You just heard that the owner, general contractor, or higher-tiered subcontractor for whom you have been working has filed for bankruptcy. You breathe a sigh of relief thinking, “at least I was paid for all of my work before they filed,” and move on to the next project. You later discover that you have been sued because some (or all) of those payments were “preferential” and must be returned. Surely, you do not have to give back the money, right? It depends.

The purpose of bankruptcy is to give debtors a breathing-spell while also leveling the playing field among all similarly-situated creditors, e.g., unsecured creditors. Generally, when a debtor files for bankruptcy protection, it is in response to pressure from creditors and being unable to pay debts when they come due. However, prior to filing, a debtor may try to avoid the inevitable by keeping some of its creditors happy so that the debtor can continue to do business and avoid bankruptcy all together. As a result, the debtor may pay some of its creditors extra money or more often, enter into some other arrangement that treats one creditor more favorably than another similarly-situated creditor. Preference claims in bankruptcy are intended to address this “preferential” treatment of some creditors over others.

What is a Preference Claim?

Section 547(b) of the Bankruptcy Code permits the debtor (in a chapter 11 case) or the trustee (in a chapter 7 case) to avoid or recover payments made to creditors (e.g., the subcontractor) prior to the debtor’s bankruptcy filing in certain situations. See 11 U.S.C. § 547(b). Specifically, if the debtor paid a creditor for amounts that the debtor owed within 90 days prior to the bankruptcy filing, there is a presumption that the payment was “preferential,” and the creditor must return the money it received. The creditor, however, may still assert defenses to contest the alleged preferential payment.

As a side note, a debtor/trustee can also recover preferential payments made between 90 days and a year prior to the bankruptcy filing if the payments were made to insiders of the debtor, i.e., the president, CEO, or managing member. While there is some overlap, this article focuses on the defenses for non-insider payments specifically in the context of construction projects.

Some Common Defenses To A Preference Claim

  • The Trust Fund Defense

 

Under section 547 of the Bankruptcy Code, a debtor/trustee can only recover money that is “property of the estate,” e.g., money that belong(s/ed) to the debtor and not someone else. Money held in trust by the debtor for the benefit of another is not considered “property of the estate.” Consequently, subcontractors defending against a section 547 preference claim commonly argue that the money paid by the debtor was not the debtor’s property at all. In other words, the debtor paid the subcontractor from funds held in trust by the debtor for the subcontractor’s sole benefit.

State law determines what constitutes a trust. In most states, the necessary requirements to establish a trust are: (1) a trustee; (2) a beneficiary; and (3) an identifiable trust property (the “res”). In construction cases, subcontractors have relied upon two sources to establish the existence of a trust: the state’s construction fund statute and/or the language in the prime contract and subcontract.

Many state legislatures drafted construction fund statutes with the express intention of creating a trust to protect higher-tiered subcontractors (and sometimes, lower-tiered subcontractors and suppliers) from non-payment for work performed or materials supplied on a project. Generally, these statutes provide that a contractor must hold in trust all money paid by the owner for the benefit of the subcontractors that performed work or supplied labor. This same rule obligates higher-tiered subcontractors to hold in trust all money for their lower-tiered subcontractors and suppliers.

In many states, the language in these trust fund statutes would satisfy the common law requirements for establishing a trust. There is a trustee, e.g., the contractor or higher-tiered subcontractor. There is identifiable trust property: the money paid by the owner (or contractor). And, there is a beneficiary: the subcontractors (or lower-tiered subcontractors and suppliers) who performed work or supplied materials for the project.

Sometimes prime contracts (and subcontracts) contain language similar to state construction fund statutes. Depending on the language in the contracts, the language may meet the requirements under state law for establishing a trust, and thus, provide an additional ground for asserting that the money paid to the subcontractor was money from a trust.

