Ed. Note: This was originally published in 2020, authored by Jason Strickland, and has been revised and updated. This is part one of a two-part series.
As the steady drumbeat of development continues across North Carolina, it is ever more important that contractors and subcontractors protect their payment rights and avoid the risk of double payment, i.e., the risk of having to pay twice for the same work.
One of the most effective methods for protecting payment rights and defending against double payment claims on private projects in North Carolina is the Notice of Contract mechanism. However, the Notice of Contract mechanism is also one of the most frequently misunderstood mechanisms within our lien law.
What is Double Payment Risk?
Double payment arises from the "contracting-chain" nature of large construction projects (See Exhibit A). Construction projects typically involve an owner retaining a general contractor or construction manager to perform the construction. The general contractor typically does not perform the work itself but rather retains subcontractors to perform different scopes of the total construction package.
Those subcontractors retained directly by the general contractor are known as first-tier subcontractors. Those first-tier subcontractors will typically retain subcontractors themselves, those subcontractors being known as second-tier subcontractors. It is not uncommon to have subcontractors or suppliers as "remote" as the second or third-tier on large construction projects.
Construction projects with subcontractors (including suppliers) at the second and third-tier levels confront the risk of default by parties in the middle tiers, particularly default by first-tier subcontractors.
The default often occurs where a first-tier subcontractor is paid by the general contractor but does not pass payments down to its second-tier subcontractors. This, in turn, creates an issue with who will bear the loss of a first-tier subcontractor's default.
Put simply, if the second and third-tier subcontractors perform work for and through a first-tier subcontractor, the first-tier subcontractor is paid for that work, and the first-tier subcontractor then defaults (e.g., by going bankrupt or by leaving the country and making themselves "unavailable" to pay anything), who carries the risk of that loss, the general contractor or the second and third-tier subcontractors?
In North Carolina, on private projects (i.e., projects not owned by the federal or state government), absent strict adherence to the Notice of Contract mechanism, the risk of loss is on the general contractor.
Why Do We Have the Notice of Contact Mechanism?
The Notice of Contract mechanism came about because of an ambiguity in North Carolina's lien statute.
Generally speaking, general contractors (i.e., those with a contract with a project owner) have rights to lien the real property; subcontractors have rights to lien the project funds.
However, in addition to their rights to lien project funds, subcontractors also have the right to step into the shoes of the general contractor and—through the magic of the legal mechanism known as "subrogation"—assert the general contractor's lien on real property.
When subcontractors were given the right to assert this subrogation lien on real property, most construction lawyers understood that the right to assert the lien on real property by second or third-tier subcontractors was limited by the subcontractor's right to a lien upon funds.
If a first-tier subcontractor had been paid in full, then the second- and third-tier subcontractors working for it would have no lien on funds (because no funds were owed to the first-tier subcontractor). Thus, the assumption was that because the second and third-tier subcontractors had no lien upon funds, they had no right to a subrogation lien on real property.
To the surprise of many of these construction lawyers in 1991, in the case of Electric Supply Co. of Durham, Inc. v Swain Electrical Co., Inc., 328 N.C. 651, 403 S.E.2d 291 (1991), the Supreme Court of North Carolina held that based on ambiguous wording in the lien statute, a second and third-tier subcontractor's right to a subrogation lien on real property was limited only by the amounts owed from the owner to the general contractor without regard to what, if anything, was owed to the first-tier subcontractor from the general contractor.
This rule created the risk of double payment on the part of the general contractor on private projects in North Carolina.
The double payment risk arises when a general contractor pays a first-tier subcontractor for work performed by second or third-tier subcontractors working for the first-tier subcontractor.
If the first-tier subcontractor defaults (or makes itself unavailable by flying off to Tahiti with the money), the second and third-tier subcontractors' lien on funds rights are limited by the amount owing to the first-tier.
In this example, that amount is $0 or nothing since the first-tier subcontractor has been paid in full. However, the second and third-tier subcontractors can also assert a subrogation lien on real property so long as money is owed from the owner to the general contractor.
This is the double payment problem on private projects: The second and third-tier subcontractors can recover through enforcement of their subrogation lien on real property, without regard to the amount, if any, owed from the general contractor to the first-tier subcontractor.
Because the general contractor already paid the first-tier subcontractor for the work at issue, the general contractor is effectively compelled to pay twice for the same work.
Put another way, the second and third-tier subcontractors can recover, through the subrogation lien on real property, without regard to the fact that the general contractor has already paid the first-tier subcontractor for the work and that the general contractor owes the first-tier subcontractor nothing further.
The owner will not be at risk of double payment. The general contractor will be forced to either pay the second and third-tier subcontractors or have their subrogation lien on real property enforced up to the amounts otherwise owed from the owner to the general contractor.
In simplest terms, the general contractor suffers a loss in the amount of the claims of the second and third-tier subcontractors, limited only by the amount owed from the owner to the general contractor at the time the subrogation lien is asserted.
