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Can a paid supplier be worse off under the Bankruptcy Code than if unpaid?


In United Rentals, Inc. v. Angell,{footnote}United Rentals, Inc. v. Angell, 592 F.3d 525 (4th Cir. N.C. 2010).{/footnote} the U.S. Fourth Circuit Court of Appeals has held that a bankruptcy preference occurred when a creditor with both mechanic's lien and bond rights received a payment ("Transfer") during the preference period. The creditor had shown that it had mechanic's lien rights at the time of the Transfer and that the bankruptcy estate had received value for the Transfer, by showing that the owners and general contractors on the projects were holding funds in amounts greater than the Transfer at the time. The general contractors also paid the debtor more than the amount of the Transfer after the Transfer.

This raises the question what it means for a mechanic's lien to be "inchoate." There is no question the mechanic's lien "relates back" to the time labor or material is supplied. A mechanic's lien can generally be filed post bankruptcy petition and the lien cannot be avoided by the trustee for this reason. Does a mechanic's lien exist from the time labor or material is supplied, as is believed by most in the construction industry, even though that lien is later "lost" if not perfected in accordance with the statute? United Rentals, Inc. v. Angell seems to say that there is no lien until it is perfected. There is nothing to exchange for a payment, except unsecured contract rights, unless the mechanic's lien has been perfected.

The relative burden of proof in such mechanic's lien and bond preferential Transfer cases has always been in question. Creditors often wish to argue and some courts have ruled that there is no preference under 11 U.S.C. § 547(b) if a creditor has not received more than it would have in a Chapter Seven liquidation or if the bankruptcy estate was not diminished by a Transfer that discharged mechanic's lien or bond rights of equal value ("above the line trustee burden issue"). Other courts have ruled instead that the trustee had met the burden of showing a preference if the creditor did not have a direct security interest in assets of the bankruptcy estate. The creditor's only option would be to prove that a contemporaneous exchange of new value had occurred under 11 U.S.C. § 547(c) ("below the line defense"). Whether the trustee or the defendant creditor has the burden of proof is often critical in a mechanic's lien and bond right preference case, given the difficulty of developing third party evidence of the funds held by owners and general contractors at the time of a payment two years earlier. The rules applied to determine whether a payment is preferential also differ depending on whether § 547(b) or § 547(c) applies.

The United State Court of Appeals for the Fourth Circuit has now ruled that United Rentals' bond rights did not present an above the line trustee burden issue under 11 U.S.C. § 547(b). "The bankruptcy court had properly rejected this argument." The § 547(b)(5) inquiry focuses "not on whether a creditor may have recovered all of the monies owed by the debtor from any source whatsoever, but instead upon whether the creditor would have received less than a 100% payout" from the bankruptcy estate. The court did not elaborate, but this seems to indicate that an "indirect transfer" is not a consideration, at least in a bond case, in evaluating whether the trustee has met the burden of proof under 11 U.S.C. § 547(b). An indirect transfer theory recognizes that the preference defendant does not have a security interest in assets of the bankruptcy estate. However, if the Transfer released a claim against a payment bond surety and that surety had a security interest in assets of the bankruptcy estate, then no preference has occurred. United Rentals, Inc. v. Angell may mean that the burden shifts to the creditor to prove a defense, unless the creditor defendant had a direct security interest in assets of the bankruptcy estate.

The Fourth Circuit then turned to the bond claim contemporaneous exchange defense. The court expressly did not decide whether an indirect transfer theory is viable in a contemporaneous exchange defense, but ruled instead that since "United never even attempted to make any claim on the bond here, the Surety never obtained any lien that it could release." One troubling aspect of this decision is that the Fourth Circuit may now require that a defendant actually make a mechanic's lien or bond claim before there is any defense to a preference. Even more troubling, it is not clear whether a mechanic's lien or bond claim notice is sufficient or it is necessary to actually file suit or even actually prevail in a trial on the bond claim before a creditor can be confident it is shielded from a preference claim. Of course it is impossible for a creditor to do any of those things once they have been paid.

Finally, the court considered United Rental's contemporaneous exchange of mechanic's lien rights defense, but said "the argument fails for the same reasons we have discussed regarding its bond argument." It is not clear which of the "same reasons" defeated United Rentals' mechanic's lien defense, but it may require a preference defendant to actually file a mechanic's lien to have a defense to a future preference action. Many courts have ruled otherwise.

