Article Courtesy of David Simonds, Katherine Lynn, and Edward McNeilly of Hogan Lovells
SJS Mech. Servs. LLC v. Walsh Construction Co. II LLC, No. BR 24-01010, 2024 WL 2701959 (W.D. Wash. May 24, 2024)
On an issue of first impression, the United States Bankruptcy Court for the Western District of Washington (the “Bankruptcy Court”) considered whether a construction lien on a property had priority over a subsequently filed deed of trust under the Restatement (Third) of Property: Mortgages § 7.6 (“Restatement § 7.6”) adopted by the State of Washington. The Bankruptcy Court held that Walsh Construction Company II, LLC (“Walsh Construction”), the holder of the construction lien, failed to show on summary judgment that its lien was senior to the deed of trust. Thus, the Bankruptcy Court denied Walsh Construction’s motion for a summary judgment arguing that its construction lien was the superior lien.
In April 2019, Walsh Construction signed a contract with Pine Esker, LLC to construct Pivot Apartments (the “Property”) owned by B-1208 Pine, LLC (the “Debtor”). In June 2019, the Debtor took out a construction loan from Bank OZK, and a deed of trust was recorded against the Property as the senior secured loan. Before beginning construction on the Property, Walsh Construction executed a document stating that its construction lien was subordinate to Bank OZK’s deed of trust. Pursuant to the State of Washington’s construction lien statute, a construction lien attaches to the property automatically, without recording, when the claimant begins providing lienable goods or services, which usually occurs when construction on a project begins. On July 16, 2019, Walsh Construction commenced construction on the Property. In May 2022, construction was completed, and the Debtor took possession of the Property. On November 2, 2022, Pivot Apartment Lender, LLC (the “Pivot Lender”) lent the Debtor approximately $32 million, of which $20 million was applied to pay off the obligation to Bank OZK. On December 16, 2022, Walsh Construction recorded a $4.2 million construction lien against the Property and filed its complaint for foreclosure. On January 16, 2024, the Debtor filed a chapter 11 voluntary bankruptcy petition, and the Pivot Lender removed the foreclosure lawsuit to an adversary proceeding in the Bankruptcy Court.
Walsh Construction argued that the Pivot Lender should not be equitably subrogated to Bank OZK’s priority position because: (1) the protections of Washington’s mechanics’ lien statute must be construed liberally in favor of those entitled to its protections, and the statutory priority scheme should take precedence over the application of equitable subrogation; (2) the Pivot Lender knew about the construction lien as it had attached when Walsh Construction first began construction on the Property; and (3) equitable subrogation would materially prejudice Walsh Construction.
The Pivot Lender argued that its deed of trust should be equitably subrogated to Bank OZK’s prior senior position because: (1) the Pivot Lender paid off the previous senior secured lender on the Property and should therefore be equitable subrogated to the senior security position, regardless of Washington’s mechanics’ lien statute; (2) knowledge of the construction lien was irrelevant; and (3) Walsh Construction would not be prejudiced by application of equitable subrogation because its security position with respect to the portion of the Pivot Lender loan balance that paid off the Bank OZK loan balance would remain unchanged.
The court held that, under Washington law, the Pivot Lender would generally be equitably subrogated to the construction lien if the requirements of Restatement § 7.6 were met. In determining this issue, the Bankruptcy Court first noted that the State of Washington had adopted the Restatement § 7.6 approach to equitable subrogation, which provides, in part, “[o]ne who fully performs an obligation of another, secured by a mortgage, becomes by subrogation the owner of the obligation and the mortgage to the extent necessary to prevent unjust enrichment.” As this issue had not yet been decided by Washington state courts, the Bankruptcy Court looked to interpretations of Restatement § 7.6 in Arizona and Nevada. The Nevada Supreme Court had determined that the plain language of Nevada’s mechanics’ lien statute affords mechanics’ liens an unassailable priority over intervening encumbrances such that the application of equitable subrogation in the mechanics’ lien context was prohibited. In contrast, the Arizona Supreme Court rejected the approach of the Nevada Supreme Court, holding that applying the Restatement § 7.6 approach to equitable subrogation of a subsequent lien was consistent with Arizona’s mechanics’ lien statute and that nothing in the text of the Arizona mechanics’ lien statute suggested the legislature intended to preclude equitable subrogation in the mechanics’ lien context.
Following the decision of the Arizona Supreme Court, the Bankruptcy Court held that, because nothing in the text of the Washington state mechanics’ lien statute indicates that the Washington state legislature intended to exempt mechanics’ liens from equitable subrogation, a Washington state court would apply equitable subrogation in the mechanics’ lien context. Further, the Bankruptcy Court found that the Pivot Lender’s knowledge of intervening liens was irrelevant because, under Washington state law, knowledge of intervening liens does not preclude application of equitable subrogation. The Bankruptcy Court also held that Walsh Construction would not be prejudiced by this approach because Walsh Construction’s construction lien would only be subordinate to the Pivot Lender’s lien up to the amount of the Bank OZK debt paid off by the Pivot Lender, leaving Walsh Construction in the same position as it was prior to the Pivot Lender transaction.
