In today’s economic environment, determining what happens to mechanics’ and materialmen’s liens in bankruptcy are increasingly important because it is not unusual for a party to fall behind on its payment obligations due to financial distress. This causes a significant interplay between mechanics’ or materialmen’s liens and the Bankruptcy Code, resulting in a number of issues that a claimant must understand if it holds lien rights against an individual or entity that declares bankruptcy.
Perfecting and Enforcing Liens Without Violating the Bankruptcy CodeWhen a party declares bankruptcy, an automatic stay arises that prohibits all further collection efforts against the bankrupt party. However, an exception allows construction lien claimants to perfect their liens after a bankruptcy filing.
Although construction liens vary from state to state, in most places they arise by statute when the materials are delivered, long before it is perfected. Once perfected, the lien has priority over virtually all encumbrances arising after the claimant delivers materials or starts work, and the lien relates back to the date the claimant first delivered materials. As long as this date is prior to the bankruptcy filing, the claimant can perfect the lien during bankruptcy without violating the automatic stay. However, the automatic stay prohibits the claimant from enforcing a perfected lien against a bankrupt party by filing a complaint.
Claimants might protest that this eliminates their ability to bring an action to enforce a lien within 180 days of its perfection, as is required by some states’ statutory mandate for lien enforcement, but the Bankruptcy Code gives the claimant a procedure to preserve the lien. The claimant can file a lien preservation notice with the bankruptcy court that indicates the claimant’s intention to preserve and enforce the lien. The notice tolls the 180-day foreclosure deadline imposed by statute and gives the claimant at least 30 days after the automatic stay is lifted to enforce the lien. The claimant must file this notice with the court and serve the bankruptcy trustee or debtor-in-possession within 180 days of the date the claimant perfected the lien. In addition to the lien preservation notice, the claimant also can petition the bankruptcy court for relief from the automatic stay.
Lien Rights May Help You Keep Payments ReceivedClaimants must understand the Bankruptcy Code’s rules for “preference” payments. If a payment received by a claimant meets certain conditions, the bankruptcy trustee or debtor-in-possession can avoid the payment and require the claimant to return the funds, making it an avoidable preference.
The bankruptcy court then can order the claimant to return the funds to the bankruptcy estate, even if the claimant was fully entitled to payment at the time it was paid, if it meets these four criteria:
- the payment is for an antecedent debt;
- the debtor made the payment while it was insolvent;
- the payment enabled the claimant to receive a greater recovery than it would have received had its claim been resolved under the Bankruptcy Code; and
- the payment was made within 90 days prior to the bankruptcy filing.
Also, preference payments are not subject to avoidance and recapture if they fall within one of several defenses. The defense most applicable to mechanics’ liens is the “contemporaneous exchange for new value” defense, which offers protection if the exchange is substantially contemporaneous and if the exchange is for new value.
Whether a payment made in exchange for a lien waiver is subject to recapture as a preference payment is a frequently litigated issue. Claimants argue the waiver furnishes new value to the bankruptcy estate by releasing the estate from a security interest, placing the payment within the new value defense. However, the 9th U.S. Circuit Court of Appeals held a preference payment made in exchange for a lien waiver is shielded by the new value defense only if the value of the lien released is equal to the payment received by the claimant. The claimant often has the difficult task of proving the value of the released lien. However, the 9th Circuit has not addressed whether the claimant’s release of the right to perfect a lien—as opposed to a release of a perfected lien—constitutes new value.
Some courts refuse to apply the new value defense in this context because the release of inchoate lien rights provides no new value to the bankruptcy estate. One recent case highlights the potential danger of unconditional lien waivers. In JLJ Contracting Company, the claimant executed an unconditional lien waiver and release in exchange for a check that was later dishonored due to insufficient funds. Although the claimant received a cashier’s check as a substitute, the debtor declared bankruptcy two months later, subjecting this check to the preference rules.
Unfortunately for the claimant, the court held the new value defense did not apply to the substitute check, making the payment subject to recapture. The claimant executed an unconditional lien waiver for the dishonored check, releasing the debtor from the security interest regarding whether the check was valid. Because the lien release was unconditional, the substitute check created no new value for the bankruptcy estate. The result was a nightmare scenario: The claimant lost its lien rights and had to return the funds to the debtor-in-possession.
To avoid this potential hazard, claimants should not execute an unconditional lien waiver when the debtor is in financial distress or near bankruptcy. Additionally, payments made for ordinary business debts are not preferences if paid in the parties’ ordinary course of business or according to the ordinary business terms of the industry. The ordinary course of business defense to an avoidable preference claim also may hinge on the treatment of construction lien rights. Because of the prevalence of pay-when-paid clauses in construction contracts and the industry practice of payments in exchange for lien waivers, a material supplier, subcontractor or contractor may be able to claim the challenged payments received were in the ordinary course of business.
The pattern of payments between the parties may be shown to be in the ordinary course of business if they have historically followed an erratic pattern due to pay-when-paid provisions and lien release cycles. These erratic and often delayed payment patterns are unfortunately part of the ordinary course of business for payments in the construction industry. A lien claimant that has released or waived its lien rights in exchange for payment also may argue that it has not received anything more than it would have received if the payment had not been made, and it received what it would have been entitled to under a Chapter 7 liquidation. In other words, if the claimant had not been paid, it would have kept its lien rights and would have been paid the same amount through the bankruptcy process.