One critical misconception is that a subcontractor’s bankruptcy means that it is going out of business. A bankruptcy by a subcontractor may actually be the method by which the subcontractor continues to operate. For many businesses, the legal process of bankruptcy may simply lead to a restructuring of debt, under Chapter 11 of the U.S. Bankruptcy Code, and operations rather than liquidation, under Chapter 7.

The real issue is what the subcontractor seeks to accomplish within the bankruptcy. For example, a subcontractor may seek to assign or transfer all of its obligations and rights, which, in turn would require the general contractor to assert its contractual rights relative to these actions.

Procedure and Timetable

The process is handled by a special federal court that considers both federal and state laws. The court reviews the fact pattern and considers a general contractor’s mechanics lien alongside all other creditors in light of the insolvency. Generally, creditors with valid liens are paid first (to the extent that the lien has equity), then creditors with claims related to the administrative costs of the bankruptcy and finally unsecured creditors.

The outcome to be determined by the court can range from full payment to the general contractor to a release of the subcontractor with regards to its duties owed to the general contractor. The timetable for this process is typically many months.

Depending on whether the bankruptcy is a Chapter 7 or a Chapter 11, the timetable for this process is typically five months to well over a year. General contractors may want to attend the 341 meeting of creditors, which is typically held 30 days after the bankruptcy filing. At that meeting, the general contractor may ask the debtor questions about the bankruptcy case, such as whether the subcontractor will continue his work.

The general contractor cannot pursue collections of any type while the case is pending without court approval. In some instances, the general contractor may be required to return payments made to it by the subcontractor within 90 days of the bankruptcy.

Automatic Stay

A general contractor faced with a subcontractor’s bankruptcy may not terminate the subcontractor agreement without court permission. This is true even if the contract between the parties says that the general contractor may terminate the relationship upon insolvency. This protection is an “automatic stay,” and courts treat it very seriously, including issuing sanctions for violations, usually in the form of punitive monetary damages.

If the general contractor does not want to be bound by the subcontractor agreement, it should quickly file a motion to lift the stay to allow the general contractor to terminate the contract.

Accounts Payable

Most general contractors operate under the assumption that a subcontractor bankruptcy is defined as an event of default by the subcontractor based either on language in the owner contract or the subcontract. On this basis, general contractors often mistakenly believe that the subcontractor has no accounts payable at the point of the bankruptcy. This may not be the case.

A subcontractor’s accounts receivable from the general contractor are property of the bankruptcy estate. This means that the accounts receivable should be listed on the debtor’s schedules as an asset, and the bankruptcy trustee may attempt to collect them. In addition, clauses that trigger default upon a bankruptcy filing are generally not enforceable in bankruptcy.

Recoupment

To the extent that the bankrupt subcontractor owes the general contractor on a claim related to the accounts receivable (i.e., the general contractor’s cost to complete based on the bankrupt subcontractor’s failure to timely complete the project), the general contractor may deducthis claim from the accounts receivable owed to the bankrupt subcontractor. This result is called recoupment.

In order to pursue recoupment, the general contractor will need to list itself as a creditor, and thereby minimize claims by the trustee that the accounts payable are owed in full. General contractors list themselves as creditors by filing a proof of their claim with the court. A wise general contractor will do so immediately after it receives the form from the court.

Lien Waiver or Preference

One danger of bankruptcy is the prospect that a transaction by the subcontractor will be deemed a preference, which can then be set aside by the bankruptcy trustee. Consideration should be given to lien waivers and whether the subcontractor has executed an affidavit of non-payment as is required under certain states.

Although a lien waiver may not meet the statutory definition of a “preference,” there is a potential problem where a subcontractor executes the lien waiver, is not in fact paid and files for bankruptcy prior to filing the affidavit of non-payment.

There is some potential that a trustee could contend that an owner and/or general contractor would be receiving more than it is entitled to receive if it took advantage of the subcontractor and failed to pay the subcontractor. The trustee may contend that it has additional time to file the affidavit of non-payment.

Accordingly, general contractors may wish to discuss the preference issue with owners and evaluate lien waivers from bankrupt subcontractors.

Rights of Property, Business Owners

Owners of real estate or the owners of the business who have contracted with a general contractor may exercise “step-in” rights to pay for the obligations of the subcontractor. Such action will also prevent a general contractor from halting work due to the bankruptcy.

Conclusion

Many of the points listed above can be included in an amendment to the main subcontracting agreement. The general contractor should also review its contract to ensure that it may assume the role of the subcontractor if the subcontractor cannot perform. It should include language requiring the subcontractor to provide information promptly upon request about its ability to continue working as well as timing. It should also cover actions the general contractor will need to take with regards to other interested parties.

Kevin Hudson, is the chair of the Construction Practice at Foltz Martin and Jimmy Luke practices in the area of bankruptcy and real estate. The firm can be found online at www.foltzmartin.com

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