United States: Primer For Construction Bankruptcies

In general, a company has two bankruptcy alternatives: liquidation under Chapter 7 and reorganization under Chapter 11.

Under Chapter 7, upon the filing of a bankruptcy petition, a trustee is appointed to gather and sell all of the debtor's assets as quickly as possible. Once the trustee liquidates all of the assets, it must pay creditors in accordance with the priority scheme mandated by the Bankruptcy Code:

• Claims secured by collateral;
• Claims entitled to priority or administrative expense priority treatment such as certain tax claims and the costs of administering the bankruptcy estate;
• General unsecured creditors; and
• Equity.

The trustee will pay creditors in whole dollars until it can no longer do so, in which case it will make a pro rata distribution to creditors at the same level of priority. There is no assurance that general unsecured creditors will receive any distribution.

Chapter 11 is generally a long, involved process. The debtor, who remains in possession and control of its business, negotiates with its creditors, and then proposes and files a plan of reorganization with the Bankruptcy Court. The debtor's plan of reorganization, once confirmed by the Bankruptcy Court, governs how the debtor will continue to conduct business and in what manner it will satisfy the claims of its creditors (repayment of claims generally follows the priority scheme noted above). Debtors generally use Chapter 11 to reorganize as a viable business, to sell the business as a going concern or, increasingly, to liquidate the assets of the business in a manner that is more orderly than under Chapter 7 liquidation.

One of the primary benefits of filing for bankruptcy (ether Chapter 7 or 11) is that the bankruptcy filing itself stops all legal actions against the debtor. This is known as the "automatic stay" in bankruptcy. The automatic stay acts as an injunction or a "shield" which prohibits creditors from beginning or continuing litigation, collection activity, or in the case of a construction contract, a general contractor's efforts to terminate the debtor's subcontract. Once the debtor files for bankruptcy, any creditor looking to take any action against the debtor or its property must first obtain permission from the Bankruptcy Court.

At some point during the bankruptcy case, a deadline will be imposed for filing claims against the debtor, known as a bar date. Bankruptcy Courts strictly enforce bar dates. A contractor that is owed money from a subcontractor or owner who files for bankruptcy should consider filing a proof of claim in the bankruptcy case for amounts owed by the debtor.

Contracts

Construction contracts are considered "executory" contracts under the Bankruptcy Code. The debtor may either assume or reject such contracts. A debtor generally has until confirmation of its plan to make a decision whether to assume or reject a contract; however, the court, at the request of a counterparty, may order the debtor to make its decision within a specified period of time. If the debtor decides to assume the contract, it must cure all defaults, including paying any past due payments and continuing with its performance on the contract. The debtor must also prove that it can adequately perform the contract going forward. If the debtor decides to reject the contract, the debtor loses all of the benefits of the contract. Past due payments owing to the non-debtor counterparty under a rejected contract become general unsecured claims and the counterparty may also have a damages claim for breach of contract.

A contract that has expired or otherwise terminated prior to the bankruptcy filing may not be assumed or rejected. Thus, if the contract is terminated prior to the bankruptcy filing, the contract does not come into the bankruptcy estate and is not administered as part of the bankruptcy case. Most construction contracts contain a provision that permits the non-debtor party to immediately terminate the contract upon the debtor filing for bankruptcy protection. This bankruptcy default is known as an "ipso facto clause" and is not enforceable in bankruptcy. If the non-debtor party wishes to terminate the contract after the bankruptcy filing, it must get permission from the Bankruptcy Court.

When a debtor continues to properly discharge its contractual obligations, the contractor may want to continue working with the debtor despite the bankruptcy. The contractor should consider attempting to protect its rights and interests by requiring the debtor to file an assumption stipulation with the Bankruptcy Court. The contractor can build into the assumption stipulation several advantages and protections that may not exist in the contract. Some of these protections include:

• Strict performance milestones;
• A joint check provision;
• Expedited termination provisions in the event of a subsequent breach by the debtor;
• The ability to replace the debtor in the event of a subsequent breach by the debtor; and
• The right to immediately set off any damages caused by the debtor's breach against any funds that may be due to the debtor.

Liens

Every state grants lien rights to contractors that contributed to a project. These lien rights must be protected under applicable state law because in bankruptcy, failure to perfect lien rights may allow the debtor to avoid the unperfected lien and reclassify the claim to general unsecured claim status.

