Protecting lien rights when the customer goes bankrupt.
Mechanics lien holders file against property owners of a project as protection against not getting paid by a general contractor or subcontractor. But what happens if the property owner files for bankruptcy?
The owner s/developer's bankruptcy does not automatically negate a mechanic's lien, said Wanda Borges, Esq., principal of Borges & Associates, LLC, in Syosset, NY. "A mechanics lien gives a creditor a good position because it has an interest in the debtor's property. It's secured debt and has a greater chance of being paid in a bankruptcy proceeding. That lien will stay intact." A mechanic's lien also is not subject to preference payment rules because the creditor has that legal right to file, Borges added. Mechanic's liens are statutory liens and as such are unavoidable in a bankruptcy proceeding and will survive the bankruptcy unaffected.
Secured creditors hold significant advantages over unsecured creditors in nearly all bankruptcy cases. A holder of a valid mechanic's lien is treated as a secured creditor and entitled to full payment, provided that the property securing the lien has value in excess of prior liens and encumbrances.
Perfecting the Lien
A perfected and enforceable mechanic's lien comprises an important claim in bankruptcy. Typically, a contractor, subcontractor or supplier will perfect its mechanic's lien before the owner files bankruptcy, said Fabyanske Westra Hart & Thomson, out of Minneapolis. If a party properly perfects its mechanic's lien pre-bankruptcy, the lien should remain enforceable as such during the pendency of the bankruptcy case, provided that the holder of the lien claim takes appropriate action during the bankruptcy case to protect the claim. This could include seeking relief from the automatic stay to commence a mechanic's lien action or filing a Section 546(b) notice, as appropriate. Regardless of the commencement of a bankruptcy case and the resulting imposition of the automatic stay, the mechanic's lien holder should be mindful to take such additional timely actions required by state law to perfect its lien.
"Even if a creditor hasn't filed at the time of the bankruptcy filing, it can still file that lien," Borges said. "The circumstances vary state by state." The mechanic's lien is treated as any other secured claim.
"In a Chapter 7 case, the value of the lien claim remains in place to the extent there is value in the subject, improved property after taking into account (i) any and all liens that have priority over the mechanic's lien claim and (ii) the value of all coordinate mechanic lien claims," FWH&T said. "In a Chapter 11 case, the rights of a mechanic's lien claimant may be modified by the terms of the reorganization plan. If a lien is not timely perfected before or after a bankruptcy case is filed, a claimant will lose its lien claim and, therefore, its claim will likely be classified as a general unsecured claim. In that case, the holder of the lien claim will not be able to look to the improved property as a lien claimant to recover all or a portion of its claim."
If it's a Chapter 11, that means there's enough money in the company for it to operate, said Chris Ring, of NACM's Secured Transaction Services (STS). Then it's a reorganization of the business. The lien would likely stay intact as a secured creditor. However, if it's a Chapter 7, it could be stripped away because that involves liquidating assets.
The timing of lien filings matter, Ring said. "In some states, it's 'first in time, first in right.' It's all based on a state's statute." If a state follows the "first spade rule," all liens have an equal position based on when the project started and then it sometimes becomes a battle of who gets paid.
The Automatic Stay
A debtor's bankruptcy filing triggers the automatic stay, which halts collection or enforcement activities against the owner, via Bankruptcy Code Section 362(a). "Collection or enforcement activities include beginning or continuing litigation, any efforts to collect money, or unilaterally terminating or enforcing a contract," said Christine Barker, Esq., senior counsel with Gordon & Rees LLP, in Irvine, CA.
The stay prohibits a creditor from creating, perfecting or enforcing a lien against the debtor and/or property of the debtor's estate, said Bruce Nathan, Esq., partner with Lowenstein Sandler LLP. The code, however, prescribes certain exceptions. Under the law, mechanic's lien creditors whose lien arose prior to bankruptcy may perfect, maintain or continue the perfection of an interest in the property if, under state law and in the absence of bankruptcy, the creditor could have perfected or maintained its mechanic's lien, Nathan said.
State laws vary. For instance, in some, the lien arises at the start of the project. Typically, however, it's when materials are delivered or the work is performed--before a lien is perfected. For that reason, the Bankruptcy Code allows a mechanic's lien creditor who performed work and/or supplied materials prior to the filing of the bankruptcy petition to perfect or maintain the lien.
Exceptions pertaining to mechanic's liens, however, do not pertain to enforcement. Section 546(b)(1) does not deal with a creditor's post-petition enforcement of its mechanic's lien rights, Nathan said. That means the bankruptcy stay applies to a creditor's post-petition action to enforce its lien rights, and the creditor cannot take any post-petition action to enforce its lien unless it obtains a Bankruptcy Court order granting relief from the stay.
"The automatic stay does prohibit filing a lawsuit to foreclose on the mechanic's lien without first obtaining Bankruptcy Court approval," Porter said. "In addition, any state court lawsuit already on file against the bankrupt party is automatically stayed (or suspended) until the Bankruptcy Court grants relief to allow the plaintiff to proceed with the action.... State court lawsuits filed against a bankrupt debtor after the bankruptcy filing but before the automatic stay is lifted are generally void and of no effect."
If you have already filed a lawsuit to foreclose on your lien, this action is also paused by the automatic stay and all proceedings cease until the automatic stay is lifted, the bankruptcy is dismissed, or the property securing the mechanic's lien is abandoned, Barker said. If you have not yet filed a lawsuit to foreclose, the automatic stay prohibits you from filing suit at this time.
A mechanic's lien creditor may file a notice of continued perfection with the bankruptcy court to preserve its rights to enforce its lien against the property. Creditors can't do anything with a mechanic's lien unless they make a motion to lift the automatic stay and the court approves the motion, Borges said. If there's plenty of equity, the court could remove the stay. In that case, however, the debtor will likely try to work something out, she said.
The creditor could also petition the court for relief from the automatic stay. After the holder of the lien perfects it, enforcement of the lien may be tolled during the stay period until enforcement is possible. The holder can also petition the court to lift the stay.
Claimants must enforce mechanic's liens within a certain time period. Once the mechanic's lien claimant learns that the automatic stay is lifted, it should then proceed in state court with an action to foreclose its mechanic's lien, keeping in mind that it could lose its rights if it fails to act promptly, Porter said.
Diana Mota, NACM associate editor, can be reached at firstname.lastname@example.org.
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