The filing of a bankruptcy petition by a party to a construction project can be a significant disruption that introduces uncertainty, added costs, and procedural challenges for interested parties. For those entities that are creditors in bankruptcy and are seeking to secure payment for work performed, the challenges can be numerous. The interplay of federal bankruptcy law and state mechanics’ lien law adds complexity to the process of securing payment for work performed. A lien claimant must often satisfy statutory preconditions under strict time limitations while not running afoul of substantive and procedural protections afforded to the bankrupt debtor.

 

Mechanics’ liens are a common device to secure the payment of labor, services, and material used to improve a property. While all states have mechanics’ lien laws, statutes vary significantly from jurisdiction to jurisdiction as to the requirements for lien creation, perfection, continuation and enforcement. In some jurisdictions, a mechanics’ lien arises when a claimant serves a notice of the lien as required by state law. Other jurisdictions allow the lien to arise either when the contract for material and services was executed or when the material and labor was first provided. In others, a lien may arise when the claimant formally records a lien with the register of deeds within a specific time period in the county where the real property is located.

 

State laws similarly diverge in respect to a claimant’s priority over other validly created and perfected liens. For instance, provided that a claimant took the necessary steps to perfect its lien within the required time period, the lien may relate back to the day where labor and delivery of materials commenced, and in effect, give the claimant priority over other interests in connection with the real property.

 

The timing and procedure to assert and perfect a lien is important when preserving a claimant’s rights. Thus, a claimant that fails to enforce its lien as prescribed by the applicable state law jeopardizes its mechanics’ lien rights and ability to recover.

 

The lack of uniformity among mechanics’ lien statutes ensures that no one rule applies to all situations. Contractors who work in multiple jurisdictions must therefore remain mindful of the jurisdiction-specific nature of the rules or else risk negative consequences. Depending on the time and procedural constraints under a state statute, a mechanics’ lien may receive more or less protection in various bankruptcy scenarios.

 

The Bankruptcy Petition, The Automatic Stay, And Mechanics’ Liens

 

The filing of a voluntary bankruptcy petition triggers the automatic stay under Bankruptcy Code, 11 U.S.C. §362(a). The automatic stay works by: (1) providing protection to the debtor from creditors attempting to take action against the debtor’s property; (2) offering equality of distribution of the debtor’s assets among claimants; and (3) permitting a more orderly administration of the bankruptcy case.

 

The automatic stay remains in effect until a judge lifts the stay at the request of a claimant, the debtor is discharged, or the item of property is no longer part of property of the bankruptcy estate. This means that, until one of those three scenarios occurs, the automatic stay generally prohibits the filing or continuation of a lawsuit, any collection calls, demands for payment, repossession of property, foreclosure sales, and garnishment or levies. A creditor who willfully or intentionally violates the automatic stay runs the risk of liability for actual damages, including attorneys’ fees and costs, and even punitive damages under appropriate circumstances.

 

At the commencement of a bankruptcy case, creditors interested in pursuing their lien rights should have a clear understanding of two provisions under §362(a) relating to the attachment, perfection and enforcement of a lien on the property of a debtor or property of a debtor’s estate. Section 362(a)(4) prohibits “any act to create, perfect or enforce any lien against property of the estate.” Section 362(a)(5) prohibits “any act to create, perfect or enforce against property of the debtor any lien to the extent that such lien secured a claim that arose before the commencement of the case.” The latter provision extends protection of the stay to property acquired after the date of the bankruptcy filing, exempt property, abandoned property, and any other property excluded from the estate under section 541.

 

Courts in various jurisdictions have interpreted these provisions to prohibit a claimant from pursuing actions necessary to perfect or maintain a mechanics’ lien claim against a debtor’s property. For example, in In re Excel Engineering, Inc., 224 B.R. 582 (Bankr. W.D. Ky. 1998), a subcontractor filed a statutory lien under state law against funds owed to the general contractor after the general contractor had filed for bankruptcy. The court held that this action violated the automatic stay because the subcontractor did not have an interest in the funds since the subcontractor did not properly file and serve notice of the lien until after the debtor’s petition was filed in bankruptcy. Similarly, in In re Baldwin Builders, 232 B.R. 406 (Bankr. 9th Cir. 1999), a landscaping contractor recorded a mechanics’ lien against an owner’s property. Subsequently, the owner filed its bankruptcy petition. The claimant filed a complaint to foreclose the lien, but it did not serve the complaint on the bankrupt debtor. Even though the claimant did not serve the complaint, the bankruptcy court concluded that the filing of the foreclosure complaint was a violation of the automatic stay and the complaint was therefore void.

