Construction disputes often boil down to a single issue: “show me the money.” Experienced contractors, owners and financiers understand the risks that come with unfinished projects and unpaid work; best practices have long included tracking first visible work, last day of work, and other issues critical to perfecting and enforcing mechanic’s lien rights. But a bankruptcy or a potential bankruptcy of a project participant introduces a new set of challenges and risks to construction projects. In the present environment, understanding some basics of federal bankruptcy procedures, and the interplay of bankruptcy and mechanic’s lien law, is important to manage risk for construction projects.

Bankruptcy is a creation of federal law, and bankruptcy cases are administered in special federal courts by judges that hear only bankruptcy disputes. Once a case is commenced, an “automatic stay” protects the debtor from creditor collection efforts, including efforts to perfect liens or cancel contracts. For these reasons your planning for potential bankruptcies needs to be in place before a critical supplier, consultant or project partner files a bankruptcy case.

Bankruptcies can be voluntary (filed by the debtor) or involuntary (where a debtor is forced into bankruptcy by its creditors). In either case, federal bankruptcy law aims to treat all similarly situated creditors the same. Because unsecured creditors do not typically receive any payment until after administrative and secured creditors are paid in full, the status of your mechanic’s lien rights at the commencement of a bankruptcy are critical to whether or not you will ultimately receive payment. While bankruptcy law allows certain steps to prevent lien rights from expiring during a bankruptcy proceeding, it is always the best practice to perfect mechanic’s liens as soon as possible for maximum protection in a bankruptcy.

At the beginning of the case, a “bankruptcy estate” is created to collect all assets that can be used to pay creditors. In a Chapter 7 bankruptcy the property of the estate is liquidated and the proceeds are used to pay creditors. If the debtor can pay creditors more by continuing to operate its business, then a Chapter 11 bankruptcy is likely to occur. Once approved by the court, a Chapter 11 bankruptcy plan becomes a new contract between the debtor and its creditors that replaces pre-bankruptcy obligations and details what payments will be received by which creditors. An individual creditor can also file a Chapter 13 bankruptcy where payments are also made over time under a plan approved by the court.

The automatic stay provides a debtor time to organize its affairs in return for turning over its assets (or the control or supervision of its business) to the court or a court appointed trustee. Construction projects are complex and time-sensitive; any delay can result in significant problems and additional expense. Obviously, the delay associated with a bankruptcy automatic stay presents significant risks to the remaining project participants. A critical step in managing bankruptcy risk is to terminate nonperforming contracts before the nonperforming entity files bankruptcy. Terminating the contract will be much simpler (and quicker) before a bankruptcy filing. After the case is filed, terminating a bankrupt entity will require court action. Basically, the creditor (or contractor) will have to ask the court: to approve an agreement with the trustee (or in a Chapter 11 case with the Debtor in Possession); or to lift the automatic stay to allow the creditor to terminate the contract; or to compel the rejection of the contract.

Even hiring a new entity to complete unfinished work by a non-terminated debtor has potential risks: perhaps the trustee will argue that the unperformed contract was assignable, with some value from that assignment flowing into the bankruptcy estate. Chapter 11 debtors can delay their decision whether to perform under outstanding (or executory) contracts, presenting another set of construction project risks. It is possible to bring a motion to force the acceptance or rejection of executory contracts in court. A debtor can only “accept” and choose to perform an executory contract by agreeing to cure all defaults under that agreement at the time of acceptance.

Requiring cure payments at the time of accepting an executory contract provides design professionals, engineers and any party who provides license rights to a bankrupt owner powerful tools to require payment to allow the completion or operation of a project in bankruptcy. Even equipment or software maintenance agreements that are part of the project contract can sometimes provide a useful way to collect from a bankrupt owner. If you regularly provide software, manuals, maintenance procedures or design drawings as part of your project performance, you should discuss with an experienced construction-bankruptcy attorney how to draft your agreements and procedures to maximize your protection in future bankruptcies.

One of the most challenging (and most litigated) aspects of bankruptcy is the demand that a payment received from a bankrupt debtor within 90 days of filing the bankruptcy be returned to the bankruptcy estate as a “preference” to benefit other creditors. Any settlement or payment agreement with a financially distressed entity needs to be evaluated, before bankruptcy, for preference implications. Secured creditors are not susceptible to preference claims, so the best practice when working with financially stressed entities is to take all necessary steps to perfect your mechanic’s lien as soon as possible, and to document the release or waiver of your lien on receipt of payment. In many jurisdictions a defense to a preference is also available where a contract has been assumed (or assumed and assigned). Some states allow conditional release of mechanic’s lien rights. You should discuss the bankruptcy implications of both types of releases with your attorney if you are working on a project in a state with such a distinction.

Monitoring project participants for financial distress is a critical part of managing construction project risk. Planning to manage that risk should be an ongoing process, and you should discuss with your attorney how to plan for those risks, and how to put systems in place to minimize your risk in the face of a bankruptcy. This article only provides a brief overview of bankruptcy issues invoked in construction projects. You should consult with a qualified construction-bankruptcy attorney when faced with even the possibility of the bankruptcy of a project partner. If you receive notice of a bankruptcy, contact your attorney immediately. Deadlines in bankruptcy cases are often much shorter than other types of litigation, and important rights to file a claim or object to the approval of a bankruptcy plan can be lost if action is delayed.