While the reality and speed of economic improvement in the construction industry is debatable, few would argue with the fact that the specter of bankruptcy is more apparent now than ever. As any contractor or construction attorney would agree, bankruptcy raises several unique issues in the construction context and, at times, can seem perilous. While one article cannot cover every bankruptcy issue relevant to the construction industry, there are a few fundamental items to understand. Below, we will discuss what happens to an ongoing contractual relationship, when it is appropriate to seek relief from the automatic stay, proofs of claim and set-off issues. The interplay between bankruptcy and state construction lien law must be understood. The focus of this article is often on general contractors, but in many respects the issues raised are also faced by owners and subcontractors.

Business bankruptcies are either liquidations under Chapter 7 of the Bankruptcy Code or reorganizations under Chapter 11 of the code. In a Chapter 7, a third-party trustee is appointed to manage the affairs of the debtor and the debtor’s affairs wind down. In contrast, in a Chapter 11, the debtor acts as a “debtor in possession” and continues its operations pending confirmation of a reorganization plan.

The purpose of a Chapter 11 reorganization is two-fold: (1) to provide the debtor the opportunity to organize its affairs and gain a “fresh start” and (2) to provide creditors with some level of fairness. The code provides bankruptcy courts with broad powers to resolve matters involving the debtor, including the ability to hear cases, resolve disputes, approve plans of reorganization over objections, approve settlements and, in appropriate circumstances, to convert reorganizations to liquidations.

The Automatic Stay and Its Impact on Contractors

The automatic stay is a significant advantage provided to a debtor in bankruptcy. The automatic stay stops parties, including creditors and contracting parties, from taking actions that would harm the debtor or debtor’s estate until the bankruptcy court has an opportunity to reach its conclusions. The automatic stay has two immediate impacts on the rights and obligations of contracting parties.

First, the automatic stay directly impacts a contractor’s right to terminate a breaching debtor-subcontractor. General contractors want to know what to do when a subcontractor or supplier files for bankruptcy before substantial completion. An uncompleted subcontract is an executory contract under the code. The short answer is: Do not default or terminate. In bankruptcy, relief by way of a court order from the automatic stay is required to terminate a debtor-subcontractor — even if the debtor-subcontractor is in breach.

Contractors may point to the contract’s “default upon bankruptcy” provision to justify termination. Such provisions related to executory contracts in bankruptcy, however, are unenforceable. The code goes further, however, and allows a trustee/debtor to either assume or reject executory contracts. In a Chapter 7, the trustee has 60 days to assume or reject. In a Chapter 11, the debtor may generally assume or reject anytime prior to the confirmation of a reorganization plan. Thus, while it is true that the drafters of some standard-form contracts have sought to include the filing of a bankruptcy petition as a default subject to termination, it is not that simple.

The above provides little solace for contracting parties dealing with a debtor. A bankruptcy filing raises significant contract- and project-related issues, including whether the debtor was or is able to purchase supplies, keep pace and pay its vendors. Most general contracts provide that time is of the essence and delay by a debtor-subcontractor may trigger an owner delay claim and subject the general contractor to an assessment of liquidated damages. As a result, subcontractor performance can have serious economic ramifications for a contractor.

To mitigate the potential impact of a bankruptcy, a contractor can employ two non-mutually-exclusive tactics to counterbalance the inability to terminate without relief from the automatic stay. Initially, a contractor must vigilantly assess and monitor performance. If there is a breach or potential for breach, the contractor may seek relief from stay to terminate or move to compel the debtor to assume or reject the contract. If the debtor assumes the contract, the parties can modify terms to protect each other. If the debtor rejects the contract, the rejection will be treated as a pre-petition breach of contract and may be the basis for a claim against the estate.Termination can then follow. A contractor may seek relief from the stay on an emergency basis.

Second, a contractor may be entitled to defend against debtor-subcontractor claims through set-off, but must resist the urge to set off against funds owed to the debtor unilaterally. Relief from stay is required to effect a set-off. Whether to allow set-off is up to the court’s sound discretion, relies in large part upon state law and is not guaranteed. With certain exceptions, §553 of the code preserves a creditor’s state law right of set-off to mutual debts and credits so long as they arose before the debtor filed its bankruptcy petition.

A contractor will have to show “mutuality” between it and the debtor related to the funds. Whether there is mutuality depends on several factors, including contract principles, the nature of the debtors, applicable state law and what source of funds are being set off (and for what purpose). One example of a state law nuance relevant to construction is whether the state laws provide for a trust fund. As detailed in the next section, trust funds may not be property of the estate or even funds owed to the debtor.

The automatic stay will also affect the enforcement of claims by or against a debtor. Litigation between a general contractor and a debtor-subcontractor involving nonconforming work, payment issues or other disputes in state court will be stayed by the automatic stay during the pendency of the bankruptcy or until relief from stay is granted. The automatic stay does not, however, stop third parties from asserting claims against others that may involve work performed with a debtor, e.g., construction lien claims against project owners or claims against the debtor’s surety. Similarly, as it relates to construction liens against a debtor-owner, a contractor may perfect a construction lien without leave from the stay, but a contractor may not seek to enforce the lien without leave.

