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06/09/2008

Nasty Surprises: The Perils of Contracting with Tenants

By: Stan Dobrowski, Calfee Halter & Griswold

Contractors regularly construct improvements for tenants, also known as lessees, often without the involvement of their landlords, also called lessors.  In many cases a contractor will enter into a contract solely with the tenant.  In other cases, a contractor will perform some of the work under such a contract as a subcontractor.

In either case, the contractor may be in for a nasty surprise if the tenant does not make payment in accordance with the contract.  In a line of cases going back to 1924, Ohio courts have held that a mechanics lien extends only to the interest of the person with whom the contract was entered, i.e., the tenant. 

In the most recent case in the line, Construction One, Inc. v. Shore Thing, Inc. (March 20, 2003) Cuyahoga Ct. App. Case No. 81135, 2003 Ohio 1339, a developer leased commercial property on the developer's land to Shore Thing, a retailer.  In turn, Shore Thing hired Construction One to improve the space.  When Shore Thing failed to pay for the improvement, Construction One filed a mechanics lien against the developer's land.   The Court ultimately held that the lien was invalid because Construction One had no contract with the developer.

Although Construction One did have a contract with Shore Thing, no lien had been filed against Shore Thing's leasehold interest.  In any event, foreclosing a lien on a tenant's leasehold interest is almost certainly more trouble that it is worth.  After all, the tenant's interest is usually little more than a right to occupy space upon payment of rent.  Anyone interested in the space can acquire it by paying the same rent to the landlord, leaving nothing for lien claimants.

Worse still, another case indicates that, in some circumstances, the contractor may not even have a claim for unjust enrichment against the landlord.  In American Railroad Construction, Inc. v. Columbiana County Port Authority (March 26, 2007) Columbiana Ct. App. Case No. 06 CO 14, the Court held that a landlord was not unjustly enriched by repairs done by a contractor under a contract with the tenant.  The landlord Port Authority leased a right of way to a railroad company under terms which required the tenant to make repairs.  When a derailment occurred the tenant hired American Railroad Construction to make repairs, but filed for bankruptcy before paying for them.  In ruling against American Railroad, the Court held that the Port Authority was not unjustly enriched because it received only what it was entitled to under the lease, repairs at the tenant's cost.

When dealing with a tenant, a contractor must look even more diligently that usual at the finances of the person with whom it is doing business to assure itself of payment.  If the tenant's financial capabilities are insufficient, the contractor might consider asking the landlord to become a party to the contract or to guaranty payment.  Most landlords, however, will not be willing to comply.

When serving as a subcontractor on a tenant's project, the subcontract must be clear that the general or prime contractor is obligated to pay the subcontractor even if the general or prime is not paid by the tenant.  A "pay if paid" or "pay when paid" clause is completely inappropriate in these circumstances.

In either situation, the contractor must pay careful attention to progress payments.  The only effective way to reduce risk is to keep progress proportionate to payment.


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