Written by:William L. Esser IVParker Poe Adams & Bernstein LLPCharlotte, N.C.willesser@parkerpoe.com

Explaining to any creditor why theymust repay funds in response to apreference lawsuit can be a

difficult task. When dealing withsubcontractors or material suppliers1 whohave been sued in connection with thebankruptcy of a general contractor (GC)or higher-tier subcontractor, the taskbecomes even more challenging. Tworecent opinions from the bankruptcycourts for the Southern District of Texasand Western District of North Carolinahighlight the problems facing subcon-tractors in this arena.

Building the FoundationBy definition, sub-contractors have nocontractual relation-ship with the ownerof the real propertyon which they per-form work, andtherefore, no contrac-tual right to sue theowner for the GC’snon-payment. State

law attempts to balance this disparity inpower by granting unpaid subcontractorsthe right to place a lien on the owner’sreal property or on money held by theowner for payment to the GC (a “lienfund”). While the requirements forobtaining and perfecting a lien vary bystate, subcontractors must typically file anotice of lien and institute litigation toenforce the lien within a statutorydeadline.

A prerequisite for any lien claim isthat the subcontractor remains unpaid. Inan ordinary construction project, paymentto subcontractors usually takes four steps:(1) the subcontractor provides its invoiceto the GC; (2) the GC presents itspayment application to the owner; (3) theowner pays the GC; and (4) the GC paysthe subcontractors. Most owners requirethat every GC payment applicationinclude “lien waivers” from thesubcontractors for all work performed as

of that date. This requirement placessubcontractors into a difficult positionsince they are releasing their lien rightsprior to receipt of payment. In order toaddress this problem, some state lienstatutes provide that lien waivers areineffective until such time as payment isactually received.

After the performance of work butbefore receipt of payment, thesubcontractor possesses “inchoate” lienrights. An “inchoate” lien is a “statutorylien that could [be] timely perfected underapplicable state law.”2 The subcontractor

that wishes to convert its inchoate rightsto a perfected lien must simply follow thesteps mandated by state law. Asubcontractor who fails to timely takethese steps loses its inchoate-lien rightsand can make no claim against theproperty or the lien fund. In such cases,an unsecured claim against the GC maybe the subcontractor’s only remedy.

The GC Files for BankruptcyWhen a general contractor files its

bankruptcy petition, it has the choice toeither reject or assume existingsubcontracts. If a subcontract is assumed,it typically ends any preference analysisbecause §365(b)(1) of the Code requiresa debtor to cure all defaults prior to theassumption of an executory contract.

If a subcontract is rejected, however,subcontractors can be separated into twogeneral categories: those who have beenfully paid for their pre-petition servicesand those who remain unpaid. Theimmediate (and understandable) reactionof the subcontractor that has received fullpre-petition payment is to breathe a big

sigh of relief. However, in an ironic twistof the Code, it may be the unpaidsubcontractor who holds the superior,long-term position.

An unpaid subcontractor that receivesnotice of a general contractor bankruptcycan immediately file its notice of lienagainst the owner’s property or the lienfund (assuming that the state statutorydeadline for filing has not passed). Absenta foreclosure of its lien claim, the unpaidsubcontractor is likely to have its lien paidoff by the owner or a bond company. Underthese circumstances, the subcontractor willhave no concerns about preference liabilitybecause there is no transfer of an “interestof the debtor in property” as required by§547(b) of the Code.

Subcontractors that have received fullpre-petition payment, however, often findthemselves having to defend a trustee’savoidance action. This was the case for thedefendants in The Liquidation Committeev. Binsky & Snyder Inc. et. al. (In re J.A.

Jones Inc.), ___ B.R. ___, 2007 WL624139 (Bankr. W.D.N.C. Jan. 16, 2007),and Lovett v. Homrich Inc. (In re PhilipServices Corp.), ___ B.R. ___, 20073788801 (Bankr. S.D. Tex. Dec. 21, 2006).

J.A. JonesIn 2005, J.A. Jones Inc. (“Jones”) was

one of the largest construction companiesin the world, with annual revenue inexcess of $2.2 billion. Jones and itsseveral dozen subsidiaries listed multipleembassies, power plants, factories andhighways around the globe, and even oneof the two Petronas Towers in Malaysia(known for being the world’s tallestbuildings) among their numerousprojects. Yet by late 2005, Jones was at acrossroads due to the financial difficultyof its German parent. With bondingcompanies beating on the door, Jones andits subsidiaries filed their bankruptcypetitions in the Western District of NorthCarolina on Sept. 25, 2003.

