractor’s right to a mechanic’s lien. The Indiana Mechanic’s Lien Statute (Ind. Code 32-28-3) allows a person who provides labor or materials to the improvement of real property (in this case, the electrical subcontractor) to hold a lien on the property. Ultimately, the electrical subcontractor can foreclose on the lien, forcing the property to be sold at auction, with the proceeds of the sale being used to pay the subcontractor and any remaining proceeds going to the owner. As a practical matter, what usually happens is that the owner of the property pays the subcontractor directly, and the subcontractor releases the lien. Instead of the subcontractor not getting paid, the owner has to pay twice.

In other words, the mechanic’s lien statute reallocates the credit risk of the general contractor so that it is borne by the owner of the property, not by the subcontractor. Technically, that’s an oversimplification because if the property does not bring enough at auction to pay the subcontractor in full, the owner has no obligation to make up the difference, but the point remains that the mechanic’s lien statute rearranges the allocation of the general contractor’s credit risk, reducing the risk to subcontractors and assigning it to the owner.

In the next blog entry, we’ll start an in-depth look at mechanics’ liens, starting with the perspective of a subcontractor.

If you’re the owner of a construction project or a construction contractor, and you’d like to speak with a lawyer regarding a dispute, including one over payment, or you’d like to have an attorney draft or review a contract for you, please feel free to contact us.

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