Owner/Developer Insolvencies and the Risks to Contractors
Developer insolvencies are unfortunately becoming more and more common in our current economic climate and often result in partially completed projects being stopped. The consequences to contractors can be significant. A number of recent resort projects illustrate what the contractors and subs can typically expect.
First, the obvious, immediate problem is nonpayment, which in turn requires the contractor to file a lien. After a lien is filed, the contractor has 120 days (in Oregon) to file a lawsuit to foreclose it. The commencement of the foreclosure suit is only the start of what can sometimes turn into a long and drawn-out battle with an uncertain outcome.
If the project involves conventional bank financing, as many do, the biggest battle will be between the contractor and the bank. If the contractor has prepared its lien properly (and mistakes here are common), it will normally have priority over the bank. While in some cases the contractor may be successful in moving the case along quickly, it 's not at all uncommon for such cases to drag on for a year or more, and this will likely be the situation if there are significant priority disputes.
In other economic climates, banks would often step up and pay off the construction liens, once any priority issues were resolved; however, that is not happening as often in the current climate for a number of reasons. First, many banks are dealing with their own insolvency issues, and some are operating under Federal Reserve supervision. Banks in those situations are often incapable of advancing new funds. Second, as a result of the recent significant decline in real estate values, the equity cushion that many banks thought they had when making the loan has disappeared. Absent having any equity to protect, many banks will simply elect to abandon their collateral to the construction lien claimants. And third, participation loans have become more common, with the result that the lender on a particular project might not be an individual bank, but instead a collection of banks, perhaps as many as 40 or 50. Negotiating with a single entity presents a different dynamic from negotiating with a committee.
In the course of the lawsuit, the contractor is obligated to the subs and suppliers. If the subcontracts contain pay-if-paid or pay-when-paid provisions, the general contractor may be protected, though not necessarily. Recent case law has held that a pay-when-paid provision still obligates the general contractor to pay subcontractors within a reasonable period of time and does not permit the general to delay subcontractor payments indefinitely.
Assuming the general succeeds in being awarded a judgment in the lawsuit, the next step is to schedule a foreclosure sale, and this can be done within approximately two to three months after a judgment is entered. If the bank has not stepped up and paid subcontractors by the time the foreclosure sale is scheduled, there is a good chance that it will not do so and will instead allow the sale to go forward. If the sheriff’s sale takes place, the bank is still protected, because it can later exercise its redemption rights to acquire the property for the amount that was bid at the sale.
However, if the owner believes there is equity in the project, and most owners are optimistic that there is, even in the face of an appraisal to the contrary, the owner will file a bankruptcy petition in time to prevent the sale. If the owner is a single-asset limited liability company, which is how many development projects are set up, a bankruptcy filing is an easy decision. Typically, the owner will wait until only a day or a few days prior to the scheduled foreclosure sale to file the petition.
In bankruptcy, the owner will likely propose a plan of reorganization that involves delaying completion of the project for a few years until the economy turns around, which will, in theory, give the owner time to locate new financing, complete the project, and pay everyone off. All of this, of course, means three, four, or maybe five years of delay in the contractor getting paid. Many contractors simply cannot wait that long.
The contractor can do a number of things to prevent this situation from happening. First, the contractor can investigate the owner’s financial condition before starting work. This might involve asking for financial statements, requesting confirmation from the lender that the financing has been approved, and ordering a Dunn & Bradstreet report. If there are concerns, the contractor should request that the owner post a payment bond. Second, the contractor should include strong language in the contract allowing it to stop work for nonpayment and to demand financial assurances in the event it has reason to question the owner’s solvency. Third, assuming that it has included strong language in its contract, the contractor should exercise its right to stop work promptly in the event of nonpayment. Fourth, the contractor should insert pay-if-paid provisions in its subcontracts. And finally, the contractor should act promptly and cautiously in filing its lien.
More than anything else, payment defaults can cause contractors significant delays. Anticipating payment issues at the contracting stage and monitoring the issues closely during performance are critical.
