Andrew Sherman is a member of Sills Cummis Epstein & Gross of Newark and is vice chair of the creditors’ rights and bankruptcy reorganization practice group. His e-mail address is asherman@sillscummis.com.

Retaining Rights When Contractors Go Bankrupt

General contractors in distress and owners can work together to minimize exposure and move projects toward completion.

by Andrew H. Sherman

A bankruptcy filing by a general contractor wreaks havoc on all parties.

The general contractor usually begins a bankruptcy case with little or no money and is confronted by many unhappy creditors, each trying to find a way to get paid.

Subcontractors are left unpaid and are forced to seek payment by enforcing their mechanic’s lien rights. And the owner will have to defend the mechanic’s lien claims of all the unpaid subcontractors and find a way to complete the project in a timely manner.

Faced with these varying interests, how can an owner complete the project and minimize cost overruns?

The owner on a construction project typically retains the right to withhold monies, hire a replacement contractor, or pay the subcontractors directly to avoid lien claims. In such cases, the owner should consider contacting the general contractor early in the bankruptcy case to address the competing interests and to try to work out a process to benefit all parties.

One process that has worked in a variety of bankruptcy cases – the establishment of trust accounts – provides protections for the owner, allows the general contractor to be paid, and creates a streamlined payment process for subcontractors.

The process begins by the general contractor obtaining a court order in its bankruptcy case to allow the owner to pay any outstanding amounts due on the project into trust or escrow accounts. The trust accounts can be established on a state-by-state or project-by-project basis, with the bankruptcy court that oversees the general contractor’s case supervising the claims process and providing a forum to resolve any disputes.

The court order should provide that the amounts in the accounts will be designated to pay the owner’s claims for any contract breach as well as valid and enforceable mechanic’s lien claims. Any balance in the trust funds would become the property of the general contractor, which it could use to operate the business or fund distributions to other creditors.

Under this scenario, subcontractors who do not have valid and enforceable mechanic’s lien claims would become general unsecured creditors of the contractor. These subcontractors would not be eligible for payment from the trust accounts. In return for the owner agreeing to pay the outstanding contract amounts into the trust accounts, the owner would require, through the court order, an injunction to enjoin subcontractors from pursuing claims directly against the owner.

Through this process, the amounts in the account become the sole source of payment for valid mechanic’s lien claims of the subcontractors. If the trust funds prove to be insufficient to satisfy all claims, the order of priority of payment would satisfy the owner’s claims first, with the remainder paid to the subcontractors on a pro rata basis.

The process is beneficial to an owner, because it obtains protections that may not be available in any other forum – a federal injunction barring all subcontractors from enforcing mechanic’s lien claims against the owner’s property. It also allows the owner to pay amounts legitimately due to a fund that will pay the subcontractors with valid liens.

Subcontractors benefit because those who have valid mechanic’s liens can be paid in a quick manner while avoiding timely and expensive litigation and the foreclosure of their lien rights.

And the process is fair to the general contractor because it enables the firm to obtain funds to pay subcontractor claims. It also creates an opportunity for the general contractor to collect any retainage.

Finally, the process also creates an incentive for the general contractor to minimize any damage claims and finish projects in a timely manner. The smaller the claims of the owner and the subcontractors, the greater the chance the general contractor can be paid in full.