Wang Electric v. Smoke Tree: Liens and Leasehold Improvements

It is rare that a construction lawsuit raises multiple useful lessons for contractors in protecting their payment rights, but Wang Electric v. Smoke Tree Resort did just that.

The 2012 Arizona Court of Appeals case, which was complicated and confusing even by a construction lawyer’s standards, can be summarized in part as follows:

Reasonable Time in Serving a Lien. A mechanics’ lien must be served within a reasonable time after it is filed. Surprisingly, in Wang Electric the court considered a 90-day delay to be reasonable but cautioned that “reasonableness” should be determined on a case-by-case basis. Takeaway: Without clear time limits, a subcontractor filing a mechanics’ lien should serve copies on every appropriate party as soon after filing the lien as time permits.

Liens Against the Tenant and Owner. When work is initiated by a tenant, a mechanics’ lien is effective against the property owner only if the tenant is an “agent” of the owner. In this case, the tenant was determined to be the owner’s agent, and the court ruled that service on one was the same as service on the other. Takeaway: Since agency relationships are not necessarily clear, whenever a situation calls for a mechanics’ lien, the lien claimant should serve the pre-lien on both the tenant and the owner and sort out the agency issues later.

Too Many Liens? Subcontractors and suppliers are allowed to “cover their bases” by serving multiple pre-liens. Takeaway: When in doubt as to who to serve your pre-lien on, it is better to serve too many parties than too few.

Liens against Tenant Improvements. A mechanics’ lien that is recorded solely against a tenant’s interest in tenant improvements can survive the lease’s termination under certain circumstances (discussed below). Takeaway: If you are filing a mechanics’ lien against a leasehold improvement, and your contract is with the tenant, you will want the tenant to be considered an “agent” of the owner. A common example of agency is that the tenant is making improvements at the direction of the owner.

Unjust Enrichment. In case your lien fails, you might be able to make an unjust enrichment claim, but only if the owner did not pay the general contractor or engaged in “dishonest conduct” (more below). Takeaway: An unjust enrichment claim is hard to win, and it is no substitute for properly preserving and enforcing your mechanics’ lien rights.

BACKGROUND

This case involves leasehold improvements at a site that long-time Phoenicians will remember as Dale Anderson’s "The Other Place" restaurant at the Smoke Tree Resort on Lincoln Drive. In October 2007, the Smoke Tree leased the vacant restaurant space to REM on Lincoln. The lease required REM to remodel the space, and Smoke Tree agreed to reimburse REM for the first $840,000 in remodeling expenses.

REM hired KAI Designs to be the general contractor, and their contract called for REM to make monthly progress payments to KAI. KAI then directly subcontracted with Wang Electric, Aero Automatic Sprinkler Co., Beecroft LLC, Adobe Paint, Adobe Drywall and other subcontractors.
Even though REM’s contract with Smoke Tree called for REM (the tenant) to pay KAI (the general), and for Smoke Tree (the owner) to reimburse REM, Smoke Tree paid the first $790,000 in construction costs directly to KAI.

In April 2008, the progress payments stopped, and unpaid subcontractors filed mechanics’ liens on Smoke Tree’s property and/or REM’s leasehold interest. Next, subcontractors filed lawsuits against Smoke Tree, REM, KAI and, in some cases, other subcontractors. All six subcontractors sought damages for breach of contract (against the general), sought to foreclose their mechanics’ liens (against the owner and tenant) and, as a Plan B, claimed that the owner and tenant had been unjustly enriched.

The waters were further muddied by the fact that, at some point during the controversy, REM’s lease was terminated, exposing the owner to claims that otherwise would have been focused on the tenant.

The ensuing flurry of claims, cross-claims, motions for summary judgment, etc., defies discussion in this simple article. However, while much of the Court of Appeals’ opinion in this case is devoted to thorny legal questions, the judges did raise some issues that have practical day-to-day importance to owners, contractors, subcontractors and suppliers.

Serving a Mechanics’ Lien on the Owner. Arizona law requires that a copy of a mechanics’ lien be served on a property owner within a reasonable time after filing. Unfortunately, the statute doesn’t define “reasonable time.” In Wang Electric, a mechanics’ lien was served on the owner three months after it was filed, and only as an attachment to a complaint.

In response to the owner’s argument that three months was unreasonably long, the Court of Appeals ruled that, in this case, 90 days was not unreasonable but offered no standard for future notifications, stating that reasonableness should be determined on a case-by-case basis.

