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December 7‚ 2011
Primer for Construction Bankruptcies
By Tony Starr
and Kevin J. Walsh
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:
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Claims secured by collateral;
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Claims entitled to priority or administrative expense priority
treatment such as certain tax claims and the costs of administering the
bankruptcy estate;
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General unsecured creditors; and
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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 (either
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:
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Strict performance milestones;
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A joint check provision;
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Expedited termination provisions in the event of a subsequent breach
by the debtor;
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The ability to replace the debtor in the event of a subsequent
breach by the debtor; and
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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
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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 pre-bankruptcy 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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