As The Economy Slows The Number Of Construction Bankruptcies Will Rise

As The Economy Slows The Number of Construction Bankruptcies Will Rise:
What A Contractor Should Know About Bankruptcy

By
William C. Last, Jr.
Attorney At Law

Since the economy has weakened there has been an increase in the number of businesses that are seeking bankruptcy protection. This article will first focus on some very basic bankruptcy concepts and will then discuss a number of issues that can arise if you have a contract with a construction company or owner that has filed for bankruptcy protection.

This article is intended to alert contractors to the issues that can arise when a party to a construction project files bankruptcy. Since bankruptcy laws are complex and their application will vary based on the factual issues, you should not rely on statements contained in this article to guide you if a party to a project files bankruptcy. If you are confronted with a bankruptcy you should seek advice of a competent bankruptcy attorney.

A Overview of Bankruptcy Concepts

The two primary goals of the federal bankruptcy statutes are: (1) providing an orderly manner for converting the assets of the debtor into cash so that the creditors can be paid in accordance statutory priorities; (2) providing a fresh start to the debtor by relieving the debt and allowing the debtor to keep certain assets that are exempt from the bankruptcy. In addition, if the debtor can reorganize or develop a plan to pay its creditors, there are bankruptcy proceedings that will allow such a plan to be formulated and implemented.

There are two basic types of bankruptcy proceedings. One proceeding, commonly referred as a Chapter 7 proceeding, provides for the orderly liquidation and distribution of the debtor’s assets. The other proceeding, commonly referred to as a Chapter 11, allows a debtor to continue ongoing business operations while a reorganization plan is developed. An individual debtor who has a regular source of income can file a Chapter 13 proceeding.

A bankruptcy is commenced by the filing of a bankruptcy petition. The bankruptcy can be either voluntary or involuntary. The petition includes information concerning the debtor’s name and address. The petition also lists the debts, the debtor’s principal assets and request for relief under the appropriate chapter.

Under a Chapter 7 proceeding a trustee is appointed to oversee the process. The trustee is responsible for gathering the assets, liquidating the assets and then distributing the proceeds. The distribution is, generally, in accordance with specific classes of claims.

If a Chapter 11 is elected the debtor can remain in possession of the bankruptcy estate or alternatively the court can appoint a trustee. Within a fixed period after the filing of the Chapter 11 petition, the debtor is required to file and serve a written disclosure statement and a plan of reorganization. The plan includes a classification of the claims and specifies how each classification will be treated under the plan. The creditors are then allowed to vote on accepting or rejecting the plan.

Once a bankruptcy is filed there is an automatic stay on all collections matters, legal proceedings, and judgment enforcement activities. The objectives of the automatic stay include maintaining the status quo, protecting the estate against a multiplicity of lawsuits in various forums, and preserving the relative priorities of creditors, pending a distribution of estate assets.

If any action is undertaken in violation of the stay the party who violates the stay can be sanctioned by the court.

If there are assets in the bankruptcy estate, the court will set a deadline for filing a claim. The claim is filed on a form that is available from the bankruptcy court. If a creditor fails to file a timely claim they can be barred from receiving any distribution from the bankruptcy estate.

Generally, once the reorganization plan is approved, any pre-bankruptcy claims are discharged and the debtor is obligated to fulfill its obligations under the plan. After the bankruptcy estate is fully administered a final decree closing the case is issued.

Some Bankruptcy Issues That Can Arise In Regards To A Construction Project

If a debtor files a bankruptcy during the period it is performing a construction contract, there are a number issues that may arise. Most of the issues are not unique to the construction industry and arise in the context of most bankruptcies. The remainder of this article will discuss some of those issues.

Executory Contracts

If the bankruptcy petition is filed during the course of a contract’s performance, one issue that will arise concerns the remaining obligations under that construction contract. For example, can the non-bankrupt party terminate the contract? Another issue is whether the non-bankrupt party has an obligation to pay any balances that are due under that contract?.

The bankruptcy laws have a provision concerning contracts that have material obligations that have not been fully performed by the time of the bankruptcy filing. Such contracts are referred to as executory contracts. If there are executory contracts, the debtor in possession or the trustee has the right to assume or reject the contract. In a Chapter 7 bankruptcy, the time for assuming or rejecting the contract is sixty days. Unless the bankruptcy court orders an earlier date, in a Chapter 11 bankruptcy the time for assuming or rejecting the contract is anytime prior to the confirmation of the reorganization plan.

Clearly, in a time sensitive construction project a problem can arise if one party to an executory contract files bankruptcy. If a non-bankrupt party to a contract decides to unilaterally terminate the contract or replace the bankrupt subcontractor without seeking a bankruptcy court order, it can be asserted that the non-bankrupt party has breached the contract or violated the automatic stay.

