It’s no secret that the construction industry is volatile. Because the failure rate of construction businesses is consistently higher than other industries, it is important for industry members to understand their rights when bankruptcy laws come into play. As we have discussed in the past, mechanics lien rights generally do well in bankruptcy. However, because bankruptcy involves a combination of federal and state law, the relationship between mechanics liens and bankruptcy can vary depending on the state. This principle was crucial when a recent Third Circuit case hinged on the underlying New Jersey lien law. Due to the nature of New Jersey Lien Laws, two material suppliers were unable to dodge the automatic stay instituted when their contractor filed for bankruptcy. In another state, the lien claims may have succeeded.
Mechanics Liens and Bankruptcy
Mechanics liens protect against bankruptcy up-the-chain because they often receive special treatment under the bankruptcy code. When a party files for bankruptcy, that party gets relief in the form of the automatic stay. Put simply, the stay creates a barrier to shield a debtor from the claims of its creditors. This barrier has some exceptions, though, including specific provisions favorable to mechanics lien claimants. For this reason, the institution of the automatic stay in bankruptcy proceedings makes it that much more important to stay on top of lien rights. In In re Linear Electric Company, Inc., two material suppliers found that while mechanics liens often prevail in bankruptcy situations, state lien laws can interfere.
For more on mechanics lien rights in bankruptcy, head over to our Indispensable Guide for Mechanics Liens in Bankruptcy.
Here’s the full holding of In re Linear Electric Company, Inc.
Cooper Electrical Supply Co. and Samson Electrical Supply Co., Inc. are material suppliers who provided materials to Linear Electric, a contractor, for several development projects. Before receiving payment on the projects, and before paying the material suppliers, Linear Electric filed for bankruptcy. About two weeks later, the material suppliers filed mechanics liens to recover the payments they were owed. In many states, these liens would attach to the underlying project property and would avoid the bankruptcy of a contractor altogether. However, due to New Jersey’s lien laws, the suppliers came out empty handed.
New Jersey Lien Laws and Bankruptcy
New Jersey liens operate on two tiers: first tier liens refer to those by contractors, and second tier liens are those liens brought by subcontractors and suppliers. If both first tier and second tier liens are brought on a project, those second tier lienors who worked under the first tier lienor must recover through the first tier- that is, when a contractor has filed a valid lien claim, lien claims made by their subcontractors and suppliers are paid from the sum of the contractor’s claim. This structure poses problems in bankruptcy.
As mentioned above, the automatic stay prevents claims from being brought by creditors after filing for bankruptcy. When a party up-the-chain (other than an owner) files for bankruptcy, in many states, this has no effect on a lien claim. The lien attaches to the property of the owner, not to property of the contractor. However, because a second-tier New Jersey lien claim comes out of the proceeds of a first tier claim, the court found that the suppliers’ lien claims were an attempt to recover from the contractor rather than the owner. Because Linear had already filed for bankruptcy, the lien claims were blocked by the automatic stay.
It’s important to note that, even under such a scenario, the suppliers in this case could still recover in many states by relating-back. When a mechanics lien relates-back, this means that the claim is considered to have arisen whenever work began. New Jersey law does not allow mechanics liens to relate-back, however, so the suppliers’ lien claims received no special treatment. Since the liens were filed just over two weeks after Linear filed bankruptcy, the claims were blocked by the automatic stay.
Mechanics liens are the most important remedy in the construction industry. The ability to cloud an owner’s title to enforce payment is powerful, and that mechanics liens often survive bankruptcy proceedings makes the claims that much more valuable. Mechanics liens endure bankruptcy in many situations, but as this recent New Jersey case has shown, liens do not always survive the automatic stay. Potential lien claimants should take note of this and take the time to understand their state’s mechanics lien and bankruptcy laws. Had these suppliers filed their lien claims a few weeks earlier, their claims might have succeeded.