The Impact of Bankruptcy on Construction Projects: What You Need to Know

The filing of a bankruptcy case can have a significant impact on any type of construction project, whether the bankrupt debtor is the owner of the project, the general contractor, a subcontractor, or even a supplier for the project. Bankruptcy creates a centralized forum for the resolution of all manner of disputes between the debtor and the debtor’s creditors, and creditors are bound by the final decisions of the bankruptcy court concerning how their claims will be treated, even if the creditor opts not to participate in the bankruptcy case. It is important to understand the myriad ways in which a bankruptcy filing concerning an ongoing construction project can impact your rights and obligations.

Types of Bankruptcy Cases and Their Implications

Bankruptcy generally serves two important, albeit sometimes competing, policy objectives: The ratable treatment of similarly-situated creditors of the debtor and providing the honest but unfortunate debtor with a fresh start. The former objective concerns which creditors of a debtor will be paid, how much, and when, while the latter involves the debtor’s discharge. How a debtor’s debts are paid (if at all) and whether and under what circumstances the debtor is entitled to a discharge of debt depend on the type of bankruptcy case the debtor files.

Chapter 7 Bankruptcy

A Chapter 7 bankruptcy case is a straight liquidation. Natural persons and business entities are eligible to file for Chapter 7 bankruptcy. In a Chapter 7 case, a trustee is appointed by the Court and takes possession of all of the debtor’s non-exempt assets, which the trustee then liquidates (i.e., sells). The trustee then disburses the proceeds of the debtor’s assets to the debtor’s creditors according to a statutory priority scheme.  See 11 U.S.C. § 726. The trustee may also pursue avoidance actions to “claw back” or “recover” certain transfers that the debtor made before filing bankruptcy in order to ensure a ratable distribution to creditors (i.e., to prevent similarly-situated creditors from receiving disparate treatment). A natural person receives a discharge in a Chapter 7 case, which generally bars creditors of the debtor from seeking to collect or enforce any claims that they had against the debtor that were in existence as of the date the debtor filed for bankruptcy. A corporation or other business entity is not eligible for a Chapter 7 discharge, and business entities that file for Chapter 7 are typically dissolved or rendered de facto dissolved following the end of the bankruptcy case.  See 11 U.S.C. § 727.

Chapter 11 Bankruptcy

A Chapter 11 bankruptcy case is a reorganization case for business and certain natural persons whose debts are too large to qualify for Chapter 13 bankruptcy. Chapter 11 bankruptcy cases are costly and often complicated, as they involve a number of administrative and reporting requirements for the debtor and can involve large numbers of creditors with competing interests. A Chapter 11 debtor files a plan, which is how the debtor proposes to deal with all of the claims its creditors hold against it. Often, a plan will propose to repay the debtor’s creditors over time using funds from the reorganized debtor’s ongoing operations, but a debtor may also permissibly propose a “liquidating plan” in which a plan trustee liquidates the non-exempt assets of the debtor’s estate, much like a trustee would do in a Chapter 7 case.  See 11 U.S.C. § 1123(b). There are a number of statutory rules and requirements that a debtor must satisfy to win “confirmation” of a plan.  See 11 U.S.C. § 1129. Creditors of a Chapter 11 debtor have an opportunity to object to confirmation of the debtor’s plan, and are also typically entitled to vote to accept or reject the plan.  See 11 U.S.C. § 1126. Once the bankruptcy court confirms the debtor’s Chapter 11 plan, that plan becomes a new, binding contract between all of the debtor’s creditors and the debtor—it is even binding on creditors who voted against the plan or opted not to participate in the bankruptcy case.  See 11 U.S.C. § 1141(a). In a Chapter 11 case, the plan typically dictates the scope and nature of the debtor’s discharge, but a corporate debtor is eligible for a discharge of debt in Chapter 11 (unlike in Chapter 7).  See 11 U.S.C. § 1141(d).

