The Fourth Circuit Court of Appeals recently ruled in the case of In re Construction Supervision Services that the property interest underlying a subcontractor’s lien on funds arises from the date it first furnishes labor or materials to a construction project.  The timing of when an interest in property arises is critical as it could allow, as it did here, a subcontractor to prime a lender’s perfected lien on accounts receivable when notice was not served until after the debtor filed bankruptcy.  This alert briefly describes the decision’s impact on the construction industry and the effect on a string of recent North Carolina bankruptcy cases. 

The automatic stay provision of the Bankruptcy Code generally prevents creditors from pursuing collection of their claims against the debtor after the bankruptcy petition date, including acts to perfect liens against the debtor’s property.  Under a limited exception, however, a subcontractor may avoid the automatic stay to perfect its lien rights post-petition if its rights constitute an “interest in property” at the time of the bankruptcy petition.  This exception makes a subcontractor’s post-petition perfection effective against third parties who acquired a perfected interest pre-petition.

In this case, several subcontractors asserted their entitlement to a lien on funds under the automatic stay exception.  The subcontractors typically delivered materials to the debtor, a general contractor, on an open account, later invoicing the debtor for amounts owed.  When the debtor filed bankruptcy, the subcontractors sought to serve notice of, and thereby perfect, their lien rights post-petition.  This included perfection of liens on funds owing to the debtor on its various projects.  The debtor’s primary lender, who maintained a perfected security interest in the debtor’s receivables, objected to the subcontractors’ post-petition notice and perfection.  The lender argued that the automatic stay exception did not apply to the subcontractors because their unperfected lien rights did not constitute an “interest in property.”  The subcontractors argued that their inchoate lien rights did, in fact, constitute an interest subject to application of the exception. 

In rejecting the lender’s arguments, the Fourth Circuit considered recent changes to North Carolina’s construction lien laws.  Specifically, the court considered a clarifying amendment enacted in 2012 to address the precise issue before the court.  Consistent with the subcontractors’ argument, the 2012 amendment provides that a lien arises and becomes an interest in property contemporaneous with the claimant’s first furnishing to a construction project.  The 2012 amendment did not control in this case because it post-dated the claims at issue, but the court nonetheless considered it instructive in determining the clarification was in line with what the legislature originally intended.

The Fourth Circuit’s ruling ultimately revives the common practice in North Carolina for subcontractors to perfect their lien rights post-petition.  This method was standard until a line of recent bankruptcy court decisions from the Eastern District of North Carolina, In re Shearin Family Investments, In re Mammoth Grading, Inc., and In re Harrelson Utilities, Inc., held that the lien rights of subcontractors could not be perfected once a bankruptcy petition was filed because no pre-petition interest in property existed.  The Fourth Circuit concluded that this line of cases misinterpreted the law, causing the North Carolina legislature to enact the clarifying amendment in 2012. 

This latest decision, in conjunction with the legislature’s amendment, finally resolve a recent area of much litigation.  Subcontractors can confidently return to North Carolina’s prior practice of perfecting their lien rights post-petition.  This eliminates the concern of many in the construction industry that obstructing this practice would result in increased lien filings as subcontractors rushed to perfect their lien rights at the first sign of financial stress, fearing an imminent bankruptcy.

For lenders, this decision highlights an area of risk in relying on accounts receivable to secure financing to customers in the construction industry.  Under North Carolina law, a subcontractor’s perfected lien on funds has priority over any other lien, including a UCC security interest in a contractor’s accounts receivable perfected prior to the date of first furnishing of labor or materials to a job site by a subcontractor.  The subcontractor may perfect its lien on funds at any time, even during a pending bankruptcy.  Additionally, subcontractors perfecting a claim of lien on funds only are not required to file their liens publicly.  Lenders providing financing to construction contractors should underwrite their loans accordingly, taking into account the potential for a subcontractor’s lien on funds to prime the lender’s UCC lien on the contractor’s accounts receivable without notice to the lender.