Additional Owner Liability for Subcontractor Lien Claims

February 14, 2006

On January 27, 2006, the North Carolina Supreme Court rendered a decision in O & M Industries v. Smith Engineering Company (No. 502PA04) which increases the Owner’s liability and obligation to pay Mechanic Lien claims against funds asserted by Subcontractors and Suppliers. 

The Supreme Court, reversing the Court of Appeals, held that once an Owner receives a Subcontractor’s Notice of Claim of Lien Upon Funds, it must withhold monies from the Contractor in the full amount of the claim.  Otherwise, the Owner incurs personal liability directly to the lien claimant to the extent of the wrongful payments made to the Contractor with no right to set-off the additional costs for completion against the funds that should have been withheld due to the lien.

This decision by the Supreme Court runs contrary to the previously held assumption by many in the construction industry that: (1) the Owner is only obligated to withhold amounts “owed” the Contractor but that determination could only be made after the Project was properly completed; and (2) if the Contractor failed to properly complete the Project, the Owner could setoff the cost of completion against the funds otherwise subject to the lien.

The underlying facts of O&M Industries were that the Owner of a manufacturing facility contracted with a Contractor for improvements to its plant.  The Contractor subcontracted with the Plaintiff to furnish certain equipment to the Project.  The Subcontractor delivered the equipment but at about the same time, served the Owner with a Notice of Claim of Lien Upon Funds in the amount of $100,000.00.  After the Owner received the Notice, it made two payments to the Contractor each in the amount of $150,000.00. The Contractor was apparently having financial difficulty and the Owner made the payments in an effort to keep the Contractor working on the Project. As you might expect, the Contractor later filed bankruptcy and failed to complete the Project.

The Subcontractor then filed suit against the Owner claiming it was entitled to recover on its Claim Upon Funds.  The Owner denied the Sub was entitled to any recovery since its cost of completion exceeded any amount owed the Contractor.  Nevertheless, the Supreme Court held that under our Mechanic’s Lien Statute (N.C.G.S. §44A-18 and 44A-20), once the Owner received the Notice, it had a duty to retain funds in the total amount of the lien.  Since the Owner made subsequent payments to the Contractor, it was considered an admission by the Owner that amounts were owed. Therefore, the Owner became personally liable for the amount of payments made to the Contractor up to the amount of the Plaintiff’s Claim Upon Funds.

If an Owner properly withholds the amount of the Claim Upon Funds, it can use any remaining contract balance to complete the project.  However, it is not clear from the  Court’s opinion whether an Owner can set-off against the withheld funds subject to the lien if the remaining funds are not sufficient for the Owner to complete the Contractor’s work.

In the Court’s opinion, it was proper to place this additional risk on the Owner because once a lien is served, the Owner has notice of a problem and can avoid or rectify the problem because it has control of the funds.  However an Owner’s exercise of that control may result in substantial delays to a Project and an increase in completion costs.  Many Contractors may deny owing any amount to a claimant or, being unable or unwilling allow a disruption of its cash flow, and refuse to complete the work unless paid. 

Under our Mechanic’s Lien Statute, a Subcontractor may assert a Claim of Lien Upon Funds “whether or not such amounts are due and whether or not performance or delivery is complete“ (44A-18(f)).  In other words, a Lien Upon Funds may be asserted by a Subcontractor in the full amount of its contract not yet due for payment from the Contractor, but under the court’s rationale, the entire amount should be withheld from the Contractor.  In such event, the likelihood of a Contractor being unable to complete a project will substantially increase.  

Conclusion

What is an Owner to do in order to avoid personal liability due to a Claim Upon Funds on a construction project?

First, an Owner should make sure its contract with the General Contractor includes provisions that require the Contractor to “bond off” any liens and indemnify the Owner against any costs or expenses, including attorney fees, incurred in connection therewith.

Second, Owners could require the Contractor to provide performance and payment bonds, although the cost of the premiums will increase the cost of the project by about one percent (1%). (Remember that on private construction projects, a Subcontractor may assert both a lien claim as well as claim against the payment bond.  

Third, (or in the alternative), an Owner should promptly withhold funds from the Contractor up to the amount of the Claim and demand that the Contractor resolve or ‘bond-off’ the lien.  Thanks to a recent amendment of our Mechanic’s Lien Statute there is now a provision which allows the bonding off of a Claim Upon Funds. Otherwise an Owner will become personally liable for the amount owed to a subcontractor and may be “paying twice” for the same work.