In order to keep the constructionprojects going and maintain the value ofits estate, Jones requested and obtainedpermission to pay pre-petition debts to

Subcontractors and Material Suppliers Beware:Preference Claims in Contractor Bankruptcies

22 June 2007 ABI Journal

About the Author

Will Esser is a partner in the Financial,Commercial and Construction DisputesGroup at Parker Poe Adams & BernsteinLLP in Charlotte, N.C., where hepractices primarily in commerciallitigation and bankruptcy law.

On the Edge

1 The term “subcontractors” is hereafter used for simplicity to refer to

subcontractors regardless of tier, as well as material suppliers dealing

with subcontractors on any tier. 2 In re 360 Networks, 327 B.R. 187, 189 (Bankr. S.D.N.Y. 2005).

William L. Esser IV

ABI Journal June 2007 23

subcontractors, thus avoiding multiple-lien claims against the owner’s property.By the end of the year, Jones had sold offthe majority of its assets. Most ongoingconstruction contracts were assumed andassigned to other general contractors, buta substantial number were also rejected.Jones confirmed its liquidating chapter 11plan with an anticipated distribution tounsecured creditors of less than fivepercent. Jones’ remaining assets,including avoidance actions, were trans-ferred to various liquidating committees.

In September 2005, the liquidatingcommittees filed hundreds of adversaryproceedings, including numerousavoidance actions against subcontractorsthat had received payments during the 90-day period before the Jones petition date.In order to globally address some of thelegal issues present in each subcontractorcase, Chief Judge Craig Whitleyestablished an opt-in procedure, wherebydefendants could join a class of “liendefendants,” have discovery deadlinesstayed in their cases and jointly file amotion for partial summary judgment onstipulated facts.3 In relevant part, allparties stipulated that each subcontractor

defendant (1) had done work on theproject, (2) had the right to file a lienagainst the property for the workperformed, (3) had received paymentsfrom Jones within the 90-day preferenceperiod, (4) had executed lien waivers asa condition for payment and (5) as a resultof receiving payment, had not filed liensagainst the property. The relevant projectswere scattered along the East Coast andwere subject to differing state lien lawsin New Jersey, North Carolina, RhodeIsland, Washington, D.C. and Virginia.

The defendants moved for partialsummary judgment on two primarygrounds.4 First, they argued that as theholders of inchoate-lien rights, they weresecured creditors. Since transfers tosecured creditors are not preferential under§547(b)(5), the transfers in exchange forlien waivers were not avoidable. Second,the subcontractors argued that the waiverof their inchoate-lien rights constituted“new value” under §547(c)(1).5

Judge Whitley rejected the §547(b)(5)argument on the ground that thedefendants did not have lien rights against

real property owned by the debtor’sestate. “[N]umerous courts, including ourown Circuit, view parties holding liens onthird-party property (but not that of thedebtor) to be unsecured creditors for§547(b)(5) purposes.”6 Thus, the fact thatthe subcontractors may have been able tofile lien claims against the owner’s realproperty is irrelevant for the plaintiff’sburden of proof.7

With regard to the §547(c)(1)defense, the court agreed that thesubcontractor’s execution of lien waiverscould provide new value to Jones. If thesubcontractors had not been paid, theywould have liened the property and beenpaid off by the owner. The owner, inturn, would have set off the amount paidagainst any amounts owed to the generalcontractor. Thus, the subcontractors’execution of the lien waivers actuallypermitted Jones to receive payment from

continued on page 78

3 This consolidation was jointly requested by all parties based on the

similar procedure employed in The Official Committee of Unsecured

Creditors of 360 Networks (USA) Inc. v. AAF-McQuay Inc. (In re:

360Networks (USA) Inc.), 327 B.R. 187 (Bankr. S.D.N.Y.).

4 The author represents approximately half of the defendants who opted

into the class and took the lead on prosecuting the motion for summary

judgment.

5 Because the avoidance actions were consolidated before the court on

stipulated facts common to each defendant, the ordinary course of

business defense—§547(c)(2)—was reserved for later determination

on a case-by-case basis.

