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Issue  133  Article  222
Published:  8/1/2006

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Subcontractor Liens Against Owner
Chris Burti, Vice President and Legal Counsel

O & M INDUSTRIES v. SMITH ENGINEERING COMPANY, North Carolina Supreme Court, No. 502PA04, January 2006. This decision presents a case where the Supreme Court determined that due to a literal reading of N.C.G.S. chapter 44A, summary judgment was correctly granted for a subcontractor seeking payment from the defendant leasehold landowner under a Notice of Claim of Lien. The claim arose after the general contractor encountered financial difficulty, stopped work on the project and the defendant claimed a set-off for the cost of completion. The Court ruled that the defendant had a duty to retain funds up to the total amount of the noticed lien under N.C.G.S. Section 44A-20. The right to set off any costs for completing the project against the retained funds would not negate defendant's personal liability to the plaintiff for payments made to the contractor after receiving the statutory notice.

O& M Industries instituted this action against the contractor and the defendant under N.C.G.S. Section 44A-18. The trial court's entry of summary judgment for plaintiff was reversed by the Court of Appeals under N.C.G.S. § 44A-20. The Supreme Court reversed the decision of the Court of Appeals.

In December 2000, defendant contracted with the contractor for the design and construction of a chemical processing system. The contractor, in turn, subcontracted with the plaintiff for the construction and delivery of a major component of the system that the plaintiff shipped in June 2001. The plaintiff believed that the contractor was in financial difficulty and served a Notice of Claim of Lien on the defendant on 8 June 2001 in the amount of $113,655.00.

The defendant made two payments to the contractor after receiving the Notice. One payment was in the sum of $164,831.25 in July and one made in early August, was in the sum of $150,000.00. The contractor ceased work in August after the second payment. The defendant estimated that its costs to complete project ranged from $25,000 to over $415,000. Shortly thereafter the contractor filed for bankruptcy and the plaintiff served another Notice of Claim of Lien on defendant in the amount of $127,392.12.

The plaintiff subsequently instituted this action and obtained a default judgment against the contractor. Then the plaintiff moved for summary judgment, alleging that the defendant was liable to the plaintiff as the result of the two payments made after receiving the Notice of Claim of Lien. Defendant also moved for summary judgment, arguing that the offset for costs necessary to complete the project barred plaintiff’s recovery. The trial court allowed plaintiff's motion and entered judgment against defendant in the amount of $113,655.00 plus interest, attorney's fees and costs.

In the Court of Appeals, the defendant argued that summary judgment was improper due to questions of material fact concerning the sufficiency of retained funds and completion costs for the project. The defendant argued that it was not obligated to pay plaintiff since the cost to complete the project exceeded the amount owed to the contractor. The Court of Appeals reversed the trial court's entry of summary judgment, agreeing that a determination of defendant's costs to complete the project was necessary to calculate the appropriate setoff amount.

In its Supreme Court appeal the plaintiff contended that the Court of Appeals failed to address and properly apply the applicable lien statutes. The Supreme Court agreed with this contention. The Court notes that the materialman's lien statute is remedial and is designed to protect the interests of those who supply labor and materials that improve the value of the owner's property. The Court makes appropriate citation to precedent for the proposition that a remedial statute must be construed broadly “in the light of the evils sought to be eliminated, the remedies intended to be applied, and the objective to be attained.” The statutory provisions at issue in this case are N.C.G.S. §§ 44A-18 and 44A-20 as they existed prior to the effective date of the 2005 revision to the Chapter. The Court distills the following portions of these Sections as being most relevant.

“Under Chapter 44A, Section 18 the first tier subcontractor is entitled to a lien upon funds owed to the contractor with whom the first tier subcontractor dealt arising out of the improvements on which the first tier subcontractor worked or furnished materials. N.C.G.S. § 44A-18(1). This lien on funds secures amounts earned by the lien claimant for labor or materials furnished, whether or not performance or delivery is complete. Id. § 44A-18(5). The lien upon funds is perfected upon giving of the notice of claim of lien in writing to the obligor in accordance with N.C.G.S. § 44A-19 and is effective upon the obligor's receipt of the notice. Id. § 44A-18(6).”