The Fourth Circuit expressly left open the issue whether mechanic's lien rights could still prevent the trustee from meeting the burden under 11 U.S.C. § 547(b). Is an indirect transfer a consideration in this analysis or will any payment be preferential if the creditor did not have mechanic's lien rights directly in property owned by the bankrupt debtor? Is it necessary to actually file the mechanic's lien on property owned by the bankrupt debtor or must the creditor only show that it would have filed that lien absent the payment?

Ironically, an unpaid supplier or subcontractor may be actually better off than a paid supplier or subcontractor in the event of bankruptcy. A sub or supplier that received payment in the 90 days prior to bankruptcy will need to return the payment as a preference, unless they can prove ordinary course of business or some other defense. The paid creditor obviously did not perfect their lien rights, since they were paid. An unpaid creditor, however, could file and enforce their lien even after the bankruptcy petition and may be paid in full.

Need to Actually Perfect or Enforce

For years most courts stated and most attorneys believed that if you had the ability to force a payment through mechanic's liens or payment bonds at the time you received a transfer payment and you could have forced the payment even after the bankruptcy, then you therefore cannot be forced to return this payment as a preference. Most courts have held that the creditor must only show that there was still time to file the mechanic's lien or on the bond when the payment was received {footnote}In re White, 64 B.R. 843 (E.D. Tenn. 1986); In re JA Jones, 361 B.R. 94 (Bankr. W.D. NC 2007); In re Mason and Dixon Lines, 65 B.R. 973, 978 (M.D. NC 1986). Prior to United Rentals, Inc. v. Angell, 592 F.3d 525 (4th Cir. N.C. 2010), Precision Walls v. Crampton, 196 B.R. 299 (E.D.N.C. 1996) had been cited by other courts as the only case holding that a transfer is avoidable unless the recipient had actually perfected mechanic's lien rights. In re Lockwood Greene Eng., Inc. v. Binsky & Snyder, Inc. (In re J.A. Jones, Inc.), 361 B.R. 94, 102-03 (Bankr. W.D.N.C. 2007). The primary variant of most cases is whether the transfer recipient still had time to enforce mechanic's lien or bond rights at the time of the transfer and/or whether sufficient sums were still owed to the debtor on the project at the time the preference payment was made "to permit a set-off," so that the estate was not diminished. In Precision Walls, the Court stated that the subcontractor had not proven the value of its lien or that the owner owed sufficient funds on the project to satisfy the lien. SeePrecision Walls, 196 B.R. at 301-02. This may be the basis of the Precision Walls decision. It is also not clear whether the preference defendant's lien had expired at the time of the transfers. A similar holding In re Joseph M. Eaton Bldrs, Inc has also been cited for the proposition that a transfer is avoidable unless the recipient had actually perfected mechanic's lien. See In re J.A. Jones, Inc., 361 B.R. at 100. In Eaton Bldrs, however, the Court found that the defendants' lien had expired well before defendants received the preferential payments. See In re Joseph M. Eaton Bldrs, Inc., 84 B.R. 56, 59 (W.D. Pa. 1988). The Court held that where that the defendants did not perfect its lien and the lien had expired at the time of the transfers, the defendants had no new value defense. Accordingly, there may be no other case law like United Rentals, Inc. v. Angell, stating that a lien or bond creditor must actually perfect or enforce lien or bond before there is a contemporaneous exchange defense, where there was time to enforce liens or bonds at the time of the transfer and the estate was augmented in an amount equal to the transfer by the discharge of liens or bonds.{/footnote} and prove the value of the mechanic's liens or bonds in order to show the estate was not diminished.{footnote}In United Rentals, Inc. v. Angell, the creditor had shown that the time to enforce its mechanic's liens and bonds had not expired at the time of the transfer and that the bankruptcy estate had received value for the transfer, by showing that the owners and general contractors on the projects were holding funds in amounts greater than the transfer at the time. The general contractors also paid the debtor more than the amount of the transfer after the transfer.{/footnote} Whether or not the preference creditor-defendant has actually enforced a mechanic's lien{footnote}In Ricotta v. Burns, the defendant could have filed a mechanic's lien at the time each transfer payment was made. The court said: neither the filing nor the enforcement of such a lien would have constituted a preference. Moreover, had the liens been filed, payment merely discharging them, without improving the creditor's position as against the general creditors of the bankrupt, would likewise have been immune from attack. It would be absurd to treat differently payments for the same debts obtained without filing liens, and the law does not do so. Consistent with common sense the courts have upheld payments where at the time the payments were made the creditor could have equally protected himself by filing a nonpreferential lien. The sole purpose of filing