Notwithstanding the automatic stay, the Bankruptcy Code permits contractors to perfect and maintain lien rights (e.g., providing pre-lien notices and recording a claim of lien) after the bankruptcy filing if such rights could have been perfected or maintained under applicable state law but for the bankruptcy filing. Although the Bankruptcy Code permits acts to perfect and maintain lien rights, it does not permit any act to enforce such rights against the debtor during the bankruptcy case. Any enforcement activity can occur only after obtaining permission from the Bankruptcy Court. Note that the automatic stay does not protect non-debtor parties. Thus, a debtor's bankruptcy will not prevent a party from pursuing (and enforcing) lien rights and other remedies against non-debtor contractors, property owners, or other third parties, including sureties and guarantors, who may be liable on the claim.

Setoff

Construction contracts (and common law) often allow the contractor to withhold and charge back against the debtor amounts due unpaid sub-subcontractors and suppliers. The debtor may demand payment from the contractor even though the debtor caused damages to the contractor by failing to timely complete a job. These are examples of setoff rights, which are preserved under the Bankruptcy Code. The automatic stay, however, prevents a contractor from realizing on these rights unless and until the contractor receives authorization from the Bankruptcy Court to setoff the obligations.

Direct Pay

Some contracts provide that if the debtor fails to pay its subcontractors or suppliers, the contractor may withhold payment to the debtor and pay the sub-subcontractors and suppliers directly. Some Bankruptcy Courts have relied on direct pay provisions to find the bankruptcy estate has no interest in these funds and that the contractor may bypass the debtor and make payment directly to the lower-tier subcontractors and suppliers. Not all Bankruptcy Courts enforce direct pay provisions, so it is prudent to obtain court authority before making such direct payments. In addition, to the extent that the Bankruptcy Court does permit direct payments, the contractor should not pay any lien claimants until they have taken all necessary steps to perfect their liens.

Replacing the Subcontractor

If the debtor ceases performing work on a project, the contractor should immediately, on an emergency or expedited basis, make a motion with the Bankruptcy Court to remove the debtor from the project and replace the debtor with another subcontractor. The replacement must be effectuated pursuant to court order to avoid violating the automatic stay and any contempt damages that could follow from that violation. If the cost of the replacement subcontractor is more than what the contractor would have paid the debtor, the contractor has an unsecured claim against the debtor for the difference.

Joint Check

Some contracts provide that a contractor may pay a subcontractor and its sub-subcontractor or supplier by joint check such that the subcontractor cannot cash the check without the signature of the supplier, thereby ensuring that the subcontractor pays the supplier with proceeds from the check. A financially distressed subcontractor that is not bound by a joint check provision could use the funds for other purposes, leaving the lower-tier subcontractor or supplier unpaid and giving rise to liens claims that the contractor must discharge.

Some Bankruptcy Courts have required debtors to continue to pay their subcontractors and suppliers under pre-bankruptcy joint-check agreements. The rationale employed by these courts is that the funds do not really belong to the debtor if the intent of the parties was to ensure that the funds were paid to the supplier. Contractors may be able to enforce properly drafted joint-check provisions to ensure appropriate payments are made.

Preferences

Filing a bankruptcy case gives the debtor (but not a creditor) the ability to avoid and recover certain transfers it made within the 90-day period prior to the bankruptcy filing. These transfers are known as preferences in bankruptcy circles. In order for preference payments to be avoided, the debtor must demonstrate, among other things, that the payment was the property of the debtor, made on account of an existing debt, and permitted the creditor to receive more than it would have in Chapter 7 liquidation. A classic preference fact pattern could be where an owner makes a payment to the contractor for amounts owed under a contract for services already rendered and then the owner files for bankruptcy within 90 days of making the payment. The Bankruptcy Code also provides several defenses to preferences, including an ordinary course of business defense, a new value defense, and a contemporaneous exchange defense.

One area that may be ripe for preference attack is the situation where a subcontractor executes a lien waiver, is not in fact paid, and files for bankruptcy prior to filing the affidavit of nonpayment. There is some potential that the debtor could assert that the contractor would be receiving more than it is entitled to receive under Chapter 7 if it did not pay for the work subject to the lien waiver.

Frequently Asked Questions

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.