In response to this double payment problem, the General Assembly, as is often the case with our lien law, did not directly overturn the Supreme Court. Instead, it enacted the Notice of Contract mechanism, which general contractors may use to protect themselves from the risk of double payment.
How Notice of Contract Works
Step 1: General Contractor Plays First Card with Notice of Contract
Under the Notice of Contract mechanism, set forth in N.C. Gen. Stat. § 44A-23, a general contractor wishing to protect itself from double payment on a private project, will first post and file a Notice of Contract. A Notice of Contract contains the following items:
- Name and address of the general contractor.
- Name and address of the owner of the real property at the time the Notice of Contract is recorded.
- General description of the real property to be improved.
- Name and address of the person, firm, or corporation filing the Notice of Contract.
A sample is shown in Exhibit B. The Notice of Contract must be both posted at a visible location on the job site and filed with the clerk of court for the county in which the project is located. This must be done within 30 days of the later of i) the building permit issuing, or ii) full execution of the contract between the owner and the general contractor.
Posting the Notice of Contract inside the jobsite trailer will probably not count as a visible location because the jobsite trailer is not always accessible. A good rule of thumb is to post the Notice of Contract in a location where a material delivery truck driver could easily hop out, locate the Notice of Contract with little or no inquiry, and take a photo of the Notice of Contract without hassle.
Further, although the statute does not require it, it is recommended that the general contractor take date-stamped photos of the Notice of Contract posted at the visible location at the job site. This will help prove that the Notice of Contract was, in fact, posted where and when it was required.
If the Notice of Contract is not timely filed with the clerk of court and posted at a visible location at the job site, the general contractor will not be protected from the risk of double payment by the statute.
Step 2: Subcontractor Responds with Notice of Subcontract
Any second- or third-tier contractor who wishes to protect itself from the risk of a first-tier's default in response to the Notice of Contract must serve a Notice of Subcontract on the general contractor. The Notice of Subcontract must be served in the same manner as a complaint, i.e., FedEx, UPS, or registered mail with receipt confirmation or by personal delivery by a sheriff's deputy.
The Notice of Subcontract must contain the following information:
- Name and address of the subcontractor.
- General description of the real property to be improved.
- General description of the subcontractor's contract, including the names of the parties thereto; and a general description of the labor and material performed and furnished thereunder.
- A statement of the following: "Request is hereby made by the undersigned subcontractor that he be notified in writing by the contractor of, and within five days following, each subsequent payment by the contractor to the first tier subcontractor for labor performed or material furnished at the improved real property within the above descriptions of such in paragraph (2) and subparagraph (3)(ii), respectively, the date payment was made and the period for which payment is made."
A sample Notice of Subcontract is shown in Exhibit C. If a second or third-tier contractor fails to serve a Notice of Subcontract, it will no longer be entitled to enforce the general contractor's lien on real property through subrogation, which will effectively eliminate the general contractor's risk of double payment with respect to that particular second or third-tier contractor.
Step 3: General Contractor Plays Last Card with Continuing Notices of Payment
If the general contractor posts Notice of Contract and the second and third-tier subcontractors provide Notice of Subcontract, then the general contractor is put back in the position it would have been in had it never posted Notice of Contract.
In order to retain the benefit of the Notice of Contract mechanism, the general contractor must play the last card. The general contractor must, each time it pays the first-tier subcontractor, provide a Notice of Payment to each and every second and third-tier subcontractor who has provided a Notice of Subcontract.
The Notice of Payment must be sent within five (5) days of the payment and must be sent via FedEx, UPS, or registered mail with receipt confirmation or by personal delivery by a sheriff's deputy.
A sample Notice of Payment is shown in Exhibit D.
If all of these listed steps above occur, then the second and third-tier subcontractors are prohibited from asserting a subrogation lien on real property.
This effectively shifts the risk of a first-tier subcontractor default from the general contractor to the second or third-tier subcontractors and eliminates the general contractor's double payment risk.
The second and third-tier subcontractors must protect themselves by using the information provided through the Notices of Payment. As soon as they receive notice of a payment to the first-tier, they should immediately lien funds if they do not receive a corresponding payment.
Note that the owner is never at risk of double payment, and the Notice of Contract mechanism does not interfere with the payment rights of the subcontractors against the first-tier subcontractor.
Note also that the first-tier subcontractor is never implicated in the Notice of Contract mechanism, at least for purposes of providing notices. Note also that in the case of a private payment bond, the Notice of Contract mechanism will not alter the obligations under that bond.
Conclusion
If you, as a general contractor, do not utilize the Notice of Contract mechanism on private projects, then you are at risk of double payment.
You should be like Nike, and just "do it."
As a subcontractor, if you do not provide Notice of Subcontract on private projects where a Notice of Contract is posted and filed, then you are at risk of being left with the proverbial bag in the case of a first-tier subcontractor default.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
