Guard Against Mechanic's Liens by Making Tenant Set Up Construction Escrow

Giving tenants construction allowances to make improvements to the property exposes you to legal risks. If the tenant doesn’t pay its contractors, they may try to collect the debt from you, which can include placing a mechanic’s lien on the property. True, most leases expressly ban tenants from letting their contractors place a lien on the property and stipulate that the landlord isn’t liable for the tenant’s debts to its contractors. But, as some landlords don’t discover until it’s too late, the clauses you include in a tenant’s lease aren’t enough to strip the contractor of its lien rights.

There is a way, however, to leverage your power over tenants to safeguard your property from liens. Take measures to ensure that they pay their contractors on time and in full so liens aren’t filed in the first place. Here’s a leasing strategy you can use to accomplish that objective.  

What’s at Stake

Getting stiffed by clients is a common occupational risk for contractors, subcontractors, suppliers, and others that perform labor and/or furnish materials for construction projects (which we’ll refer to collectively as “contractors”). That’s why each state has a statute allowing contractors to file a legal instrument called a mechanic’s lien to secure their right of payment. The mechanic’s lien is a potent remedy because it attaches to and forms a cloud over the property where the work is done. Result: It may be impossible for the owner to sell or refinance the property until the debt is paid and the lien is discharged.

Of course, in the context of tenant improvements, the property being encumbered belongs to the landlord. And in almost all cases, the lien is enforceable even if the landlord isn’t a party to the underlying construction contract and has no direct dealings with the contractor.

Consent Is as Good as a Contract

While rules vary by state, a contractor performing work for a tenant doesn’t need to have a direct relationship to place a lien on the landlord’s property. The contractor need only show that the landlord consented to the work. Consent doesn’t have to be express. It can also be implied via the landlord’s actions in procuring and controlling the work. What makes this scary is that the lease provisions landlords commonly rely on to police the construction of tenant improvements are often all the evidence the contractor needs to establish the requisite control, including clauses providing for:

• The payment of a tenant improvement allowance;
• The tenant’s obligation to provide the landlord prior notification of improvement work;
• The landlord’s right to approve all such work; and/or
• The landlord’s right to approve the contractors the tenant selects to do the work.

The mere fact that the landlord owns the property and stands to benefit by the improvements may be enough to make a mechanic’s lien enforceable.

Example: A restaurant tenant goes out of business without paying the $50,000 it owes its electrical contractor for improvement work. So the contractor puts a lien on the property. You can’t do that, the landlord objects, because I wasn’t a party to the contract and didn’t give my express consent to the work. But the New York court flatly disagrees. There doesn’t have to be a “direct relationship” between the landlord and the tenant’s contractor, the court explains. All that’s needed to establish liability is that the landlord “was an affirmative factor in procuring the improvement to be made, or [in] having possession and control of the premises assent[s] to the improvement in the expectation that he will reap the benefit of it.”

Turning to the lease in question, the court finds ample proof of the benefits the landlord would “reap” from the work in the provisions requiring the tenant to convert the property to a first-class saloon within a few months and stating that if the work wasn’t done on time, the lease would end and the landlord would keep the improvements [Ferrara v. Peaches Café LLC, 2018 WL 6047993].

How to Protect Yourself from Liens

Theoretically, you could minimize mechanic’s lien liability risks by staying totally out of the process and letting tenants make their own improvements without your knowledge, consent, or input. But for many if not most landlords, the cure of giving tenants total control over improvements is worse than the risk of mechanic’s liens.

Luckily, there’s a better approach for landlords not willing to allow the inmates to run the asylum: Maintain your improvement allowances and oversight of improvement work but create a mechanism to ensure that the tenant pays its contractors and that the work is done properly before it receives a penny in improvement funds.

Set Up Escrow Account

One of the downsides of this strategy is that it requires extensive monitoring and checking on the tenant’s bill paying. But there’s no law that says you must do all of that yourself. A “hands off” alternative is to put the improvements money into an escrow account administered by a title insurance company.

The leasing strategy: Add a lease clause requiring the tenant to set up a construction escrow account with a title insurance company. Then, require the tenant to deposit enough money into the account to ensure full payment of its contractors. Before releasing the escrow funds, the title insurance company will review the key documents to verify that there’s no chance of a mechanic’s lien. If so, it will pay the contractor out of the escrow funds, and you pay the work allowance to the tenant. In addition to providing effective insulation from lien risks, such arrangements are generally acceptable to tenants, according to attorneys.

The Review Process

Before using the escrow funds to pay the tenant’s contractors, the title insurance company satisfies itself that all payment conditions have been met by reviewing:  

• A statement from the tenant listing all the contractors who worked on the improvements project;
• The contractors’ affidavits—that is, sworn statements listing all of the contractors’ subcontractors and suppliers involved in the work and how much each of them is owed;
• The interim and final architect’s certificates stating that the work for which the contractor is requesting payment has been completed satisfactorily; and
• All lien waivers from the contractors, subcontractors, or suppliers; and
• All requests for payment from those contractors, subcontractors, and suppliers.

Add Six Provisions to Your Lease

Your lease clause, like our Model Lease Clause: Establish Escrow Account to Pay Contractors for Tenant Improvements, should contain six provisions to set up an effective construction escrow account mechanism with the tenant:

1. Tenant duty to set up escrow account. Require the tenant to set up an escrow account with a title insurance company that the landlord designates [Clause, par. a].

2. Tenant duty to pay for escrow account. Specify that the tenant must set up the escrow account at its sole cost and expense [Clause, par. a].

3. Tenant duty to deposit full amount of work costs. Ensure the escrow account contains adequate funds by requiring the tenant to deposit the full amount it expects to owe the various contractors for the work. Also require the tenant to deposit additional money to cover any cost increases incurred once the work begins [Clause, par. e].

4. Tenant duty to get landlord consent to withdraw from escrow account. Ban the tenant from taking money out of the escrow account unless it first gets your consent to do so [Clause, par. f].

5. Landlord right to withdraw from escrow account. In case the tenant doesn’t pay the contractor promptly, reserve the right to take money out of the escrow account so you can make the payment yourself. Also give yourself the right to use escrow funds for removing any mechanic’s lien that the contractor files in connection with the work [Clause, par. g].

6. Conditions of release of escrow funds. Although it doesn’t necessarily have to issue a title insurance policy for the work performed, the title insurance company must at least verify that the work is insurable. Accordingly, the lease should indicate that the title insurance company will hold onto the escrow funds and refrain from making payments until it receives from the tenant the documents it needs to verify insurability [Clause, pars. c and h].

Title Company Review of Lien Waivers

Title companies can also help you if your state allows for “lien waivers”—that is, contractual agreements by a contractor to waive its lien rights with regard to the contract work. Several states (including Rhode Island, Connecticut, Maryland, Indiana, and Montana) ban lien waivers as against public policy. In others (such as California, Florida, New York, New Hampshire, Vermont, Virginia, West Virginia, Kentucky, Tennessee, Mississippi, Kansas, and Missouri), lien waivers are allowed only after the work begins. But the other states do allow for lien waivers (or at least don’t expressly prohibit them). See our Lawscape: Lien Waiver Laws to find out the lien waiver rules of your state.