In today's challenging construction market, contractors and developers must be prepared to handle bankruptcy law issues that may arise during the course of their construction projects. Given the recent increase in bankruptcy filings, any contractor or developer involved in significant construction operations will inevitably be required to deal with another project participant seeking protection under the U.S. Bankruptcy Code, 11 U.S.C. §§ 101-1532 (hereinafter, the Code). No doubt, the filing of a petition for bankruptcy will have a negative impact on the flow of work and the supply of materials on a construction project.
Avoiding delays and additional costs are the primary concerns when any party on a construction project files for bankruptcy protection. The time to protect from, and minimize, the adverse consequences associated with a bankruptcy filing is at the very beginning when parties negotiate and draft their contract. Indeed, the drafting of the contract is a critical stage in heading off adverse consequences associated with a contractor and/or supplier becoming insolvent during the course of a project. To properly account for bankruptcy law issues that will ultimately arise from the commencement of a bankruptcy case, one must have a basic understanding of the Code and be familiar with the overall framework over which the bankruptcy courts operate.
Basic Terms, Rights and General Overview
The bankruptcy case commences with the "debtor" filing a petition seeking relief under the Code. Generally, a debtor will either seek to liquidate all assets (governed by Chapter 7 of the Code) or attempt to reorganize (governed by Chapter 11 of the Code). There are significant distinctions between liquidation proceedings under Chapter 7 and reorganization proceedings under Chapter 11. In a liquidation proceeding, the debtor is terminating all operations. In contrast, under a reorganization proceeding, the debtor is attempting to restructure and continue operations. Moreover, in a Chapter 7 liquidation case, a trustee is appointed to oversee and administer the debtor's bankruptcy estate during liquidation, the primary purpose of which is to generate cash to pay the debtor's creditors. A trustee is not always appointed in a reorganization proceeding under Chapter 11 unless there are specific needs. Generally, in a Chapter 11 reorganization proceeding, the debtor will be referred to as the "debtor in possession," who serves as the trustee of the bankruptcy estate during reorganization and reports to the bankruptcy court. It is important to keep in mind that most bankruptcy filings start as attempts to reorganize under Chapter 11, only to be later converted to a liquidation proceeding under Chapter 7.
The Automatic Stay
Upon the filing of the petition, all collection efforts by creditors against the debtor must stop pursuant to §362 of the Code, which provides for an automatic stay. As the name indicates, the "automatic stay" occurs immediately upon the filing of the petition– without the need for an order from the bankruptcy court– and halts all action against the debtor and the property of the bankruptcy estate. The automatic stay is extremely broad in scope and, aside from limited exceptions, applies to almost all formal or informal action taken against the debtor or the property of the estate by anyone. A violation of the automatic stay may result in severe sanctions against the offending party, including the award of damages, costs, attorneys' fees and, in appropriate circumstances, punitive damages to an injured party.
With the filing of the petition, the debtor is required to provide a complete listing of all creditors, a schedule of assets and liabilities, a schedule of current income and expenditures, and a statement of the debtor's financial affairs. It is important to review the schedule of assets and liabilities filed by the debtor to determine whether the debtor has properly identified all contracts and/or debts and the amounts due in relation thereto. A creditor should confirm that the amounts listed on the debtor's schedules comport with the creditor's financial records and whether the debts reported are properly classified as secured or non-secured. The amount of the reported debt and its classification as secured versus nonsecured have significant implications with regard to priority for payment allowed under the Code and whether the filing of a claim against the bankruptcy estate is necessary. For example, if a creditor discovers that the debtor has listed the amount of the debt as being less than what is actually owed to the creditor, the creditor should file a "proof of claim" against the bankruptcy estate noting the correct amount of the debt. Likewise, a priority creditor should file a proof of claim and indicate the priority status of the claim if not properly identified by the debtor. Regardless of the information contained in the debtor's schedules, a creditor of the bankruptcy estate should file a proof of claim to protect its interest and give notice of its claim.
