Navigating the Intersection Between Construction Law and Bankruptcy Law
Tennessee construction law and federal bankruptcy law have an uncomfortable relationship. Rules governing the rights and responsibilities among owners, prime contractors, subcontractors, and suppliers are ordinarily well-established and understood by the various participants. But overlay a bankruptcy filing and things can get very complicated very quickly. Avoiding powers, lien priorities, termination rights and claims disputes, among other potential fights, can create confusion, or worse. This article discusses 5 strategies to help protect your client’s position before a bankruptcy, and 5 strategies to employ after a bankruptcy case is filed.
BEFORE A BANKRUPTCY FILING
Experienced construction law attorneys are typically very good at recognizing when a counter party (or their own client) starts to experience financial difficulties. In fact, construction lawyers are oftentimes the first to recognize a contractor’s slide toward bankruptcy, especially by paying attention to disputes involving workmanship and payment. What can a subcontractor or supplier do to protect its position when dealing with a prime contractor or owner that is on shaky financial footing?
(1) Mechanics and Materialman’s Liens & Bond Rights
Mechanics and materialman’s (“MM”) liens are a legally engineered protection to allow contractors and material suppliers to seek payment for goods and services provided as part of a construction project. It takes diligence and attention to maintain and enforce MM liens, but they can make all the difference in the event of a subsequent bankruptcy filing. For example, under Tennessee law, a notice of non-payment must be provided within 90 days of last day of the month labor and materials were provided and a lien must be filed within 90 days of the completion of the work or improvement. There are also time limits on enforcement.
A creditor who has been diligent about lien rights will have much better protection if a bankruptcy is filed. The creditor will have preference defenses. Perhaps most importantly, the creditor will likely be treated as a secured creditor, with possible priority over all other secured creditors in the bankruptcy.
Generally, a payment bond protects against disruptions or financial loss due to a contractor's failure to complete a project or failure to pay the subcontractors. These bonds are “accessory” payment protections for parties that provide services or materials in connection with a construction project.
(2) Personal Guaranty
With a personal guaranty in place, a contractor is more likely to pay your client first, and more likely to stay on or close to payment terms. As long as the contractor himself does not file bankruptcy, then even if the company files bankruptcy, your client may still pursue the individual on the guaranty.
(3) Payment Terms
A client’s payment terms are also important. Creditors that force a contractor to maintain agreed upon payment terms have a smaller receivable if a bankruptcy is filed and further reduce exposure to preferential payments.
(4) Get Out If You Can
If you learn the contractor is struggling financially, one option is to terminate the contract before a bankruptcy filing. This must be done in accordance with the terms of the contract. After a bankruptcy petition is filed, your client may not be permitted to terminate the contract without bankruptcy court approval.
Tennessee provides statutory reclamation rights. Generally, reclamation is the seller's right to require an insolvent buyer to return goods purchased on credit. If insolvency is suspected, reclamation rights would survive bankruptcy if all the correct procedures are followed.
AFTER BANKRUPTCY IS FILED
After a contractor files bankruptcy, what should your client do to protect its rights? What happens to MM liens? Here are some general tips to help construction clients navigate bankruptcy.
(1) MM Liens and Bankruptcy
Tennessee courts have long held that mechanic’s lien rights arise when the labor is performed, or the material is furnished. Those rights are perfected when the lien is filed and served in accordance with the Tennessee lien statute. Bankruptcy Code 11 U.S.C. § 546(b) generally provides that the rights and powers of a Chapter 7 Trustee/Chapter 11 Debtor are subject to “any generally applicable law.” Section 546(b)(1) permits the post-petition perfection of a MM, that arose prior to the bankruptcy filing, to be effective against any third party that acquired rights in the property prior to the date of perfection. This means that the automatic stay (11 U.S.C. § 362), does not prevent a MM’s creditor, whose lien arose prior to bankruptcy, from perfecting its lien post-petition. The automatic stay does, however, prevent enforcement of the lien. The amount of the lien is the value of the materials or labor furnished.
