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The Hidden Complexities of Construction Bankruptcy

The construction business can present numerous challenges for the bankruptcy law practitioner as well as for the entity who is filing for bankruptcy protection. In many construction projects, there are numerous subcontractors involved who could at any time file for bankruptcy and disrupt the ebb and flow of the contract, creating delays, labor disputes, cost overruns and other problems. General contractors also find themselves at times unable to pay its subcontractors or have to file bankruptcy if financial issues are overwhelming enough to pursue this course of action.

Contractors and subcontractors can prepare for a construction bankruptcy by knowing bankruptcy law, the implications of the various chapters and how some measures can be taken to lessen the blow and the costs that can result. Since so many contractors and vendors are involved in a project, a failure of one to perform can lead to problems for the other involved parties that in some cases can be avoided or softened with proper preparation and legal counsel.

In many construction bankruptcy cases, there are similar issues concerning construction liens, surety bonds and executory contracts.

Construction Liens

Those in the building trades are familiar with mechanic’s liens, which allows an electrician, carpenter or other trade professional to place a lien on the building or property if they are not paid for their work. These subcontractors do have to comply with the requirements in getting their lien perfected so that it has priority in a bankruptcy case.

In a Chapter 7, however, these rights may clash if they are considered a voidable preference. These are payments made to a creditor 90 days before filing that were in an amount that is more than what it would have recovered in the bankruptcy. If it is a voidable preference, the trustee can demand repayment.

Executory Contracts

An executory contract is one where the parties have yet to complete their obligations, such as a lease or contract for certain materials or to perform certain services or labor. In a Chapter 11 filing where the debtor, usually a contractor, wishes to continue business operations while reorganizing, the debtor and the trustee have the option of assuming or continuing with the terms of the contract or rejecting it. If the contract is assumed, it has to be done before the reorganization plan required in a Chapter 11 case is confirmed, or typically within 60 or 120 days after filing although the period may be longer. The other party, though, can request that the decision be made sooner. The debtor’s decision to assume or reject a particular contract has to be approved by the bankruptcy court in a Chapter 11.

An executory contract that has value to the estate will generally be assumed. If it is a Chapter 7 liquidation, it is unlikely such a contract will be assumed since the debtor lacks the ability to perform at all.

If the contractor does want to assume the contract, it must demonstrate that it can meet the terms of the contract including payment of all arrearages and prompt payment of any expenses incurred for past defaults under the subcontract. The court can also require the debtor to stipulate terms with the supplier or subcontractor that may include the right to immediately terminate the contract without further action and to replace the party if it does not perform under the contract

If the contract is rejected, any claims by the other party for damages incurred by the breach or rejection become a pre-petition unsecured debt and given low priority regarding payments under the plan.

Surety Bonds

In most if not all major construction projects, and many smaller ones, the contractor must be bonded to ensure payment to whomever commissioned the project. When certain work is not performed or payments not made, the aggrieved party looks to the bond issuer for compensation.

Unlike other collection actions, a surety bond is not subject to the automatic stay provisions of a bankruptcy and collection activity can continue. Consequently, when the bond issuer pays out on the bond, it can seek reimbursement from the debtor contractor or company. Under the terms of the bond agreement, the surety bond company may also be able to monitor the construction project, which can include how funds are to be dispersed.

Negotiating Terms in Anticipation of Bankruptcy

Contractors and subcontractors can attempt to avoid certain issues if they can contract the work performed by lower tier contractors or suppliers to be supplied by others. If that contractor or supplier files for bankruptcy, the general contractor or company is able to use a replacement to complete the scope of work without the need to terminate that contract and without delaying its progress.

Another measure used to protect the general is by granting subcontractors a security interest in their payments so that they are not subject to the voidable preference claims of a trustee and will not need to assert liens or other claims.

Anticipating the very real possibility of some party involved in a construction project to seek bankruptcy protection should be a high priority for any contractor or subcontractor. Knowing what can occur and taking measures to protect your interests by consulting with an experienced bankruptcy attorney before entering into a construction project is a cost of doing business that will turn out to be in your best interests.

Dheeraj K. Singhal
About the Author
I help people keep the things they want and get rid of the things they don't want. I have been a lawyer for over 12 years and there are few things I enjoy more then getting great results for the people that trust me with their legal problems.