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What Should Construction Contractors Do When a Property Owner Files For Bankruptcy?

February 11, 2022 Construction Industry Legal Blog

Reading Time: 8 minutes


A bankruptcy filing by a property owner can bring a construction project to a screeching halt, and create a serious risk of substantial losses for the contractor, as well as subcontractors and suppliers. This article will provide an overview of what happens when a property owner files for bankruptcy and what contractors and subcontractors can do with their construction lien rights in bankruptcy to try to protect their interests.

Property Owner Files For Bankruptcy

What Happens When a Property Owner Files for Bankruptcy?

When a property owner files for bankruptcy, a “Notice of Commencement of Case” will be sent to all creditors listed in the owner’s bankruptcy petition to let them know that the bankruptcy has been filed and to provide deadlines for key events in the bankruptcy. The list of creditors receiving the Notice should include the general contractor of an incomplete construction project. However, it may not include subcontractors if they are not already creditors known by the owner.  Upon receipt of such a Notice, or of learning of an owner’s bankruptcy on a construction project, contractors and subcontractors should quickly consult legal counsel to ensure they take necessary action to protect their rights and do not take actions that would run afoul of bankruptcy law.

Avoiding violating bankruptcy law is an important consideration for contractors when a property owner files bankruptcy because a bankruptcy filing triggers what is known as the automatic stay.  The bankruptcy automatic stay prohibits all creditors from proceeding with collection actions, lawsuits, and enforcement of judgments against the debtor. See 11 U.S.C. § 362.  As explained in more detail below, the automatic stay applies to actions to enforce a construction lien, subject to certain exceptions.  Creditors, including construction lien holders, that violate the automatic stay can be subject to claims for damages and attorney’s fees from the debtor, including punitive damages in appropriate circumstances.  See 11 U.S.C. §362(k)(1).

The Impact of Bankruptcy on the Construction Contract

Work doesn’t automatically come to a stop when a property owner files for bankruptcy.  When a bankruptcy is filed, contracts where each party has not yet fully performed all obligations are known as executory contracts. 11. U.S.C. § 365; In re Gencor Industries, Inc., 298 B.R. 902 (Bankr.M.D.Fla. 2003).  The general contractor’s contract with the property owner is generally considered to be an executory contract, which means the contractor is not necessarily relieved from performance just by the fact that the property owner filed bankruptcy.

Instead, the property owner debtor will have the opportunity to either assume or reject the executory construction contract as part of the bankruptcy. In re Gencor Industries, Inc., 298 B.R. at 909.  If the debtor assumes the contract, the contractor will be required to continue to perform if the debtor cures prior defaults and provides adequate assurances of future payment.  If the debtor rejects the contract, the contract will be terminated, and the contractor will not be required to provide further performance.  The debtor has some time after the filing of a bankruptcy to make the decision to assume or reject the contract, and the contractor cannot simply terminate the contract before that decision is made.  It is important to note that contract provisions that deem the filing of bankruptcy as a material breach and allowing the non-bankrupt party to terminate or stop work under the contract are disfavored by the courts and are generally unenforceable. See 11 U.S.C. § 365(e)(1); In re Yates Development, Inc., 256 F.3d 1285 (11th Cir. 2001).

The Impact of Bankruptcy on Construction Liens

After receiving notice of a bankruptcy filing, contractors need to act quickly to protect their rights.  Contractors and subcontractors that have lien rights under applicable construction lien laws may have the ability to assert what is known as a secured claim in bankruptcy.  Secured creditors are those that have their claims for payment secured by a lien or mortgage on the property of the debtor.  They typically have a much better opportunity to obtain a recovery on their claims in bankruptcy, as secured creditors are typically paid before unsecured creditors.  Therefore, it is critical that available construction lien rights are preserved in bankruptcy.

While the automatic stay that comes with a bankruptcy filing prevents actions to enforce or collect on a debt, it does not necessarily prevent a contractor from taking actions to perfect its construction lien. This is because the Bankruptcy Code provides that, so long as the applicable state construction lien statute provides that the recording of a lien relates back to the period before the bankruptcy was filed, a construction lien can be perfected even after a property owner files bankruptcy without violating the automatic stay. See 11 U.S.C. 546(b)(2).

Many state laws provide for some relation back for construction liens.  Under Florida law, for example, a timely recorded construction lien will relate back to the date that the notice of commencement was recorded in the public records at the outset of the project. See Fla. Stat. § 713.07(2). For Florida contractors, this means that even if the property owner files bankruptcy prior to the contractor recording its construction lien, the contractor can still perfect its construction lien by recording it in the public records where the property is located.  The contractor will have still have to meet Florida’s timing requirements of recording the construction lien within 90 days of the last day of furnishing labor or materials to the project.  See Fla. Stat. § 713.08(5). Failure to timely will so result in a loss of lien rights and any secured claim in the bankruptcy.

Similarly, subcontractors or other lienors that do not have a direct contract with the owner still have to timely serve their notice to the owner under Fla. Stat. § 713.06(2) in addition to timely recording their claim of lien to perfect their construction lien rights.  This is true even if the owner files bankruptcy prior to the deadline to serve the notice to the owner.  Like recording the lien, service of the notice to the owner is an act of perfection of the lien and does not violate the automatic stay. A lienor required to serve a notice to the owner that fails to timely do so will also lose their construction lien rights and secured creditor status in bankruptcy.

What Can Be Done With a Perfected Construction Lien in Bankruptcy?

Once the construction lien is perfected, it acts as a lien on the owner’s property and makes the contractor a secured creditor in the bankruptcy proceeding.  However, the construction lienholder cannot take any steps to enforce or collect on the lien outside of the bankruptcy process due to the automatic bankruptcy stay.  But the pendency of the bankruptcy will toll any statute of limitations for enforcement of the construction lien outside of bankruptcy. For example, Florida’s requirement under Fla. Stat. § 713.22 that an action be filed to foreclose a construction lien within one year of the date the lien was recorded will be tolled during the pendency of the bankruptcy.

Perfected construction lien holders may petition the bankruptcy court for relief from the automatic stay to enforce their lien in state court notwithstanding the bankruptcy. Relief from the automatic stay would allow the lienholder to foreclose on the property under state law outside of the bankruptcy and apply the proceeds to the debt. 11 U.S.C. § 362(d); see also In re Lindsey, 854 Fed.Appx. 301 (11th Cir. 2021); In re Mack, 347 B.R. 911 (Bankr.M.D.Fla. 2006).  Typically, a bankruptcy court will only allow relief from the automatic stay if the creditor can show that there is no equity in the property subject to the construction lien (meaning the value of the property is less than the amount of the lien) and the property is not necessary for an effective reorganization of the debtor.  See 11 U.S.C. § 362(d).  The burden of proof on a motion for relief from stay is on the creditor lienholder.  If the bankruptcy court denies relief from stay, the construction lien will nevertheless remain valid and the contractor will still maintain its status as a secured creditor in the bankruptcy, with payment to be determined in accordance with bankruptcy law.

Conclusion

It can be a challenging time for contractors on a construction project when a property owner files for bankruptcy, especially when a construction lien has not yet been filed or perfected. However, bankruptcy law and the Florida construction lien law (and that of many other states) allows for the perfection of construction liens notwithstanding the bankruptcy filing. Importantly, this must be done for the lienor to perfect and preserve its construction lien rights in the bankruptcy.  Where construction and bankruptcy law meet, it is important to consult an attorney with experience and knowledge of both construction law and bankruptcy to ensure that the proper steps are timely taken by the contractor to preserve its rights and maximize the opportunity for recovery of amounts owed in bankruptcy.

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