Chapter 13 Bankruptcy

A Chapter 13 bankruptcy is a reorganization, similar to Chapter 11, but it is limited to natural persons who earn a regular income. See 11 U.S.C. § 109(e). There are debt limits for a Chapter 13, however, so some individuals with debts exceeding those limits must either file for Chapter 11 or Chapter 7. In a Chapter 13 case, the debtor gets to retain all of his or her non-exempt property (whereas in a Chapter 7 case, this non-exempt property is sold by the trustee to pay creditors) and proposes a plan to repay creditors over a period between three and five years based on the debtor’s projected disposable income. A Chapter 13 trustee is appointed to collect the plan payments from the debtor and distribute them to creditors in accordance with the Chapter 13 plan. A Chapter 13 plan is much less flexible than a Chapter 11 plan, and most of the requirements for the Plan are set forth by statute.  See 11 U.S.C. § 1325. Unlike in Chapter 11, creditors in a Chapter 13 case do not ballot, or vote on, a Chapter 13 plan, but any creditor or party in interest may object to confirmation of a Chapter 13 plan. Once the bankruptcy court confirms a Chapter 13 plan, that Plan becomes the new “contract” between the debtor and his or her creditors, pursuant to which the creditors will be paid on their claims. Once the debtor completes all payments required under his or her plan, the debtor is eligible for a discharge of debt. See 11 U.S.C. § 1328.

Rights and Protections for Creditors

Whether creditors are paid in full, paid nothing, or are paid something in between these two extremes largely depends on the nature and extent of their claim against the debtor.

Secured vs. Unsecured Creditors

A secured creditor holds at least two separate rights in connection with their debt: (1) an in personam (or personal) claim against the debtor (whether the debtor is a natural person or a business entity) arising from the creditor’s right to secure a money judgment against the debtor for failure to repay the note or loan agreement; and (2) an in rem (or property) right in certain collateral that the debtor can look to for repayment of the debt—as to the collateral, the creditor has the right to recover the collateral upon a default by the debtor, liquidate the collateral, and apply the proceeds from the sale of its collateral to its unpaid claim.  See generally N.C. Gen. Stat. § 25-9-601 et seq.; N.C. Gen. Stat. § 45-21.16. This distinction is critical, because a discharge in bankruptcy only affects the creditor’s in personam rights to recover the debt from the debtor personally—it does not affect the creditor’s in rem rights to recover the debt from its collateral.  See 11 U.S.C. § 524(e). The most common types of secured creditors are creditors with a security interest in a debtor’s vehicle or equipment (a security interest governed by Article 9 of the Uniform Commercial Code) and creditors with a deed of trust or mortgage on the debtor’s real property to secure repayment of a debt. These types of secured creditors are consensual secured creditors, because the debtor at one point voluntarily executed a security agreement or deed of trust conveying to the creditor a security interest in the collateral at issue. However, creditors may also become secured creditors without the consent of the debtor—the most common example is when a creditor sues a debtor for an unpaid loan and obtains a money judgment against the debtor, which will automatically attach as a judicial lien on any real property owned solely by the judgment debtor in the County where the judgment was entered. See N.C. Gen. Stat. § 1-234. 

Secured creditors typically fare much better in bankruptcy than unsecured creditors, because a secured creditor has in rem rights in its collateral that an unsecured creditor does not. A secured creditor is entitled to be paid at least the value of its collateral from the debtor in the bankruptcy case, regardless of which chapter the bankruptcy case is filed under (unless the creditor voluntarily agrees to accept less favorable treatment). See 11 U.S.C. § 506(a). Oftentimes, a secured creditor in bankruptcy has a “bifurcated claim,” meaning that they hold both a secured claim against the debtor, up to the value of their collateral, and an unsecured claim against the debtor for the remaining balance owed. For example, assume that Bank loans Debtor $10,000 to purchase a car and Debtor grants Bank a purchase money security interest in the car to secure the Debtor’s repayment of the Loan. Debtor later files for bankruptcy, at which time the Debtor still owes Bank $8,500, but the car is only worth $6,000. Under these facts, the Bank would have a “bifurcated claim” in the case—it would have a secured claim for the value of the car–$6,000, and an unsecured claim for the remainder of the debt ($2,500). This means that even if Debtor pays a $0.00 dividend to general unsecured creditors in the case (which is quite common in no-asset Chapter 7 cases), Bank will still recover at least $6,000 in the bankruptcy case, either through cash payments over time (in a Chapter 13) or through the trustee surrendering the car to Bank to sell at auction (as would likely be the case in a Chapter 7 case). 

On the other hand, unsecured creditors typically receive pennies on the dollar for their claims in bankruptcy cases, and oftentimes will receive nothing in a no-asset Chapter 7 case, where the debtor does not own any non-exempt property. Thus, ensuring that you are a secured creditor in your debtor’s bankruptcy will enable you to be best-positioned to maximize your recovery from the debtor in bankruptcy.  For example, in the construction project context, an unpaid supplier or subcontractor is entitled to file a claim of lien on real property for the amount of their unpaid debt. See N.C. Gen. Stat. § 44A-8.  Provided that the creditor complies with the statutory requirements for perfecting a claim of lien on real property (and the lien is not otherwise avoidable by a trustee or the debtor in bankruptcy as a preference or fraudulent transfer), if the owner of the property files for bankruptcy, that creditor will likely have a secured claim in the case.

