Legal and Regulatory

Determining Owner’s Rights When the General Contractor Is in Bankruptcy

Can an owner rely on the provision that filing for bankruptcy constitutes a default under the contract?
By Kenneth A. Rosen
February 7, 2022
Legal and Regulatory

An owner of property under construction just learned that its general contractor commenced a Chapter 11 bankruptcy case. What are the owner’s rights?

The contract with the general contractor provides that a bankruptcy filing constitutes a default under the contract. Can the owner rely on that provision and terminate the contract due to the general contractor's bankruptcy filing? In most circumstances, the answer is no, as doing so without prior bankruptcy court approval may violate the automatic stay. A termination provision tied to a bankruptcy filing is referred to as an ipso facto clause. To terminate the contract, the property owner should make an expedited application to the bankruptcy court and set forth the harm (i.e., damages) being suffered by the owner as a result of the general contractor's delays and other defaults under the contract.

After filing for Chapter 11 bankruptcy, a general contractor debtor may either assume (affirm) or reject (breach) its contract with the property owner. This may have severe consequences to the property owner and may be contrary to the property owner’s wishes. To assume a contract in bankruptcy, a debtor must cure all defaults under the contract and demonstrate its ability to perform under the contract. It is therefore important that a contract include specific and discernible benchmarks that the general contractor is required to meet. The general contractor's failure to meet material benchmarks provides the owner with a basis to terminate the contract prebankruptcy, and makes it more difficult for the general contractor to assume the contract in bankruptcy over the owner’s objection.

The general contractor and the property owner may assert claims against each other for damages under the contract. The right of offset (the owner’s damages against the general contractor and the general contractor's damages against the owner) is not absolute or automatic, as the prior approval of the bankruptcy court is often required. To preserve setoff rights, a good practice is to explicitly delineate in the contract between the general contractor and the property owner what damages and claims may be subject to setoff, including their impact on the owner’s future progress payments and the parties’ obligations to subcontractors. The amount of damages should be readily quantifiable. For example, a contract may provide for per diem penalties if specific benchmarks are missed.

A property owner may be concerned about subcontractors filing liens against its property when the general contractor fails to pay them. The Bankruptcy Code may provide some protection to the owner based on the general contractor's bankruptcy filing. The automatic stay triggered upon a bankruptcy filing enjoins creditor actions against the debtor and its assets. At least one bankruptcy court has held, however, that the automatic stay triggered by the general contractor's bankruptcy shields the property owner from unpaid subcontractors’ construction liens. To the extent any such lien is filed by a subcontractor, it would not be enforceable. Case law is not uniform here, however, as state law may authorize a subcontractor to file its mechanic’s lien and for that lien to relate back to when the subcontractor started work on the project. In such an instance, the automatic stay may not be violated because the lien is deemed filed when the contractor commenced work on the project rather than the actual date on which the lien was filed.

A property owner can take other steps to minimize its exposure to unpaid subcontractors. As part of its contract with the general contractor, an owner may require a representation by the general contractor that all funds received by the general contractor from the owner are being held in trust and will be remitted to subcontractors in a timely manner. As a fiduciary, if the general contractor were to divert those funds, for whatever reason, it would expose the general contractor to breach-of-trust claims and potential individual liability.

A contract provision may also condition final payment by the owner to the general contractor to be made after the completion of the project and after the deadline for subcontractors to file mechanic’s liens expires. An owner could also require that the general contractor identify all subcontractors used on the project and provide proof of payment prior to the owner’s final payment to the general contractor. An owner may require the issuance of joint checks to the general contractor and to subcontractors, further reducing the risk of subcontractor liens.

To limit future disputes, a contract should provide that any modifications or changes must be agreed to in writing. This is particularly important when it applies to payments that were made to the general contractor but were intended to be made upon the occurrence of specific milestones or for subcontractors. The general contractor's prior written representation avoids later disagreements concerning intent.

Many general contractors do not maintain separate bank accounts for each project, making it their custom to commingle funds received from multiple owners. Once commingled, the funds often lose their separate identity and cannot be traced. Therefore, a property owner should require that its general contractor establish a separate bank account showing each receipt and disbursement as it relates to the project. In the event of a bankruptcy, funds in the general contractor's segregated account are less likely to become property of the debtor’s estate (and thus shared with other creditors) and may be used exclusively to satisfy project-related claims.

A construction contract with a general contractor may provide for a waiver of lien rights. Such waivers, even if they are clear and unambiguous, may not insulate the property owner from claims brought by subcontractors, as such waivers may be deemed to be against public policy in certain jurisdictions. Rather than, or in addition to, including a blanket lien waiver in its contract with the general contractor, an owner may require that the general contractor receive a mechanic’s lien waiver from its subcontractor as a condition of payment. Subcontractors can often be required to give a conditional waiver in order to receive payment. The key for a property owner in protecting its rights upon a general contractor's bankruptcy filing is speed. Seeking prompt relief from the bankruptcy court based on actual, readily quantifiable, provable and ongoing harm (i.e., damages) improves the owner’s ability to stem future damages and complete the project by the same or a replacement general contractor.

by Kenneth A. Rosen

Kenneth A. Rosen, Esq., is Partner and Chair Emeritus in the Bankruptcy and Restructuring Department of Lowenstein Sandler.

*The views expressed herein are those of the authors and are not necessarily shared by other persons at Lowenstein Sandler LLP. Each case is unique. The law is subject to interpretation. Also note that states vary widely with respect to mechanic’s lien rights and trust fund obligations. This article is not intended to provide legal advice.

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