Secured Creditors
A secured creditor will have a secured claim with respect to the collateral that serves to secure the debt owed. The collateral securing the debt may consist of real property or inventory and/or accounts receivable belonging to the debtor. Accordingly, if certain property in the debtor's possession is subject to a valid lien, security interest or mortgage, then the trustee in a Chapter 7 case will typically abandon the property subject to a valid lien, security interest and/or mortgage as not benefiting the bankruptcy estate because the property cannot be sold to generate any money to pay any claims other than the secured creditor's claim. Typically, however, the trustee in a Chapter 7 case will not decide what property to abandon until late in the case, which may take months. Therefore, upon receiving notice of the filing of a petition under Chapter 7, a secured creditor should immediately contact the trustee to determine whether the trustee will agree to abandon the property which serves as collateral or consent to relief from the automatic stay. If the trustee will not agree to abandon the property, the secured creditor may seek relief from the automatic stay by filing a Motion for Relief from Stay, which should be granted by the bankruptcy court unless there is equity in the property subject to the mortgage or lien, which can be realized for the benefit of the other creditors of the debtor's bankruptcy estate. If the trustee decides to use the property for the benefit of the bankruptcy estate, then the secured creditor may request adequate protection from the bankruptcy court if the trustee wants to retain possession of the property. For example, the trustee may be required to set aside funds or post a bond or other security to protect the value of the property. The secured creditor may also file a claim for "administrative expense" to the extent that the secured creditor's property has been devalued or harmed during the period of time the trustee retained possession of the property.
Priority Creditors
In a Chapter 7 case, the trustee distributes the bankruptcy estate's unencumbered assets in the order specified in §726 of the Code. Priority claims, defined in §507 of the Code, are paid first. Section 507(a) sets out nine priorities, to be paid in descending order. To recover on a priority claim, the priority creditor should file a proof of claim and indicate the priority status of the claim on the proof of claim form. Each category of priority claim must be paid in full before any priority claim in the next succeeding class is paid. Within a given priority class, distribution is made on a pro rata basis if there are insufficient assets to pay in full all claimants of that class.
Unsecured Creditors
Section 726 of the Code specifies the order in which unsecured creditors are paid in a Chapter 7 case. General unsecured claims are paid only after all priority claims (which include administrative claims) are paid in full. As a result, unsecured claims typically receive nothing at all or only a small portion of the claim amount. Unfortunately, most claims arising from the default of a contractor, subcontractor or supplier on a construction project will fall into the unsecured creditor class. Nonetheless, in the context of a construction project, it is important to note that an exception applies to a valid set-off claim, which will be treated as a secured claim to the extent of the allowed set-off. The fact that a set-off claim is given secured claim status is important if litigation ensues with the trustee.
Scheduling of Events Following the Filing of the Petition
After the filing of the petition, if the debtor is seeking to liquidate under Chapter 7, the debtor's business will close and the trustee will take over all non-exempt assets and property of the debtor. In a Chapter 11 reorganization case, the debtor will most likely continue operations but on a limited basis. From a contractor's or developer's perspective, it is important to note that most Chapter 11 debtors will do as little as possible while in the reorganization stage, which is obviously detrimental to efforts to complete a construction project. At this point, the automatic stay goes into effect, and no collection or enforcement efforts against the debtor are allowed without a court order granting relief from, or lift of, the automatic stay. Accordingly, a contractor or developer affected by a Chapter 11 filing may request that the court require the trustee or debtor in possession to provide adequate assurance that it will be able to perform its contractual obligations for ongoing projects.
The Meeting of Creditors
Next, the bankruptcy court will send notice to all creditors of the "meeting of creditors" required by §341 of the Code. At the meeting of creditors, the trustee and the creditors may question the debtor. The meeting of creditors will be held within 20 to 40 days of the date of the filing of the petition or the date of an order for relief (in the case of an involuntary petition). The trustee presides over the meeting of creditors, at which the trustee will examine the debtor to determine that nothing has been omitted from the schedules. If there are significant assets in the bankruptcy estate and interest by the creditors, a special meeting of creditors may be subsequently convened.