6 2007 WL 624139 at *5 (2007) (citing to Smith v. Creative Financial

Mgmt. Inc. (In re Virginia-Carolina Fin. Corp.) 954 F.2d 193, 199 (4th

Cir. 1992)).

7 This is markedly different from cases in which the owner of the real

property is the debtor in bankruptcy. In such situations, the

subcontractors’ inchoate-lien rights do relate to property of the estate

under §547(b)(5). See Bryant v. JCOR Mechanical Inc. (In re The

Electron Corp.), 336 B.R. 809 (10th Cir. B.A.P. 2006) (materialman who

held inchoate lien against property of estate did not receive more than it

would have in a chapter 7 liquidation); In re 360Networks (USA) Inc.,

supra (same).

Copyright 2007American Bankruptcy Institute

Please contact ABI at 703-739-0800 for reprint permission.

78 June 2007 ABI Journal

the owner that it otherwise would nothave received.

The liquidation committee argued thatthis analysis was inappropriate because itwas based on an assumption that thesubcontractors would have timelyexercised their state law lien rights. Thecommittee cited cases in which therelease of potential litigation claimsagainst the debtor was held not toconstitute new value.8 The court rejectedthis argument and adopted an “objectiveapproach” to determine that a reasonablesubcontractor would lien the property anda reasonable owner would pay off thesubcontractor and look for indemni-fication from the debtor.

To make any otherassumption would defyreality. It would alsopenalize the lien creditorfor accepting payments...A subcontractor wouldnot long remain inbusiness if it made apractice of refusingpayments from itsgeneral contractor infavor of enforcing lienrights against theunderlying project. Noone would hire such asubcontractor.9

The court noted, however, that thesubcontractor must also prove that at thetime of the transfer, the owner’sindemnification claim against the debtorwas secured by property of the estate(whether by setoff or otherwise). This isthe key to the new-value defense in atripartite (owner, GC, subcontractor)situation. “If the owner still owes thedebtor [GC], then its indemnity claim canbe setoff and is secured... If there is nodebt to setoff, however, then the owner’sclaim for indemnification is simply anunsecured debt and there is no ‘newvalue.’”10 Because the cases had beensubmitted on stipulated facts, the Jones

court entered a joint-scheduling order topermit the defendants to conductdiscovery and prove that the owner had acomplete right of setoff at the time thetransfers were made.11

Philips ServicesThe U.S. Bankruptcy Court for the

Southern District of Texas reached avirtually identical result in Lovett v.Homrich Inc. On June 2, 2003, PhilipServices Corp. (PSC), a Houston-basedindustrial and metal services company,and 43 affiliates filed their chapter 11petitions in the Southern District of Texas.Specializing in services to the oil andgasoline industry, PSC was arguably thelargest resource recovery andenvironmental services company in NorthAmerica. It had been formed only threeyears earlier, having emerged as thesurviving entity from the 1999bankruptcy of a prior Canadian company.

Although the Bankruptcy Code often

does a good job of protecting

secured rights granted by state law,

it falls short when dealing with

subcontractor lien claims.

PSCs’ chapter 11 plan was confirmedon Dec. 11, 2003, and provided for theestablishment of a liquidating trust topursue avoidance actions. On June 1,2005, the trust filed an avoidance actionagainst Homrich Inc., a demolitioncompany that had provided subcontractorservices for PSC on the construction of aMichigan powerhouse for Ford MotorCo. and Rouge Steel Co. Unlike the Jonesdefendants, Homrich actually filed a lienagainst the project, and only released thelien after receiving payment of$936,741.35 from PSC. Homrich arguedthat the payment was not preferentialbecause (1) the payment it received wastrust funds and not property of the estate,(2) the transfer did not allow it to receivemore than in a chapter 7 liquidation under

§547(b)(5) and (3) it provided new valueto PSC by releasing its lien.

Judge Wesley W. Steen rejectedHomrich’s trust and §547(b)(5) arguments.First, Judge Steen held that a subcontractorcan only prove that the funds it receivedwere trust funds if it can trace those exactfunds back to the owner of the project.Homrich was unable to trace the fundsbecause the owner paid PSC’s lenders,which then would advance new funds toPSC without specifically earmarking themfor payment to Homrich. Second, the courtfound that Homrich’s lien did not attach toproperty of the estate and therefore couldnot be viewed as a secured claim under§547(b)(5). “Although in all likelihoodHomrich would have been made whole byFord/Rouge even had debtor not made thetransfer, the court must focus on whetherthe transfer of funds would have affectedother creditors in a chapter 7 liquidation.”12

The court found, however, thatHomrich was entitled to judgmentbecause it had given new value to PSC byreleasing its construction lien against theowner’s property.

