How Contract Drafting Effects the Establishment of a Lien Fund

According to the New York Lien Law, a mechanic’s lienor who is a subcontractor may only recover on its lien claim if it can establish there is a Lien Fund. That means the lienor must establish that funds were due and owing from the owner to the contractor in an amount at least equal to the amount of the lien. If the lienor in either a private or public setting cannot establish the validity of a Lien Fund, then the lien is subject to dismissal.

The Lien Fund concept is designed to protect an owner against an unfair “double liability.” In other words, if the owner has paid its contractor in full, an owner and its property should not be liable to pay a subcontractor simply because the contractor is the reason for, and source of, the non-payment. To that extent, a subcontractor’s mechanic’s or public improvement lien is derivative of the contractor’s claim against the owner. The Lien Fund concept also applies to a sub-subcontractor lien, so the sub-subcontractor must establish a contractor-subcontractor Lien Fund.

Generally, in order for the lienor to recover, it must establish that the Lien Fund existed on the date of the filing of the mechanic’s lien. If it can, then assuming the lienor can meet all the other requirements of proving the validity of its lien, it will be entitled to a recovery. In Specrite Design LLC v. Elli N.Y. Design Corp. (S.D.N.Y. 14 Civ. 6154) (July 26, 2017), Judge Edgardo Ramos addressed whether this general rule applies when the lienor was retained by a contractor that had been defaulted by the owner. Judge Ramos found that the general rule does not apply in these circumstances. Under the specific facts presented in Specrite, the lienor would not be able to foreclose on its lien even though the contractor was purportedly owed monies on the date of the filing of the subcontractor’s mechanic’s lien.

The procedural background of the Specrite case was more complicated than the typical lien foreclosure action. We will just summarize the relevant facts. The owner of the project in question was the Dormitory Authority of the State of New York (“DASNY”). The general contractor was J. Kokolakis Inc. (“Kokolakis”). Kokolakis subcontracted with Elli NY Design Corp. (“Elli”). Elli, in turn, subcontracted with Specrite Design, LLC (“Specrite”). Elli allegedly breached its contract with Specrite by failing to tender it payment. As a result, Specrite filed a public improvement lien and commenced a legal action in federal district court against both Kokolakis and Elli (the “Foreclosure Action”). Previously, Elli had commenced a state court breach of contract action against Kokolakis, and Kokolakis counterclaimed for breach of contact (the “State Court Action”).  Because the Specrite lien was bonded by Liberty Mutual Insurance Company (“Liberty Mutual”), it appeared in both actions and DASNY did not appear in either action.

Kokolakis and Liberty Mutual moved to stay the Foreclosure Action pending before Judge Ramos until the State Court Action was resolved. The key question that needed to be answered in order to determine if a stay should be issued was whether a Lien Fund existed for the benefit of Specrite. The Parties’ dispute revolved around when the amount of the relevant Lien Fund should be established.

Kokolakis and Liberty Mutual alleged that the subcontract allowed Kokolakis to utilize any of Elli’s earned and unearned funds to cure an Elli default. These monies could properly be deducted from any Lien Fund that was otherwise payable to Elli, and thus deplete the monies that might be available to Specrite. As a result, Kokolakis and Liberty Mutual argued that the Foreclosure Action should be stayed until the State Court Action determined whether Elli had defaulted and, if so, the amount of any remaining Lien Fund.

Specrite alleged, on the other hand, that the Lien Fund was determined at the time the lien was filed. If this were true, then any subsequent default by Elli would be irrelevant and therefore there would be no reason to stay the Foreclosure Action to await the outcome of the State Court Action.

Judge Ramos found that Kokolakis and Liberty Mutaul’s analysis of the Lien Law was correct, and that a stay of the claims in the Foreclosure Action relating to the lien should be granted until a determination regarding the Elli purported default was rendered in the State Court Action. The reasoning of Judge Ramos was based on the derivative nature of the lien. Because Specrite’s lien claim was subject to any monies which were owed by Kokolakis to Elli, the court should consider whether Elli defaulted on its contract before it addressed the other grounds regarding validity of the Specrite lien.

The court declined to follow a New York Court of Appeals decision which relied on the rule that the Lien Fund was established at the date of the lien filing. The facts set before the court in American Radiator Co. v. New York, 223 N.Y.193, 198 (1918) were distinguishable. In the American Radiator case, the contract in issue did not permit the owner to apply earned monies by the contractor to complete the project in question after default. In the Kokolakis-Elli subcontract, on the other hand, certain deductions were contractually authorized. Thus, the Specrite case was more analogous to the facts presented in Scarsdale National Bank & Trust Co. v. U.S. Fidelity & Guaranty Co., 264 N.Y. 159 (1934).

The Specrite decision highlights, among other things, the importance of proper contract drafting. Without specific language in a contract authorizing the deduction of monies against any sum which might be otherwise due and owed to a subcontractor, the Lien Fund would have been established at the date of the filing of the lien. That would have meant, in the Specrite case, that Kokolakis or its bonding company, Liberty Mutual, might have eventually been found liable to Specrite even though Elli’s default required Kokolakis to spend far more money correcting Elli’s deficiencies than any monies that were purportedly owed by Elli to Specrite. A well drafted contract was the main bulwark protecting Kokolakis and Liberty Mutual from this inequitable result.