Nearly everyone reading this article has probably, at least once, dealt with a situation where a general contractor or subcontractor fails to make payments as they become due. In response, the construction industry developed practical mechanisms to deal with such issues and keep projects moving forward. Among the most frequently used are joint checks. While a good mechanism for making sure that initially the money gets where it needs to go, a recent case tells us that joint checks may not be a good mechanism for making sure that the money stays where it needs to stay. Specifically, a new decision from the United States Bankruptcy Court for the Eastern District of Virginia tell us that joint check agreements-even if a sub-subcontractor and supplier will not work or supply without one-may not protect payments should the troubled subcontractor file bankruptcy. Unfortunately, under this recent decision, it is unclear what a subcontractor, sub-subcontractor or supplier can do to be able to keep doing business with a troubled general contractor or subcontractor.
The case of Gold v. Myers Controlled Power, LLC (In re The Truland Group, Inc.), involved a preference claim against a supplier of electrical equipment to another company who supplied that same equipment to the eventual debtor. A preference claim is a claim created by the bankruptcy code that allows a bankruptcy trustee to recover payments made to creditors in the ninety days prior to the filing of a bankruptcy. The fact that the debtor owed the money to the creditor is a not a defense to such claims.
In this case, when it became apparent to the supplier that the debtor was not paying for the equipment, the supplier refused to continue supplying additional equipment absent a joint check agreement. In order to supply more equipment, the supplier demanded that the general contractor pay it directly and provide a guarantee of payment to the supplier. The general contractor-obviously interested in keeping the project going-agreed to make payment via joint check for certain amounts due to the supplier. The court also found that while the supplier had explored making a claim against the debtor's bond, they did not do so and instead relied on the joint check agreement.
While the negotiations regarding the joint check agreement were happening, the supplier-in reliance on the general contractor's representations that it would enter into a joint check agreement-supplied additional equipment. Shortly after the joint check agreement was signed, the supplier supplied additional equipment. Approximately a month after the joint check agreement was signed, the general contractor made a payment by joint check of $2,107,039.86.
After the debtor filed bankruptcy, the bankruptcy trustee successfully sought to avoid the joint check payment of $2,107,039.86 as a preference. Judgment was entered against the supplier requiring the supplier to pay the $2,107,039.86 to the bankruptcy estate. The supplier filed a notice of appeal on August 7, 2018.
In order for a payment to qualify as a preference, the debtor must have transferred a property interest to the supplier. The court held that the joint check agreement itself was a preference. It reached this decision by relying on a case from Connecticut that held that a joint check agreement transferred the right to the receivable to the supplier (i.e. that a joint check agreement is effectively an assignment). While state law may not always be so kind to joint check agreements, assignments are generally considered a transfer of property for preference purposes. Subcontractors and suppliers probably need to adopt the belief that a joint check agreement itself can be preferential if it actually assigns the right to a receivable.
Where the court's opinion gets very confusing is that the court also seems to have determined that the payment by joint check was also a preference. This seems counterintuitive. The court seemingly determined that the joint check agreement could be a preference because it transferred the right to payment from the debtor to the supplier but also that the payment itself is a transfer of the debtor's property. It is unclear how the payment could be a transfer of the debtor's property if the joint check agreement had already transferred the right to that property. It seems that the court counted the transfer of the same asset as a preference twice.
One of the major defenses raised by the supplier was what is known as the contemporaneous exchange defense. At its most basic level, this defense protects payments received in exchange for property given to a debtor. Here, the supplier argued that the additional equipment was sold to the debtor in exchange for the joint check agreement. The court generally seemed to agree with this factually, but held that the exchange was not contemporaneous because the actual payment was made awhile after the joint check agreement was signed. The conclusion seems to be that-while the joint check agreement itself is a transfer of property-it cannot be part of a contemporaneous exchange even if it is acknowledged that the equipment would not be supplied "without the [joint check agreement] being put into place" and at least seem of the equipment was supplied only two days after the joint check agreement was signed
This leaves us quite befuddled about what a supplier or subcontractor can do when its customer is starting to struggle on a project. The practical ways that the industry mitigates the impact of contractor or subcontractor default, do not seem to offer much protection when the bankruptcy code intervenes. While it is a complicated question for a subcontractor who may have a contract that it needs to continue performing, it seems that the only safe strategy for suppliers is to:
(1) decide when your customer is a substantial credit risk,
(2) stop supplying to them despite other protections that may be offered,
(3) record mechanic's liens and make bond claims,
(4) resist any practical efforts by the general contractor or owner to make payments if it would involve giving up lien or bond rights,
(5) effectively force the customer into default on the project, and
(6) collect on those lien and/or bond claims after the customer is in bankruptcy.
If put into action, this "solution" is, of course, likely to increase defaults and the severity of those defaults. This will cause additional damage at all levels of the industry. However, it is unclear following this decision what else a supplier can do to protect itself. In the case described above, the supplier was effectively punished for trying to keep the project moving forward. $2,107,039.86 is a pretty steep penalty for being cooperative and reasonable. The only solution seems to be to stop helping.
As noted this decision is now on appeal. It is the author's opinion that this opinion is extremely anti-construction industry. I would encourage anyone needing more information, to discuss this decision with your counsel or the proper people with any trade organizations in which you are a member. If anyone would like a copy of the court's opinion or has questions or comments, please feel free to contact me at pschrader@fullertonlaw.com.