Can a paid supplier be worse off under the Bankruptcy Code than if unpaid?

In United Rentals, Inc. v. Angell, the U.S. Fourth Circuit Court of Appeals has held that a bankruptcy preference occurred when a creditor with both mechanic's lien and bond rights received a payment (“Transfer”) during the preference period. The creditor had shown that it had mechanic's lien rights at the time of the Transfer and that the bankruptcy estate had received value for the Transfer, by showing that the owners and general contractors on the projects were holding funds in amounts greater than the Transfer at the time. The general contractors also paid the debtor more than the amount of the Transfer after the Transfer.

The relative burden of proof in such mechanic's lien and bond preferential Transfer cases has always been in question. Creditors often wish to argue and some courts have ruled that there is no preference under 11 U.S.C. § 547(b) if a creditor has not received more than it would have in a Chapter Seven liquidation or if the bankruptcy estate was not diminished by a Transfer that discharged mechanic's lien or bond rights of equal value (“above the line trustee burden issue”). Other courts have ruled instead that the trustee had met the burden of showing a preference if the creditor did not have a direct security interest in assets of the bankruptcy estate. The creditor's only option would be to prove that a contemporaneous exchange of new value had occurred under 11 U.S.C. § 547(c) (“below the line defense”). Whether the trustee or the defendant creditor has the burden of proof is often critical in a mechanic's lien and bond right preference case, given the difficulty of developing third party evidence of the funds held by owners and general contractors at the time of a payment two years earlier. The rules applied to determine whether a payment is preferential also differ depending on whether § 547(b) or § 547(c) applies.

The bankruptcy court had ruled in United Rentals, Inc. v. Angell that the trustee had met the burden of 11 U.S.C. § 547(b), by showing just that general unsecured creditors would receive little or no distribution in a Chapter Seven liquidation. The existence of mechanic's lien or bond rights played no role in this analysis. The bankruptcy court had further ruled that the creditor could not show a below the line contemporaneous exchange for its mechanic's lien rights, because the creditor had never actually perfected it rights by filing a mechanic's lien. This was based on a case unique to the Eastern District of North Carolina, Precision Walls, Inc. v. Crampton. The bankruptcy court allowed the case to go to trial on the contemporaneous exchange of the creditor's payment bond rights, but put the burden on the creditor to prove that the creditor would have enforced its payment bond rights if the Transfer payment had not been received. This is the first known case in which this burden has been put on a preference defendant. It is questionable whether a creditor could ever prove what it would have done absent payment or whether that is relevant, since the payment intervened and made it impossible to enforce bond rights. In any event, United Rentals could not prove that it would have enforced bond rights and the bankruptcy court disallowed the contemporaneous exchange defense on this basis. The district court affirmed on the same reasoning as the bankruptcy court.

The United State Court of Appeals for the Fourth Circuit has now affirmed the district court. The Fourth Circuit first ruled that United Rentals' bond rights did not present an above the line trustee burden issue under 11 U.S.C. § 547(b). ”The bankruptcy court had properly rejected this argument.” The § 547(b)(5) inquiry focuses "not on whether a creditor may have recovered all of the monies owed by the debtor from any source whatsoever, but instead upon whether the creditor would have received less than a 100% payout" from the bankruptcy estate. The court did not elaborate, but this seems to indicate that an “indirect transfer” is not a consideration, at least in a bond case, in evaluating whether the trustee has met the burden of proof under 11 U.S.C. § 547(b). An indirect transfer theory recognizes that the preference defendant does not have a security interest in assets of the bankruptcy estate. However, if the Transfer released a claim against a payment bond surety and that surety had a security interest in assets of the bankruptcy estate, then no preference has occurred. United Rentals, Inc. v. Angell may mean that the burden shifts to the creditor to prove a defense, unless the creditor defendant had a direct security interest in assets of the bankruptcy estate.

The Fourth Circuit then turned to the bond claim contemporaneous exchange defense. The court expressly did not decide whether an indirect transfer theory is viable in a contemporaneous exchange defense, but ruled instead that since “United never even attempted to make any claim on the bond here, the Surety never obtained any lien that it could release.” One troubling aspect of this decision is that the Fourth Circuit may now require that a defendant actually make a mechanic's lien or bond claim before there is any defense to a preference. Even more troubling, it is not clear whether a mechanic's lien or bond claim notice is sufficient or it is necessary to actually file suit or even actually prevail in a trial on the bond claim before a creditor can be confident it is shielded from a preference claim. Of course it is impossible for a creditor to do any of those things once they have been paid. This seems to go further than the bankruptcy court, which only required proof that the creditor would have made a bond claim absent the payment.

The result could be that an unpaid creditor is better off than a paid creditor. A creditor with mechanic's lien or payment bond rights that received payment during the preference period will need to return that payment as a preference. If the same creditor was unpaid before the bankruptcy, however, it could still enforce mechanic's lien or bond rights post petition and could receive the same payment, if sufficient funds were still owed to the debtor. The bankruptcy estate could be in the same financial position in both instances, even without collecting the preference claim. In other words, the estate could be actually better off and the creditor worse off if the debtor pays a creditor that had mechanic's lien or bond rights. A debtor could avoid paying a mechanic's lien or bond creditor by simply paying them and then filing bankruptcy.

