Effects of Bankruptcy on a Construction Project

Category | Briefing Papers

Imagine a renowned construction company with ongoing projects in the hundreds of millions of dollars. The construction company builds highways, tunnels, bridges, dams, and roads around the world. Many of its projects cost millions of dollars more than originally anticipated. The owners dispute the company’s right to recover the additional costs. An enormous cash shortage results and the company is unable to meet its ongoing obligations. To the surprise of contractors, suppliers, employees, banks, and bonding companies all over the world invested in the projects, the company and its auditors have “cooked the books” and understated expenses. The company collapses under the weight of its auditors’ and CFO’s secrets and the company abruptly files bankruptcy, leaving everyone involved scrambling for payment. What do you do when a contractor files bankruptcy?

Immediate action is required when a party is served with a bankruptcy petition in a construction context. Bankruptcy on a construction project affects the rights and obligations of all parties, including owners, general contractors, subcontractors, sureties, laborers, and suppliers. The parties’ contractual rights will be altered by bankruptcy law in ways that will not reflect the intent of contracting parties. This paper discusses generally the issues affecting a contractor or subcontractor faced with the bankruptcy of an owner or contractor above it in the payment chain.

What is the Bankruptcy Code?

The Bankruptcy Code is a body of federal law that governs all bankruptcies. The person or company filing bankruptcy is the “debtor” and the entities seeking payment from the debtor are the “creditors.” The primary purposes of bankruptcy law are to provide the debtor with a “fresh start” and to distribute the debtor’s assets equitably among creditors. Chapters 7, 9, 11, 12, and 13 of the Bankruptcy Code provide relief for particular types of debtors. The two most common types of bankruptcy are Chapter 7 and Chapter 11. A bankruptcy case under any chapter is commenced when the debtor files a voluntary petition or creditors file an involuntary petition. In a Chapter 7 bankruptcy (i.e., liquidation), the bankruptcy trustee collects the debtor’s assets, reduces the assets to cash, and distributes the assets in accordance with the Bankruptcy Code’s distribution schedules. Secured creditors will be paid to the extent of their secured interest in the assets. Unsecured creditors are near the bottom of the priority list (just above equity holders in the debtor). They will be paid pro rata according to the amount of their approved claim.

Chapter 11, in contrast, typically involves business reorganization and rehabilitation. The debtor may remain in control of its business and repay creditors through an approved plan of reorganization. The debtor itself may manage the bankruptcy proceeding or the court may appoint a trustee. The largest number of bankruptcy filings for construction companies are Chapter 11 filings. Companies in Chapter 11 hope that debt reorganization and the Bankruptcy Code’s protections will provide time to recover from financial problems. Bankruptcy practitioners experienced with construction bankruptcies, however, often recognize that construction companies cannot be reorganized. The Bankruptcy Code is not equipped to deal with construction contracts and the construction industry’s practical constraints, and reorganization becomes exceedingly difficult.

How do you Protect Your Claim Against the Bankrupt Contractor?

A creditor’s right to share in the bankruptcy estate depends whether the creditor has a “claim,” as recognized under the Bankruptcy Code. Recognized “claims” under the Code include: (1) a right to payment, or (2) a right to recover for breach of performance if the breach gives rise to a right to payment. The primary creditors in a contractor bankruptcy are the owner, the lender, the contractor’s surety, and subcontractors. The surety (sometimes) ends up paying off subcontractor creditors through payment bonds and completing the work (when permitted by the court) under performance bonds.

With very limited exceptions, in order to be protected, a creditor must file a “proof of claim” with the bankruptcy court. The proof of claim must be filed before the deadline imposed by the court and must be in the format required by the court. A claim is deemed allowed unless a party objects. If there is an objection, the bankruptcy court will determine the amount of the claim after notice and hearing.

