Trent Cotney, Partner, Adams and Reese, LLP
As discussed earlier in Part One of this article (FRM August 2022), bankruptcy filings in the construction industry can impact everyone involved in a project. From the property owner to the general contractor to the subcontractor, trades and beyond, all parties will likely worry about whether the project will continue and how everyone will be paid.
No matter what your role is in a construction project, it is critical that you know your rights and can protect yourself if another party enters bankruptcy. This article will describe what protections you have and what you can put in place.
Creditor Claims
Once a party files bankruptcy, creditors who request a payment distribution must file a proof of claim. The deadline for that claim is called the bar date. The creditor must complete the proof of claim form, sign it and attach all supporting documentation. If the bar date has passed, a creditor will face difficulty asserting a claim for debts. Claims are usually classified by four terms:
■ Secured: This type of claim is secured by collateral or a lien against specific personal or real property. A common example is the mortgage a person has on a home. In construction, a claim from a contractor, subcontractor or consultant can be secured by a perfected mechanics’ lien against real property.
■ Administrative: This type of claim is filed by a lawyer, accountant or another professional who provided services after bankruptcy was filed.
■ Priority: This is an unsecured claim for specific benefits or unpaid wages not to exceed $4,650 per claimant. It also applies to some taxes, consumer deposits and alimony.
■ General unsecured: This claim pertains to everything not considered secured or priority. One example is payment owed to a material supplier or vendor.
When a party files for Chapter 11 bankruptcy, it reorganizes and continues to operate its company. After filing, the debtor is then labeled a debtor-in-possession (DIP) since it still possesses its company and assets. A committee of its creditors is often formed to monitor the DIP’s business and negotiate a reorganization. After a plan is confirmed, the DIP and its creditors consider it a new contract, which supersedes all others. The DIP is then relabeled as a reorganized debtor. Usually, the plan stipulates payments to unsecured creditors over several years. It also includes provisions if the reorganized debtor does not make the agreed-upon payments.
If the DIP and the committee cannot agree on a reorganization plan, the issue may go before a court. In some cases, the bankruptcy judge may convert the case to a Chapter 7 filing. That means the debtor will have to liquidate.
After a Chapter 7 filing, the debtor’s assets are liquidated and the creditors are paid based on a specific hierarchy. First, secured creditors have legal rights to named assets, so they receive the items held as collateral or they receive funds from their sale. Next, administrative parties, such as attorneys, accountants and other professionals who provided post-bankruptcy services, receive payment. After that, payments are provided to unsecured creditors, such as pre-bankruptcy vendors and consultants and those with pre-bankruptcy wage claims.
During a Chapter 11 reorganization, the DIP is not allowed to pay creditors without a court order or an approved reorganization plan but it can take more than a year for such a plan to be confirmed. This delay can cause a financial strain for all parties involved. However, contractors and subcontractors are compelled to continue working despite the bankruptcy since the DIP’s contract is an asset to the estate.
Some contracts have bankruptcy termination clauses; however, by and large, they are not enforceable. Given that, any party contracted with the DIP must obtain court approval before it can terminate its work on a project.
Most construction contracts are executory contracts. The Bankruptcy Code does not precisely define the word executory but the term implies that during bankruptcy proceedings, both the debtor and the other parties are obligated to continue working. Failure to do so would constitute a material breach.
In a bankruptcy case, executory contracts can be considered either an asset or a liability. The bankruptcy court will approve such contracts to be assumed or rejected, depending on their value to the estate.
As mentioned earlier, one type of secured claim is held by a perfected mechanics’ lien against real property. In general, mechanics’ liens are statutes created to offer protections in the construction industry. They protect contractors, material suppliers, consultants and vendors from non-payment for services or goods. And if they are perfected, these liens elevate claims to secured status.
To attain the perfected designation, the creditor must file a notice of perfection. This notice states that the creditor has taken all proper and necessary steps prior to the bankruptcy filing. However, mechanics’ lien laws are quite technical. It is essential that all parties comply with the mechanics’ lien statutes; otherwise, they can lose their rights to claims.
In Florida, those contributing to a private work of improvement have the right to a mechanics’ lien. It provides a statutory lien against real property for which a contractor, subcontractor, supplier, etc. has furnished labor, materials or services. The dollar amount of the lien is equal to the value of the materials or labor supplied and the lien holder has the right to foreclose on that property.
Another option for protection is a payment bond which most public projects require but may also be present on private projects depending on project size. Recognize that like Florida lien law, there are a variety of steps required to perfect payment bond claims.
An automatic stay is entered as soon as a bankruptcy filing is complete. The stay halts all foreclosure and collection efforts. For example, if a contractor, subcontractor or consultant files for bankruptcy, a lien claimant cannot file a lawsuit or seek payment for pre-bankruptcy
services. If an owner files for bankruptcy, a contractor or subcontractor cannot seek payment for pre-bankruptcy services or record a mechanics’ lien.
However, the automatic stay does allow collection against property that is not part of the estate. For instance, if a contractor files bankruptcy, a subcontractor could foreclose on a mechanic’s lien against the owner’s real property, since it is not included in the bankruptcy estate.
As you can see, bankruptcy can have serious repercussions on construction projects, impacting all parties involved. When bankruptcy is filed, a creditor must halt all collection activity. Contractors, subcontractors and other trades may be obligated to stay on the job
until the automatic stay is lifted or they receive court approval.
It can be tricky to know what your rights are and what claims you are entitled to and you may be unsure how quickly you can seek the payments you are owed.
If you are being affected by a bankruptcy or have questions about your contracts, mechanics’ liens or other bankruptcy protections, be sure to use your FRSA free legal member benefit and contact us at any time for initial advice.
The information contained in this article is for general educational information only. This information does not constitute legal advice, is not intended to constitute legal advice, nor should it be relied upon as legal advice for your specific factual pattern or situation. Trent Cotney is a Partner and Construction Practice Group Leader at the law firm of Adams and Reese LLP and FRSA General Counsel. For more information on this subject, please contact the author at trent.cotney@arlaw.com.
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