Financial Defaults

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Last week, the California Court of Appeal ruled that a property owner was entitled to a jury trial in a dispute with a lender despite the fact that the loan agreement contained a jury waiver provision and a New York choice-of-law provision.

The case involved the San Francisco apartment complex known as the Rincon Towers. In 2007, the plaintiffs borrowed $110 million on a two-year loan to finance the acquisition.  In 2009, the plaintiffs failed to repay the loan. The plaintiffs claimed that under the terms of the loan agreement they were entitled to a one-year extension of the maturity date.  The lender disagreed and instead completed a nonjudicial foreclosure sale.

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…

A retail construction project illustrates the risks to an owner when the general contractor encounters financial problems. As is typically the case, the general’s financial troubles started when he got behind in payments on earlier projects. As a result, the initial payments on the retail project went to pay subs and suppliers from the earlier projects, which…

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…

When disputes arise between an owner and its lender, and the lender, for any number of reasons, stops funding a project, the question of whether the contractor can sue the lender sometimes arises. The theory often advanced is that the lender knew the contractor had started work and, if it did not intend to advance the…

While the technical requirements for preparing and filing liens offer countless opportunities for mistakes, two in particular seem to predominate. The first is the failure to properly calculate the 75-day period for filing the lien. The 75-day period begins to run from the earlier of (i) the day the contractor or supplier ceased to provide…

Risks of Termination

While most construction contracts permit the owner to terminate a contractor in the event of default, any owner will be well counseled to exercise such rights cautiously. The risks of termination are both practical and legal. Terminating the contractor will almost certainly result in delays. Finding a replacement contractor can be difficult, particularly if the project suffers from defective work. The cost of a replacement contractor can be significantly more than the amount left in the contract, and this in turn can lead to financing problems and perhaps even result in a default of the construction loan. The owner might not have the ability to assume the subcontracts, which could require any replacement contractor to also find subs to take over uncompleted work. Enforcing warranties later on could be difficult due to disputes over who was responsible for which portion of the work. And perhaps most concerning of all is that in most cases, the termination is likely to generate a lawsuit in which the contractor will be seeking all sorts of damages, including lost profits on this and possibly other projects.

Faced with these risks and problems, owners often elect to continue with a defaulting contractor, sometimes even in the face of enormous problems. Nevertheless, there are circumstances when termination needs to be considered and exercised. Careful planning, detailed analysis, and good documentation are critical.

Importance of a Well-Drafted Contract

Termination needs to be considered at the contracting stage, and well-drafted default and termination provisions are critical. The contract needs to set out clear, objective standards for what will constitute events of default and reasonable, but not overly burdensome, notice provisions. Many contracts will provide that the contractor is entitled to notice and an opportunity to cure. The time periods for curing need to be spelled out and should not be unreasonably short or long.

Termination for Convenience Provisions

Owners should try to include in their contracts provisions allowing them to terminate the contract for convenience. Such provisions are common in most public construction contracts. Owners should resist provisions that require the owner to pay the contractor some amount of unearned overhead and profit and instead commit only to payment for compensation earned up to the point of termination, plus reasonable winding-down (demobilization) expenses.

Right to Supplement Work Provisions

Owners might also consider trying to include in their contracts a provision authorizing them to supplement the contractor’s work force in the event of default. Such a provision essentially permits the owner to hire additional work crews to supplement the contractor’s work force. Any such provisions need to be drafted carefully, and such an arrangement presents its own set of risks and problems, but is a less risky option than termination and one that, in appropriate circumstances, might be of real benefit to the owner.

Strict Compliance with Contract Termination Provisions

When problems arise during the course of a project that might warrant termination, the owner needs to refer to the contract and follow all of the notice and pre-termination procedures precisely. At the same time, though, the owner’s initial response should be to consider options other than termination. One step might be a meeting with the contractor to discuss the defaults and to try to reach an agreement on a schedule and procedure for curing them. In the course of pursing termination alternatives, the owner needs to notify the contractor that efforts to resolve the defaults short of termination will not result in a waiver of the defaults or of any rights. If the owner agrees to give the contractor additional time for curing defaults or agrees to other concessions, the agreement needs to be spelled out clearly in a writing that clarifies precisely what the owner has agreed to and when the owner will be permitted to proceed with termination. Any such agreement will effectively result in an amendment of the contract and will therefore warrant the same attention to detail that went into drafting the original contract.

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.