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December 5‚ 2011
Building Success Despite Failure
By Tony Starr
and Kevin J. Walsh
In today’s economy, we continue to see bankruptcies occurring
in the construction sector. An owner, contractor, or subcontractor in
financial distress can easily delay a project — or worse,
jeopardize the project in its entirety. Contractors need to understand
their rights in order to minimize their exposure in bankruptcy-related
situations.
Protecting
Contractors — Frequently Asked Questions
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Q.
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If a contractor learns that a subcontractor is in
financial distress or receives notice that the subcontractor is closing
down its business, what should the contractor do?
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A.
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Terminate the contract before a bankruptcy filing by
following the procedures set forth in the contract. If the contractor
does not effectively terminate the contract prior to the bankruptcy, then
the contractor must obtain bankruptcy court approval before terminating
the contract post bankruptcy. Additionally, unless lien waivers are
received, use joint checks or do not make further payments. In this
situation, the contractor wants to be sure that payments reach the
sub-subcontractors and suppliers who actually performed the work for
which payment is sought by the subcontractor so lien waivers should be
obtained from these lower-tier entities.
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Q.
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If a subcontractor files for bankruptcy, can the
contractor pursue rights under the subcontractor’s performance bond?
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A.
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Yes — the automatic stay applies to and prevents acts
against the debtor. The stay does not prevent acts against the
subcontractor’s performance bond surety or any guarantors.
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Q.
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If a subcontractor files for bankruptcy, what can the
contractor do to expedite assumption or rejection of the contract?
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A.
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As a counterparty to a contract
with a debtor, the contractor could file a motion with the court to
compel the debtor to assume or reject the contract. Assumption means the
debtor reaffirms the contract and must perform according to its terms. In
order to assume a contract, the debtor must cure all past defaults and
must convince the judge that it can perform under the contract in the
future. An assumed contract can be modified if the parties to it agree to
do so. By rejecting the contract, the debtor is breaching it as of the
date of the bankruptcy filing. Non-performance under the contract by the
debtor may be sufficient grounds for the contractor to bring a successful
motion to force the debtor to reject the contract. If the debtor rejects
the contract, the contractor is then free to arrange for the remaining
work to be performed by another subcontractor.
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Q.
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What steps can a contractor take to protect itself from a
subcontractor bankruptcy?
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A.
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Some prebankruptcy
considerations a contractor can build into the contract include an
explicit right of setoff for all jobs with the subcontractor, joint check
provisions, and periodic lien waiver requirements including lien waivers
from sub-subcontractors and lower-tier suppliers. It is always important
for a contractor to make sure on a regular basis that amounts paid to a
subcontractor on account of work performed by a sub-subcontractor or
material supplied by a lower-tier supplier are timely paid by the
subcontractor to the lower-tier subcontractors and suppliers and are not
diverted by the subcontractor to another purpose. These lower-tier
subcontractors and suppliers if unpaid could assert lien claims or
payment bond claims against the contractor’s payment bond which would
survive a subcontractor bankruptcy. If the contractor no longer wishes to
do business with the subcontractor and grounds exist to terminate the
contract, the contractor should act quickly to terminate the contract
prior to the bankruptcy filing. A contract terminated prior to the
bankruptcy does not become part of the bankruptcy case. But termination
must be done in accordance with the procedures set forth in the contract.
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Q.
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If an owner files for bankruptcy, can the contractor keep
working for the owner?
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A.
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If a valid contract exists between the contractor and
owner, the contractor must continue to perform pursuant to the terms of
the contract, even if the debtor does not. The contractor will be
entitled to be paid according to the terms of the contract and will have
an administrative expense priority claim for any unpaid, post-bankruptcy
amounts due. As noted above, if the debtor does not perform its
obligations under the contract, the contractor can, and should, seek to
force the debtor to assume or reject the contract, or seek relief from
the stay in order to terminate the contract.
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Q.
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If an owner files for bankruptcy, can the contractor
pursue lien rights?
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A.
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The automatic stay prevents enforcement of lien
rights. The bankruptcy code provides an exception to the stay for
ministerial acts necessary 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. The date of
perfection of the lien relates back to the date that it would have been
perfected under applicable state law.
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attorneys.
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