Thus, if the bankrupt entity is party to an executory contract, the non-bankrupt party can seek a court order forcing the bankrupt party to assume or reject the contract. On the other hand, if the contract was legally terminated prior to the bankruptcy filing, the contract generally will not treated as part of the bankruptcy estate. On the other hand, if bankrupt party was in default but was not legally terminated prior to the bankruptcy filing, the debtor in possession or trustee could assume the contract if it can establish that it can cure the default or provide “adequate assurances” that the default will be cured in a timely fashion.

Mechanic’s Liens and Stop Notices

As previously stated, the automatic stay prevents any further collection activity. That activity can include the recording of a mechanic’s lien, or filing a stop notice when the owner of the project is the party who has filed for bankruptcy protection. It can also be an issue when the non-bankruptcy party seeks to foreclose on mechanic’s lien.

California law requires that a lawsuit be filed to foreclose on a mechanics lien within 90 days (Civil Code §3144) after recordation. If a property owner files for bankruptcy, his creditors are subject to an automatic stay on the filing and prosecution of lawsuits. Yet, under California law, the filing of a foreclosure suit (i.e., an enforcement action) is required to maintain the lien. Quite simply, if no suit is timely filed, the lien becomes void. Thus, if you want to foreclose on a mechanics lien on a piece of real property owned by a bankrupt debtor you are subject to a “Catch 22.”

For a number of years the commentators recommended filing the lawsuit but not serving it on the debtor. In a recent case, entitled In re Baldwin Builders (BAP No. CC-97-1830BRiJ), the Bankruptcy Appellate Panel (“Court”) examined this issue and declared that the commentators’ advice should not be followed.

After concluding that filing a post-bankruptcy filing of a foreclosure lawsuit is a violation of the automatic bankruptcy stay, the Baldwin Court then considered the type of notice that must be given in the bankruptcy proceeding concerning a mechanics lien. The Baldwin Court concluded that the notice must be in the form of a secured claim filed in the bankruptcy court. The Baldwin Court also stated that the aforementioned notice must be filed with the bankruptcy court and a copy served on the debtor and the bankruptcy trustee within 90 days after the mechanics lien is recorded. The Baldwin decision makes it clear that if the requisite notice is not provided within the 90 day period, the lien claimant loses its lien rights.

It should be noted that one commentator still recommends filing an action to foreclose on the lien. Once again, if you are confronted with this “Catch 22" it is essential that you consult competent bankruptcy counsel. .

Similarly, the possibility of violating the automatic stay can also arise when a party seeks to file and enforce a stop notice that would impact a bankrupt debtor’s interest in construction funds that are subject to the stop notice claim.

Ability To Claim A Setoff

A non-bankrupt contracting party may consider using funds owed a bankrupt party to satisfy claims that are being asserted against the non-bankrupt party due to the other party’s bankruptcy. Such an act could act as a legal setoff or defense to payment in a non-bankruptcy situation. While the bankruptcy laws recognize the right to a setoff, certain requirements must be satisfied.

Generally, under bankruptcy law a creditor can offset a mutual debt owing by such creditor to the debtor (a) if it arose before the commencement of the bankruptcy and (b) if there is a claim of such creditor against the debtor that arose before the commencement of the case. Such an offset would be barred if such a claim was transferred, by an entity other than the debtor, to such creditor within 90 days of the bankruptcy filing or if the debt owed to the debtor by such creditor was incurred by such creditor within 90 days of the bankruptcy filing.

If a creditor claims an offset but does not fall within the requirements, it maybe forced to pay those sums to the bankruptcy estate or violate the automatic stay by making such an improper offset.

Conclusion

As previously stated, this discussion of bankruptcy law is only a brief overview of the issues that can arise. If you are involved in a project where a party files for bankruptcy protection you should discuss your obligations with a competent bankruptcy attorney.

If you are involved in a construction project where one party appears headed toward a bankruptcy filing you should seek guidance as to best means to protect your financial interests before the third party files bankruptcy. Once the bankruptcy is filed, you should consider suspending payments to the bankrupt party and any lien claimants that had claims against the bankrupt party, until you obtain proper legal guidance through the maze of bankruptcy laws.

This article, © 2003, was written by William C. Last, Jr. The quoted text and other parts of the article are from SB 800. Parts of the article are from the Civil Code section 1375. Mr. Last is an attorney who has been specializing in Construction Law for over eighteen years. Mr. Last also holds a California A&B contractors license. If you have any questions Mr. Last can be contacted at 415-764-1990 or 650-425-7679 or by e-mail at wclast@lastlawfirm.com. He has other articles on his web site: lhfconstructlaw.com. This bulletin is published periodically to provide general information about current legal issues. If you have a specific legal question or need legal advice, you should contact an attorney