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.
Assignment of Contract
If the debtor assumes the contract, it has the absolute right to assign it, notwithstanding any contractual provision to the contrary. This is not uncommon in developer bankruptcies.
Continuation of the Project – Practical Issues
As a practical matter, the debtor’s ability to continue with the project will depend in large part on the amount of equity it has in the property and often on the lender’s willingness to cooperate. To use any cash that is subject to the lender’s security interest, the debtor first needs to convince the court that the lender is adequately protected with other collateral. It, of course, cannot do that if the property’s value has declined to the point that the lender is under-secured. In such a situation, it is unlikely the project will continue.
The debtor is absolutely obligated to pay the contractor for obligations incurred post-petition. The automatic stay will not prohibit the contractor from stopping work due to nonpayment of post-petition obligations; however, the contractor should be cautious in pursuing, for post-petition defaults, other remedies that may affect assets of the estate.
A “preference” is essentially any payment made by a debtor to a creditor within 90 days of filing bankruptcy that permits the creditor to receive more than it would have received in a Chapter 7 liquidation. For the most part, it is unlikely that payments to contractors, subcontractors, and suppliers will result in preference claims. There are two closely related reasons for this. First, because under Oregon law a contractor’s lien rights attach and are perfected upon performance of the work (as opposed to the filing of a formal written lien), the contractor is secured and is therefore, in most cases, not receiving more than it would have received in a Chapter 7 liquidation. Second, because the contractor typically signs a lien release in exchange for receipt of payment, the alleged preference is subject to the contemporaneous exchange defense (i.e., the contractor gave up something of equal value at the same time that it received the alleged preference payment). While contractors will normally not be at risk of preference claims, there are unique situations when they will be.
Plan of Reorganization
The debtor’s ultimate goal in the bankruptcy is to obtain approval of a plan of reorganization. In the current economic climate, the plans that many bankrupt developers will be proposing will be to essentially mothball the project for a few years to allow the economy to turn around and then restart the project when property values rise to a sufficient level. Such a plan could involve stopping the project for three, four, or even five years. For some contractors, that could mean waiting a long time before getting paid.