Copyright: Zerbor

In March of 2017, the Third Circuit examined whether the filing of a New Jersey statutory mechanic’s lien after the commencement of a bankruptcy case violated the automatic stay. The Third Circuit affirmed the District of New Jersey’s holding, and concluded that since the construction liens in question were effective as of their post-petition filing date, the automatic stay of Section 362(a)(4) applied and precluded the lien filing. Accordingly, the decision has significant impacts on commercial creditors—potentially removing one form of relief for a contractor’s failure to pay while in bankruptcy, and, state lien law dependent, may offer contractor-debtors certain strategic advantages within the Circuit.

While the Third Circuit’s ruling has, on its face, significant implications for contractors and suppliers, the court’s underlying reasoning quickly lends support to other broader, policy-driven bankruptcy arguments. In rendering its decision, the Third Circuit found that the bankruptcy court, even as a non-Article-III court, can constitutionally decide the issue presented in Linear as the scope of the automatic stay involved a matter of “public rights,” which bankruptcy courts could resolve even without the consent of parties. As an extension, the Third Circuit’s decision has been cited favorably in support of arguments for non-consensual third-party releases in bankruptcy actions.

In In re Linear Electric Company, Cooper Electrical Supply Co. and Samson Electrical Supply Co. (the suppliers), sold electrical products to contractor, Linear Electric Co. for use in several development projects. 852 F.3d 313, 317-18 (3d Cir. 2017). Thereafter, Linear filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code, at which time, the third-party development owners had not fully paid Linear, and Linear had not fully paid the suppliers.

Two weeks after Linear’s Chapter 11 filing, the suppliers, pursuant to N.J.S.A. §2A:44A-3(a), filed construction liens on property into which Linear had incorporated the suppliers’ materials. Linear thereafter moved to discharge the liens as violating the automatic stay, arguing that the liens attached to Linear’s accounts receivable by way of contractual interests in amounts owed by the owners and, accordingly, creation of the liens were acts against estate property. The suppliers contended the construction liens did not attach to Linear’s accounts receivable but instead to the property interests of the third-party owners, and therefore the suppliers’ creation of liens was not an act against property of the bankruptcy estate.

The bankruptcy court granted Linear’s motion, and held that the construction liens were void ab initio for violation of the automatic stay. The District Court affirmed and the suppliers appealed.

In affirming the District Court’s holding, the Third Circuit examined whether the suppliers violated the automatic stay by filing the construction liens, and found that the lien claim payment process under New Jersey law made clear that the suppliers’ liens were against Linear’s accounts receivable and, thus, the suppliers’ creation of the liens violated the automatic stay. Id. at 321-24. The Third Circuit reasoned that because under New Jersey’s lien law, a lien fund would first allocate money in equal parts to valid claims by the suppliers (assuming no lien was filed by Linear), the suppliers would be fully paid by amounts Linear would have received from the development owners. The Third Circuit further reasoned that that amount would be reduced accordingly and would have otherwise been property of the estate.

The Third Circuit flatly explained, “In effect, the lien claim payment process would transfer a portion of an asset of [Linear] to [the Suppliers] …. Thus, Cooper and Samson’s filing to perfect their liens violated the automatic stay.” Id at 321.

Importantly, the Third Circuit distinguished New Jersey lien law from Pennsylvania lien law, where the lien of a supplier or subcontractor relates back to the date when work on the project first began. Id. at 321-22. Specifically, the Third Circuit distinguished the case In re Yobe Electric, 728 F.2d 207 (3rd. Cir. 1984), where a construction lien was considered to have been filed before the bankruptcy petition under Pennsylvania lien law and therefore the automatic stay did not apply.

Implications for contractors and suppliers are quite clear. The Third Circuit’s affirmation of the Bankruptcy Court and District Court’s rulings signals specific considerations for contractors and suppliers largely related to timing, i.e., a quicker construction lien filing for a supplier may preclude automatic stay exclusion of a lien claim in New Jersey, whereas a faster bankruptcy filing may reduce estate claims for a contractor-debtor.

Not as clear, and perhaps more interesting, is the role the Bankruptcy Court’s decision and the Third Circuit’s affirmation recently played in the potential broadening of Bankruptcy Court powers. The Bankruptcy Court in In re Millennium Lab Holdings II, examined if Article III of the Constitution allows Congress to authorize a bankruptcy court to decide whether a Chapter 11 plan containing a non-consensual third-party release should be confirmed or, instead, requires that this determination be made by a district court. 575 B.R. 252 (Bankr. D. Del. 2017). The question examined is hotly debated. See, e.g., “A New Millennium of Article III Analysis: Which Court—a Bankruptcy Court or a District Court—Must Decide Whether to Confirm a Plan that Contains a Nonconsensual Third-Party Release?” (Part II) by Ben H. Logan.

In Millennium, the Bankruptcy Court held that the Stern analysis, which is concerned with constitutional authority of bankruptcy courts to decide state law claims, is inapplicable to the consideration of an objection to a proposed Chapter 11 plan, even a plan which, as a result of its inclusion of a non-consensual third-party release, would prevent a non-debtor third party from pursuing state law claims. The Bankruptcy Court also held that whether non-consensual third party releases incorporated in proposed Chapter 11 plans were legally permissible, and whether such plans could be confirmed, were matters which the bankruptcy court, even as non-Article-III court, had the power to determine.

In reaching its conclusion, the Bankruptcy Court leaned heavily on Linear quoting Linear’s finding that the claims at issue, as related to the automatic stay, arose under federal bankruptcy laws—rights created by Congress—and as such were public rights, which are entrusted to non-Article III courts. Id. at 278. Extrapolating Linear’s holding, the Millennium court stated that the “Third Circuit has effectively endorsed the view that confirmation of a plan is a public right.” Id. The Millennium court, after factually analogizing Linear, went on to find that “[t]here is no question, then, that, if the proper standard is met, a bankruptcy judge may enter a final order in a core matter that impacts or even precludes a state law action between two non-debtors.” Id. at 278-79.

As indicated by Millennium’s holding, the consequences of the Third Circuit’s decision in Linear as related to the constitutional arguments presented therein may prove far reaching. The Delaware Bankruptcy Court took a large step in expanding the Third Circuit’s constitutional findings in Linear to encompass confirmation of a plan containing non-consensual third-party releases. The unfolding of Linear’s progeny will undoubtedly result in a continued bankruptcy powers tug-of-war for years to come.

 

Buterick is an associate with Hill Wallack in Princeton. He is a member of the firm’s Creditors’ Rights/Bankruptcy, Corporate Law and Venture Capital, and Emerging Markets practice groups. Holdren is counsel with the firm and a member of its Creditors’ Rights/Bankruptcy practice group.