A Sacramento bankruptcy judge issued a hard hitting judgment against Bank of America for the way it handled a single residential foreclosure in Lincoln, California.  Referring to the famous novelist whose works evoke oppressive and nightmarish characteristics, Judge Klein wrote: “Franz Kafka lives… [and] he works at Bank of America.”  This ruling has been widely discussed for the hefty award recovered by the plaintiff.  In addition to the harsh ruling, Judge Klein memorialized a rule that was not previously addressed in case law – the affirmative duty of an attorney to search bankruptcy filings to confirm whether a violation of a stay order was likely.  While this rule could arguably be characterized as dicta, because there were no claims against the attorneys in the suit, all attorneys should take note of this rule or risk serious consequences.  The relevant facts are summarized below.

In 2008, the plaintiffs entered into a loan with the expectation that they could refinance or modify the loan immediately after closing. However, after closing, Bank of America said that it would not consider a loan modification request unless and until the homeowners ceased making payment.  Accordingly, in 2009, the homeowners defaulted on their loan payments, which triggered a series of troublesome events.  During the course of the ensuing years, Bank of America strung along the homeowners with multiple “lost” loan modification requests, while at the same time pursuing foreclosure.

Following the market crash in 2008-09, the $2.8 billion Fontainebleau development in Las Vegas was halted with 70 percent of the construction completed. Naturally, numerous mechanic’s liens were filed by contractors, subcontractors, professionals and suppliers ("claimants"). In the bankruptcy proceeding, the lenders asserted novel and potentially legally destabilizing theories against the claimants’ rights: a.) the

In Pioneer Construction, Inc. v. Global Investment Corp. (Dec. 21, 2011, No. B225685), Cal.App.4th [2011 WL 6382113], the Second District Court of Appeal recently affirmed a timely topic in this depressed construction market:  lien claimants must protect their rights, and buyers of property out of bankruptcy must verify the validity of lingering lien claims.

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

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

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.