The Big “B” – Bankruptcy on the Construction Project

by Wendel, Rosen, Black & Dean LLP
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UntitledIt’s not often that I find myself in bankruptcy court, but there I was. A lone construction attorney surrounded by bankruptcy lawyers speaking in a foreign tongue – “cram down!,” “cash collateral!,” “executory contract!”

And the natives weren’t exactly friendly.

Bankruptcy on a construction project is one of the biggest fears for owners and contractors. At best it can slow down a project and at worst it can cause a domino effect of bankruptcies as contractors and suppliers aren’t paid, causing the entire project to fail.

A Very, Very Brief History of Bankruptcy

Before there were modern bankruptcy laws if you were a debtor any number of terrible things could happen to you. The Greeks would force you and your family into slavery until the creditor recouped his losses. Genghis Khan was less forgiving, and if you became bankrupt three times, you were put to death. The English were perhaps the most lenient and would just throw you into debtor’s prison.

Today in the United States you won’t be put to death, forced into slavery, or thrown into jail. Rather, we Americans, perhaps shaped by our colonial roots, will give you a “fresh start” by allowing you to reorganize and pay down all or part of your debts (Chapters 9 – public entities, 11 – individuals and companies, 12 – farmers, or 13 – individuals only) or simply liquidate your assets and start anew (Chapter 7 – individuals, couples and companies).

Bankruptcy Basics

One of the most important features of the U.S. Bankruptcy Code is the “automatic stay.” When an individual or business entity files for bankruptcy an automatic stay is triggered on all collection actions, legal proceedings and judgment enforcement activities. The idea is to maintain the status quo to give the debtor time to reorganize or liquidate its assets. Any action taken in violation of the automatic stay can be sanctioned by the court.

Also important under the U.S. Bankruptcy Code is the concept of “secured creditors,” “unsecured creditors” and “priority claims.” Secured creditors are creditors who hold a security interest in an asset of the debtor such as a deed of trust in connection with a mortgage or a security agreement in connection with a car loan. Unsecured creditors are, as their name implies, creditors who don’t hold a security interest. And priority claims are claims given priority such as tax obligations, alimony and child support. Under the U.S. Bankruptcy Code, secured creditors and priority claims get paid first and unsecured creditors get paid last, which is extremely important in bankruptcy, because getting paid first means getting paid most and getting paid last means getting paid least, or not at all.

Generally, the most common bankruptcy scenarios on a construction project are: (1) the owner files for bankruptcy; (2) the general contractor files for bankruptcy; or (3) a subcontractor files for bankruptcy. Each presents its own unique challenges and solutions for getting paid.

When the Project Owner Files for Bankruptcy

How will I know when a project owner files for bankruptcy?

A bankruptcy begins when a debtor files a bankruptcy petition with the bankruptcy court, usually, the U.S. District Bankruptcy Court in the district where the debtor resides or has his principal place of business. Typically, within a week after the petition is filed, the court will send a Notice of Commencement of Case to all creditors listed in the petition. When the debtor is the owner of an uncompleted construction project the Notice of Commencement of Case will usually include the general contractor. Typically, though, word that a project participant has filed for bankruptcy spreads pretty quickly.

If you are a creditor and did not receive a Notice of Commencement of Case you should file a Request for Special Notice with the bankruptcy court so that you receive future notices.

If I’m the general contractor do I need to continue to perform work under my contract with the owner?

Yes. Partially performed construction contracts are considered to be “executory contracts” meaning the obligations of the parties to the contract have not yet been completely performed (i.e., completion of work by the general contractor and payment by the owner). The trustee, in a Chapter 7 case, and the debtor, in Chapter 11 and 13 cases, gets to choose whether to assume or reject an executory contract.

The decision whether to assume or reject an executory contract usually turns on whether assuming the contract would result in a net economic gain to the bankruptcy estate.

In Chapter 7 cases, the deadline for assuming or rejecting an executory contract is 60 days (unless extended) from the date the bankruptcy petition was filed with the bankruptcy court. In Chapter 11 and 13 cases, the time for assuming or rejecting an executory contract is anytime prior to confirmation of the debtor’s reorganization plan. A non-bankrupt party can also seek a court order requiring the trustee or debtor to assume or reject an executory contract earlier.

But what if there is a provision in the contract that says if the other party becomes insolvent or files for bankruptcy it is considered a material breach of the contract allowing the non-breaching party to rescind the contract?