Proofs of Claim, Back Charges and Set-off

A proof of claim is the means by which a creditor registers a claim for damages or money owed by the debtor as of the date of the bankruptcy filing. The code generally provides that a claim is a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured.”

Filing a timely proof of claim is essential. Typically on motion, the bankruptcy court will set a “bar date,” which translates into the last possible date for a creditor to file a claim. While there are certain claims deemed filed, by virtue of the debtor including them in its schedules, a contractor cannot rely upon inclusion in the debtor’s schedules.

First, construction claims are typically disputed, including those for nonconforming work, delays, inefficiencies or costs related to pre-petition termination. Second, even if there is agreement that there is a claim, there is likely disagreement related to amount and scope. Last, in the case of a general-subcontractor relationship, it is not unusual that the debtor-subcontractor will look to the general contractor to fund the bankruptcy estate. To protect its claims, filing a timely proof of claim by the general contractor is necessary.

A contractor’s proof of claim must be inclusive and include claims of set-off and back charge against retention, alleged monies owed or claims made by the debtor.

Impact of State Trust Fund and Construction Lien Laws

Trust-fund laws have a considerable effect upon a bankruptcy. Trust-fund statutes are aimed at providing additional protections to down-stream contractors, subcontractors and suppliers who supply labor and materials on a progress payment basis, while protecting project owners once the contract amounts have been exhausted. Generally, the operation of a trust-fund law provides that once an owner pays a general contractor, or a general contractor pays a subcontractor, etc., those funds are deemed to be held in statutory trust for the next level of contractors and vendors (i.e., beneficiaries).

Regionally, New York, New Jersey and Maryland each count themselves as trust-fund states, while Pennsylvania and Delaware do not. Even among trust-fund states, there can be considerable differences in application and impact. In an era where large general contractors and subcontractors are working across state lines, construction-bankruptcy practitioners must have a handle upon the applicable lien law project-by-project and state-by-state.

There are three important trust fund/lien law points. First, a trust-fund statute can decide whether money due to a debtor is property of the estate or not. Generally, property of the estate is distributed in accordance with the code’s preferences, with secured claims being paid before unsecured claims. Oftentimes, subtier vendors and suppliers hold unsecured claims. Once paid to a debtor, payments that would be defined as trust funds would not be property of the estate, but rather would be limited for the benefit of its vendors, etc. (See Universal Bonding Ins. Co. v. Gittens and Sprinkle Enterprises , 960 F.2d 366 (3d Cir. 1992), which held that once monies were paid to a debtor-contractor, those monies were to be placed in a statutory trust pursuant to New Jersey’s Trust Fund Act and could not be allocated to general creditors or used by a contractor in an effort to reorganize.)

Second, the applicable trust-fund law itself may determine whether a claim, in whole or in part, involves trust funds. For instance, certain added labor costs may be included in the trust-fund corpus, but equipment costs may not. Such a distinction may impact that creditor’s ability to be made whole.

Last, mechanic’s/construction lien laws will also come into play in the bankruptcy context. A debtor-subcontractor or supplier may still have the ability to perfect and file a lien claim against property or funds, as the case may be, for the value of what they may claim is due. A post-petition lien filing can place the same restraints and burdens upon the general contractor and owner as had the lien been filed before bankruptcy. Added efforts, i.e., relief from the automatic stay, will be necessary to remove the lien and such a removal must now occur in the context of the bankruptcy proceedings.

The simple fact is that bankruptcy can be fraught with risk. Upon learning of a subcontractor’s petition for bankruptcy, the contractor must perform an assessment of contract performance, vigilantly monitor future performance, consider its back charges and set-offs and prepare to file a proof of claim. A contractor must avoid acting unilaterally to terminate or affect a set-off, as such actions are likely violations of the automatic stay. It must be aware of the potential for claims under applicable trust-fund or lien statutes, which can affect its use of funds, its entitlement to funds and other issues. Opportunities exist to work around many of the bankruptcy impediments, but if employed, they must be properly used to avoid violating the Bankruptcy Rules, thereby compounding the adverse impact of bankruptcy. •

James H. Landgraf is of counsel at Dilworth Paxson. He has more than 30 years of experience handling construction contracting, construction litigation and complex commercial and business litigation. His clients include public and private owners, commercial and residential real estate developers, prime contractors, subcontractors, suppliers and design professionals.

Gaetano P. Piccirilli is an associate at Dilworth Paxson and represents general contractors, construction managers, trade contractors, real estate professionals and developers in commercial litigation, claims litigation, pension (multi-employer plan) litigation, real estate disputes and zoning/code matters.