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Could California Private Works Stop Notice Claims Be Challenged on Basis That State Stop Notice Law is Preempted by Federal Lending Regulations?

In this era of declining property values, owner abandoned projects, and defaulting developers, the private works stop notice has become a central element in contractor payment claims. The private works stop notice is served on a construction lender along with a bond, and creates a lien on undisbursed construction loan funds. But a recent trial court order in a Federal District Court in Arizona shows that this remedy of last resort may be threatened by a new legal challenge.

While mechanic's liens have traditionally been a primary remedy for unpaid contractors, they have lost much of their value as a reliable source of payment during the Great Recession. A mechanic's lien taps into equity in the improved property. But if the property is "underwater" (i.e. the value of liens exceeds the value of the property) and/or is subject to foreclosure by senior lenders, then a mechanic's lien may be essentially worthless. This scenario has become increasingly common during these turbulent economic times. A recent report by First American CoreLogic states that over one-third of residential properties in California are currently in a negative equity position.

In response many contractors are turning to the previously rarely used private works stop notice. Instead of creating a security interest in the real property in question, the stop notice attaches to any construction loan funds earmarked but not yet distributed by the construction lender. To be effective the stop notice must be timely served upon the construction lender and accompanied by a surety bond in favor the said lender. Once served the lender is required to hold the stopped funds until the contractor's dispute is resolved.

Lenders are hostile to these stop notices because it forces them to hold and distribute funds on loans which are likely already in default. In response it appears that at least one lender is testing a new legal defense to private works stop notices, and that a Federal District Court in Arizona is validating its theory.

The case in question is Jeffery C. Stone, Inc. d/b/a Summit Builders v. MidFirst Bank, U.S. District Court of Arizona, Case No. CV-09-01218-PHX-ROS. In MidFirst Bank, general contractor Jeffery C. Stone, Inc. ("JCS") entered into a contract with a developer to construct condominiums. The developer then secured construction financing from MidFirst Bank to fund the project. During the pendency of the project the developer defaulted on the loan and the stopped paying JCS. JCS alleged it was owed approximately $1.5 million for already work performed and served a bonded stop notice on MidFirst Bank pursuant to Arizona state law (A.R.S. §33-1058). After JCS filed a lawsuit relative to the stop notice MidFirst Bank had the case removed to Federal District court, and then challenged the stop notice in a Motion for Summary Judgment.

In the motion MidFirst Bank challenged the stop notice on the grounds that Arizona's state private works stop notice laws were unenforceable because they were preempted by Federal lending statutes and regulations.

The Supremacy Clause (Article VI, §2) of the U.S. Constitution, provides that, "The Laws of the United States ... shall be the supreme Law of the Land; ... any Thing in the Constitution or Laws of any state to the Contrary notwithstanding." The US Supreme Court has interpreted this clause to bar states from regulating subject matter within the purvey of federal regulation. In other words, states cannot regulate a given subject matter already governed by federal government legislation. This ensures that the federal government remains the supreme governing authority in the areas it chooses - and is authorized by the Constitution - to regulate

In practice, if a litigant can show that a particular law is preempted by federal regulation then the court cannot enforce the said law. That is what MidFirst Bank succeeded in doing in this case.

MidFirst Bank argued that it was a federally charted saving association and therefore subject to exclusive federal regulation by the Office of Thrift Supervision ("OTS"), as mandated by The Home Owner's Loan Act of 1933. MidFirst Bank cited OTS regulations proclaiming that the OTS "occupies the entire field of lending regulation" for federal savings associations and case law stating that there is "no room for state regulatory control" of these lenders. More specifically, MidFirst Bank cited an OTS regulation specifically providing that any state law "purporting to impose requirements regarding ... disbursements and payments" be preempted. 12 C.F.R. 560.2(b)(11).

The court in MidFirst Bank then examined the Arizona private works stop notice statute in light of these clear preemption limitations. The court noted that the relevant Arizona law provided that lenders served stop notices "shall withhold from the borrower ... out of the construction fund sufficient monies to answer the claim." The court then concluded, "Absent this Arizona statute, however, MidFirst would not be required to disburse any funds. Thus, the Arizona statute is a straightforward attempt to control MidFirst's actions regarding disbursements of loans. Because laws regarding "disbursements" are explicitly identified in the preemption regulation, the analysis ends here; the law is preempted." Based upon this conclusion the court granted MidFirst Bank's motion for summary judgment.

Notwithstanding other considerations, it should be noted that the theory used in MidFirst Bank should not be applicable in cases when a stop notice is served on a state-charted savings associations. These thrifts are not subject to exclusive OTS regulation and therefore in theory should clearly be subject to state stop notice laws.

The question for California contractors is whether or not a similar defense is possible in California courts. California private works stop notice provisions are set forth in Civil Code §3156 et seq. Section 3159 and 3162 provides that when served a bonded stop notice a "construction lender shall withhold funds pursuant to the bonded stop notice..." On its face the California scheme appears similar to the Arizona scheme in that it could be construed as an attempt to control a lender's actions regarding the disbursement of loans. Therefore California statutes may also be susceptible to a preemption challenge.

In sum, California contractors and their attorneys should be prepared to face these arguments when litigating private works stop notices. If California courts (or federal courts interpreting California law) are similarly receptive to preemption arguments then the landscape for contractor payment claims will become even more difficult for contractors.

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