Establishing a trust, however, is only one part of the analysis. Oftentimes, debtor contractors receive payments from owners and deposit all funds into a single, general operating account, co-mingling the “trust funds” with the debtor contractor’s other non-trust monies. As a result, bankruptcy courts have required the defendant subcontractor claiming that the money is “trust funds” to engage in a tracing analysis: the defendant subcontractor must show that the money it received from the contractor can be traced back to the identifiable money the contractor received from the project owner for the purposes of paying the subcontractor. If the money cannot be traced back to the project owner’s payment, then courts have held that the defendant subcontractor cannot establish that the money is not “property of the estate” for purposes of establishing a defense to a section 547 claim.

  • The Debtor Received “New Value”

 

Another common defense available to all defendants to a preference claim is the “new value” defense. The “new value” defense is a statutory defense available under section 547(c)(1). Under this defense, a defendant subcontractor can avoid having to return its payments if it can show that it gave “new value” in exchange for the payment. For example, if the subcontractor only continued to perform under the subcontract upon payment, and did indeed perform, a court may find that the subcontractor provided “new value” to the debtor contractor.

Subcontractors have also successfully claimed that they provided “new value” by executing a lien release in exchange for the payment. For example, a lien release given at or around the payment may constitute new value to the debtor depending on the circumstances surrounding the payment. The facts of each lien release and subsequent payment will determine the availability of this defense. Bankruptcy courts, however, have found that a lien release given in advance of the payment does not constitute new value to the debtor.   Under this scenario, bankruptcy courts have found that, if a project owner has made final payment to the debtor contractor when the subcontractor was paid and released its lien, then there was no new value to the debtor. The value – the lien release – provided by the subcontractor did not flow to the debtor contractor, but flowed to the owner.

If, however, the project owner retained project funds, the subcontractor’s lien release may constitute new value. To illustrate, when a project owner retains funds and a subcontractor still has a lien claim, then the project owner could pay the subcontractor to obtain the lien release and offset that payment against what the owner owes to the debtor contractor. If, instead, the debtor contractor pays the subcontractor directly and obtains the lien release, then the project owner would pay what it owes the debtor contractor in full for that subcontractor. As a result, the subcontractor may have given new value to the debtor contractor indirectly by virtue of its lien release because the lien release entitled the debtor contractor to be paid in full by the project owner.

  • The Payments Were Made in the “Ordinary Course”

 

Section 547(c)(2) of the Bankruptcy Code provides another potential statutory defense for defendants to a preference claim – the ordinary course defense. See 11 U.S.C. § 547(c)(2). As its name suggests, the ordinary course defense examines the debtor’s relationship with the defendant subcontractor. If the defendant subcontractor can establish that the payments were made in the ordinary course under one of two tests, then the bankruptcy court may find that the defendant subcontractor can keep its money.

Under the first test, the so-called “subjective prong”, bankruptcy courts examine whether the payments at issue are consistent with the ordinary course of affairs between the defendant subcontractor and the debtor contractor. Several factors are considered in this analysis: the length of the relationship; the frequency of the payments; the amount of past payments (where they full or partial payments); the method of payment (wire, cash, check); whether there was any unusual collection activity, such as demands for payment; and whether the defendant subcontractor took advantage of the debtor contractor’s weak financial condition. The circumstances of the prior payments are then compared to the payments at issue.   If the payments at issue are similar to the other payments, then the defendant subcontractor may be able to claim that the payments at issue were in the ordinary course of its affairs with the debtor contractor.

Under the second test, the “objective prong,” bankruptcy courts examine whether the payments at issue were made according to ordinary business terms. If the payments are consistent with industry terms, then a defendant subcontractor may have a defense to the section 547 preference claim.

Conclusion

Oftentimes a debtor or the trustee, faced with pressure from creditors or a looming statute of limitations, will bring a section 547 preference action or make a demand for payment without examining the merit of the claim. The law provides for several different defenses to the defendant subcontractor: the trust fund defense, the new value defense, and the ordinary course defense. These defenses are non-exhaustive and other defenses may exist depending on the individual facts of the case. Depending on the facts of your case, you may not have to give your money back.