Imagine this scenario: your client is a contractor, subcontractor or materialman on a construction project. Having completed the work, your client is promptly paid in full. Because of this, your client doesn’t bother to file a mechanic’s lien on the project. However, within 90 days after the payment, the payor, usually the contractor or general contractor (or the owner), files for bankruptcy. Then sometime in the ensuing two years, long after any lien perfection periods have run, your client receives a polite letter from the debtor’s bankruptcy or creditor trustee requesting return of the funds paid, claiming them to be a voidable preferential transfer under Section 547(b) of the U.S. Bankruptcy Code.1 What should your client do? Perhaps more importantly, should your client have done anything differently at the time of the payment?

This situation presents an interesting interplay between the state statutory mechanic’s lien framework that is designed to progressively protect the interests of the lower — and therefore most vulnerable — members of the project food chain and the United States bankruptcy system that was developed in part to treat each level of priority of creditors and parties in interest on an equal basis according to their level. Thus, Bankruptcy Code Sections 546(b) and 362(b)(3)2 allow mechanic’s lien claimants to timely perfect (but not enforce) their liens post-petition upon the project’s real property as if there were no bankruptcy filing, with, under most states' laws, the lien’s priority relating back to the start of the project. The fly in the ointment, however, is Code Section 547, which specifically allows the bankruptcy trustee or debtor-in-possession to seek to recover payments made within the 90-day pre-petition window, on the theory that the payments constitute a preferential transfer, i.e., your client will have received a larger payment than it would otherwise receive along with other members of the same level or class in a bankruptcy liquidation. Had the mechanic’s lien been timely perfected prior to the payment in the situation posed above, the alleged preferential payment would have been protected to the extent of the value of the lien upon the owner’s property.

Not surprisingly, situations of a similar nature have occurred from time to time, and bankruptcy courts have approached the question in a variety of different ways. Some courts have focused on the inchoate nature of the lien rights at the time of the payment as underpinning a potentially viable defense to a preference recovery claim. One notable decision by the late Judge William J. O’Neill held that there could be a “contemporaneous exchange for new value,” and thus an effective defense under Bankruptcy Code Section 547(c)(1), where it could be established that the project owner could have withheld funds or retained payments due the debtor/contractor in order to satisfy the lien claim. Consequently, the right to withhold would have been constructively released by the debtor’s payments, and the inchoate lien waiver given in exchange — thereby resulting in no depletion of the debtors’ bankruptcy estate — could be construed as “new value” for purposes of an effective defense.3 Important factual questions establishing the 547(c)(1) defense would include whether or not the contractor required a lien waiver in exchange for the payment and/or whether the parties intended the non-assertion of the lien to be part of the exchange. Other courts have reached similar results, simply finding sufficient new value in the failure to perfect the lien4 or where a surety was involved and the payment otherwise reduced or released the debtor’s obligation to the surety on a bond.5 On the other hand, some courts have found no value to the contractor simply because it did not directly receive any value in exchange.6 More recently, other ways to achieve protection anticipatorily have proven unsuccessful. For instance, efforts by materialmen on oil and gas projects to file “contingent preference liens” following payment in an attempt to protect themselves against preference claims have been rejected, the bankruptcy court holding that because no debts were owed to the claimants at the time of perfection the liens were invalid under state law and the actions violated the automatic stay and were not protected by §546(b).7 Similarly, an attempt to enforce a state court judgment based on lien rights through state court rather than perfecting via §546(b) was held to be a stay violation.8

Thus, in answer to the questions posed at the outset of this article, notwithstanding that even today it is still not settled whether the release or non-assertion of the mechanic’s lien will suffice to withstand a preferential transfer claim, this is clearly not a reason to refrain from taking the payment. After all, there may never be a bankruptcy and, therefore, a preference. Even if there is a bankruptcy, the debtor-in-possession or trustee may decide not to make a demand or initiate suit. If there is a demand, the client’s bankruptcy counsel will know how to handle it, and raising a seemingly viable defense will in many instances result in the settlement at a significant discount.

Moreover, at the time of the payment, a number of precautions can be taken depending on the circumstances, each of which can remove, or at least undermine, a recovery claim. Your client can require payment in advance and work against the deposited funds, thus eliminating the “antecedent debt” element of a voidable preference. Your client could require the payment to be made C.O.D., thus constituting a “contemporaneous exchange” at the time of the work performed or material supplied. Your client could set up a joint check payment arrangement. In multiple payment situations, other commonly-used defenses, such as the “ordinary course of business” or “new value” defense may be available. Additionally, as discussed above, a clear lien waiver or release document, or other clear expression of the relinquishment of the lien rights as being one exchange — expressly reflecting the payment amount and the fact of the exchange — in short, anything which could help establish, further down the road, that the debtor’s bankruptcy estate, its equity, has not been depleted by virtue of the payment (because rights that would constitute equivalent value to the bankruptcy estate were given up at the time of the payment) may be sufficient to constitute an effective defense. Of course, different projects have different documentation requirements and procedures, and in some instances would require the imposition of additional time, effort and paperwork, or simply may not be possible to obtain the protection described above. Certainly this is one instance where lien waiver or release requirements may ultimately turn out to be a blessing rather than a burden.