Samuel M. Starr and Kevin J. Walsh – December 5, 2011
In today’s economy, we continue to see bankruptcies occurring in the construction sector. An owner, contractor, or subcontractor in financial distress can easily delay a project — or worse, jeopardize the project in its entirety. Contractors need to understand their rights in order to minimize their exposure in bankruptcy-related situations.
Protecting Contractors — Frequently Asked Questions
Q. If a contractor learns that a subcontractor is in financial distress or receives notice that the subcontractor is closing down its business, what should the contractor do?
A. Terminate the contract before a bankruptcy filing by following the procedures set forth in the contract. If the contractor does not effectively terminate the contract prior to the bankruptcy, then the contractor must obtain bankruptcy court approval before terminating the contract post bankruptcy. Additionally, unless lien waivers are received, use joint checks or do not make further payments. In this situation, the contractor wants to be sure that payments reach the sub-subcontractors and suppliers who actually performed the work for which payment is sought by the subcontractor so lien waivers should be obtained from these lower-tier entities.
Q. If a subcontractor files for bankruptcy, can the contractor pursue rights under the subcontractor’s performance bond?
A. Yes — the automatic stay applies to and prevents acts against the debtor. The stay does not prevent acts against the subcontractor’s performance bond surety or any guarantors.
Q. If a subcontractor files for bankruptcy, what can the contractor do to expedite assumption or rejection of the contract?
A. As a counterparty to a contract with a debtor, the contractor could file a motion with the court to compel the debtor to assume or reject the contract. Assumption means the debtor reaffirms the contract and must perform according to its terms. In order to assume a contract, the debtor must cure all past defaults and must convince the judge that it can perform under the contract in the future. An assumed contract can be modified if the parties to it agree to do so. By rejecting the contract, the debtor is breaching it as of the date of the bankruptcy filing. Non-performance under the contract by the debtor may be sufficient grounds for the contractor to bring a successful motion to force the debtor to reject the contract. If the debtor rejects the contract, the contractor is then free to arrange for the remaining work to be performed by another subcontractor.
Q. What steps can a contractor take to protect itself from a subcontractor bankruptcy?
A. Some prebankruptcy considerations a contractor can build into the contract include an explicit right of setoff for all jobs with the subcontractor, joint check provisions, and periodic lien waiver requirements including lien waivers from sub-subcontractors and lower-tier suppliers. It is always important for a contractor to make sure on a regular basis that amounts paid to a subcontractor on account of work performed by a sub-subcontractor or material supplied by a lower-tier supplier are timely paid by the subcontractor to the lower-tier subcontractors and suppliers and are not diverted by the subcontractor to another purpose. These lower-tier subcontractors and suppliers if unpaid could assert lien claims or payment bond claims against the contractor’s payment bond which would survive a subcontractor bankruptcy. If the contractor no longer wishes to do business with the subcontractor and grounds exist to terminate the contract, the contractor should act quickly to terminate the contract prior to the bankruptcy filing. A contract terminated prior to the bankruptcy does not become part of the bankruptcy case. But termination must be done in accordance with the procedures set forth in the contract.
Q. If an owner files for bankruptcy, can the contractor keep working for the owner?
A. If a valid contract exists between the contractor and owner, the contractor must continue to perform pursuant to the terms of the contract, even if the debtor does not. The contractor will be entitled to be paid according to the terms of the contract and will have an administrative expense priority claim for any unpaid, post-bankruptcy amounts due. As noted above, if the debtor does not perform its obligations under the contract, the contractor can, and should, seek to force the debtor to assume or reject the contract, or seek relief from the stay in order to terminate the contract.
Q. If an owner files for bankruptcy, can the contractor pursue lien rights?
A. The automatic stay prevents enforcement of lien rights. The bankruptcy code provides an exception to the stay for ministerial acts necessary to perfect and maintain lien rights (e.g., providing pre-lien notices and recording a claim of lien) after the bankruptcy filing, if such rights could have been perfected or maintained under applicable state law but for the bankruptcy filing. The date of perfection of the lien relates back to the date that it would have been perfected under applicable state law.