Unconditional or Conditional Lien Releases: Choose Carefully or Lose Your Lien Rights, A Case Analysis

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Introduction

Credit Managers are routinely faced with the decision of how, when and whether to issue a release of their mechanics' lien, stop notice and bond rights to effectuate payment. In order to receive payment, the owner, general contractor or subcontractor of a public or private work of improvement will, in almost every instance, require that an executed lien release be given before payment is made. A creditor, however, does not want to release its lien before payment has been made. Although the requirements for lien releases vary from state to state, some jurisdictions have enacted statutes that are intended to protect lienholders from unintentionally waiving lien rights, while still providing owners and construction lenders with some certainty of payment.

For example, in Arizona and California, the state legislatures have enacted statutes that protect lienholders by requiring specific formalities to be followed before lien releases will be valid. (See California Civil Code §3262(d) and Arizona Revised Statutes $33-1008). In addition, Arizona, California and other jurisdictions have provided for different types of lien releases depending on how payment is made. A conditional release is routinely given in exchange for payment made by a regular check or when a release is required before payment will be made. An unconditional release, on the other hand, is given when a creditor has been paid in full, unconditionally. Additional requirements exist for progress payments and final payments. Thus, it would seem that in states where the process of releasing lien rights has been set forth by statute, the decision is easy; a lienholder needs only to determine whether the Hen release is conditional or unconditional and for a progress payment or a final payment.

Oftentimes, however, owners, general contractors or subcontractors hold a payment hostage unless and until they receive the release they want, despite the comprehensive statutory scheme. It is not unusual for an owner, general contractor or subcontractor to demand an unconditional release before payment will be made, despite the fact that payment will be made by a regular check that can easily be returned unpaid for non-sufficient funds. The decision to issue an unconditional release when a conditional release is warranted could mean the difference between preserving a creditor's mechanics' lien, stop notice and bond rights or losing them completely when a check bounces or when payment has not been received. One recent court opinion illustrates the danger of issuing an unconditional lien release when a conditional lien release is warranted.

The JWJ Contracting, Inc. Opinion

In Endo Steel, Inc. v. Janas (In re JWJ Contracting Co., Inc.) 371 P. 3d 1079 (9th Cir. 2004), the United States Court of Appeals for the Ninth Circuit affirmed a lower court's holding that a payment made to a subcontractor, Endo Steel, Inc., within 90 days of the general contractor's bankruptcy petition, was a preference. This determination turned on the type of lien release issued by the subcontractor.

The City of Phoenix retained JWJ as the general contractor for its public work of improvement to the Sky Harbor International Airport. As required by state law, JWJ obtained a payment bond that guaranteed payment to subcontractors and suppliers. JWJ subcontracted with Endo Steel to supply and install steel reinforcing bars required for the project. On April 14, 1994, JWJ issued a check to Endo Steel for the sum of $194,286.71 as payment for work performed and material supplied by Endo Steel. Upon receipt of the check, Endo Steel issued an unconditional release of lien in accordance with Arizona Revised Statutes §33-1008.

The check was dishonored for non-sufficient funds and, upon demand by Endo Steel, JWJ issued a cashier's check 19 days later (May 2, 1994) for the full amount. JWJ's bankruptcy petition was filed on July 1, 1994.

Preference Actions Under 11 USC §547(b) And The 'Contemporeneous Exchange' Exception

Under federal bankruptcy law, if a debtor pays a debt incurred within 90 days of the filing of a bankruptcy petition, the bankruptcy trustee may avoid the payment by instituting a preference action. (11 USC §547(b)). If the bankruptcy trustee is successful in a preference action, the creditor must disgorge the payment plus interest. As explained by the Ninth Circuit, the purpose of the bankruptcy trustee's power is twofold: first, it discourages creditors from outmaneuvering other creditors in an effort to carve up a financially unstable debtor during its slide into bankruptcy, and second, it promotes the prime bankruptcy policy of equal distribution among similarly situated creditors. (In re JWJ Contracting, Inc., supra, 371 F.3d at 1081, citing Danning v. Bozek (In re Bullion Reserve of North America) 836 F.2d 1214 (9th Cir. 1988). See also Morrison v. Champion Credit Corporation (In re Barefoot) 952 F.2d 795, 797-798 (4th Cir. 1991)).

There are some exceptions to the avoidance power of the bankruptcy trustee including when a transfer is a 'contemporaneous exchange for new value.' The applicable statute, 11 USC §547(c)(1), provides that a bankruptcy trustee may not avoid an otherwise preferential transfer, if such transfer was (A) intended by the debtor and the creditor to be a contemporaneous exchange for new value give to the debtor; and (B) in fact a substantially contemporaneous exchange.

A pre-existing judicial precedent, O'Rourke v. Seaboard Surety Co. (In re. E.R. Fegert, Inc.) 887 F.2d 955 (9th Cir 1989), had held that a lien release constitutes new value, and is therefore an exception to a preference transfer. In Fegert, the general contractor had paid its subcontractor and a supplier the total amount owing to them for work performed and material supplied to the project within 90 days of filing for bankruptcy. The bankruptcy trustee sought to set aside the payments as preferential transfers. The Ninth Circuit affirmed two lower courts' rulings that the transfers counted under the exception of 11 USC §547(c)(1) as contemporaneous exchanges for new value. The court explained that by paying its subcontractor and supplier, the general contractor avoided its surety's automatic and equitable lien. Avoiding the surety's indemnity rights constituted 'new value' to the bankruptcy estate, making the payment an exception to the preference statute.