United had put on evidence that it had both mechanic's lien and bond rights at the time of the Transfers and evidence of the dates the debtor had received payments from the general contractors after the Transfer payment. However, the court stated that

even if the money the Debtor paid to United in the transfers was eventually offset by the Debtor's later receipt of funds that the Surety might otherwise have claimed, United has not shown when the Debtor received this ‘new value.'" Accordingly, regardless of whether the transfers set in motion a chain of events that resulted in the Debtor's recoupment of the amounts paid, United did not show that such new value was "'given to the debtor' . . . as part of a 'contemporaneous exchange.'"
In this case, the only benefit that United showed the Debtor was given as part of the contemporaneous exchange for the transfers was the extinguishment of its debt, which does not fit within any of the five new-value categories.

This may indicate that an indirect transfer is not a valid consideration in evaluating a contemporaneous exchange defense. The court went on to state that

Furthermore, even assuming arguendo that the transfers were part of a contemporaneous exchange for new value, United produced no evidence that the Debtor and United intended that would be the case. United failed to produce evidence that the parties viewed this transaction as anything more than the payment of the debt of an as-yet unsecured creditor; no evidence demonstrated when the parties believed the Debtor might recoup some of the transferred funds or even that they believed any funds would be recouped.

There is only one other known lower court case that has ever discussed a need to prove intent in a contemporaneous exchange, although the word “intent” definitely does appear in 11 U.S.C. § 547(c)(5). There are some cases that have noted that the creditor had provided a mechanic's lien or bond waiver, but no case has stated that evidence of a waiver was necessary to prove intent. It is not clear whether a waiver would prove intent under United Rentals, Inc. v. Angell.

Finally, the court considered United Rental's contemporaneous exchange of mechanic's lien rights defense, but said “the argument fails for the same reasons we have discussed regarding its bond argument.” It is not clear which of the “same reasons” defeated United Rentals' mechanic's lien defense, but Precision Walls was the only case that had ever required a preference defendant to actually file a mechanic's lien to have a defense to a future preference action. Many courts have ruled otherwise.

This raises the question what it means for a mechanic's lien to be “inchoate.” There is no question the mechanic's lien “relates back” to the time labor or material is supplied. A mechanic's lien can generally be filed post bankruptcy petition and the lien cannot be avoided by the trustee for this reason. Does a mechanic's lien exist from the time labor or material is supplied, as is believed by most in the construction industry, even though that lien is later “lost” if not perfected in accordance with the statute? United Rentals, Inc. v. Angell seems to say that there is no lien until it is perfected. There is nothing to exchange for a payment, except unsecured contract rights, unless the mechanic's lien has been perfected.

It is not clear whether preference defendants will now need to actually file mechanic's lien and bond claims or only prove that they would have if the payment was not received. No other U.S. Circuit Court of Appeals has ever required either. This decision may be at odds with other U.S. Circuit Court of Appeals, District Court and Bankruptcy Court decisions that have recognized the release of inchoate mechanic's lien rights as “value” exchanged for a payment. This decision may also be at odds with other decisions recognizing the effect of an indirect transfer when evaluating whether the bankruptcy estate was diminished or whether a payment that extinguished mechanic's lien or bond rights is preferential.
The Fourth Circuit stated that “this holding makes perfect sense when viewed in the context of § 547(c)(1)'s purpose, to accommodate the need of financially unsteady companies to use checks to pay for new transactions.” However, it would seem that this holding could actually hasten the demise of financially unsteady construction companies. Creditors may now need to file mechanic's lien and bond claims before accepting any payment to be certain of protection from future preference claims. This would disrupt construction projects and business relations, cause unsteady subcontractors to lose jobs and increase legal fees for businesses, without any identifiable public policy advantage. There is no question a preference defendant must show that a bankruptcy estate was not diminished by a Transfer to prove a contemporaneous exchange defense. This is a sufficient standard to protect the general unsecured creditors in a bankruptcy.

United Rentals, Inc. v. Angell raises many questions. How does a creditor show that a contemporaneous exchange was intended? Construction suppliers may need to require waivers signed by both the creditor and the debtor in exchange for all payments received and make sure those waivers are clear that both parties intend the payment to be in exchange for mechanic's lien and bond rights. Is this sufficient evidence of intent? How does the creditor show when the debtor received value for the Transfer? Is the waiver sufficient here? Other courts have required only the evidence of United Rentals, that sufficient funds were still owed to the debtor at the time of the Transfer. Is it necessary to actually file a mechanic's lien or bond claim or can a creditor show only that it would have filed its mechanic's lien or bond claim? How would a creditor ever show what it would have done absent the payment? Both the payment and the bankruptcy intervened. Must the creditor show what it would have done absent the payment and absent the bankruptcy or show what it would have done after the bankruptcy filing? Is actually filing a mechanic's lien or bond claim notice sufficient or is it necessary to actually file suit or prevail in a trial before a creditor can be confident it is shielded from a preference claim?

The Fourth Circuit expressly left open the issue whether mechanic's lien rights could still prevent the trustee from meeting the burden under 11 U.S.C. § 547(b). Is an indirect transfer a consideration in this analysis or will any payment be preferential if the creditor did not have mechanic's lien rights directly in property owned by the bankrupt debtor? Is it necessary to actually file the mechanic's lien on property owned by the bankrupt debtor or must the creditor only show that it would have filed that lien absent the payment?

Ironically, an unpaid supplier or subcontractor may be actually better off than a paid supplier or subcontractor in the event of bankruptcy. 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.

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?

James D. Fullerton is an attorney and president of the law firm of Fullerton & Knowles, P.C., with attorneys licensed in Virginia, Maryland, Pennsylvania and the District of Columbia. Visit the firm website at www.FullertonLaw.com where you can use the Free 450 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, and credit management. The website also offers over 30 commonly used contract forms, including Change Orders, Waivers, Joint Check Agreements, Quotes, Proposals, Credit Applications and Guarantees.
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