Mechanic’s Lien & Bond Rights in Bankruptcy Preference Cases
Can a paid construction supplier or subcontractor be worse off under the Bankruptcy Code than if unpaid? If a construction material supplier could enforce mechanic’s lien or bond rights to successfully obtain payment after a bankruptcy petition, could receipt of the same payment prepetition be an avoidable preference? The United States District Court for the Eastern District of North Carolina is faced with these questions in at least two cases at this moment.
This District Court ruled in 1996 in Precision Walls, Inc. v. Crampton that a creditor would have to return an alleged preferential payment, unless it had actually perfected the mechanic’s lien (filed in the land records) at the time of receipt of payment. This is the only court in the country and even the only court in North Carolina that has made this ruling. Both the Middle District and the Western District of North Carolina have ruled otherwise. The result has been difficult for construction suppliers and subcontractors doing business in the Eastern District of North Carolina.
In order to make sure they have no preference exposure, creditors in the Eastern District of North Carolina must refuse a payment until they have actually filed their mechanic’s lien and then release the lien in exchange for payment. Creditors and their attorneys sometime file a mechanic’s lien for money they have been paid, to avoid preference exposure. This obviously disrupts projects and business relations and increases legal fees. In most cases, creditors are not that aggressive and simply have to return all money they received in the 90 days prior to a bankruptcy, even if they could have enforced lien or bond rights at the time of payment.
Ironically, an unpaid supplier or subcontractor is actually better off than a paid supplier or subcontractor in the event of bankruptcy with this rule. A sub or supplier that received payment in the 90 days prior to bankruptcy will need to return the payment as a preference, unless they can prove ordinary course of business or some other defense. The paid creditor obviously did not perfect their lien rights, since they were paid. An unpaid creditor, however, could file and enforce their lien even after the bankruptcy petition and may be paid in full.
In a recent case Angell v. United Rentals, Inc., the creditor had both mechanic’s lien and bond rights at the time of the payment. The Bankruptcy Court for the Eastern District of North Carolina first ruled that the creditor had received a preference despite the mechanic’s lien rights, because of the 1996 Precision Walls case and because the creditor had never actually filed its mechanic’s lien. This brought the court to the payment bond rights, which had also never been enforced. Unlike the mechanic’s lien rights, the court did not identify a need to actually make a bond claim. However, the court ruled that the creditor had the burden of proving that it would have made a bond claim if it had not received the payment. Since the creditor failed to prove it would have made a bond claim, the payment was a preference. This case has now been appealed to the District Court.
The Kiddco case was similar, but was based entirely on payment bond rights. Kiddco, Inc. was a site and concrete subcontractor on a bonded public project that threatened to demobilize and make a bond claim because of payment default. Kiddco and the surety eventually entered into a “Ratification Agreement,” whereby Kiddco released any claim against the surety for (later preferential) payments received and returned to the job. Kiddco later received some payments directly from the surety. Like the United Rentals case, the Bankruptcy Court ruled that Kiddco had not proven that it would have made a bond claim and would have been paid if it had never received the preferential payment. This Kiddco appeal is also now pending in the same District Court.
The District Court may now revisit the Precision Walls case and decide whether Precision Walls really means that a payment is a preference unless the creditor had actually filed its mechanic’s lien. The District Court may also decide if the same rule applies to a bond case or whether it is necessary and sufficient to prove that the creditor would have made a lien or bond claim absent payment. In looking at this question, the relative burden of proof may become important. Does the creditor have the burden of proving that it would have made a bond claim or does the trustee need to prove that the creditor would not have enforced rights? Does it matter whether the creditor was even aware of its rights, or is it enough that the alleged preferential payment automatically discharged security rights in the debtor’s assets and allowed the debtor to later receive more funds from owners or general contractors?
This interplay between mechanic’s lien or bond rights and the Bankruptcy Preference Law has long been an area of argument. In order to show a preference, the bankruptcy trustee must show that the payment allowed the creditor to receive more than they would have in a Chapter 7 liquidation. Mechanic’s Lien and Payment Bond rights can generally be perfected after a bankruptcy petition. In most states, a supplier is not “stayed” by the bankruptcy from perfecting Mechanic’s Lien or Payment Bond rights. Many credit managers and their lawyers want to say it is that simple. If the creditor could have made a Mechanic’s Lien or Payment Bond claim in a Chapter 7 liquidation, then a payment received for a release of those rights cannot be a preference.
We know it is not quite that simple. What if the Mechanic’s Lien or Payment Bond rights had expired at the time the payment was received? What if the debtor still required a release in exchange for the payment? What if the debtor and creditor both thought the creditor still had rights? Courts have been consistent that this payment is still a preference, if the time to perfect lien rights had expired at the time of the payment.
Courts also say that the payment is still a preference if it “diminished the estate,” and made less money available for distribution to general unsecured creditors. It does not matter whether the creditor could have received payment form any source whatsoever in a Chapter 7 liquidation. The question is whether the creditor could have enforced payment from the debtor (bankruptcy estate). If the creditor enforced the mechanic’s lien against the property owner, could the property owner have forced the debtor repay them? In other words, was the owner holding enough of the debtor’s money to repay themselves? If so, there was no preference. If the debtor had not made the payment, the creditor could have enforced the mechanic’s lien against the property owner, the property owner would then withhold the same amount of money from the debtor. The creditor and the debtor are in the exact same financial position whether the payment was made or not. The estate was not diminished and the same amount of money was available for general unsecured creditors. There was no preference. This is sometimes called “triangulation” or the “indirect transfer rule.”