these liens is to secure payment. Surely receipt of payment itself should not be less secure than the lien which could have secured it. Moreover, the essence of a preference is that it depletes the bankrupt's estate available to remaining creditors. Where the payment merely avoids the bite of a lien which the trustee could not have successfully attacked, no such depletion occurs. Ricotta v. Burns, 264 F.2d 749, 750 (2d Cir. 1959 (emphasis added) (internal citations omitted). In a later case, the Second Circuit cited Ricotta and stated "where a material man could have filed liens for building materials furnished the bankrupt and the filing or enforcement of the lien would not have constituted a preference, the court would treat payments for the debts as if liens had been filed." Miller v. Wells Fargo Bank International Corp., 540 F.2d at 565 (emphasis added).The Ninth Circuit has held that a transfer made "in discharge of a California inchoate mechanic's lien may not be avoided by the Trustee as a preference..." The court determined that the preference defendant held an inchoate lien at the time of the transfer, the "filing of which was not required by statute until some time [after the transfer]. Since the time for perfecting defendant's lien had not expired, the defendant accepted the payment "in satisfaction" of inchoate mechanic's lien right and payments were therefore not avoidable as a preference. Greenblatt v. Utley, 240 F.2d 243, 244-247 (9th Cir. 1956){/footnote} or bond,{footnote}The fact that a creditor did not actually send or enforce a bond claim does not impact the creditor's status at the time of the transfers or the fact that the estate was not diminished. When a debtor contractor breaches its contract, it precludes debtor's entitlement to retained funds, and thus these funds are not property of the estate. In re Jones Constr. & Renovation, Inc., 337 B.R. at 585, (citing First Indem. of Am. Ins. Co. v. Modular Structures (In re Modular Structures), 27 F.3d 72 (3d Cir. N.J. 1994)); (In re Pacific Marine Dredging and Constr.), 79 B.R. 924, 929 (Bankr. D. Ore. 1987). The court is less concerned with whether payment has yet been made by a surety than with the obligation to pay claimants. The surety's obligation, brought about by the debtor's breach of contract, makes the doctrine of equitable subrogation applicable. In other words, if the debtor had not paid the creditor the transfers, the property of the estate and value of assets available to general unsecured creditors would automatically be reduced by the same dollar amount. Id. "A hypothetical liquidation (assuming the payment was not made) would not have provided any greater estate for distribution to unsecured creditors." Field v. Insituform East, Inc. (In re Abatement Environmental. Resources, Inc.), 307 B.R. 491, 499 (Bankr. D. Md. 2004)."[T]he fact that the surety did not actually make the payments to the subcontractors [does not] require the application of a different equitable rule." In re E.R. Fegert, Inc., 88 B.R.at 260 (BAP 9th Cir. 1988), aff'd 887 F.2d 955 (9th Cir. 1989). Since the transfers "avoided the imposition of an equitable lien by the surety on future payments under the contract, there was no diminution of the estate." Id. The surety's equitable lien "prevails over the trustee even though the surety has not perfected its rights under the Uniform Commercial Code ("U.C.C.")..." In re E.R. Fegert, Inc., 88 B.R.at 260 (BAP 9th Cir. 1988), aff'd 887 F.2d 955 (9th Cir. 1989);see also National Shawmut Bk. of Boston v. New Amsterdam Cas. Co., 411 F.2d 843, 849 (1st Cir. 1969); First Ala. Bk. v. Hartford Acc. & Indem. Co., 430 F. Supp. 907, 910 (N.D. Ala. 1977). The transfers "are in the nature of a trust to reimburse the surety who is forced to pay on its bond." (In re Pacific Marine Dredging and Constr.), 79 B.R. 924, 928 (Bankr. D. Ore. 1987). The surety's equitable lien is "superior to all other liens." The "surety has no filing obligations. The lien is one created by equity, not by statute." The estate was not diminished by the transfers, because the discharge of the surety's equitable lien provided the debtor money from the general contractors equal to the amount of the transfer.{/footnote} however, should not impact the above the line trustee burden analysis or the new value defense.{footnote}A debtor that really wanted to avoid paying a certain lien or bond creditor could accomplish that end by actually paying the creditor right before bankruptcy. "The Debtor/Contractor could, in effect, avoid payment of any or all subcontractors by paying them within 90 days of bankruptcy and then simply waiting until 60 days after substantial completion of the work before filing the action to recover the preference. By doing so, the subcontractor could effectively be denied its lien rights." In re Dick Henley, Inc., 38 B.R. at 215.{/footnote}

There is no need for the creditor to prove what it would have done absent payment. There is no doubt that a mechanic's lien or bond claimant must perfect, enforce and successfully prosecute it's case to judgment before the ability to force payment from either mechanic's liens or payment bonds is finally established. However, the intervening payment made it impossible to perfect, enforce or sucessfully prosecute an action to judgment.

