When Your General Contractor Files Bankruptcy

by Pepper Hamilton LLP
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This article was published in Law360 on October 16, 2014. © Copyright 2014, Portfolio Media, Inc., publisher of Law360. It is reprinted here with permission.

The case is Branch Banking & Trust Co. v. Construction Supervision Services Inc. (In re Construction Supervision Services Inc.), 753 F.3d 124 (4th Cir. 2014). After a general contractor filed bankruptcy, several of its subcontractors requested clarification from the court about whether they could file notices post-petition to perfect liens for construction materials and equipment supplied prepetition. The bankruptcy court agreed that they could, the district court affirmed, and a lender appealed to the Fourth Circuit.

Generally if a lien is unperfected on the date that a bankruptcy petition is filed, (1) the automatic stay prevents the creditor from perfecting post-petition, and (2) the unperfected lien can be avoided using the trustee’s “strong arm” powers.

However, Section 362(b)(3) of the Bankruptcy Code contains an exception from the automatic stay for “any act 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 limits 546(b) ...” (emphasis added). Section 546(b) limits a trustee’s powers when applicable laws permit perfection of “an interest in property to be effective against an entity that acquires rights in such property before the date of perfection” (emphasis added).

The court and the parties agreed that applicable law allowed retroactive perfection, so the appeal turned on whether the subcontractors had “an interest in property” on the bankruptcy petition date. Since “interest in property” is not defined in the Bankruptcy Code, the Fourth Circuit looked to the “plain language” and quoted definitions from Black’s Law Dictionary, American Heritage Dictionary and Oxford English Dictionary online. The court noted that it held in prior opinions that “interests” are broader than just “liens” and commented that other circuits have also drawn this distinction. In its view, this made sense because a lien is a mechanism for enforcement of preexisting rights.

In the context of the construction liens, state law provided remedies to subcontractors who furnished services and materials in connection with an improvement of real property, including the right to obtain a lien on funds owed to the general contractor arising from the improvements. As provided in the statute, the “liens upon funds granted under this section shall secure amounts earned by the lien claimant as a result of having furnished labor, materials, or rental equipment at the site of the improvement under the contract to improve real property, ... whether or not such amounts are due and whether or not performance or delivery is complete.”

Under the statute, the lien is granted by giving notice of the claim of lien and is effective upon receipt of the notice. However, a subcontractor is entitled to a lien upon delivery of the materials and equipment. As described in a state law treatise, the supplier has an inchoate lien that arises at the commencement of work that is preserved by providing notice. Upon perfection, the lien rights vest and relate back to the commencement of work.

There had been several previous bankruptcy court decisions that interpreted the state’s statute to mean that the notice of claim of lien both created the interest as well as perfecting the lien. This meant that subcontractors who had not given notice would not have an interest at the time the bankruptcy was filed, and thus would not have the benefit of Section 546(b) and the related exception from the automatic stay.

The statute was amended by the state Legislature in response to these decisions to clarify that the intent was that rights arose upon the delivery of materials, as opposed to only later when the notice is sent. Although the amendment was not applicable to the claims under consideration by the Fourth Circuit, it viewed this as relevant for interpreting the intended meaning of the statute.

In the end, the Fourth Circuit concluded that the subcontractors became entitled to a lien as soon as they furnished materials. Since the subcontractors delivered materials prior to the bankruptcy filing, they had an “interest in property” as of the petition date. Since the state statute provided that once the lien was perfected by giving notice it related back to the commencement of work, the subcontractor claims came within Section 946(b) and the automatic stay exception. The claims could not be avoided using the strong-arm powers and the subcontractors could provide the required notice of claim of lien post-petition based on the exception from the automatic stay.

There are many state-specific variations for construction liens. However, there is a common theme in many of the statutes that the priority of liens relates back to the commencement of work. Be aware that in these states, all is not lost when the general contractor files bankruptcy, and subcontractors may be able to perfect their construction liens post-petition.

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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