If the owner had already paid the debtor in full, however, we come to a different result. Perhaps the creditor could have enforced its mechanic’s lien and forced the property owner to pay a second time. However, the payment still diminished the estate and is still preferential, if the owner had no way to extract payment from the debtor. On the mechanic’s lien side, this concept is related to the “defense of payment” in many states. In such states, the mechanic’s lien claimant cannot make an owner pay a second time. In this case, the creditor will have no lien rights at the time of the payment, if the owner had already paid the debtor in full. In a defense of payment state, a payment to the creditor will be preferential once the owner has paid the debtor in full.
There is less court case law on payment bond rights, but the results and the theories are similar. When a debtor has a payment bond, their bonding company has an “equitable lien by right of subrogation” on all money owed the debtor on the project. In other words, once the bonding company has to pay a supplier claim, the bonding company has the right to collect from the owner any money owed to the debtor on that project. Sometimes courts seem to say that any payment on a bonded project can never be a preference, because the funds were subject to the bonding company’s equitable lien and never became property of the bankruptcy estate. The courts also sometimes employ an indirect transfer theory and ask whether the alleged preference diminished the estate or allowed the debtor to receive equal funds from the owner. If the owner was still holding enough money to reimburse the bonding company at the time of the alleged preference payment, then the payment did not diminish the estate and was not a preference. If the creditor has made a bond claim at the time of the payment, the bonding company would have paid and then extracted an equal sum of money from the debtor’s estate by collecting from the owner.
One of the biggest issues in the pending United Rentals case is the burden of proof. A big problem for unsecured creditors in a bankruptcy is that it is normally easy for the trustee to meet its burden of proof in a preference case and the creditor must then produce evidence to defend. The trustee must show that the creditor received more than they would have in a Chapter 7 liquidation, but this normally means just showing that general unsecured creditors will receive no payout in the bankruptcy. Creditors especially have difficulty defending, because these preference cases are typically filed two years after the payments. It is difficult to get evidence from the debtor itself, because documents are disorganized and employees have left.
A payment in the ordinary course of business is an example of an “affirmative defense” in which the creditor has the burden of proof. A contemporaneous exchange for new value, including a subsequent advance for new value, is another example of a creditor affirmative defense. The release of lien or bond rights in exchange for a payment can be characterized as a contemporaneous exchange for new value. If the release of lien or bond rights is viewed as an “exchange,” the creditor will have the burden of proof. It is difficult to get information from general contractors and owners two years after the fact in order to prove that they were holding sufficient funds on the debtor so that the estate was not diminished by the payments. If the creditor has this burden of proof, they will at least incur higher costs trying to collect evidence and will often be unable to do so.
These burdens are generally reversed in the case of a secured creditor. A secured creditor generally would have received the same payment in a Chapter 7 liquidation, as long as the collateral had sufficient value. If the payment was not received, the secured creditor could have foreclosed on its collateral in a Chapter 7 liquidation. Trustee has the burden to prove otherwise. A very big issue for mechanic’s lien and payment bond creditors is whether these rights make them secured creditors and whether the trustee has the burden of proving they are unsecured or undersecured. It seems fairly clear that if the debtor is the owner of the real estate, then a mechanic’s lien claimant has a security interest in property of the estate, same as a mortgage lender. The trustee should have the burden of proof, just as the trustee would if trying to recover mortgage payments made to a mortgage lender. The same should be true in a state like North Carolina with a “Lien on Funds” statute, that provides the creditor a direct lien on the money held by an owner and owed to a debtor.
What if the debtor is a general contactor or subcontractor? The creditor mechanic’s lien claimant has a lien in the owner’s property and the owner is not the bankruptcy debtor. This is now a “triangulation” or an “indirect transfer rule” case. In a payment bond case, the creditor again does not have a lien directly in the debtor’s property. It is the bonding company that has the equitable lien in funds owed to the debtor by owners. The creditor still did not receive more than it would have in a Chapter 7 and did not diminish the estate. This would mean the trustee has the burden to prove otherwise. If this is characterized as an exchange of a lien or bond release for the payment, however, this sounds like a creditor affirmative defense. Which is correct? Does it have to be one or the other, or can it be both at once? These are questions in many preference cases that may get answered in the Angell v. United Rentals, Inc. case.
The creditor hopes to establish in the Angell v. United Rentals, Inc. case that the proper standard is whether the creditor received more than it would have in a Chapter 7 and did not diminish the estate, not proof that the creditor actually did enforce or actually would have enforced mechanic’s lien or bond rights. The creditor also hopes to establish that the Bankruptcy Court erred in holding that the Trustee had met its burden of proof under 11 U.S.C. § 547 and further erred in placing the evidentiary burden on United Rentals. Even with this improper burden, however, United Rentals feels that it met any burden under 11 U.S.C. § 547 (c) in establising a contemporaneous exchange for new value.
You can track the progress of this case, see the court orders entered and the legal briefs and arguments filed by all parties at www.FullertonLaw.com , where you can also see a Free 720 page online internet Construction Law Survival Manual with valuable information about construction contract litigation, mechanic’s liens, payment bond claims, bankruptcy, the Uniform Commercial Code, as well as credit management and contains over 30 commonly used contract forms, including Change Orders, Waivers, Joint Check Agreements, Quotes, Proposals, Credit Applications and Guarantees.
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