What should a subcontractor do to protect its payment rights if it has signed a contract, started construction, furnished materials, and the general contractor files for bankruptcy? The short answer is “tread lightly.” The bankruptcy laws vary from state to state, but in every state, the law will change the basic rules of the game, and the creditor needs to be aware of these laws prior to proceeding. This article provides a brief overview of the bankruptcy laws, how they change the rules and what creditors can do to protect their payment rights.

How is a subcontractor limited by a general contractor's bankruptcy filing?

When a party files bankruptcy, the bankruptcy court imposes an “automatic stay.” The automatic stay bars commencement or continuation of any proceedings against the debtor or the debtor's property. A bankruptcy petition filed by a general contractor will prevent the subcontractor from demanding payment for pre-bankruptcy services, filing a lawsuit, or enforcing a judgment.

What are the subcontractor's remedies and options?

The subcontractor should consider two different sources for payment, and should pursue them both. These sources are (1) the debtor's bankruptcy estate and (2) third parties who are obligated to pay the subcontractor (ie. property owners or bond holders).

Clarification: The bankruptcy “estate” is represented by either a bankruptcy Trustee (in a Chapter 7 case) or the debtor-in-possession (in a Chapter 11 case). For simplicity's sake, we refer in this article only to the Trustee; however, in a Chapter 11 case, the appropriate reference is to the “debtor-in-possession.”

How can the subcontractor proceed against the bankruptcy estate?

First, the subcontractor should generally file a “Proof of Claim” in the bankruptcy action without delay. The subcontractor wants to get in line to obtain a proportionate share of whatever money is available after creditors with better positions are paid. Second, if there is still work to be performed under the contract, the subcontractor may make a motion in the bankruptcy court to force the Trustee to either assume or reject the contract. If the contract is assumed, the Trustee must cure all past defaults and agree to timely perform under the contract going forward. If the contract is rejected, the subcontractor is no longer legally required to perform the balance of the contract and is entitled to file a claim for damages resulting from the rejected contract.

How can a subcontractor proceed against a third party?

Although the automatic stay limits the actions a subcontractor can take against the general contractor, it does not prevent the subcontractor from pursuing other parties not in bankruptcy. The subcontractor can take steps to collect against any parties who have guaranteed the general contractor's debt. For example, when a project is bonded, a subcontractor that is owed money by a bonded general contractor can seek payment from a surety bond issued to guarantee the general contractor's performance of its contract.

Are Mechanic's or Materialmen's Liens barred by the Bankruptcy Proceeding?

No, provided the party in bankruptcy is not the owner of the property. A mechanic's or materialmen's lien is created pursuant to state law. All states grant contractors, subcontractors, suppliers, and others the right to have their unpaid bills satisfied out of the real property that was improved by their labor or materials. A subcontractor who has provided services or materials has the right to file a mechanic's or materialmen's lien on the real estate records to secure payment for services or materials. The lien acts as a lien on the real property and is satisfied either by the owner paying to have the lien removed or foreclosure of the underlying real estate with the proceeds from the sale used to pay the debt.

Caution: Mechanic's lien laws are technical, vary from state to state, and lien rights can be lost if the subcontractor does not comply precisely with the mechanic's lien statutes. Mistakes such as waiting too long to file the lien, or failing to personally serve all the necessary parties, can result in a loss of your lien rights.

What other approaches can a subcontractor take to recover payment?

Another approach a subcontractor can take is to establish an interest in contract proceeds due from an owner to the contractor based on theories of statutory, express or constructive trusts. The claim is that funds due to the debtor-general contractor never became property of the bankruptcy estate because payment was intended for the subcontractor.

Is there anything a subcontractor can do before a bankruptcy to avoid problems of non-payment by the general contractor?

The subcontractor may arrange to have the contractor's customer (property owner) make payment with a joint payee check. If the general contractor files for bankruptcy, there is still the possibility that the Trustee may attempt to recover payments as a preferred or unauthorized transfers. However, most courts rule that joint check payments are not recoverable by the Trustee, because the payment was “earmarked” for the subcontractor. Another option is to ensure that the general contractor has purchased a performance bond covering payment in the event of a default by the general contractor.

CONCLUSION

The bankruptcy of a general contractor is an unwelcome event; however, there are steps that a subcontractor can take to protect its payment rights. Specific problems facing parties to construction contracts in bankruptcy cover a wide and complex range of bankruptcy principles and each state's laws are different. For these reasons, when a party to a construction project becomes involved in a bankruptcy case, it is important to consult a bankruptcy attorney. Nevertheless, careful planning (i.e. obtaining surety bonds or joint payees on owner's checks) and swift action (filing proof of claim and mechanic's liens) can help minimize a subcontractor's exposure.

(This article contains a general discussion of the law. You should consult with your attorney on the issues regarding bankruptcy. This article does not constitute and should not be treated as legal advice as to any particular situation.) Readers are encouraged to submit any comments to the attorneys listed below.

Founded in Saint Paul in 1943, Felhaber, Larson, Fenlon and Vogt, P.A. has offices in Minneapolis and Saint Paul. With over 55 attorneys, the firm serves clients in the areas of corporate and commercial law, employee benefits, employment law, estate planning, health care, intellectual property, labor law representing management, litigation, real estate, transportation law, and workers' compensation.