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Construction after the Real Estate Boom

Protecting Yourself and Finding Success in a Volatile Market
By Kevin S. Blanton and Joseph J. Devine

Second Part of a Two-Part Serie

This article is the second part of a two-part series that addresses how to handle a project that has “gone broke.” Last month we discussed steps to take prior to providing goods or services (see July 2010 USGlass, page 34). This part will address what to do when payments from the owner are stopped or delayed and how to position your company for the best possible result if a project goes into bankruptcy.

When a project is in trouble, often the owner will slow the timing of payments and, as things get worse, eventually not make them at all. In such an event, a glazing contractor needs to look to available remedies within the terms of its contract with the owner as well as other legal remedies that are available to maximize the chances of getting paid.

When entering into contracts or purchase agreements, contractors should negotiate specific provisions that permit the termination of the contract in the event of non-payment by the owner or when the project is stopped for an extended period of time. By way of example, commonly used forms provided by the American Institute of Architects (AIA) provide that a contractor may terminate the agreement if the project is stopped for a period in excess of 30 days or if the owner has not made payments within the time frames stated in the agreement.

Although termination of the contract may mitigate any future losses suffered by a glazing contractor or vendor, if one has to resort to such an extreme measure, the owner and the project are likely already in financial crisis. One way a glazing contractor may protect itself is to file a mechanic’s lien to assist in recovering payments due. In addition, the contractor may have rights under performance and payment bonds posted with respect to the project and finally, if all else fails, a contractor has the right to sue the owner for damages or invoke other legal remedies, either inside or outside of an owner’s bankruptcy proceeding.

Mechanic’s Lien
A mechanic’s lien is an encumbrance on real property for the benefit of one who supplied labor or materials to improve real property. Mechanic’s liens are available in most jurisdictions by statute. Each state is different so before filing a mechanic’s lien one must ensure that the statutory requirements are followed strictly as failure to do so may cause the lien to be ineffective.

Generally, anyone supplying labor or materials incorporated into the construction of a project may file a mechanic’s lien; however, some states require that the entity filing the mechanic’s lien have a certain degree of contractual privity with the owner so that sub-subcontractors may be prohibited from filing. Mechanic’s liens may be filed on construction projects, renovation projects, certain improvements to land and, in some instances, by those providing specially fabricated materials that have little to no value if not incorporated into a specific project. Mechanic’s liens are generally not available for demolition projects and mechanic’s liens may not be filed against government-owned properties.

The typical process involved in filing a mechanic’s lien consists of a pre-lien notice, the filing of the lien itself and the subsequent foreclosure of the lien. The effect of the lien on the owner is significant. A mechanic’s lien becomes a cloud on the title to the real estate upon which it is filed, similar to that of mortgage or tax lien. The act of filing the lien may cause default under an owner’s financing documents and ultimately, the foreclosure of the mechanic’s lien may result in the owner’s loss of the project. Because of this, banks providing construction financing often require an owner to pay off the lien or post a bond guaranteeing payment within a relatively short period of time after a lien is filed against a property. As a result, filing a mechanic’s lien will generally get quick attention from the owner and force a resolution of the contractor’s claims.

Before attempting to file a mechanic’s lien, it is important to check that prospective lien waivers have not been filed or that the right to file mechanic’s liens has not otherwise been waived by the contractor or by the action of the parties.

Performance and Payment Bonds
Another method of recovery that may be available to a contractor is a payment bond claim. A payment bond is essentially a guaranty by a third party to the owner or lender that the contractor will pay its subcontractors and vendors for labor and materials used in the project. Accordingly, if a contractor does not pay a glazing contractor, they may have a claim that may get paid by the surety under the bond. It is important on a bonded project to follow the correct procedure regarding timing and notice to the owner and, if required, to the surety, to assure that the ability to have the claim paid by the surety is not compromised.

Legal Remedies
If none of the aforementioned options are available, the glazing contractor may sue for non-payment. Prior to initiating suit, the applicable contract provisions and relevant statutes should be reviewed to determine the forum in which a claim should be filed (in many contracts it is custom to waive jury trials or to require arbitration or mediation), the time limits in which to file any notice and cure rights that must be provided prior to filing such an action. The available claims to a party not receiving payment may include breach of contract, unjust enrichment and third-party beneficiary claims. In addition, if the owner of the project has filed for bankruptcy, one may make claims inside the framework of the bankruptcy proceeding.

Bankruptcy
Regardless of how well a subcontractor attempts to mitigate risk and protect itself from slow or non-paying owners, the one thing that cannot be avoided is the bankruptcy of an owner or project. As a contractor or vendor there are two main types of bankruptcy that you will face. The first, often called a “liquidation,” is a proceeding under Chapter 7 of the bankruptcy code. In a Chapter 7 bankruptcy, a trustee is appointed by the court to accumulate and then liquidate the assets of the bankrupt company, called the “debtor.” The proceeds of the liquidation are then used to pay administrative expenses related to the bankruptcy and claims of those that are owed money by the debtor (“creditors”). Claims are paid on a pro-rata basis based on the priority status of the claim.

Often in a Chapter 7 proceeding creditors get little or no payment on their outstanding obligations. The second type of bankruptcy that one is likely to face is a Chapter 11 proceeding. In a Chapter 11 bankruptcy, the debtor remains in business and enters into a plan to pay its creditors over time and often at a discount.

