I’ve discussed the intersection of bankruptcy and mechanics liens several times here on the Construction Payment Blog, both in general terms and through specific court decisions. These discussions have caused me to believe strongly that, in terms of construction projects, the mechanics lien is the best way to get paid in the face of a party’s bankruptcy. It’s unfortunate, but bankruptcy is all too common in the construction industry, so it’s important to recognize how to be best protected.

Bankruptcy’s Automatic Stay

The “automatic stay” is one of the cornerstone principles of bankruptcy protection. The automatic stay is triggered by Bankruptcy Code Section 362(a), and bars collection efforts and other creditor actions against the debtor and/or his property once the bankruptcy has been filed. As soon as the debtor filed for bankruptcy protection, the provisions of Bankruptcy Code Section 362(a) immediately spring into place to form a sort of protective barrier around the debtor and his assets. After Bankruptcy is filed, attempts by creditors to get paid are prohibited – it is the bankruptcy court’s responsibility to determine the course of action, and apportion the debtor’s assets (that can be claimed by the creditors). Actions prohibited by 362(a)(4) and (a)(5) include:

(4) any act to create, perfect, or enforce any lien against property of the estate;

(5) any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title;

As I have mentioned before, however, the mechanics lien instrument puts a creditor in a significantly better position than most other creditors, even most other secured creditors. Because the Bankruptcy Code provides certain exceptions to the automatic stay, including allowing a creditor to perfect an interest in property that attached prior to the filing of the bankruptcy petition, mechanics liens may generally be filed (perfected) after the automatic stay has been triggered.

Does It Matter Which Party in the Construction Project Files for Bankruptcy Protection?

The reason it may matter which party files for bankruptcy protection relates back to the automatic stay, and other provisions of bankruptcy law.
As we have seen, one of the reasons that a mechanics lien is such a powerful tool for procuring payment is that it allows the lien claimant to get around the privity of contract rule and recover payment from all parties above them on a construction project. This is clearly a useful feature, but does the lien claimant’s ability to recover (or path to recovery) change depending on who files for bankruptcy protection?

The short answer to that question is, like it so often is for questions regarding mechanics liens, maybe.

The reason it may matter which party files for bankruptcy protection relates back to the automatic stay, and other provisions of bankruptcy law. As soon as a debtor files a bankruptcy petition, all of the debtor’s property (more specifically, “all legal or equitable interests of the debtor in property”) become the property of the bankruptcy estate. The property included in the bankruptcy estate is subject to the automatic stay, and collection efforts against that property are forbidden.

The property that becomes property of the estate, therefore, is determined by the identity of the party filing for bankruptcy protection.

in a construction project context, the identity of the party filing for bankruptcy protection is essential to determining how the lien claimant can go about recovering the money owed
So, in a construction project context, the identity of the party filing for bankruptcy protection is essential to determining how the lien claimant can go about recovering the money owed. If the property owner is a different entity than the general contractor, and the general contractor is the party filing for bankruptcy protection, the property itself would not become part of the bankruptcy estate. Since the property is not part of the bankruptcy estate, the automatic stay would not apply to that property – this means that a lien claimant would likely be able to proceed against that property even during the automatic stay period of the general contractor’s bankruptcy proceeding. Note, however, that if the project is incomplete, the general contractor may have some interest remaining in the contract for the improvement itself, such that the project could be frozen throughout the automatic stay period.

If, however, the developer/general contractor owns the property, for example on new construction prior to sale, the property would become part of the bankruptcy estate – and subject to the provisions of the automatic stay.

This is just another wrinkle in the complex relationship between the provisions of bankruptcy law and the mechanics lien.