Construction Bankruptcy, Lien and Bond Claim Rights May Survive – Part I

This is the first installment of a two-part post on common bankruptcy issues encountered in construction.

The Bankruptcy Code is Federal law.  Bankruptcy courts are part of the federal (not state) judiciary system.  Lien and bond claim law, however, can involve federal or state law.  Federal bankruptcy intersects state lien and bond law when a participant in a construction project goes broke.  As with anything else, there are winners and losers when someone on a construction project goes bankrupt.  The goal is to take the available action to protect yourself.  The winners are the ones who get out of the project before the bankruptcy occurs, obtain a security interest for their claims, or swiftly assert their available rights once the bankruptcy petition is filed.  The losers are generally the ones who become unsecured creditors in the bankruptcy estate.  Unsecured creditors share in whatever meager assets remain in the bankruptcy estate after secured creditors and administrative fees are paid.

  1. 1.                  Fundamentals of Bankruptcy Law

In every bankruptcy case there is an automatic stay of proceedings against the debtor (the entity that goes bankrupt) and its assets.  A “stay” means no legal or collection action can be taken after filing the bankruptcy petition.  The stay applies to any litigation against the debtor, enforcement of lien claims against the debtor’s assets, or any debt collection activities against the debtor or its assets.[i]  A violation of the automatic stay is a contempt of court, and may subject a violator to claims for damages, costs, attorneys’ fees, and possible punitive damages.[ii]  Therefore, it is important to understand what can or cannot be done once the bankruptcy has been filed.

The automatic stay is limited to actions that could have been commenced before the bankruptcy petition is filed or are based upon claims arising before the filing of the petition.  Actions on claims that arise after the commencement of the bankruptcy are not stayed.  Even if the claim arises against the debtor after the commencement of the stay, the stay protects the debtor from any act to obtain possession or control of the debtor’s property or the creation or enforcement of any lien against the debtor’s property.

  1. 2.                  Lien Perfection – Private Projects

To properly commence a lien claim, it must both be filed within a certain time frame (90 days after last work is performed in Washington) and then a lawsuit must be brought within eight months thereafter.  Mechanics and materialmen’s lien claims may be filed by recording a Claim of Lien after the commencement of a bankruptcy case.[iii]  The rationale is that liens arise under state law when the work is performed and the material is delivered (the filing relates back to the first day work was performed or materials were delivered).  So the recording of the lien after the bankruptcy is filed does not “create” the lien but merely gives the public notice of its existence.  While the stay prohibits filing of a lawsuit to enforce the lien, the code does extend the period for filing the enforcement suit for 30 days after the stay has been lifted.  Therefore, claimants may continue to record a lien after bankruptcy has been filed notwithstanding the automatic stay.  This is true as long as the lien or work giving rise to the lien arose prior to filing of the bankruptcy petition, which is the case in the vast majority of mechanics lien claims in a bankruptcy situation.  While mechanics lien law varies significantly among states, mechanics liens generally arise either when labor and/or materials were supplied by the claimant or when work on the project was first commenced.  Both of these dates are generally well before the lien was perfected (filed).

Therefore, if the claimant, whether a general contractor or subcontractor, provided work or supplied material prior to the bankruptcy filing, the lien is allowed to be filed after the bankruptcy filing, even with a broad automatic stay.  Thus the claimant’s rights will generally survive a bankruptcy and will not be discharged.

In addition to filing a lien, the claimant must, within eight months (in Washington State), file a lawsuit.  As indicated, the exception permitting a lien claimant to perfect the lien does not go so far as allowing a lawsuit to enforce the lien.  The claimant’s rights can still be protected however since the bankruptcy filing will normally toll any deadline to enforce a lien during the bankruptcy proceedings, the lien can be enforced after the bankruptcy discharges most of the other claims.  Lien claimants can rely on § 108(c) of the Bankruptcy Code which extends the time for filing suits against a debtor for 30 days after the automatic stay is lifted, if the limitation period had not expired before the bankruptcy case was filed.  In other words, as long as the eight-month filing deadline had not expired at the time the bankruptcy was filed, a lien claimant can bring its lawsuit to foreclose on the mechanics lien within 30 days after the bankruptcy stay is lifted.  Nevertheless, many lawyers seek a “comfort” order or stipulation approved by the Bankruptcy Court permitting the claimant to proceed with its lien enforcement rights despite the bankruptcy.

Thus, mechanics lien claimants have the ability to both (i) perfect their liens after the automatic stay, and (ii) emerge “whole” after the bankruptcy concludes.  Having a security interest in the property (a perfected lien in real estate) puts the lien claimant in a much better position to recover the amounts owed.

  1. 3.                  Surety Bonds – Public Projects

The automatic stay does not stop actions against a surety bond because the bonding company is not the debtor, and the bond pledged by the bonding company is not an asset of the debtor.[iv]  In the unusual case where the debtor pledges its own assets as the bond, however, the debtor’s pledged assets are protected by the automatic stay.

Comments:  In the second post on “Construction Bankruptcy, Lien and Bond Claim Rights May Survive,” we discuss insurance, non-party, and preference issues.

[i] 11 USC § 362

[ii] 11 USC § 363(h)

[iii] 11 USC § 362(b)(3)

[iv] In re Dunbar, 235 B.R. 465 (B.A.P. 9th Cir. 1999) aff’d, 245 F.3d 1058 (9th Cir. 2001).