Generally, these types of provisions, known as ipso facto (“by the fact itself”) clauses, are unenforceable. They are only two narrow exceptions in which they are enforceable: (1) if a party becomes insolvent but does not file for bankruptcy. However, if a bankruptcy is later filed, a termination based on insolvency may not be enforced; or (2) if the trustee or debtor is not permitted under “applicable law” to assume or assign the executory contract. This likely would not apply to construction contracts, although an argument might be made on public works projects that a trustee or debtor in possession cannot assume or assign an executory contract under the California Public Contracts Code.

What happens if the trustee or debtor assumes the construction contract?

In Chapter 7 cases, if the trustee decides to assume a construction contract it must obtain an order from the bankruptcy court permitting it to do so. In Chapter 11 and 13 cases, if the debtor decides to assume a construction contract it must receive permission from the court through a confirmed reorganization plan. The non-bankrupt party to the contract may object to the assumption of the executory contract.

If a trustee or debtor assumes a construction contract, the debtor’s bankruptcy estate becomes bound by the contract, and all amounts owed thereafter by the debtor under the contract are usually entitled to be paid in full as administrative expenses. Furthermore, if the debtor was in default prior to assuming the construction contract, the debtor must cure all monetary defaults and provide adequate assurance of future performance under the contract.

A trustee or debtor who has assumed a construction contract may, in addition to performing the contract, assign the contract to a third-party.  Contract provisions restricting the ability to assign the contract are generally unenforceable. If a trustee or debtor assigns a construction contract there must be adequate assurance of future performance by the assignee.

What happens if the trustee or debtor rejects the construction contract?

If a trustee or debtor rejects a construction contract, the bankruptcy estate loses any benefits it had under the contract, and is liable for all damages caused by the rejection, which is considered a breach of contract. Damages caused by the rejection of an executory contract such as lost profits, costs to retain a replacement contractor, etc.  are treated as unsecured claims. 

What can I do if I have not been paid for the work I performed?

If you have not been paid for work you performed you should file a Proof of Claim with the bankruptcy court unless the Notice of Commencement of Case indicates that no claims are to be filed. In Chapter 7 and 13 cases, the deadline to file a Proof of Claim is 90 days after the First Meeting of Creditors. In Chapter 11 cases, the court sets the deadline to file a Proof of Claim. If you did not timely file a Proof of Claim, you can ask the court for permission to file a late Proof of Claim but you have to show “excusable neglect” for your failure to file a timely Proof of Claim.

Is there anything else I can do other than filing a Proof of Claim?

Maybe. As discussed, when an individual or business entity files a bankruptcy petition there is an automatic stay on all collection actions, legal proceedings, and judgment enforcement activities. However, the automatic stay only applies to collection actions, legal proceedings, and judgment enforcement activities directed at the debtor.

Therefore, if there is a construction lender on the project, the automatic stay does not prevent a non-bankrupt party from “serving” a bonded stop payment notice on the construction lender, although it would likely prevent a non-bankrupt from party from filing or continuing a lawsuit to “enforce” a bonded stop payment notice.

Furthermore, the automatic stay does not prevent a non-bankrupt party from “recording” a mechanics lien. It does, however, prevent a non-bankrupt party from filing or continuing a lawsuit to “foreclose” on a mechanics lien, and if lawsuit to foreclose on a mechanics lien has already been filed, a Notice of Stay of Action should be filed in the state court proceeding.

If a lawsuit to foreclose on a mechanics lien has not yet been filed, the U.S. Bankruptcy Code allows the non-bankrupt party to file a Notice of Continued Perfection to toll the 90-day deadline to file suit to foreclose on a mechanics lien. Like the deadline to file suit to foreclose on a mechanic’s lien, a Notice of Continued Perfection must be filed with the bankruptcy court within 90 days of recording the mechanics lien. A Notice of Continue Perfection could also likely be used to toll the deadline to file suit to enforce a bonded stop payment notice.

A party to a construction project can also file a motion for relief from the automatic stay to permit the party to file or continue pursuing a lawsuit to foreclose on a mechanic’s lien (or enforce a bonded stop payment notice). This is typically done if there is concern that the value of the property might decrease (e.g., waste by the owner), the position of the mechanics lien holder may erode (e.g., owner not able to pay real property taxes), or if the owner lacks equity in the property.

When the General Contractor Files for Bankruptcy

Unless otherwise noted, the comments above in the section “When the Project Owner Files for Bankruptcy” also applies to this section.

How will I know when the general contractor files for bankruptcy?

