The Intersection of Bankruptcy Preferences and Mechanic’s Lien Waivers — A Wrong Turn Can Be Costly
An article co-authored by Greg Gillis and Michael
Galen was featured by the American Bar Association Forum on Construction Law in
its October 2019 Under Construction newsletter. The article appears
The impact of a
bankruptcy commenced by an owner, general contractor, or subcontractor can
result not only in project delays, but can also be costly to the non-bankrupt
parties involved in the construction project.
A recent case from the U.S. Bankruptcy Court for the
Northern District of Texas discusses the potential bankruptcy implications of
what is a common occurrence in the construction industry — a contractor signing
a lien waiver in exchange for payment from an entity that files for bankruptcy
within 90 days of the payment date.
In In re BFN Operations LLC, No. 16-32435-BJH,
2019 WL 2387168 (Bankr. N.D. Tex. June 4, 2019), the project lessee, BFN
Operations, LLC (“BFN”) contracted with PLT Construction Company Inc. (“PLT”) to
construct a nursery pad storage addition and loading dock on land leased by BFN
in North Carolina for a lump sum contract of $470,569. PLT submitted seven
invoices totaling $478,760.05. On March 25, 2016, while PLT was owed
$290,532.21, PLT signed a “Final Payment Lien Waiver” and was paid in full 60
days later on May 25, 2016.
On June 17, 2016, BFN filed a Chapter 11 bankruptcy
petition commencing its bankruptcy case (the “Bankruptcy Case”). The case was
later converted to a Chapter 7 bankruptcy case. Two years later, the Chapter 7
Trustee in the Bankruptcy Case filed an adversary complaint against PLT to
recover the $290,532.21 paid to PLT claiming, among other things, that the
payment was a preferential transfer because it was paid within the 90 days prior
to the filing of the Bankruptcy Case.
The elements of an avoidable preference under Bankruptcy
Code § 547(b) are that the payment: (1) was for the benefit of a creditor; (2)
was on account of an antecedent (prior) debt; (3) was made while the debtor was
insolvent; (4) was made within 90 days before the bankruptcy case was filed; and
(5) enabled the creditor to receive a larger share of the bankruptcy estate than
if the transfer had not been made.
Only the last element was disputed. PLT argued that the
pre-bankruptcy payments did not allow it to receive more than it would have
received through a bankruptcy liquidation because under North Carolina law, PLT
had an inchoate statutory lien right against BFN’s leasehold interest that it
would have perfected had it not waived its lien rights in exchange for payment.
Black’s Law Dictionary defines the term
“inchoate” as “[p]artially completed or imperfectly formed” or “just begun.” It
defines an “inchoate interest” as “a property interest that has not yet vested.”
“Inchoate liens” are considered statutory liens that could have been timely
perfected under applicable state law had the creditor not been paid. This is an
area in which each state’s specific lien law intersects with bankruptcy law.
North Carolina, like Arizona and many other states, grants an unpaid contractor
who has met certain statutory lien prerequisites a period of time to record its
mechanic’s lien against the real property that benefitted from the contractor’s
labor performed or materials supplied.
Frequently when a property owner pays a contractor, the
owner requires that the contractor execute a “lien waiver” waiving the
contractor’s rights to a lien against the project for the amount of the payment
received. In consideration of the payment, the contractor waives its right to
lien for the work performed for which payment was received. Depending on the
language of the lien waiver, the waiver is effective upon receipt of the payment
in good funds.
This process is effective, unless and until the entity
making the payment files for bankruptcy and demands return of the payment(s) as
an avoidable preference. The Trustee in the BNF Bankruptcy Case argued that
although PLT did have an inchoate lien right under North Carolina law for the
work it performed, PLT released that right when it signed the Final Payment Lien
Waiver. PLT received the payments after signing the waiver, which was within the
90-day preference period. According to the Trustee, because the lien was waived
before the payment was made, PLT no longer had an inchoate lien right at the
time of payment and should therefore be left with an unsecured claim in the
Bankruptcy Case after avoidance of the payment.
PLT countered that its lien waiver did not become
effective until after it was paid in full. If PLT had not been paid by
BNF, it could have perfected its inchoate lien. Had perfection occurred, PLT
would have been a secured creditor in BNF’s Bankruptcy Case, meaning it would
have been entitled to payment in full when the debtor liquidated.1
The Court agreed with PLT, and found that PLT’s waiver
of its inchoate lien right was expressly conditioned upon its receipt of the
payment. Once the payment was received, PLT’s waiver became effective as of the
date the waiver was signed.
The Court further held that the existence of an inchoate
lien right prevented the Trustee from establishing the fifth preference
element — that the payment caused PLT to get a larger share of the estate than it
would have received in a liquidation. It reasoned that if courts do not protect
holders of statutory lien rights from avoidance, they would face a “Hobson’s
Choice” between either accepting payment (and risking that it could be avoided
if the payor files for bankruptcy), or declining payment in order to perfect
their inchoate statutory liens (which is not commercially reasonable).
Courts in a majority of the Circuits agree with this
analysis and hold that if the creditor could have perfected a lien under state
law at the time the payment was made, then the payments are not avoidable. See
Ricotta v. Burns Coal & Bldg. Supply Co., 264 F.2d 749 (2d Cir. 1959);
Official Comm. of Unsecured Creditors of 360Networks (USA), Inc. v. AAF–McQuay,
Inc. (In re 360Networks (USA), Inc.), 327 B.R. 187 (Bankr. S.D.N.Y. 2005);
Johnson Mem’l Hosp. Inc. v. New England Radiator Works (In re Johnson Mem’l
Hospital, Inc.), 470 B.R. 119 (Bankr. D. Conn. 2012); Matter of Alkap, Inc., 54 B.R. 151 (Bankr. D.N.J. 1984);
Liquidating Trust v. Mo-Tech Corp. (In re E.D.C.
Liquidating, Inc.), 2017 WL 499883 (Bankr. N.D. Ohio Feb. 7, 2017); In re Golfview Developmental Ctr., Inc., 309 B.R. 758, 769 (Bankr. N.D. Ill. 2004);
re Carney, 396 B.R. 22 (Bankr. N.D. Iowa 2008); Greenblatt v. Utley, 240 F.2d
243 (9th Cir.1956); Hopkins v. Merlins Insulation, LLC (In re Larsen), 2008 WL
4498890 (Bankr. D. Idaho 2008) (unpublished); Bryant v. JCOR Mech., Inc. (In re
Electron Corp.), 336 B.R. 809 (10th Cir. BAP 2006); But see, Precision Walls,
Inc. v. Crampton, 196 B.R. 299 (E.D.C.C. 1996); In re Joseph M. Eaton Builders,
Inc., 84 B.R. 56 (Bankr. W.D. Pa. 1988).
In sum, counsel should consider whether their client had
inchoate lien rights under state law when faced with defending a payment alleged
to be preferential. It is also important to be aware of the prevailing law in
the jurisdiction in which the dispute arises and whether that jurisdiction
follows the majority rule described above. As is illustrated by the BNF
Bankruptcy Case, inchoate lien rights may provide strong arguments to a
defendant when litigating a preference action in Bankruptcy Court.
1The facts are unclear in the decision, but we must
assume the equity of the leasehold interest exceeded $290,532.21 in order for
PLT to be fully secured in the Bankruptcy Case.