“The statutory scheme set out in Chapter 44A, Section 20 to protect the subcontractor's lien on funds once notice has been given provides: first, that the obligor shall retain funds up to the total amount of liens as to which notice has been given, id. § 44A-20(a); second, that the obligor shall be personally liable if the obligor makes further payments to a contractor or subcontractor against whose interest the lien or liens are claimed; id. § 44A-20(b); and third, that an obligor who makes a payment after receipt of notice and incurs personal liability is entitled to reimbursement and indemnification from the party receiving such payment; id. § 44A-20(c). Significantly, this section of the statute makes no provision for a setoff against the retained funds in the event the cost of completing the project exceeds the amount of retained funds.”

To the Court, the dispositive issue turned on whether the payments made by defendant to the contractor after notice, totaling $314,831.25, made the defendant liable. Based on the quoted portions of statute interpreted under rules of liberal construction, the Court found the answer to be affirmative “if the notice of lien is effective”.  The Court notes that the “the statute says plainly and unequivocally: ‘and in addition the obligor shall be personally liable to the person or persons entitled to liens.’” The Court also found that the retention of more than enough funds to satisfy the lien was not sufficient to mitigate the liability.

The Supreme Court stated that “the ‘retain funds’ prong of subsection 44A-20(a) and the ‘further’ or ‘wrongful payments’ prong of subsection 44A- 20(b) are discrete.” In such cases, “in the event of an obligor's wrongful payment, the lien continues upon the funds, and the obligor becomes personally liable to the noticing party up to the amount of the wrongful payment, not exceeding the total claims with respect to which notice was received before the payment”.

The Court’s reasoning is straightforward. “In keeping with the mandate that mechanics and laborers be provided an adequate lien on the subject matter of their labor, the statute creates a risk shifting mechanism for subcontractors. Prior to notice to the obligor, the subcontractor bears the risk of loss or nonpayment by the general contractor. When notice is served, the risk shifts to the obligor to the extent that the obligor is holding funds. With this notice the burden of assuring payment of the subcontractor's lien shifts to the obligor who owns the project, is receiving construction funds, and receives the benefit of the subcontractor's labor and materials. The owner is, thus, put on notice of a general contractor's potential breach and is apprised of the need to take precautions necessary to protect the project and to ensure that subcontractors remain on the job.”

In the absence of the “wrongful payments” made subsequent to a Notice of Lien on Funds as described in N.C.G.S. § 44A-20(b), personal liability on the part of the obligor is not triggered. The Court of Appeals, in its decision, applied a setoff analysis. The Supreme Court held that the Court of Appeals' reliance on Lewis-Brady Builders and Watson Electrical was misplaced. This was because the setoff in the prior case was allowed due to the fact that the owners did not make any post-Notice payments to the general contractor. Instead, the owner merely arranged completion of the project by another contractor.

In this case, the Supreme Court ruled that the defendant had a duty under Section 44A-20 to retain funds up to the total amount of the noticed lien. Once the defendant made further payments to the contractor after receiving notice, it violated this duty. By making any payment that reduced the fund below an amount sufficient to protect the subcontractor, the payments triggered liability up to the lesser of the amount of the payments, or the amount of the claims noticed.  The Supreme Court explains that the “reason the obligor becomes personally liable by making a payment after receiving a notice of claim of lien is that the obligor is then on notice that a potential problem exists and, having control of the funds, is in a position to avoid or rectify the problem.”

The defendant also made arguments based upon estoppel and novation that the Court of Appeals did not deem necessary to address. The Supreme Court in reversing the Court of Appeals stated explicitly that they did not express any opinion on these arguments. In reversing the Court of Appeals’ reversal of the trial courts summary judgment motion, the Supreme Court remanded the case to the Court of Appeals for consideration of the defendant's remaining assignments of error.

The lesson that we can take from this opinion is that any payment after notice may imperil the property owner. All payments made after notice should be made in a fashion that will secure a release of the lien. Circumstances where the general contractor denies an obligation due to alleged deficiencies on the part of the subcontractor can be particularly difficult where there is also a dispute between the owner and the contractor. Bonding off the notice of claim of lien on funds pursuant to N.C.G.S. Section 44A-16 may provide the only workable protection for the property owner. This relief was clearly made applicable to this type of claim by amendments to N.C.G.S. Section 44A-20(f) effective in 2005 and that did not exist at the time the facts giving rise to this litigation occurred.

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