Filing Claims and Participating in Bankruptcy Proceedings

When a debtor files for bankruptcy, they fill out an exhaustive list of schedules, in which they set forth everything they own (their assets) and everything they owe (their debts and creditors). Creditors will typically receive a notice in the mail that their debtor has filed for bankruptcy, which will contain important information about the case and key deadlines by which the creditor must act if they wish to participate in the bankruptcy process. As noted above, for a creditor with notice of the bankruptcy case, participation in the bankruptcy case is purely voluntary, but the creditor will be bound by the results of any Chapter 11 or Chapter 13 plan even if the creditor opts not to participate. Thus, it is typically a good idea to proactively participate in your debtor’s bankruptcy case in order to protect your interests and maximize your recovery.

• Proof of Claim

A proof of claim is the formal mechanism by which a creditor informs the bankruptcy court, the debtor, and all other creditors that they have a claim against the debtor and wish to be paid on that claim. In certain limited circumstances, a creditor need not file a proof of claim if their debt is properly listed in the debtor’s schedules. See 11 U.S.C. § 1111(a).  However, in other cases, a proof of claim is required if the creditor wants to receive any distribution from the case. For example, in a Chapter 13 case, a creditor must file a proof of claim to receive distributions under the Chapter 13 plan from the Chapter 13 trustee. A creditor who fails to file a proof of claim in these circumstances will not receive payments from the Chapter 13 trustee, but they will still be bound by the terms of the Chapter 13 plan and the debtor’s discharge.  See 11 U.S.C. § 1327(a).  There is a strict deadline for filing a proof of claim in every case, and an untimely-filed proof of claim may be disallowed by the bankruptcy court upon the objection of the debtor or another party in interest.  See 11 U.S.C. § 502(a); Fed. R. Bankr. P. 3007.

• Creditor Committees

In larger Chapter 11 cases, the Court may authorize the formation of one or more creditor committees. See 11 U.S.C. § 1102. There is typically an unsecured creditors committee, which represents the aggregate interests of all unsecured creditors in the case, and may serve as the primary point of contact for the debtor when negotiating plan treatment. See 11 U.S.C. § 1103. Importantly, unlike most creditor’s counsel, counsel for an unsecured creditor’s committee is authorized to be paid by the debtor’s bankruptcy estate, as opposed to being paid by the creditors. See 11 U.S.C. § 503(b)(3)(F). Many Chapter 11 cases do not have any creditor committees, but larger and more complex cases may have multiple different committees representing multiple different types of creditors (for example, in large “toxic tort” or asbestos bankruptcy cases, it is common to have one committee of current talc claimants and another committee representing the interests of future, as-yet unidentified talc claimants). In a construction bankruptcy case filed by the owner or general contractor of the project, for example, the bankruptcy court might authorize the formation of an additional committee comprised solely of suppliers and subcontractors who are owed money on the project. See 11 U.S.C. § 1102(a)(2).

Impact on Ongoing Contracts and Projects

When the debtor filing bankruptcy is a key player in an ongoing construction project, whether the owner, general contractor, or a key supplier or subcontractor, the bankruptcy case can have significant impacts on the progress of the project, and may also materially impact whether and to what extent unpaid creditors on the project are paid on their claims.

Automatic Stay

The most immediate and impactful consequence of a debtor filing for bankruptcy is the imposition of the automatic stay.  See 11 U.S.C. § 362(a). The automatic stay, as its name implies, is a worldwide injunction that takes effect automatically upon the debtor filing for bankruptcy. The stay prohibits any creditors of the debtor from initiating or continuing any actions to collect, enforce, or recover on any debt owed by the debtor. If a creditor has a pending lawsuit against the debtor, the creditor is enjoined from moving forward with the lawsuit until the bankruptcy case is closed or dismissed, or until the bankruptcy court grants the creditor relief from the automatic stay to pursue its lawsuit. If the debtor is in default under a secured loan, the creditor may not repossess the debtor’s collateral once the debtor files for bankruptcy. There are limited exceptions to the automatic stay, and an important one for creditors in a construction bankruptcy case is found in 11 U.S.C. § 362(b)(3). In layman’s terms, this subsection permits a creditor to take actions to perfect its lien even though the bankruptcy case has been filed, but there are a number of complexities to this exception that can be a trap for the unwary. For example, if state law requires the creditor to file suit to perfect its lien (for example, like North Carolina does with respect to a mechanics’ lien—see N.C. Gen. Stat. § 44A-13(a)) and the creditor has not done so before the bankruptcy case is filed, the cross-reference in § 362(b)(3) to § 546(b) informs the creditor that in lieu of filing suit to perfect its lien, it can file a notice with the bankruptcy court and serve it on all required parties rather than filing the lawsuit—if the creditor instead files a lawsuit after the bankruptcy case is filed, the creditor has violated the automatic stay, whereas a creditor who files and serves the required notice has not violated the stay and has properly perfected its claim of lien for purposes of the bankruptcy.

