Bankruptcy by the Developer/Owner: Mechanics Lien Rights May Still Prevail!

by Nossaman LLP

The rate of bankruptcies among construction industry participants is higher than some think.  The bankruptcy of a developer creates an “automatic stay” under federal law preventing almost all collection activities, including actions to perfect a lien.  However, there are unique exceptions to the automatic stay that will protect some parties in the construction industry, such as the right for a contractor to seek protections for payment of unpaid work on a residential or commercial project.  Upon a developer’s bankruptcy, two sets of laws that may conflict need to be harmonized: federal bankruptcy law and applicable state law relating to mechanics liens.  Since a violation of the bankruptcy automatic stay is a contempt of court, it is important to understand what can and cannot be done once a bankruptcy has been filed.

When any party files for bankruptcy, one of the first protections gained is the “automatic stay” under United States Bankruptcy Code section 362. The automatic stay broadly bars collection efforts and other creditor actions against the debtor and/or the debtor’s property. While numerous, some of the specifically prohibited actions include: “(4) any act to create, perfect, or enforce any lien against property of the estate; (5) any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title; …”  11 U.S.C. § 362(a).

Since a mechanics lien almost always qualifies as “a lien against property of the estate”, a cursory examination of the Bankruptcy Code leads to the conclusion that mechanics liens, and actions to record or otherwise perfect mechanics liens, are strictly prohibited after the filing of a bankruptcy case.  Claimants are concerned they may miss a deadline under state law to perfect a lien that would apply but for the bankruptcy.  However, mechanics lien claimants may be entitled to an “exception” from the automatic stay upon taking proper actions both inside and outside the bankruptcy case.  This exception permits significant relief for such a creditor:

“… to perfect, or to maintain or continue the perfection of, an interest in property to the extent that the trustee’s rights and powers are subject to such perfection under Section 546(b) [of the Bankruptcy Code] … ”.  11 U.S.C. §Section 362(b)(3).

Despite one of the most important safeguards created for debtors in bankruptcy — the automatic stay — claimants may continue to record and perfect a mechanics lien even after the bankruptcy has been filed notwithstanding the automatic stay.  This is true as long as the lien or work giving rise to the lien arose prior to the filing of the bankruptcy petition, which is the case in the vast majority of mechanics lien claims in a bankruptcy situation. While mechanics lien law varies significantly between states, mechanics liens generally arise either when labor and/or materials were supplied by the claimant, or when work on the project first commenced.  Both of these dates are generally well before the lien is perfected (filed). This means that, if the claimant, whether a general or subcontractor, provided work or supplied material prior to the bankruptcy filing, the lien is allowed to be perfected after the bankruptcy filing, even with the broad automatic stay.  Thus, the claimant’s rights will generally survive a bankruptcy case and will not be discharged.

It is important to note that the exception permitting a claimant to perfect the lien does not go so far as to allow actions to enforce the lien.  Nonetheless, the claimant’s rights can still be protected since the bankruptcy filing will normally toll any deadline to enforce a lien during the bankruptcy proceeding, so that the lien can be enforced after the bankruptcy discharges most of the other claims.  Many practitioners will simply seek a comfort order or a stipulation approved by the Bankruptcy Court permitting the claimant to proceed with its lien enforcement rights despite the bankruptcy.  Mechanics lien claimants therefore have the ability to both 1) be perfected after the automatic stay, and 2) emerge “whole” after the bankruptcy process concludes.  This exception places a mechanics lien claimant in a much better position to recover the money owed in (or after) a bankruptcy proceeding.   Nossaman lawyers can assist both debtors and creditors in this and other types of bankruptcy proceedings.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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