The Intersection of Bankruptcy Preferences and Mechanic’s Lien Waivers — A Wrong Turn Can Be Costly
This article was featured by the American Bar Association Forum on Construction Law in its October 2019 Under Construction newsletter.
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); The 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); In 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.