Bankruptcy as an Event of Default - Unenforceable Contract Provisions
Contract provisions stating that either the owner or the contractor’s bankruptcy will constitute an event of default are common. A corresponding provision typically sets out the nonbreaching party’s rights in the event of default, one being the right to terminate the contract. For all practical purposes, these provisions are meaningless and unenforceable.
Section 365 of the Bankruptcy Code deals with the debtor’s right to assume or reject executory contracts. (“Executory contracts” are essentially contracts for which performance is not yet complete. A construction contract is an executory contract.) That same section also gives the debtor the right to assign such contracts. Section 365(e)(1) states that any provision in an executory contract that permits one party to terminate the contract in the event of the other’s insolvency or in the event that the other files a bankruptcy petition is unenforceable. And section 365(b)(2)(A) similarly states that any provision in an executory contract that prohibits the debtor from assuming and assigning the contract is unenforceable.
A participant at one of our recent “Financial Defaults” seminars suggested one possible reason for using such a provision. If the contract is guarantied by a third party and the guaranty obligation is triggered only by a default under the principal contract, such a provision might work to trigger the guaranty. To us that seems unnecessary, since the guaranty could be drafted to state that it is triggered by the principal’s default.
Notwithstanding section 365’s nullification of bankruptcy default provisions, they continue to be used with presumably little effect.
Owner/Developer Bankruptcies - What the Contractor Can Expect
What should a contractor expect when the owner files for bankruptcy? That’s a difficult question to answer briefly. Our best advice is to see a bankruptcy attorney quickly. Bankruptcy is a highly technical area of law that few attorneys understand. It’s wholly unreasonable to expect that a nonattorney could navigate his or her way through the system.
We emphasize the word “quickly” for good reason. When a project owner files for bankruptcy, it is very likely that major decisions about what will happen with the project and how contractors will be paid will be made immediately, often within less than a week. Those issues and others will need to be addressed in a series of what are commonly referred to as “first-day orders,” and the hearings on such matters are sometimes held literally on the first day after the petition is filed.
Rather than providing a technical explanation of the important Bankruptcy Code provisions, we will instead simply provide some highlights of issues that are likely to come up, along with a few practical pointers. Our goal is to provide only an idea of what to expect.
The Automatic Stay
An automatic stay goes into effect immediately upon the filing of a bankruptcy petition. The stay prohibits creditors, such as contractors, from taking any action to collect amounts due from the debtor and is very broadly construed. Violations of the stay are often met with sanctions.
Construction Liens and Bankruptcy
Notwithstanding the automatic stay, section 362(b)(3) of the Bankruptcy Code permits creditors to file liens for the purpose of continuing the perfection of an existing lien. Since, under Oregon law, a contractor’s lien originates when a contractor starts work or a supplier begins delivering materials, contractors and suppliers are permitted to file construction liens after the owner has filed for bankruptcy, notwithstanding the automatic stay. However, in states in which a construction lien does not exist until it is filed, contractors are not allowed to file liens after the owner has filed for bankruptcy.
Once the lien is filed, the contractor has two options: (i) the contractor may file a motion seeking relief from the automatic stay for the purpose of foreclosing the lien or (ii) the contractor may serve the debtor (or, in some cases, the bankruptcy trustee) with a notice under section 546(b)(2), which, as with filing an action to foreclose, serves to continue the lien until the automatic stay is terminated. If the second option is followed, the contractor needs to file a lawsuit to foreclose the lien within 30 days after the automatic stay’s termination, which will typically be the end of the bankruptcy case.
Assumption or Rejection of Contract
As discussed in an earlier blog, a provision in a construction contract providing that the owner’s bankruptcy filing will constitute an event of default is likely unenforceable. Instead, the debtor will be free to either assume or reject the construction contract at any time before confirmation of a plan of reorganization. In many cases that could be several months. The contractor may ask the court to shorten the time for the debtor to assume or reject the contract, and courts are typically asked to do that with respect to construction contracts.
To assume a contract, the debtor is required to cure all defaults, which would obviously mean paying the contractor, and all of the contractor’s subs and suppliers, in full. In addition, the debtor is also required, as a condition of assumption, to provide adequate assurances that it will be able to make future payments on the project.
Continue Reading...