Under the terms of theprime contracts be-tween Ford/Rouge andthe debtor, when Hom-rich filed its lien andgave notice of the lien,Ford/Rouge had theright to withhold fundsdue debtor. This was,effectively, a lien ondebtor’s account re-ceivable from Ford/Rouge, which wasreleased, dollar fordollar, when the lienwas released.13

Because the parties stipulated that theretainage and other amounts owed byFord/Rouge to PSC were more than theamount of the transfer, Homrich had acomplete new value defense.14

ConclusionAlthough the Bankruptcy Code often

does a good job of protecting secured rightsgranted by state law, it falls short whendealing with subcontractor lien claims.Trade vendors and other similarly situated

On the Edge: Preference Claims in Subcontractor Bankruptciesfrom page 23

8 The liquidation committee relied heavily upon In re 360Networks, which

noted that “the majority of courts considering this issue [whether the

release of a right to perfect a mechanic’s lien constitutes new value]

have held that such release does not constitute new value.” 327 B.R.

at 192.

9 Jones, 2007 WL 624139 at *7.

10 Id. See, also, O’Rourke v. Seaboard Surety Co. (In re E.R. Fegert Inc.),

887 F.2d 955 (9th Cir. 1989) (subcontractors’ release of claims against

surety bond provided new value to the debtor); In re Fuel Oil Supply &

Terminaling Inc., 837 F.2d 224 (5th Cir. 1988) (debtor could not recover

payments to defendant because of “tripartite relationship” in which

debtor’s payment obligation was guaranteed by fully secured letter of

credit and defendant provided new value by releasing letters of credit).

11 The liquidation committee appealed this decision to the district court,

but subequently entered a consent order finding that the bankruptcy

court’s order was interlocutory. At the time this article went to

publication, most of the consolidated Jones actions were still pending

and the parties were actively engaged in discovery.

12 PSC, 2006 WL 3788801 at *12.

13 Id. at *14.

14 The liquidating trust appealed this order on Jan. 5, 2007 (Case No. 07-

cv-00049). At the time of publication, the parties had fully briefed the

appeal, but no decision had been entered by the district court.

ABI Journal June 2007 79

creditors conduct their business with theknowledge that their claims are unsecuredand can factor this into their credit terms.Subcontractors, however, have notbargained to provide unsecured services.Rather, when entering into a new contractwith a GC, subcontractors rely upon theirstate law right to file liens against theowner’s property, and thus anticipate thatthey will have security for payment.

Under the Code as interpreted in theJones and PSC cases, however, this relianceis not properly protected.15 A subcontractor

offered payment by a financially troubledGC is faced with a Hobson’s choice: Eitheraccept the payment and subject itself topossible avoidance actions down the road,

or take the commercially unreasonableaction of refusing payment and seekingpayment directly from the owner inresponse to lien claims. The reasonablesubcontractor will take the payment andrelease its lien claims. It should not therebysubject itself to an avoidance action. In thewords of the Second Circuit, “[s]urelyreceipt of payment itself should be no lesssecure than the lien which could have secured it.”16 ■

15 Allowing a subcontractor to assert a new value defense is insufficient

protection because the defendant bears the burden of proof on all

§547(c) defenses. The cost and time involved in proving a new value

defense relating to even a moderately-sized construction project can be

excessive and is not a risk that the subcontractor has bargained for. A

good example of this is the recent case of Liquidating Trust v. Metl-

Span, Ltd. (In re Pameco), 356 B.R. 327 (Bankr. S.D.N.Y. 2006), which

involved a materialman’s release of lien in exchange for payment by the

debtor. The Pameco court reached the same legal conclusions as the

Jones and PSC courts (i.e., subcontractor cannot succeed on §547(b)(5)

but has potential §547(c)(1) defense), but ruled against the

subcontractor on the new-value defense because the subcontractor had

not met its burden of proving that the owner had a secured right of

setoff against the debtor.

16 Ricotta v. Burns Coal & Building Supply Co., 264 F.2d 749, 750-51 (2d

Cir. 1959).