If you find yourself in the position of having an owner file for bankruptcy during the course of a project, the following are some of the most important considerations that you will have. These considerations are generally applicable to all bankruptcy.

Automatic Stay
Once a company files for bankruptcy, all activities to collect money from the debtor must stop. Any claims that are pending must now be raised (even if previously raised in another court) in bankruptcy court. This process, called the “automatic stay,” is designed to give the debtor some breathing room and give them a chance to have their situation reviewed by the bankruptcy court. If collection efforts continue against the debtor after the creditor is put on notice of the bankruptcy filing, the debtor may recover damages and sanctions from the creditor in certain instances.

Executory Contract
The bankruptcy code allows a debtor in a Chapter 11 case to assume or reject executory contracts. For bankruptcy purposes, an executory contract is a contract under which both parties have outstanding obligations at the time the bankruptcy petition is filed. If you have an ongoing contract and it is assumed by the debtor, the debtor must cure any existing defaults, including payment defaults, and the contractual relationship will continue throughout the bankruptcy case. On the other hand, if the debtor decides to reject your executory contract, you will be left with an unsecured claim against the debtor for the amount due and any damages you may suffer. Because the claim is unsecured, your chances of recovering payment for the full amount of the claim may decrease.

"Regardless of how well a subcontractor attempts to mitigate risk and protect itself from slow or non-paying owners, the one thing that cannot be avoided is the bankruptcy of an owner or project."

Section 503(b)(9) Administrative Claims
Administrative expenses are expenses incurred after the filing of the bankruptcy incurred in conducting the Debtor’s business or protecting its property. Administrative expenses are entitled to priority over most other types of claims and, as such, get paid prior to the typical unsecured claims of contractors.

Section 503(b)(9) was added to the bankruptcy code in 2005 and grants administrative claim priority for the value of any goods received by a debtor in the ordinary course of a debtor’s business within 20 days before the commencement of the bankruptcy case. This section was enacted so that debtors could not avoid paying for goods they acquired at a time when they knew they would be unable to pay because of their impending bankruptcy and is a useful tool for those that supplied goods and services to a debtor immediately prior to the bankruptcy filing for which they have not been paid.

Reclamation Claims
Once a bankruptcy case has commenced, a vendor may take back or reclaim goods it sold to a debtor if the requirements of Section 546(c) of the Bankruptcy Code are met. To reclaim the goods, a written demand for reclamation must be made. The demand must be made no later than 45 days after receipt of goods by the debtor, or no later than 20 days after the date of the debtor’s petition for bankruptcy, if the 45-day period expires before the commencement of the bankruptcy case. Where possible, vendors should consider this option as it may allow them to place items back into inventory to be sold at later time to a purchaser that is in a better position to pay. This result is much better than wading through the bankruptcy process in the hope of getting at least a partial payment and exposing oneself to the risk of getting none.

Critical Vendors
In a Chapter 11 case, creditors often refuse to continue supplying the debtor with critical services or materials unless all the creditor’s claims that arose before the debtor filed bankruptcy are paid immediately, even though such claims are not entitled to priority under the bankruptcy code. There is nothing that requires a vendor to continue to supply goods to a bankrupt company, so the threat of cutting off critical services or materials is one that quickly gets the attention of a debtor struggling to reorganize and keep its business alive.

Some bankruptcy courts have authorized the immediate payment of such “critical vendors” when it becomes clear that a Chapter 11 debtor cannot continue operating without the services or materials that a critical vendor supplies. If you are fortunate enough to be in this position, your leverage can be used to force back payments as well as ongoing payments during the course of the bankruptcy proceeding without regard to how your claims may have otherwise been classified or scheduled to be paid. When the bankruptcy court permits such payments, it is usually within the debtor’s discretion to determine which “critical vendors” will get paid.

Unsecured Proofs of Claim
Unless one is able to fit into one of the categories above, most glazing contractors will find that their claims are designated as “unsecured.” An unsecured claim is one of the last claims to be paid out in bankruptcy and often unsecured creditors are forced to accept deep discounts. In order to be paid on an unsecured claim in a Chapter 7 proceeding, a written proof of claim must be filed with the bankruptcy court asserting your right to be paid. An unsecured creditor however, is not required to file a proof of claim in a Chapter 11 case if the claim was already disclosed by the debtor in the schedules it filed with the bankruptcy court and the claim is not listed as disputed, contingent or unliquidated.

In a Chapter 7 case, a proof of claim must be filed no later than 90 days after the first date set for the meeting of creditors. In a Chapter 11 case, the deadline for filing a proof of claim is established by the bankruptcy court. If a creditor does not timely file a proof of claim, the creditor may lose its right to be paid.

Conclusion
In today’s challenging economy, it is almost inevitable that one of your customers or project on which you are working will go broke. With careful planning you can mitigate these risks. When signs of trouble, such as slow or non-payment start to happen, you can attempt to cut your losses and terminate the relationship and you will enhance your opportunity to get paid by promptly enforcing your right under your contracts and provided by law. If you are unable to recover or if bankruptcy filing prevents you from exercising some of the more traditional remedies, such as enforcing mechanics’ liens, bond claims or filing suit, by paying careful attention to the considerations outlined above and seeking the advice of a professional familiar with the bankruptcy process, you will be able to place yourself in the best position to receive the largest possible available distribution in the bankruptcy case.

Kevin S. Blanton and Joseph J. Devine are partners with Schnader Harrison Segal & Lewis LLP. Their opinions are solely their own and not necessarily those of this magazine.

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