Executory Contracts and Unexpired Leases

In many cases, a creditor’s claim against a debtor is easy to compute because the parties have ceased their business dealings before the debtor ever filed for bankruptcy (such as where a creditor has a judgment against a debtor for an unpaid loan). In other cases, where the debtor and creditor are in an ongoing business relationship, the bankruptcy case can present additional complications on how that relationship will look moving forward. For example, the Bankruptcy Code provides certain rights and limitations on debtors who are parties to an executory contract or an unexpired lease, and those rights and limitations often vary depending on whether the debtor in bankruptcy is the lessee or the lessor under the unexpired lease.  See 11 U.S.C. § 365.  Importantly, it can be a violation of the automatic stay for a creditor to refuse to continue to tender performance to the debtor under the terms of an executory contract or unexpired lease, and if you have such a contract or lease with a debtor, you should contact experienced bankruptcy counsel for advice before taking any action with respect to the same.

Mechanics’ Liens and Bond Claims

As discussed above, there is a specific method that creditors must use to perfect their mechanics’ liens in bankruptcy cases if they have not already filed suit on their claim of lien before the bankruptcy case is filed.  Similarly, depending on who the debtor is with respect to the project, there may be third-party obligors in the case as a result of the debtor or owner bonding off liens that were filed before the bankruptcy case was filed. The lien creditors will need to determine their order of priority, as higher-priority liens are paid in full before lower priority liens are paid at all, and they may also engage in negotiations with the debtor and third-party obligors for a resolution of their claims—many times these agreements must be presented to and approved by the bankruptcy court to be enforceable.  See Fed. R. Bankr. P. 9019.

Legal Strategies for Navigating Bankruptcy in Construction

While having your debtor file for bankruptcy almost always means some type of loss, creditors can mitigate the impact of these losses and minimize their exposure in bankruptcy by taking certain actions prior to the case being filed, actively participating in the case to protect their rights and maximize their recoveries, and by retaining experienced bankruptcy counsel early in the process.

Prebankruptcy Planning

In the construction project context, the most important step an unpaid subcontractor or supplier can take is to assert and perfect its mechanics’ lien rights as soon as possible. As discussed above, in a bankruptcy case with multiple competing mechanics’ liens on the same property, creditors may be subject to poorer treatment if their liens are unperfected or junior in priority to the liens of other creditors, which is particularly problematic if the value of claims asserted exceeds the value of the real property.

Responding to a Bankruptcy Filing

Recall that the automatic stay goes into effect as soon as the debtor files for bankruptcy. By the time a creditor receives a notice in the mail that the debtor has filed for bankruptcy, the automatic stay is already in effect. Thus, the first and most urgent step in responding to a bankruptcy filing is to ensure that the creditor ceases any actions that might violate the automatic stay. Are you on a payment plan with the debtor that has been set up for automatic debits on your end? Better cancel that ASAP to avoid a stay violation. Do you have a repo agent out looking for the debtor’s car? Better call them off right away. 

Seeking out Legal Counsel

Due to the many unforgiving deadlines in bankruptcy, which can have material adverse impacts on a creditor’s rights if missed, it is imperative that creditors seek the advice of experienced bankruptcy counsel right away.  If the creditor has not yet taken steps to create and perfect its mechanics’ lien, construction law counsel and bankruptcy counsel can help the creditor evaluate its options while ensuring that it does not run afoul of the automatic stay or other bankruptcy-specific rules.

How Smith Debnam Can Help with Construction Bankruptcy

With a diverse team of attorneys specializing in both construction law and bankruptcy law, Smith Debnam is uniquely suited to provide creditors with zealous representation of their rights in a bankruptcy case, regardless of whether you are a general contractor dealing with a bankrupt owner, or a third-tier subcontractor. The most important takeaway from this article is that bankruptcy is a serious legal process that can result in the loss of important legal rights if you fail to timely take action, so you should consult an experienced bankruptcy attorney right away when you learn that a bankruptcy filing is affecting a project your company is working on.