Bankruptcy is a significant credit and collections challenge in the construction industry. We all fear it.  A customer filing for bankruptcy protection translates into attorney fees, payment delay and non-collectable debts. How do credit departments prepare for and respond to these bankruptcy situations?

A few months ago, we ran a Bankruptcy Blog Series. These posts focused on a bankruptcy filing’s effect on a mechanics lien claim. The series concluded with an uplifting message to credit departments in this summary post: Why Mechanics Lien Claims Help You Get Paid In Fact of Bankruptcy.

Now, in the midst of our Joint Check Blog Series, we examine how joint check agreement obligations and benefits stand up in a bankruptcy filing. You’ll likely be surprised with how vulnerable your joint check agreement is in a bankruptcy event.

Bankruptcy: What You Must Fear

Let’s start by looking at bankruptcy filings generally and what credit departments should fear – aside from getting stiffed on payment – when a party to a construction project seeks bankruptcy protection.  Mostly, they should fear Bankruptcy Code Section 547: Preferences.

The danger here is explained nicely in a March 2010 American Bar Association Business Law article titled “Preference: When Can A Trustee Claw Back Payments To Creditors?

The Bankruptcy Code permits the trustee or debtor-in-possession to “avoid” certain preferential transfers that a debtor made to creditors in the 90-day period prior to the filing of a bankruptcy petition. Preferential transfers should not be confused with fraudulent conveyances. Though they are often lumped together, they are distinct concepts. A preferential transfer focuses on whether a creditor has received a payment that results in that creditor getting better treatment than other creditors in light of the bankruptcy.

When a party files bankrupt, a trustee is appointed to oversee the disbursement of assets held by the business. It is the trustee’s job to make sure that all creditors are treated fairly and equally.  So, if Creditor A is owed $100,000 and Creditor B is owed $50,000, all other things being equal those two creditors should be paid the same percentage of their debt.  If the percentage paid is 10%, Creditor A will get $10,000 and Creditor B will get $5,000.

The “Preferences” statute in the Bankruptcy Code allows the trustee to turn back the clock for 90 days before the bankruptcy was filed and to take payments made during that period into account when coming up with who should receive what in the bankruptcy distribution. If you get paid too close to a bankruptcy filing, you may be required to pay the customer back!

Are Payments Made Under Joint Check Agreements Subject To A Bankruptcy Preference?

What if you have a joint check agreement signed requiring more than one party to pay your debt?  In other words, what if the bankrupt party and a non-bankrupt party have signed a joint check agreement promising to pay your debt?  Can you disregard the bankruptcy filing and just go after the non-bankrupt party? Can you rely on this to prevent a §547 Preference claw back?

Well, as these things go, it depends.

First, it depends on the terms of the joint check agreement itself. If a third-party non-bankrupt owner or contractor is required under the agreement to make payments through a joint check, most bankruptcy districts will determine that the bankrupt party does not have a requisite “interest” in the funds, and therefore, they will not be subject to the preference.

On the other hand, in those circumstances where the non-bankrupt party simply may issue a joint check and need not issue the joint check (which happens), many bankruptcy districts may consider these payments subject to the §547 preference.  Here is how Mr. Peterson explains the situation in his above-linked article:

The bankruptcy trustee may argue that, because the Contractor was a joint payee on the joint check, the Contractor had the requisite “interest” in the check proceeds and the payment to the Supplier was a preference…Under certain circumstances, the trustees or debtors have been successful in recovering payments made to Suppliers pursuant to joint checks, especially where courts determine that the Owner or Contractor did not have an independent obligation to pay the Supplier…

Second, it depends on where you are.  Even though bankruptcy law is federal law and theoretically the same in every state, that does not prevent the various court districts from interpreting the law differently.  As such, how this particular issue gets handled will depend heavily on where the bankruptcy filing is being litigated.

Can You Recover Unpaid Amounts Under A Joint Check Agreement When Your Joint Payee Is Bankrupt?

The other issue to consider when holding onto a joint check agreement where your joint payee is in bankruptcy is what rights you have for unpaid amounts post-bankruptcy.

The bankruptcy trustee will eye all payments still due hoping to get them added to the bankruptcy estate. To do so, the trustee will be faced with the same situation as above, namely the question of whether the bankrupt party has an “interest” in the joint check payment. If the bankrupt party has the requisite interest it will get added to the estate. If not, it’ll flow directly to the non-bankrupt party.

Again this issue will likely boil down to whether the paying party has the actual obligation to pay the non-bankrupt party.  If the joint check agreement merely authorizes the owner (or GC) to make payment by joint check, the trustee will be successful at re-routing the payments to the estate. If the joint check agreement mandates payment by joint check, the non-bankrupt party will likely be successful at getting the payment directly and avoiding the bankruptcy interests therein.

Conclusions & Joint Check Agreement Best Practices

So, if you’re a credit manager how do you ensure your joint check agreements avoid these bankruptcy perils and really protect your company in the event of a bankruptcy?  While you’ll never be able to avoid the situation and risk entirely, here are some best practices:

1) Make Your Company A Party To The Joint Check Agreement: We hinted at this in previous posts within the Joint Check Blog Series. Make sure you are announced in the agreement as a party to the agreement,and make sure that you are a signatory on the agreement.  Your company should be a party to the agreement, and thus, you should have defined rights therein.

2) Obligate The Owner or Contractor To Pay You:  A lot of joint check agreements merely give the owner or general contractor permission to issue joint checks.  You want your joint check agreements to obligate the owner or general contractor to issue joint checks to you.

3) Make The Joint Check Agreement Restrictive On Your Joint Payee: Make the joint check agreement clearly demonstrate that it benefits you and not your joint payee.  Include language that the joint payee must endorse the check to your favor, that it cannot revoke the agreement and that it merely serves to hold the payment in trust to get the payment to you.

4) Do Not Allow Any Portion To Go To The Joint Payee:  Make sure your joint checks are written separately from any other checks due to the joint payee.  You want the entire joint check amount to be payable to you. If the joint payee is owed other money on the project you want that to get paid to the joint payee in a separate instrument