Bankruptcy of the owner or developer of a real estate construction project can be very unsettling to contractors. But a declaration of bankruptcy by the developer, in and of itself, does not constitute a breach of contract such that the contractor can stop working. Contract provisions providing that the contract is terminated if a party becomes insolvent or files for bankruptcy are generally unenforceable.

Partially-performed construction contracts are executory contracts, meaning that the obligations of the parties to the contract have not yet been fully performed. The Bankruptcy Code allows a bankruptcy trustee (in a Chapter 7 dissolution case) or the debtor-in-possession (in a Chapter 11 reorganization case) either to assume or to reject an executory contract. A debtor-in-possession has until the time of the confirmation of its plan of reorganization to decide if it will assume or reject the contract. The contractor may ask the bankruptcy court to require the debtor-in-possession to make a decision on the contract sooner, but the court will most likely give the debtor-in-possession a fair amount of time to make the decision.

The key in determining whether to assume or reject an executory contract is whether the assumption of the contract would add value to the bankruptcy estate or reorganized business. If the contract will add value, it will likely be assumed, and if it represents only liability, it will likely be rejected. In the context of a Chapter 7 liquidation case, it is quite unlikely that the bankruptcy trustee will decide to assume a construction contract. In most cases, the debtor will already have breached the contract prior to declaring bankruptcy, and the contractor or contractors will have set off defenses or counterclaims against any amounts that may be owed to the bankruptcy estate.

Rejection of an executory contract under the Bankruptcy Code constitutes a breach of the contract for which the contractor can then assert a claim. Rejection of the contract frees the bankruptcy estate from the obligation to perform, but it does not make the contract disappear. The contract is not cancelled, repudiated, rescinded or in any other way terminated. Therefore, while rejection under the Bankruptcy Code affects the parties’ future performance under an executory contract, it does not affect the provisions of the agreement that have been fully executed. The bankruptcy estate will be liable for all damages caused by the breach, but such damages will be treated as pre-petition, general unsecured claims on the estate by the Bankruptcy Code.

Given the unlikelihood of the assumption of a construction contract following a bankruptcy declaration by the owner or developer of the project, the contractor’s best option to protect its interests is to secure its lien rights. A mechanic’s lien or materialman’s lien is a security interest in real property in favor of an unpaid laborer or supplier of construction services and/or materials on a non-public project. These liens, if properly perfected, elevate to secured status the contractor’s claims for payment when the owner has filed for bankruptcy. Every state in the nation grants those contributing to a private work rights to a mechanic’s lien against the real property on which the contractor furnished materials or labor for the value of the materials or labor furnished. Mechanic’s lien laws vary from state to state, but they are generally very technical in their application, and lien rights can easily be lost if the contractor does not precisely comply with the statutory requirements.

After the Claim of Lien is filed, it must be perfected and foreclosed upon according to the precise requirements of the relevant state law lien statutes. Most importantly, the lien claimant typically must first file an action against the entity from whom the debt is owed (i.e., the “Lien Action”) within a fixed amount of time from the date the Claim of Lien is filed of record. The Lien Action is a prerequisite for filing a direct action against the property owner — in other words, a claimant usually cannot collect against the real property until and unless he has a judgment against the entity owing the debt. The property owner is not a necessary party to the Lien Action, so the claimant generally must also file a Notice of the Lien Action within a fixed period of time after the Lien Action is filed.

In many states, the law provides that if the debtor files bankruptcy, the contractor does not have to commence an action against the debtor and instead may bring an action directly against the property owner. However, the contractor must continue to comply in all respects with the requirements of the lien statute, or its lien will become unenforceable. Courts have held that the automatic stay provided by the Bankruptcy Code does not forbid the filing of the notice of commencement because the purpose of the notice is providing potential purchasers of the property with constructive notice that would enable them to determine whether the claim of lien still existed. If the contractor fails to file the required notice of commencement, the claim of lien is lost.

The key point to take away is that the bankruptcy filing’s automatic stay does not always operate to obviate or postpone the requirements for perfection of materialman’s liens under state law. The contractor should seek qualified legal counsel as soon as possible after learning of a bankruptcy filing to help navigate the requirements of its particular jurisdiction. The contractor also will require counsel regarding any required filings in the bankruptcy court to ensure that its lien rights can be protected there as well. For example, if a lawsuit on a materialman’s lien has not been filed, the Bankruptcy Code allows the contractor to file a Notice of Continued Perfection to toll the statutory deadline to file suit to foreclose on the lien; this notice must be filed with the bankruptcy court within 90 days of the recording of the lien.