It should be noted that in the case of a mortgage lender or any other secured creditor, any trustee could make the same argument that the secured creditor must prove that it would have properly enforced its security to obtain payment. However, there is no known case of any trustee trying to make this argument. The payment automatically discharges the security. "[E]very payment made by the debtor increases the debtor's equity in the collateral, thereby proportionally enhancing the value of the bankruptcy estate."{footnote}Small v. Williams, 313 F.2d 39, 44 (4th Cir. 1963).{/footnote}

We can never know whether claims would have been properly perfected or enforced, because that payment intervened. Payment must alleviate the need to perfect or enforce or to prove that either would have been done properly. Asking a defendant to prove what would have happened without payment is an impossible burden. In any event this burden would be with the trustee, as either mechanic's lien or bonds would establish the defendant as a secured creditor.

The correct question must be whether the defendant could have forced payment through mechanic's liens or bonds at the time of payment, which would have resulted in the same payments despite the bankruptcy, all without diminishing the bankruptcy estate for the benefit of general unsecured creditors.

If a preference defendant has to show that it did or that it would have perfected or enforced, the public policy ramifications are enormous.

First, any construction supplier or subcontractor would need to refuse payment and instead file mechanic's lien or on bonds as an ordinary practice (as soon as the debtor was one day beyond its ordinary terms) to avoid bankruptcy preference claims, even if there is no reason to suspect an imminent bankruptcy.

The only safe path would be to actually file mechanic's lien or on bonds in all cases, to be released on receipt of payment. This would disrupt projects and business relations, generate legal fees and consume court resources toward no end. In some cases, it may be possible to reach agreement with an owner, general contractor and debtor that liens will be filed and immediately released. This has obvious problems, but is the only risk free alternative. There will be cases with enough money involved that creditors must proactively take this action. This may be profitable for mechanic's lien and payment bond lawyers, whose services will be necessary at every monthly construction progress draw.

It will help if the debtor acknowledges a bond claim and/or mechanic's lien at the time of payment and agrees that mechanic's liens or bonds are released in exchange for this payment. This could be done in the form a of a progress payment waiver, similar to waivers used now, but both the creditor receiving payment and the debtor must sign.{footnote}However if the debtor is not the bond principal, then it may also be necessary to get the bond principal to also "acknowledge" the bond claim.{/footnote} This is obviously a better alternative to actually perfecting mechanic's liens and/or against payment bonds before accepting payment. You can see an example of such a lien and bond waiver in the Appendices as a Subcontractor and Supplier Lien and Bond Waiver.

All construction suppliers or subcontractors will also want to enforce mechanic's liens and bonds immediately on any bankruptcy for money it has been paid in the ninety days prior to the petition. This would certainly disrupt projects and business relations, and make any orderly bankruptcy reorganization impossible. It is, of course, very questionable whether a supplier or subcontractor can file a mechanic's lien or on the bond for money it has been paid. At a minimum the creditor would have to swear a false affidavit that it was owed the sum paid.{footnote}In re Golfview Developmental Center, Inc., 309 B.R. at 768.{/footnote} An unpaid supplier would be better off than a paid supplier on bankruptcy.If creditors have received large payments on mechanic's lien or bond projects from a debtor that files bankruptcy, they should request that the bankruptcy court shorten the time for the debtor to bring a preference action. This allows the creditor to bring the bonding company, the property owner and general contractors into the preference lawsuit, before the deadlines to enforce liens and bonds expire and while they still have records or witnesses readily available.

James D. Fullerton is an attorney and president of the law firm of Fullerton & Knowles, P.C., with attorneys licensed in Virginia, Maryland, Pennsylvania and the District of Columbia. Visit the firm website at www.FullertonLaw.com where you can use the Free 720 page online internet Construction Law Survival Manual with valuable information about construction contract litigation, mechanic's liens, payment bond claims, bankruptcy, the Uniform Commercial Code, and credit management. The website also offers over 30 commonly used contract forms, including Change Orders, Waivers, Joint Check Agreements, Quotes, Proposals, Credit Applications and Guarantees.
© 2011 James D. Fullerton, Esq. • Clifton, VA • 703-818-2600 • www.FullertonLaw.com


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