A secured claim is a claim secured by a lien on property in which the estate has an interest. The claim is unsecured to the extent that equity in the property to pay the creditor’s claim is less than the amount of the allowed claim. For example, if the property is worth $1 million, there is a prior secured claim of $500,000, and the creditor has a claim for $750,000, the creditor has a $500,000 secured claim and a $250,000 unsecured claim. A claim is unsecured where there is no collateral securing the claim.

What is the Effect of the Automatic Stay?

The automatic stay is triggered when the bankruptcy petition is filed. The automatic stay prevents all collection efforts against the debtor or the debtor’s property. Creditors are prohibited from: (1) commencing or continuing a lawsuit, (2) enforcing a judgment against the debtor, (3) creating, perfecting, or enforcing a lien against property of the estate (although as discussed below, in some situations a mechanic’s lien may be perfected after the bankruptcy filing), or (4) collecting, assessing, or recovering a claim against the debtor that arose pre-bankruptcy. A construction contract that has not been terminated before the bankruptcy petition is filed is a contract in which the debtor has property rights, and is protected by the automatic stay. Accordingly, the non-debtor party cannot terminate a contract upon a bankruptcy filing unless it obtains court approval to do so.

Any actions that violate the automatic stay are void. A creditor violating the stay may be subject to severe sanctions, including paying costs, attorneys’ fees, or punitive damages, and returning monies collected. If you are not sure whether the automatic stay applies, it is safest to obtain relief from the stay before taking any action. A creditor may obtain relief from the automatic stay for cause, including bad faith and mismanagement of the creditor’s property. The court may lift the stay if the creditor’s property is losing value or if the debtor owes the creditor more than the property’s fair market value.

What will Happen to Construction Contracts in Bankruptcy?

If a party to a construction contract files bankruptcy, the other parties should not act to terminate the contract, even if the contract contains a clause allowing termination in the event of bankruptcy. This type of contract clause is invalid according to the Bankruptcy Code. Further, the contract is not automatically terminated by a default in contract performance before the bankruptcy petition’s filing. Even if the defaulting party is not likely to complete the contract, the only way to take action against that party is to: (1) seek relief from the automatic stay, or (2) request that the debtor immediately assume or reject the executory contract, as discussed below.

A debtor or trustee has the choice to assume, assign, or reject executory contracts. An “executory contract” is not defined in the Bankruptcy Code, but a contract is generally considered to be “executory” if the contract is not fully-performed. A construction contract is considered executory unless it has been completed before bankruptcy. The debtor or trustee will decide to assume, assign, or reject the contract based on whether the contract benefits the bankruptcy estate. A contractor or owner in bankruptcy will likely assume profitable contracts and reject unprofitable contracts.

If the debtor assumes the executory contract, the debtor agrees to perform the remaining contract duties. The debtor must show that contract assumption will benefit the estate. In order to assume, the debtor must: (1) cure any default or provide the other contracting party with “adequate assurance” that all defaults will be promptly cured and the debtor will be able to complete its performance under the contract, and (2) compensate the other party for actual monetary losses resulting from the default. Thus, the difficulty for the insolvent contractor is that it has to cure, or provide adequate assurances that it will cure, all defaults and pay all damages before it can assume the contract. If the contract is assumed and then breached, the non-debtor party is entitled to damages. Those damages become an administrative expense of the bankruptcy estate, rather than an unsecured claim. Administrative expenses are paid first to the extent that there are funds available that are not subject to secured claims.

The debtor may assign the contract, but must first assume the contract and do everything necessary to perfect the assumption as stated above. Generally, the non-debtor party to the contract may not prohibit, restrict, or condition the assignment, and contrary contract terms purporting to do so are ineffective.

The debtor may also reject an executory contract. The standard for rejection is similar to that for assumption: can the debtor show that the bankruptcy estate is benefited by rejection of the contract? Rejected contracts are treated as breached, and the non-breaching party has an unsecured damages claim. The breach is treated as if it had occurred before the bankruptcy proceeding.

The timing for assumption of contracts is 60 days after filing of the petition (in a Chapter 7 case) or any time before confirmation of the reorganization plan (in a Chapter 11 case). If a party wants to know where it stands regarding a contract, the party may move the bankruptcy court for an early election. This is especially true where the debtor has breached the executory contract.

