Bankruptcy and Construction

As if keeping a project on budget and on time is not enough, more and more in today’s economic climate the proverbial monkey wrench of bankruptcy is being thrown into the myriad of construction issues owners, contractors, and subcontractors face on construction projects.  In blunt terms, while bankruptcy may be a mechanism to provide a “fresh start” to a financially troubled entity, its effect on others is quite the opposite.

Bankruptcy takes various forms based on the particular chapter of the bankruptcy code invoked by the party seeking protection (“debtor”).  Chapter 7 is known as a liquidation and is invoked when there is no chance of the debtor continuing its business.  Under a liquidation, the assets of the debtor (“property of the estate”) are distributed to creditors based on the priorities established by the bankruptcy code.  Chapter 11 for a business (Chapter 13 if an individual) is a reorganization in which the debtor develops a plan to organize its finances and operations to stay in business.  The plan must be approved by the court and the creditor’s committee.  The committee is made up of representatives of the various categories of creditors.  During the reorganization process, the debtor has the ability to assume or reject executory contracts, that is contracts where the parties still owe obligations to one another. 

The key protection afforded by filing a bankruptcy petition is the imposition of an automatic injunction preventing creditors from taking action against the debtor and its property.  This is known as the “automatic stay.”  While it is provided to give the debtor an opportunity to determine how to administer its assets, reciprocally, the automatic stay may be extremely disruptive to the construction process.  As such, understanding some of the basics of bankruptcy may enable construction participants to mitigate the problems.

Another key component in bankruptcy is determining what assets are “property of the estate”.  If the asset is property of the estate, then the bankruptcy court has control of the asset.  Simply because the debtor is in possession of cash proceeds does not automatically result in a determination that such cash is property of the estate.  For example, if a general contractor files for bankruptcy protection, a subcontractor or material supplier may argue that construction proceeds paid by the owner to the debtor contractor are not property of the estate.  In those states which have enacted builder’s trust fund statutes, and the statute is sufficient to create an express trust, i.e. that the contractor is holding construction proceeds in trust to pay subcontractors and suppliers, the bankruptcy court is likely to determine that such funds are not property of the estate and allow distribution to the unpaid subcontractor or supplier.

Unfortunately, Pennsylvania has not enacted a builders trust fund statute; however, an unpaid subcontractor or supplier may argue the existence of a “constructive trust” if they can show a sufficient equitable interest in the proceeds which are in the possession of the debtor.  A lower tier subcontractor or supplier may find it beneficial to add language to their contracts in which the funds are held in trust by the contractor to avoid the bankruptcy court gaining control of contract proceeds.  An important factor considered by the bankruptcy court in enforcing such trust language is that the trust agreement must create a trust at the time the money comes into the possession of the debtor rather than creating a trust in the event the contractor misapplies the funds to another debt.

Joint check agreements do not always protect lower tier entities from those funds being grabbed by the estate of the debtor.  In order for a joint check agreement to remain outside the debtor’s estate, the agreement must include language creating an express trust.  Many unilateral letters of instruction from the debtor, which may be revoked at will, are insufficient to create an express trust.  Other construction security or financing devices typically remain outside the property of the estate.  For example, performance bonds and payment bonds issued on behalf of the debtor as principal will be treated as independent obligations of a bonding company and not part of debtor’s estate.  Letters of credit, sometimes issued to assure performance of construction, are also typically considered to be outside the debtor’s estate.  These instruments, therefore, provide a creditor recourse for collection outside the bankruptcy courts.

If the bankruptcy debtor is the owner, construction participants have alternatives to distributions through the bankruptcy courts.  The most common is the mechanics’ lien.  This statutory lien created by statute is not a lien against the contracting party, but a lien on the real property improved by the contractor’s goods or services.  If the property is owned by the debtor, the automatic stay will prohibit the enforcement of a lien, but it will not prohibit a party from perfecting the lien (filing the claim).

Other problems arise with bankruptcy.  Understanding that the goal is to maximize the size or amount of debtor’s estate, which ultimately benefits creditors, some of the actions to build the estate may single out otherwise innocent parties.  One of these instances arise in a Chapter 7 liquidation where the trustee of debtor’s estate seeks to avoid a transfer made by the debtor within 90 days of the petition date as a preference.  A finding of a preference would require the return of property to the debtor’s estate if the transfer was made by the debtor while it was insolvent and enabled the creditor to receive more than it would have received in the Chapter 7 liquidation.