In JWJ, the bankruptcy trustee similarly sought to avoid JWJ's payment to Endo Steel as a preference under the bankruptcy code. However, Endo Steel argued, relying on the Fegert opinion, that the contemporaneous exchange for new value exception set forth in 11 USC §547(c)(1) applied to the transaction between JWJ and Endo Steel. The bankruptcy court agreed and rejected the trustee's position, holding that JWJ's payment was a contemporaneous exchange for new value in the form of the initial release of lien rights, and the payment was therefore exempt from avoidance pursuant to Bankruptcy Code §547(c)(1).

However, the Bankruptcy Appellate Panel reversed the bankruptcy court's ruling, and the Ninth Circuit agreed. In explaining that the bankruptcy court was wrong, the Ninth Circuit found an important factual difference with Fegert. In JWJ, the check, which was exchanged simultaneously for an unconditional lien release of Endo Steel's surety claim, was dishonored. The Ninth Circuit found the cashier's check which had been issued to replace the dishonored check, changed the transaction from a contemporaneous exchange for new value into a new and distinct credit transaction.

Previous cases had held that when a bounced check is given by the debtor in exchange for new value provided by a creditor, any subsequent payment to make the bad check good is not a contemporaneous exchange for new value. In Morrison v. Champion Credit Corp. (In re Barefoot) 952 F.2d 795 (4th Cir. 1991), relied on by the Ninth Circuit in JWJ, the debtor paid its debt to a secured creditor (not a mechanics' lien) by check and the creditor released its security interest before the check cleared. After the check bounced, the debtor made three wire transfers to the creditor to replace the dishonored check. The Fourth Circuit Court of Appeal upheld the avoidance of the transfers stating that the exception for a contemporaneous exchange does not ordinarily apply to credit transactions, and the dishonored check created a new prebankruptcy debt owed by the debtor to the creditor. According to the court, any subsequent payment to make good on the dishonored check is actually a payment satisfying the 'new' debt, which is a preference.

The Consequences Of Endo Steel's Unconditional Lien Release

In an attempt to distinguish the facts from Barefoot, Endo Steel argued that the lien release it issued to JWJ was effective only upon receipt of payment, and therefore Endo Steel gave 'new value' when it received the cashier's check on May 2-even though the lien release was issued on April 14. The Ninth Circuit rejected this argument because the lien release that Endo Steel executed was an unconditional release, rather than a conditional release.

The Court explained that when Arizona revised its lien statute in 1992, it provided four standardized forms of lien releases; conditional and unconditional releases for installment (progress) and final payments. Although the statute warns lienholders to use the conditional form if they have not been paid, Endo Steel used the unconditional form. (In re JWJ Contracting, Inc., supra, 371 F3d. at 1082).

The court held that Endo Steel's unconditional release given on April 14, in exchange for what turned out to be a bad check, resulted in a credit transaction. The bounced check received on April 14 created a new unsecured debt, which was extinguished by the May 2 cashier's check. Thus, the April 14 unconditional release and the May 2 payment were not contemporaneous. The May 2 payment was therefore an avoidable preference under §547(b) of the Bankruptcy Code.

What Would Have Happened Had Endo Steel Issued A Conditional Release?

The question which then arises is: had Endo Steel issued a conditional release, would the result have been different? First, it must be pointed out that Endo Steel should have used the conditional release in any event. If payment is made by regular check, a conditional release is specifically authorized under the Arizona lien release statute. It is likely that if JWJ's check not only bounced, but JWJ refused to-or simply couldn't-make repayment, Endo Steel would have lost its lien rights by issuing the unconditional lien release. Arizona Revised Statutes and the California Civil Code have almost identical lien release statutes. The conditional release is to be used "where the claimant is required to execute a waiver and release in exchange for, or in order to induce the payment of, a progress [or final] payment and the claimant is not, in fact, paid in exchange for the waiver and release." (see California Civil Code §3262(d) and Arizona Revised Statutes $33-1008). In both the California and Arizona statutes, the conditional release specifically provides that the release is not valid until the check is paid by the bank upon which it is drawn.

Therefore, the decision in JWJ would probably have been different if Endo Steel issued a conditional release to JWJ rather than an unconditional release. If Endo Steel issued a conditional release, the transaction should not be avoided by the bankruptcy trustee as a preference transfer because, under the language of California and Arizona's lien release statutes, a conditional release is not valid until payment is made, and since a creditor would maintain its mechanics' lien, stop notice and bond rights until payment is actually received, notwithstanding the previously executed conditional release, the conditional release is a contemporaneous exchange for new value.

Conclusion

When considering how, when and whether to issue a lien release, lienholders must pay particular attention to not only what is being released, but also what is being received in exchange for the release. If funds being received are certified, then an unconditional release is appropriate. However, when a lien release is issued in order to induce payment or when payment is made by a regular check, a conditional release, if allowed in the jurisdiction where the project exists, is mandated.

When issuing lien releases for payment for material supplied to works of improvement, it is important to understand your state's statutory scheme for lien releases and to follow that scheme very carefully. You should always check with your legal counsel to ensure that important rights are not being released. In states where conditional and unconditional mechanics' lien releases exist, be careful not to acquiesce in the demands of an owner, general contractor or subcontractor to issue an unconditional release when a conditional release is warranted; such as when payment is made by a regular bank check. The issuance of an unconditional release when a conditional release is warranted could mean the loss of your mechanics' lien, stop notice or bond rights, when payment is not received or when a check bounces, even if you are lucky enough to obtain a new check; because the payor files for bankruptcy less than 90 days later.

[Author Affiliation]

ROBERT SCHWARTZ, ESQ.

[Author Affiliation]

You may reach Robert D. Schwartz, Esq., Poindexter & Doutré, Inc., Los Angeles, CA by phone at 213-628.8297, or by e-mail at rschwartz@pdlawyers.com.

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