(2) Reclamation After Bankruptcy is Filed
Tennessee reclamation rights are governed by specific statutory rights. The Bankruptcy Code, 11 U.S.C. § 546(c), modifies the seller’s ability to enforce its state-law reclamation rights. Once a bankruptcy case is initiated, Section 546(c) provides the exclusive remedy for a seller who is seeking to reclaim its goods. In re Julien Co., 44 F.3d 426 (6th Cir. 1995). Section 546(c) does not protect the right of reclamation against the trustee's avoiding powers unless the requisites of the section are met. Section 546(c) provides that a seller has 20 days from that date to file a claim for reclamation. The goods must have been sold to the buyer in the ordinary course of business and received by the debtor no more than 45 days before the petition date while the debtor was insolvent and the goods must still be in the debtor’s possession and identifiable. Further, the reclamation demand must be in writing. A reclaiming creditor’s rights are subject to the prior rights of a creditor with a security interest in the debtor’s inventory.
If a reclamation claimant fails to properly comply with 11 U.S.C. § 546(c), then it may still attempt to seek payment as an administrative expense of the estate pursuant to section 546(c)(2).
(3) Rights Under the Construction Contract
Many construction contracts contain provisions that permit immediate termination if the contractor seeks bankruptcy protection (commonly known as an “ipso facto clause”). Theses clauses are generally unenforceable in bankruptcy and any termination of a contract must be approved by the Bankruptcy Court.
Most of the time, construction contracts are “executory” contracts under the Bankruptcy Code. The debtor may either assume or reject such contracts, and generally in a Chapter 11 case, the debtor has until confirmation of its plan of reorganization to decide whether to assume or reject a contract. However, the court, at the request of a party, may order the debtor to make its decision earlier by filing a motion to compel assumption or rejection.
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 the benefits of the contract. Any damages resulting from the rejected contract become general unsecured claims as of the date of the petition.
Construction contracts often contain setoff or withhold and charge back provisions. Generally, setoff rights are preserved by the Bankruptcy Code. Setoff rights, however, may not be enforced without authorization from the Bankruptcy Court.
(5) Joint Checks and Trust Funds
Joint checks or two-party checks are often used by owners to ensure general contractors will pay their subcontractors and material suppliers. At least some Bankruptcy Courts have required debtors to continue to honor prepetition joint-check agreements finding those funds are not property of the estate and do not belong to the debtor if the intent of the parties was to pay subcontractors and material suppliers.
Tennessee treats payments received by a contractor for the labor and materials supplied by its subcontractors or suppliers as trust fund monies. Generally, this means contractors in these states are deemed fiduciaries of the subcontractors and suppliers for whose labor and materials they receive payment. As a matter of general principle, construction trust funds that are classified and protected by statute are not part of a bankruptcy estate and lie outside the reach of avoidance actions. See Selby v. Ford Motor Co., 590 F.2d 642, 647 (6th Cir. 1979) (interpreting an analogous Michigan statute) (citations omitted); accord In re R.W. Leet Elec., Inc., 372 B.R. 846, 853 (B.A.P. 6th Cir. 2007) (Parsons, J.) (“There is no dispute that any monies paid to the Debtor by contracting parties would be held in trust by the Debtor and would not constitute its property.”) (citing Michigan law).
However, the Sixth Circuit has recognized an important limitation on the general principle: Construction trust funds are exempt from a bankruptcy estate “so long as the funds can be traced.” Id. at 645 (citations omitted); It must be established that the payments actually paid to [the subcontractor] are traceable to the trust funds received by the Debtor. Tracing is important because a party asserting a claim to trust funds must demonstrate an interest in the account that holds those funds. In re Strauss Co., Inc., No. 1:18-BK-12972-SDR, 2021 WL 4436159, at *8 (Bankr. E.D. Tenn. Sept. 27, 2021).
The trust fund designation may be irrelevant either because it is common (and not improper) for a contractor to comingle funds in an operating account, or it is too expensive for a creditor to forensically trace funds.
Construction and bankruptcy are both complex areas of the law. When they intersect, the results can cause confusion and frustration. Attorneys who represent owners, prime contractors, subcontractors and suppliers will serve their clients well by always considering the implications of a counter party (or their own client) filing bankruptcy and taking steps to protect their position if a bankruptcy happens.