• Secured Lenders Beware: Well Testing and Drilling by Third-Party Constitutes First Actual Physical Improvement Under Michigan Construction Lien Act
  • March 12, 2012 | Authors: John T. Gregg; Patrick E. Mears
  • Law Firms: Barnes & Thornburg LLP - Chicago Office ; Barnes & Thornburg LLP - Grand Rapids Office
  • The Michigan Court of Appeals recently held that well testing and drilling performed on vacant real estate that was later developed into a subdivision constituted the first actual physical improvement under the Michigan Construction Lien Act, MCL 570.1191 et seq. (the Act). As such, when a secured lender subsequently advanced funds and recorded its mortgage on the real estate, the secured lender was subordinate in priority to a construction lien claimant who performed services after the secured lender’s mortgage was recorded. E.T. MacKenzie Co. v. Sutton Place-Raisin Twp., L.L.C., Case No. 297864 (Mich. Ct. App. Nov. 22, 2011).

    In E.T. MacKenzie, the owner of the real estate contracted with a third party for well drilling and testing prior to the owner’s purchase of the real estate. When the third party completed its work, PVC pipes extended approximately five feet above the ground. Thereafter, the owner obtained a loan from the lender, granted the lender a mortgage on the real estate, and used the proceeds of the loan to purchase the real estate.

    Approximately six months later, the owner and the plaintiff/construction lien claimant contracted for the plaintiff to provide services related to the real estate. The plaintiff timely recorded a claim of lien under the Act and, after the owner refused to provide payment in full, commenced suit for damages and to foreclose on the real estate. The trial court held that the lender’s mortgage had priority over the plaintiff’s construction lien because the third party’s test wells and drilling did not meet the statutory definition of an “actual physical improvement.” The plaintiff appealed, arguing that the test wells and drilling of the third party were “actual physical improvements.”

    Under the Act, a construction lien has priority over all other liens or interests that are recorded after the first physical improvement. MCL 570.1119(3). The “first actual improvement” is considered to be an actual physical change or alteration “which is readily visible and of a kind that would alert a person upon reasonable inspection of the existence of an improvement.” MCL 570.1103(1). However, as part of a so-called “due diligence exception,” the first actual improvement excludes “labor that which is provided in preparation for that change or alteration, such as surveying, soil boring and testing. . .” Id.

    On appeal, the lender argued that because the wells were installed for testing purposes only, the wells fit within the due diligence exception to the first actual physical improvement. In support, the lender relied on another recent decision from the Michigan Court of Appeals. See Mich. Pipe & Valve-Lansing, Inc. v. Hebeler Enterprises, Inc., 292 Mich. App. 479; --- N.W.2d --- (Mich. Ct. App. May 3, 2011).

    In Mich. Pipe, a contractor installed a test well in order to obtain a water sample from the acquifer below the real estate. The PVC pipes for the wells extended one foot above ground. The lender argued that because the well was installed only to test the real estate in preparation for an improvement, the installation itself was not an actual physical improvement. The Mich. Pipe court disagreed and explained that the inquiry is whether the act results in a permanent presence on the property, not whether the action itself constitutes a form of testing. Because the drilling of the well in Mich. Pipe resulted in a permanent presence, the court held that the due diligence exception was not implicated.

    Applying a similar rationale, the E.T. MacKenzie court found that because the test wells were readily visible and of a kind that would alert a person upon reasonable inspection of the existence of an improvement, the wells constituted the first actual physical improvement to the real estate. The court emphasized that the wells were permanent and visible due to the five foot high PVC pipe. Because the lender’s mortgage was recorded after the first actual physical improvement, the court held it was subordinate to the plaintiff’s construction lien.

    The court also rejected arguments that the plaintiff’s work was unrelated to the initial drilling by the third party. First, the court noted that the Act does not specify that the projects must be related. Second, the court noted that even if such a requirement existed, the drillings did relate to one another since they were both improvements necessary for the construction of the subdivision.

    The decision in E.T. MacKenzie serves as yet another reminder to mortgage lenders to ensure that no physical improvements have been made to the mortgaged real estate. It is therefore imperative that the lender physically inspect not only the mortgagees records, but also the real estate itself and any filings or applications at the local, county and state level related to the real estate. Lenders should also realize that even though a mortgagee may not own the property, the “first actual physical improvement” may have nonetheless occurred in furtherance of a construction project.