This is Part II of a two part blog on Construction Bankruptcy issues. For Part I, click here.
- 4. Insurance
An insurance policy obtained by the debtor is the property of the bankrupt estate. Therefore, claims against the debtor’s insurer are prohibited by the automatic stay. “First-party” insurance coverage compensates the insured for losses that it has sustained. Property insurance and builder’s risk insurance are examples of first-party coverage. First-party insurance policies and their proceeds are property of the bankruptcy estate. An insured’s ability to recover under these policies and the coverages afforded by them should not be impaired by the insured filing a bankruptcy action after coverage became effective.
Third-party coverage is general liability coverage. The insurer agrees to make payments on behalf of the insured to third parties to which the insured is liable. Many liability policies expressly state that a bankruptcy filing by the insured will not relieve the insurance company of the obligations under the policy. Generally, the proceeds from such third-party policies are not treated as property of the bankruptcy estate because the estate does not have the right to any of the sums paid by the insurer. The proceeds, after all, are being paid to a third party, not the debtor.
Generally, if there is a question of whether or not the automatic stay is applicable, creditors request that the Bankruptcy Court rule on the issue, keeping in mind that actions taken in violation of the automatic stay are void and can result in substantial penalties.
- 5. Non-Parties
The automatic stay protects only the debtor and the debtor’s assets. Claims against a co-defendant to the debtor are not automatically stayed unless the debtor is a necessary party or a real party in interest. Therefore, if a partnership files a bankruptcy petition, the automatic stay does not protect general partners from claims against them arising from the partnership. The stay also does not protect officers or directors of the corporation that files for bankruptcy.
- 6. Preferences
If a debtor makes a payment within 90 days of filing bankruptcy, there is the potential of having to refund that payment to the debtor. The payments made within the 90-day period before the bankruptcy filing are presumed “preferences.” A preference is a payment or other transfer of assets by the debtor during the 90 days prior to the bankruptcy filing that results in the person receiving more than he or she would have otherwise received in a Chapter 7 bankruptcy proceeding.[i] The 90-day preference is increased to one year for a payment or transfer of assets to an insider of the debtor.
Imagine a subcontractor’s disappointment, after having completed the project and received final payment from the general contractor, upon learning that the general contractor has gone bankrupt and the bankruptcy trustee demands return of all payments made within 90 days of the general contractor’s bankruptcy filing. That is when defenses to preference claims become important topics. The most common defenses against preference claims in bankruptcy are:
The Payment Was Not Made From the Debtor’s Property
As part of its affirmative case in a preference action, the trustee (or debtor) must prove that the funds in question were the debtor’s property. There are a number of contexts in which a prime contractor may pay a subcontractor from funds that, for bankruptcy purposes, would not be considered the prime contractor’s property.
For example, a contractor may pay a subcontractor from funds that are impressed by a trust that precludes the use of the funds for purposes other than payment to subcontractors. Trusts may be created by statute or contract. Therefore, in many construction contracts, proceeds are designated as “trust funds,” requiring that the proceeds be applied first to pay bills owed to subcontractors. Some courts hold that the key element in creating a trust is the explicit requirement that the trustee maintain the funds in a segregated account for the benefit of the identified party. The mere fact that the funds be held in a “trust” may not be sufficient to create a trust.
In addition, “earmarked” funds are funds transmitted by the project owner to the contractor with the express direction to apply the funds solely to pay certain specified subcontractors for work performed on the project. Payments made by the owner to the contractor by joint check, for example, create a basis for invoking the earmarking doctrine.
Contemporaneous Exchange for New Value
Payment to a subcontractor within the 90-day preference period in exchange for the subcontractor’s release of lien is generally considered to be an exception to the preference doctrine.[ii] Therefore, when a subcontractor has lien rights on an owner’s property and the general contractor makes a payment and later files for bankruptcy, the payment is not preferential because the release of the lien is considered a “contemporaneous exchange for new value.”
On public works projects or private projects where a payment bond is in place, subcontractors could argue that if the general contractor had not paid the amount owed, the subcontractor would have asserted a payment bond claim and would have been paid by the surety. Based on subrogation principles, the surety would have asserted an equitable lien against the undisbursed contract funds in the amount of the claim, and that lien would have taken priority over the debtor’s estate’s interest in the contract funds. The bonding company’s equitable lien on contract funds is a contingent right that arises as of the time that the bonds are originally executed. By paying the debt itself, the contractor releases the surety from its contingent obligation to pay the debt, and, contemporaneously therewith, the surety released its equitable lien over the contract funds. Again, according to this argument, the release of this equitable lien constitutes a contemporaneous exchange of new value to the debtor.[iii]
Payment Made in the Ordinary Course of Business
A preference is voidable where the debt is incurred in the ordinary course of business of both the contractor’s and subcontractor’s business, and the debt is paid according to ordinary business terms. As part of this analysis, courts will focus on the ordinary course of business between a particular debtor and creditor, and generally look to the matter and timing of the payments to determine whether they are consistent with the standard practices in the industry. For example, if the payment was made on a 45-day-old invoice, to successfully use the ordinary course of business defense, the contractor would need to show that the debtor typically made its payments 45 days late, and the normal business practice in the industry was to pay 45 days after the invoice date.
Subsequent Advance of New Value
A subcontractor that advances new value to the debtor after receiving a payment may also have an affirmative defense to a trustee’s preference action. For example, the subcontractor may sell services or material to the debtor after the alleged preferential transfer. Arguably, the subcontractor under these circumstances has provided new value to the estate within 90 days of bankruptcy filing, and therefore should not be deemed to have depleted the estate.[iv]
Comments: Washington law provides a mechanism for an unpaid contractor or supplier to give a Notice to Construction Lender to and receive payment from the construction lender in certain instances.[v] If the lender does not properly withhold funds after receiving timely notice, its priority position will be removed in favor of the claimant. This procedure is an end run around the bankruptcy process.
[i] 11 U.S.C. § 547(b).
[ii] Matter of Andersen Plumbing Co., 71 B.R. 19 (Bankr. E.D. Cal. 1986).
[iii] In Re ER Feger, 88 BR. 258 (B.A.P.) (9th Cir 1988), aff’d, 887 F. 2d 955 (9th Cir 1989).
[iv] 11 U.S.C. § 547(c)(4).
[v] RCW 60.04.221 and RCW 60.04.226.