 

Exceptions To The Automatic Stay And Lien Rights

 

Bankruptcy Code §362(b) provides certain exceptions to the automatic stay that allow a mechanics’ lien claimant to perfect its lien after a bankruptcy has been filed. Although Section 362(b) does not provide an exception for the creation of the lien, which is prohibited by 362(a)(4) and (5), the section does permit a claimant to perfect, maintain and continue the perfection of its lien. Specifically, Section 362(b)(3) prescribes protection from the automatic stay for a claimant who had an interest in property predating the bankruptcy petition but had not perfected its interest at the time of the bankruptcy filing.

 

For the exceptions under Section 362(b) to apply, the claimant must first satisfy the notice requirement pursuant to Section 546(b). If a claimant’s lien arose prior to the filing of the bankruptcy petition under applicable state law, then Section 546(b) allows for the perfection or continuation of perfection of the lien after the bankruptcy petition has been filed. Clearly, this analysis begins with a determination of the claimant’s rights under state law at the time of the bankruptcy filing.

 

If a lien claimant is prohibited by the automatic stay from foreclosing its lien claim but is under strict time limitations to file a foreclosure action, the Bankruptcy Code does provide some options. Section 546(b)(2) permits the claimant, who is required by state law to commence a foreclosure action to enforce its mechanics’ lien, to provide written notice of its claim in the bankruptcy proceedings in lieu of filing of the foreclosure. However, the section provides little guidance for how to properly provide notice when attempting to assert or enforce a lien, and in practice the notice requirement under section 546(b)(2) can vary by jurisdiction. In In re McCord, 219 B.R. 251 (Bankr. E.D. Ark. 1998), a contractor filed suit to foreclose a mechanics’ lien two hours and fifty minutes after homeowners filed for bankruptcy. Under Arkansas law, a mechanics’ lien is perfected when a complaint to foreclose the lien is filed with the clerk of the court. The bankruptcy court found that the contractor’s lien arose and related back to the time of performance since the filing had satisfied the state requirements for perfection. Accordingly, the contractor did not violate the automatic stay.

 

In comparison, under Alabama law, in order to maintain a mechanics’ lien, a general contractor is required to first file a verified statement of the lien within six months after the last work was performed and then commence an action in state court to enforce the lien within six months after the maturity of the debt secured by the lien. In In re Cook, 384 B.R. 282 (Bankr. N.D. Ala. 2008), the court found that a contractor’s post-petition filing of an amended petition seeking enforcement of its lien did not provide sufficient notice under Section 546(b)(2), and therefore violated the automatic stay.

 

WhileSection 362(b) may allow for a claimant to perfect its lien post-petition, claimants should be aware at the commencement of a bankruptcy case of the relationship between state laws that will permit the assertion and enforcement of those liens and whether the Bankruptcy Code authorizes the application of any exceptions.

 

When a general contractor files for bankruptcy, fewer issues arise regarding the protection of a subcontractor’s lien. In situations where a subcontractor attempts to collect from a debtor-contractor, the automatic stay will remain effective. Under certain jurisdictions involving earmarking, statutory trust fund, or constructive trust, it is often common for subcontractors to claim that certain funds in the debtor’s possession are beyond the control of the bankruptcy trustee and should therefore be disbursed directly to the subcontractor. In In re Crea, 31 B.R. 239 (Bankr. D. Minn. 1983), the court concluded that under state law there was no trust relationship between a general contractor and subcontractor that would assist the subcontractor in avoiding the effects of the Bankruptcy Code and automatic stay.

 

However, a contractor’s bankruptcy should not disrupt efforts to perfect or foreclose a lien on a non-bankrupt owner’s property. For instance, in In re Perry, 312 B.R. 723 (Bankr. M.D. Ga. 2004) a subcontractor’s mechanics’ lien against an owner’s real property did not violate the automatic stay entered as a result of a general contractor’s bankruptcy because the lien did not attach to any of the debtor’s property. Notwithstanding, a creditor should remain mindful of whether state law requires naming a debtor as a defendant in a foreclosure action as a real party in interest.

 

A Comment On Best Practices For Lien-Claimant Creditors

 

The wide variation of lien statutes among states creates a complex landscape for multi-jurisdiction contractors. As a result, it is imperative to understand the relationship between the Bankruptcy Code and the mechanics’ lien state laws and remain mindful of the underlying substantive state law that give rise to the lien rights. At the outset of a bankruptcy case, in order to avoid a lapse of lien rights, claimants should take immediate action to assess their rights and obligations under applicable state law. At a minimum, this means understanding whether the lien claim arose pre-petition or post-petition, determining whether any post-petition steps will be necessary to perfect the claim and whether any exceptions to the automatic stay are present, and identifying all statutory deadlines for perfection and enforcement of the lien claim. Because statutory time limitations can be unforgiving and procedural actions in bankruptcy court can present practical challenges or prove time-consuming, time is usually of the essence in these matters. By undertaking an immediate assessment and engaging counsel as quickly as possible, the claimant will set itself up for the best chance of preserving and pursuing all available rights.