It happened…the company has not yet been paid for work that it completed on a project when someone hears the dreaded “B” word: “bankruptcy.” The first thing to do if someone owes the company money is to verify that bankruptcy petition has been filed with a United States Bankruptcy Court. The term is often used to loosely describe a company closing its doors, projects that are being foreclosed by lenders or a company having severe cash flow issues. If the company is unable to independently verify that a bankruptcy case has been commenced, a bankruptcy attorney can access the federal database of case filings and can quickly confirm whether or not a case has been filed. Assuming that a bankruptcy case has been filed, the contractor must act quickly to observe the automatic stay of bankruptcy by ceasing all collection efforts and litigation against the debtor. Simple enough, right?
Here is the scenario: A subcontractor on a project to erect a privately owned office building is owed $100,000 for work already performed. Before any payments are received, the general contractor files for protection under the United States Bankruptcy Code. The subcontractor quickly files a mechanic’s lien. Since the property is owned by the owner, not the bankrupt general contractor, the subcontractor thinks he will either be paid in full or, more likely, negotiate a settlement with the owner. But maybe not. In March of this year, the United States Court of Appeals for the Third Circuit determined that two subcontractors in this very position violated the general contractor’s automatic stay.
Specifically, in the case of In re Linear Electric Company, Inc., the Third Circuit examined this scenario with respect to a project located in New Jersey. Applying New Jersey mechanic’s lien law, the Circuit Court found that the liens attached to receivables due from the owner to the general contractor. Having determined that the liens attached to the receivable, which was property of the debtor under the United States Bankruptcy Code, the Court found that it was a violation of the bankruptcy stay for the subcontractors to file mechanic’s liens.
One of the key facts in Linear Electric is that, under New Jersey law, a mechanic’s lien only relates to the amount that the owner owes, but has not yet paid. As the lien only relates to amounts not yet paid, the Court viewed the lien as a lien attaching to the receivable owed to the bankrupt general contractor. Voilà: a violation of the automatic stay. This would not be the case in some jurisdictions, where a subcontractor’s mechanic’s lien is unaffected by an owner’s payment to the general contractor.
A lesser determining factor in Linear Electric was that, in New Jersey, mechanic’s liens attach and are determined on the day that they are filed. Conversely, in states such as Pennsylvania, a mechanic’s lien relates back to “the date of visible commencement upon the ground,” which almost always predates a bankruptcy filing in these scenarios, such that filing a post-petition mechanic’s lien may not be a violation of a bankruptcy stay, even where the owner filed the bankruptcy.
The subcontractors in Linear Electric probably thought they were doing the right and responsible thing, by protecting themselves with the filing of a mechanic’s lien against the owner’s property. Unfortunately, the language contained in the applicable state mechanic’s lien law converted an act designed to collect a debt from third party, into a violation of the automatic bankruptcy stay. As violations of a bankruptcy stay can result in both actual and punitive damages, often including payment of the debtor’s attorney fees as well as company attorney fees in defense, a stay violation can be a very costly mistake.
The takeaway form Linear Electric is that no matter what state a subcontractor does business in, a seemingly simple thing like the automatic bankruptcy stay can be complicated by applicable state law. Before taking any action to collect a debt after a bankruptcy is filed, consult with competent counsel.