When the debtor is the general contractor on an uncompleted construction project, the bankruptcy court will send a Notice of Commencement of Case to all creditors listed in the debtor’s bankruptcy petition, which will usually include the general contractor’s unpaid subcontractors and suppliers. If you are a creditor and did not receive a Notice of Commencement of Case you should file a Request for Special Notice with the bankruptcy court so that you receive future notices.

If I’m the owner can I terminate the general contractor if it files for bankruptcy?

No. Partially performed owner-contractor construction contracts are considered “executory contracts,” and only the trustee in a Chapter 7 case, or the debtor in Chapter 11 and 13 cases, get to choose whether to assume or reject an executory contract. However, the trustee or debtor must obtain court approval.

If I’m a subcontractor do I need to continue to perform work under my contract with the general contractor?

Yes. Partially performed subcontracts are considered “executory contracts,” and only the trustee in the Chapter 7 cases, or the debtor in Chapter 11 and 13 cases, get to choose whether to assume or reject an executory contract. However, the trustee or debtor must obtain court approval.

If I’m the owner what can I do to ensure my project gets completed?

Because the U.S. Bankruptcy Code’s automatic stay only applies to collection actions, legal proceedings, and judgment enforcement activities directed at the debtor, the owner can make a claim against the general contractor’s performance bond, if any.

If I’m a subcontractor or supplier, other than filing a Proof of Claim with the U.S. Bankruptcy Court, what can I do if I have not been paid for the work I performed?

Again, because the U.S. Bankruptcy Code’s automatic stay only applies to collection actions, legal proceedings, and judgment enforcement activities directed at the debtor, a subcontractor or supplier can in addition to filing a Proof of Claim: (1) record and file suit to foreclose on a mechanics lien on the owner’s property if it’s a private works project; (2) serve and enforce a stop payment notice on the owner, or bonded stop payment notice on the construction lender, if any; (3) make a claim against the general contractor’s payment bond, if any.

If an owner’s contract with the genial contractor has a provision allowing the owner to pay subcontractors and suppliers of the general contractor directly or by joint check, the owner may be able to argue that undisbursed contract funds are not part of the bankruptcy estate, and that the owner be allowed to cut checks either directly or by joint check to the general contractor’s subcontractors and suppliers in order to avoid the recording of mechanic’s liens or serving of stop payment notices.

When a Subcontractor Files for Bankruptcy

Unless otherwise noted, the comments above in the section “When the Project Owner Files for Bankruptcy” also applies to this section. 

If I’m the general contractor can I terminate a subcontractor if it files for bankruptcy?

No. Partially performed subcontracts are considered “executory contracts,” and only the trustee in a Chapter 7 case, or the debtor in Chapter 11 and 13 cases, get to choose whether to assume or reject an executory contract. However, the trustee or debtor must obtain court approval.

If I’m a supplier or second-tier subcontractor do I need to continue to perform work under my contract with the subcontractor?

Yes. Partially performed subcontracts and purchase orders are considered “executory contracts,” and only the trustee in the Chapter 7 cases, or the debtor in Chapter 11 and 13 cases, get to choose whether to assume or reject an executory contract.  However, the trustee or debtor must obtain court approval.

If I’m the general contractor what can I do to ensure the subcontractor’s scope of work gets completed?

Because the U.S. Bankruptcy Code’s automatic stay only applies to collection actions, legal proceedings, and judgment enforcement activities directed at the debtor, a general contractor can make a claim against the subcontractor’s performance bond, if any.

If I’m a supplier or second-tier subcontractor, other than filing a Proof of Claim with the U.S. Bankruptcy Court, what can I do if have not been paid for the work I performed?

Again, because the U.S. Bankruptcy Code’s automatic stay only applies to collection actions, legal proceedings, and judgment enforcement activities directed at the debtor, a supplier or second-tier subcontractor can in addition to filing a Proof of Claim: (1) record and file suit to foreclose on a mechanics lien on the owner’s property if it’s a private works project; (2) serve and enforce a stop payment notice on the owner, or bonded stop payment notice on the construction lender, if any; (3) make a claim against an upstream contractor’s payment bond, if any.

If the general contractor’s contract with the subcontractor has a provision allowing the owner to pay subcontractors and suppliers of the general contractor directly or by joint check, the owner may be able to argue that undisbursed contract funds are not part of the bankruptcy estate, and that the general contractor be allowed to cut checks either directly or by joint check to the subcontractor’s suppliers and second-tier subcontractors in order to avoid the recording of mechanic’s liens, serving of stop payment notices, or claims against the general contractor’s payment bond.

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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