The trustee will take possession of all non-exempt assets and determine the validity of any liens. The trustee will then liquidate assets that are free and clear or that have equity above any liens or mortgages. The trustee will also abandon assets with no equity or value. At some point, the trustee will attempt to recover all outstanding debts due to the debtor and commence litigation ("adversary proceedings") against parties who owe the debtor money. The trustee will also attempt to recover any "preferential payments" made by the debtor to creditors within the 90-day time period (the "preference period") preceding the date of the bankruptcy filing. In other words, the trustee has the power to recall and/or undo transactions entered into by the debtor during the 90-day time period prior to the bankruptcy. Without doubt, creditors view the impact of preference avoidance litigation by the trustee as the most frustrating and painful result of the bankruptcy process. The trustee may also attempt to recover any transfers or payments made within one year before the bankruptcy for less than fair value.
Finally, if no objections are received, the debtor is ultimately granted a discharge of its debts. At the conclusion of the case, the trustee will file a report of receipts and disbursements, and then will distribute the money in the bankruptcy estate to the creditors.
Precontract Remedies to Minimize Damages Resulting from a Bankruptcy
Given the drastic effect of the automatic stay resulting from a bankruptcy filing, strong contract terms can assist a contractor or developer in completing the work and keeping the money flowing on a construction project. Examples of strong contract terms that will assist in coping with a bankruptcy filing include: (1) a termination clause with a short cure period (this helps because if the contract is terminated prior to the filing of the bankruptcy petition, the trustee has no right to cure — allowing dealings with other parties to finish the project in the event of a Chapter 11 filing); (2) requiring a payment and performance bond (obligations under the payment and performance bond may be enforced irrespective of the bankruptcy and are not subject to the automatic stay); (3) providing for the right to take over and complete the work upon the failure of the subcontractor or supplier (assists in completing the work on the project and defending against subsequent claims by the trustee); (4) a "pay when paid" clause in the subcontract so that the right to payment does not vest in the subcontractor or supplier until the owner pays (allows a defense to the trustee's claim for payment of any contract balances not funded); (5) the right to set off damages and/or claims arising from other contracts or projects (provides a right to setoff claims on other project or contracts in the event litigation ensues with the trustee); (6) inserting an arbitration clause to require resolution of claims without bankruptcy court or other judicial intervention (keeps claims out of the bankruptcy court and allows for expeditious resolution of claims); (7) allowing for payments to be made directly to vendors, suppliers and sub-subcontractors (keeps the project moving forward); (8) providing for the right to make payments by joint checks (demonstrates the debtor's lack of control concerning payments to vendors, sub-subcontractors and/or suppliers, thereby allowing a defense to a subsequent claim asserted by the trustee alleging a right to receive such payments); (9) a no-damage-for-delay clause (protects against delays caused to the project arising from a bankruptcy filing); and (10) a vestiture of title provision regarding materials paid for in the name of the owner or contractor (this is helpful in defending against claims by the trustee and/or secured creditors regarding materials and/or supplies that are alleged to be property of the bankruptcy estate or subject to a security interest or lien).
Although these contract provisions will not prevent a party working on a construction project and who is experiencing financial hardship from filing for bankruptcy, these contract terms will serve to minimize delays to the project and any damages that may result from a bankruptcy filing, including any subsequent litigation that may arise with the trustee. It should be noted that contract terms that provide for termination upon the occurrence of an insolvency or the filing of a petition for bankruptcy protection are unenforceable.
What to Do Upon Receiving Notice of the Bankruptcy Filing
As with any important legal matter, the first thing a contractor or developer should do upon receiving notice of a bankruptcy filing is to contact legal counsel. Bankruptcy law is complex, and the courts of the various federal circuits have interpreted provisions of the Code differently. Accordingly, it is important to be aware of the special nuances, local rules and decisions that apply in the specific jurisdiction where the bankruptcy case was commenced.