Can an Owner or Contractor Pay Certain Creditors on the “Eve of Bankruptcy?”

The bankruptcy estate may “reach back” and recover certain “preferential” transfers made by the debtor within 90 days preceding bankruptcy, or within one year preceding bankruptcy if the transfer benefited an insider of the debtor. The theory is to promote equality of distribution among creditors. Creditors are thus deterred from grabbing whatever they can immediately before the bankruptcy filing and debtors are prohibited from paying “preferred” creditors (e.g., only pay debts which the company president personally guaranteed). If a transfer is found to be a preference, the creditor who received the payment will have to repay the money.

What Happens to Mechanic’s Liens in Bankruptcy?

The ability to perfect and enforce mechanic’s liens is important in bankruptcy. Ideally, a contractor, subcontractor, or supplier perfects any mechanic’s liens under state law before the owner files bankruptcy. In Minnesota, a mechanic’s lien is perfected by serving and filing a lien statement within 120 days after the last work on the project. If a party properly perfects its mechanic’s lien pre-bankruptcy, the lien will typically “pass through” the bankruptcy unaffected.

The mechanic’s lien is similar to any other secured claim. In a Chapter 7 case, this means that the full value of the lien claim remains in place if the property has sufficient unencumbered value to satisfy the entire claim. In a Chapter 11 case, the rights of a mechanic’s lien claimant may be modified by the terms of the reorganization plan.

If a lien is not perfected before the bankruptcy is filed, a contractor, subcontractor, or supplier may be relegated to the status of an unsecured creditor. Unsecured creditors are last in line, and only recover their claims if there is money left over after the secured creditors are paid. The good news, however, is that liens can be perfected in most states after the bankruptcy filing without violating the automatic stay. In Minnesota, for example, a party may perfect lien rights after an owner files bankruptcy without violating the automatic stay. In re: Victoria Grain Co. of Minneapolis, 45 B.R. 2, 6 (Bankr. D. Minn. 1984). In other states, you should consult a bankruptcy attorney to evaluate whether the applicable state law and the Bankruptcy Code permit perfecting mechanic’s lien rights after the bankruptcy petition is filed.

While a mechanic’s lien claimant may be able to perfect its lien post-petition, enforcement or foreclosure of the lien is not permissible and any attempts to enforce the lien violate the automatic stay. See In re: Victoria Grain, 45 B.R. at 6. The automatic stay creates problems because state law usually requires lien claimants to foreclose within a short period of time from the last date of work. Thus, a contractor should seek relief from the automatic stay to foreclose a lien or, instead, file a proof of claim with the bankruptcy court to preserve its rights.

All is not lost, however, if the statutory period for enforcement of the lien expires before you can obtain relief from the automatic stay. The Bankruptcy Code generally extends statutes of limitations for creditors. Bankruptcy courts have held that the statutory enforcement period for mechanic’s liens is tolled and does not expire during the pendency of the bankruptcy proceeding.

The bottom line for mechanic’s lien claimants is (1) if possible, perfect the lien before the bankruptcy filing, (2) if the lien has not been perfected before the bankruptcy, the Bankruptcy Code does not relieve the claimant from the obligation to perfect its lien within the time provided under state law, and (3) the Bankruptcy Code’s automatic stay precludes the claimant from enforcing the lien (e.g., commencing a lien foreclosure action) unless the claimant receives relief from the automatic stay or the bankruptcy case is dismissed.

Are Arbitration Clauses Still Valid?

The bankruptcy court has the discretion to not enforce an arbitration clause in a construction contract. Recent cases have favored enforcing arbitration clauses in bankruptcy cases unless the arbitration frustrates the reorganization effort or otherwise conflicts with the Bankruptcy Code’s purposes. Accordingly, arbitration clauses can generally be enforced by the contracting party, unless the debtor rejected the contract as explained above.