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Insurance Coverage for "Hidden" Mechanics' and Materialmen's Lien Claims in North Carolina is Disappearing

Even in good economic times, lien claims asserted by subcontractors and material suppliers abound and lead to costly disputes.  As in many states, North Carolina’s materialmen’s lien statutes create a system where “hidden” or non-recorded liens come into existence, but are not perfected by public filings until later, at which time the law provides materialmen’s liens retroactive priority status over certain intervening liens.  Two recent legal developments are further complicating the challenges faced by construction, real estate and lending interests in North Carolina.
The most recent development is the May 10, 2012 surprising announcement (reprinted below) by Fidelity National Title Group, which includes Chicago Title, Commonwealth Land Title and Fidelity National Title.  They will stop selling materialmen’s lien coverage for North Carolina commercial and residential properties with recent construction or construction loans or both (i.e., properties for which potential lien claimants may have the ability to file timely lien claims, and  the proposed purchaser and/or lender cannot obtain legal priority of record over those potential liens not yet filed at time of closing).   Other title insurers are expected to follow suit in curtailing coverage.  If prompt legislative action is not taken, the unavailability of such insurance coverage may have the effect of severely squeezing North Carolina’s construction industry by limiting the availability of funds and raising the cost of doing business to offset the risks presented by uninsurable hidden liens.
The second development is taking place in the US Bankruptcy Courts located in North Carolina.  Reversing previous practice in this area, the Bankruptcy Court for the Eastern District of North Carolina recently issued an opinion concluding that subcontractors and suppliers can serve a notice of claim of lien upon funds post-petition without violating the automatic stay.  The Court ruled that North Carolina’s lien statute explicitly provides that a lien on funds is granted upon the furnishing of materials, labor or equipment.  Although the lien is not perfected at this time, the subcontractor still has the right to the benefit of the lien upon funds.  To perfect the lien, the subcontractor must give notice, but the giving of notice is merely the last step in perfecting the interest in property.   As such, the lien claimants were granted a lien on funds pre-petition, and could perfect the lien by serving the notice of claim post-petition without violating the automatic stay.  This development drastically changes the dynamics for all parties involved in a contractor’s chapter 11 bankruptcy case.  No longer is the debtor’s post-petition income protected from the lien claims of pre-petition subcontractors and material suppliers.  No longer is the primary secured lender’s interest in the debtor’s receivables insulated from the competing claims of materialmen’s liens perfected post-petition.  The resulting strain on the debtor’s cash flow jeopardizes the debtor’s ability to continue operations and pay post-petition operating expenses as incurred.  Ultimately, the debtor’s unsecured creditors may see their chances of any recovery dwindle as the debtor’s business contracts amid competing pressures.  If the pressures result in a collapse of the debtor’s business, even those with perfected materialmen’s liens stand to lose, if the debtor defaults before completing a project and the resulting damage claims result in setoff of funds payable to the debtor.

An Open Letter to Approved Attorneys of Chicago Title, Commonwealth Land Title, and Fidelity National Title

May 10, 2012

Dear Approved Attorney:
Chicago Title, Commonwealth Land Title, and Fidelity National Title announce that we will be curtailing mechanics' and materialmen's lien coverage in situations posing a significant risk of broken priority under applicable NC law at the time of their closing, effective for commitments issued after Friday, June 15, 2012.
Historically, North Carolinians could be assured they had some of the lowest rates, the lowest closing costs and the lowest claims losses in the Country, -- but no longer. Unfortunately, in recent years, we have paid increasing and significant losses from mechanics' lien coverage in North Carolina, creating a significantly higher claims ratio than the national average.  The claims submissions continue unabated in the current market.
To address this problem, for the past several years, our companies and others have made extensive efforts, negotiating in good faith on a multitude of proposals and investing substantial amounts of time in attempts to create a legislative framework whereby innocent purchasers and lenders could be protected by law. Our goal was to provide protection for buyers purchasing and lenders extending loans on properties with recent or contemplated construction.
Unfortunately, thus far, our attempts have been thwarted or ignored. Unless and until this priority protection for these innocent parties under the law is provided, the risk is uncontrollable and unacceptable.
Situations affected will include commercial and residential properties with recent construction or construction loans or both, i.e. those for which potential lien claimants may have the ability to file timely lien claims under N.C.G.S. Chapter 44A, Article 2, and for which the proposed purchaser and/or lender cannot obtain legal priority of record over those potential liens not yet filed at time of closing.   These are typically referred to as "broken priority" situations because priority cannot be assured at law and of record.
We recognize that, due to current law, this will have a significant impact on:
  • Owners who are not protected by the current law and who may be unable to obtain this protection on new construction, residential or commercial
  • Lenders who are similarly unprotected by the current law and may be unwilling to provide loans for construction on or purchase of these properties without this coverage
  • Owner-builders who may be unable to provide assurance of the coverage to construction lenders, purchasers or their lenders
  • Contractors and suppliers who may no longer be able to assume title insurance policy coverage is available if they are not paid by the appropriate party with whom they contracted
  • Attorneys representing all of the above, whether in closing transactions or mechanics' lien litigation
We have negotiated in good faith for a reasonable solution to this "broken priority" or "hidden lien" problem in North Carolina in the hopes of avoiding this eventuality. We continue to stand ready to participate in any constructive meaningful negotiations to that end. However, because no such solution has been reached and there appears to be no prospect of a solution in the near future, we are no longer in a position to provide this coverage with no means of effectively and reliably assessing and managing the risk, for ourselves or our insureds. We would be remiss in our fiscal responsibilities to all of our insureds to continue to provide this coverage in these high risk situations.
Please feel free to contact your local Chicago Title, Commonwealth Land Title, or Fidelity National Title counsel to discuss any questions.
© 2023 Poyner Spruill LLP. All rights reserved.National Law Review, Volume II, Number 149

About this Author

Lisa P. Sumner, Bankruptcy Litigation Attorney, Poyner Spruill Law Firm

Lisa practices in the areas of Bankruptcy and Commercial Litigation, and she is the Assistant Leader of our Financial Services Section. She is licensed and has practiced in the federal and state courts in North Carolina, South Carolina, and Virginia.

Representative Experience

  • Represent secured and unsecured creditors, including creditors’ committees, in bankruptcy court on contested matters such as cash collateral, DIP financing, claims objection and lien contests, stay relief, confirmation, and executory contracts

  • ...