After the filing of the bankruptcy, the following steps should be taken: (1) examine the petition and the debtor's schedules to make sure they are accurate (you are looking for your contract/account to make sure the debtor has accurately characterized and reported the debt); (2) determine the number of creditors and how many are secured creditors; (3) determine the need to file a proof of claim (see Sidebar on facing page); (4) consider the need to file any motions (i.e., motion for stay relief, compel assumption or rejection of contracts, and/or any injunctive relief); (5) develop a strategy to keep supplies and money flowing on the project; (6) attend the meeting of creditors; (7) consider scheduling a meeting with the trustee or the largest secured creditors to settle any property disputes and obtain release of materials held as property of the estate or as collateral under a security agreement; (8) review and determine whether there is any insurance or bonds in place to cover any losses to the project; and (9) preserve any bond claims and/or mechanics lien claims.
Once the bankruptcy case commences, the contract terms previously negotiated will serve to facilitate resolution of issues that typically arise with the debtor in possession, the trustee or a secured creditor of the bankruptcy estate. For example, in a Chapter 11 case, if the debtor was terminated for cause prior to the filing of the Chapter 11 case, the owner or general contractor might contract with another party to complete the work on the project. If, however, the debtor was not terminated prior to the filing of the Chapter 11 case, the debtor in possession and/or trustee would have the right to cure any prior defaults and be provided with an opportunity to complete their contractual obligations on the project. This would inevitably delay the progress of work on a construction project since resolution of issues in bankruptcy court takes considerable time and does not follow preestablished construction schedules.
Another example is in the context of a Chapter 7 liquidation, where the trustee or a secured creditor may be asserting a claim over materials and/or supplies that were previously paid for but not yet delivered to the project site. In such circumstances, it is not uncommon for the trustee to claim that the materials or supplies in the debtor's warehouse are property of the estate, or, alternatively, the secured creditor (typically a bank) will claim that the materials or supplies in the debtor's warehouse constitute inventory, which serves as collateral for a loan under a broadly worded security agreement. It is at this point that the contract terms vesting title upon payment for the goods in the name of the owner or the general contractor will serve to defend against such claims. The practice of having a broadly worded release divesting all title to goods or supplies provided on a project, and releasing all claims in exchange for payment, also serves to defend against such subsequent claims by a trustee or secured creditor.
Mechanics Lien and Bond Claims
The impact of bankruptcy on mechanics liens depends upon when, in accordance with state law, the lien arises. In many states, the lien relates back to the date of the occurrence of a certain event specified by statute, such as the recording of a notice of commencement or the performance of work on the project. Accordingly, a claim of lien may be considered a pre-petition claim (i.e., arising prior to the commencement of the bankruptcy case). This is significant because a party that can assert a statutory lien claim that relates back in time to a date prior to the filing of the petition will be allowed to perfect its lien rights without violating the automatic stay. Typically, bankruptcy courts will allow a lift of stay to allow lien actions to proceed because the debtor is not deemed to have equity in such property. By contrast, in some states, the lien does not arise until a certain action is taken such as the filing of a petition with the state court. In those states, those actions would be prevented by the automatic stay. Accordingly, a bankruptcy filing may substantially diminish a contractor's lien rights.
Payment and performance bond claims are not treated as part of the bankruptcy estate proceedings and, therefore, are not subject to the automatic stay. To the extent there is a payment or performance bond in place to guarantee the performance of the debtor, a developer or contractor is well advised to perfect its bond claims to offset any losses and/or impacts to the flow of work on a construction project.
Conclusion
No bankruptcy case is the same. It is necessary to consider all facts and circumstances when planning to deal with a bankruptcy filing and its effect on the progress of work on a construction project. The best time to address issues that may arise from a bankruptcy filing is at the negotiation-and-contract-drafting stage. The contract terms should allow for the right to terminate quickly and allow for the nonbreaching party to complete the work and pay sub-subcontractors, suppliers and vendors directly. If, however, a bankruptcy case commences and litigation results, good legal counsel and sound litigation strategy will serve to minimize delays and damages on a project. Ultimately, the most important goals in effectively managing a bankruptcy filing during the course of a construction project are to (1) keep the money flowing, and (2) complete the work on the project.
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.