As a practical matter, subcontractors should disregard the 90-day lag period that the court allowed here. Rather, in the absence of clear time limits, a subcontractor filing a mechanics’ lien should serve copies on every appropriate party as soon after filing the lien as time permits.

Preliminary 20-Day Notice Requirements. As a general rule, on commercial projects it is wise to serve a preliminary 20-day notice (or “pre-lien”) on all responsible parties, including the property owner or the owner’s agent.

However, when work is initiated by a tenant, a mechanics’ lien typically attaches only to the leasehold interest and tenant improvements. The property itself is subject to the lien only if the tenant is found to be an “agent” of the owner. Since agency relationships are not always clear, it is a good practice to serve the pre-lien on both the tenant and the owner.

In Wang Electric, the owner (Smoke Tree) argued that a mechanics’ lien was invalid because the subcontractor served a pre-lien on the tenant (REM) but not on the owner directly. The court ruled that, in this case, the tenant was an agent of the owner because the lease required the tenant to extensively remodel the property in accordance with plans and specifications approved by the owner. Thus, for lien purposes, service upon the tenant was the same as service upon the owner.

On a related issue, the owner challenged another mechanics’ lien on the grounds that the subcontractor sent too many pre-liens. The sub had sent three pre-liens – to the owner, to the tenant, and to an agent of the two parties. The court rejected the owner’s challenge, noting that “a Laborer may ‘cover its bases’ by serving multiple preliminary 20-day lien notices naming different owners and reputed owners as long as such service is timely.” The moral is, when in doubt as to who to serve your pre-lien on, better to serve too many parties than too few.

Mechanics’ Liens Against a Terminated Leasehold Interest. When a commercial tenant contracts for construction work, it creates a complicated situation with respect to the mechanics’ lien. As mentioned earlier, the termination of REM’s lease exposed Smoke Tree to claims that normally would have been aimed at the tenant.

In Wang Electric, all of the subcontractors except one had lien rights against the owner’s interest because the tenant was ruled to be an “agent” of the owner. The exception, Adobe Drywall, had lien rights only against the leasehold estate. That became a problem when the tenant’s lease was terminated.

Adobe Drywall argued that, despite the lease termination, it still had a right to claim a lien against the improvements that REM left behind. The court found that a mechanics’ lien, recorded solely against a tenant’s interest in improvements made to a leased property, will survive the lease’s termination if:

• the landlord does not have an ownership interest in the improvements; or

• the landlord does have an ownership interest in the improvements, but the tenant acted as the landlord’s agent in contracting with the party filing the lien.
  

If you are filing a mechanics’ lien against a leasehold improvement, and your contract is with the tenant, you will want the tenant to be considered an “agent” of the owner. Again, that occurs most often when the owner directs the tenant to make improvements.

Claims of Unjust Enrichment as an Alternative to a Lien Claim. When a mechanics’ lien does not hold up, it is not uncommon for the lien claimant to fall back on an “unjust enrichment” argument. Such was the strategy of some subcontractors in the Wang Electric case. In reviewing those claims, the court noted that unjust enrichment cases “fall into two categories: ones in which the owner has fully paid the general contractor and ones in which the owner has not.” The court went on to affirm that “[R]ecovery under ... unjust enrichment is not available in the former category, because the owner is not unjustly enriched if it fully paid its obligation. But when the owner has failed to fully pay its obligation ... recovery for unjust enrichment is available."

Historically, in Arizona, an unjust enrichment claim had to meet five conditions:

• an enrichment,

• an impoverishment,

• a connection between the enrichment and impoverishment,

• the absence of justification for the enrichment and impoverishment, and

• the absence of a remedy provided by law.
  

However, the Wang Electric court considered an additional component: “[F]or a tenant's contractor to attach liability upon an owner of property under an unjust enrichment claim, the contractor must be able to show that the landlord has engaged in some form of improper, deceitful, or misleading conduct.”

It is impossible to tell from the court’s opinion what exactly constitutes “improper, deceitful, or misleading conduct,” and clarification will probably require the arrival of another unjust enrichment claim at the Court of Appeals.

Thus, if your lien fails, an unjust enrichment claim may be your last hope against the owner, but only if (1) the owner has not fully paid the general contractor for the work performed, and (2) you can prove that the owner engaged in dishonest conduct. However, you should assume that such a claim will be dicey at best, and it is no substitute for Plan A (i.e., preserving and enforcing your mechanics’ lien rights).