Accepting Payment Before A Construction Lien Is Filed: Catch-22?

Johnson Memorial Hospital, Inc. v. New England Radiator Works (In re Johnson Memorial Hospital, Inc.), 470 B.R. 119 (Bankr. D. Conn. 2012) –

Creditors of a distressed company often look for strategies to reduce bankruptcy preference exposure, and construction contractors are no exception.  Johnson Memorial Hospital dealt with a payment during the preference lookback period to a contractor that had not yet filed a construction lien, although it would have been entitled to do so if it had not been paid.  If the paid claim was analyzed as an unsecured claim, the payment would be recoverable as a preference, while if the claim was treated as secured by a construction lien, it would not.

A payment made (1) to a creditor, (2) for or on account of an antecedent debt, (3) while the debtor was insolvent, and that (4) is made within 90 days before the petition filing date, and (5) allows the creditor to receive more than it would receive in a chapter 7 liquidation proceeding, constitutes a preference under Section 547 of the Bankruptcy Code.  Subject to various defenses, a preference may be recovered from the creditor for the benefit of the bankruptcy estate.

Under Connecticut law, a statutory mechanic’s lien takes effect on the date that the project commences, and the contractor has until 90 days after completion of its work to record its lien.  In this case, a contractor entitled to a mechanic’s lien completed work on August 15 and received payment on September 17.  There was no basis for filing a construction lien once the contractor was paid, although filing would still have been timely if payment had not been made.  On November 4, the hospital filed bankruptcy.

The hospital sued to recover the September payment as a transfer within 90 days of bankruptcy that constituted a preference.  Putting aside various other defenses, the bankruptcy court focused on the contractor’s right to a mechanic’s lien, and consequently whether it received more than it would have received in a chapter 7 liquidation.

If the contractor had recorded its mechanic’s lien on September 17, the hospital would not have been able to avoid the lien.  Section 545 of the Bankruptcy Code provides special rules governing the avoidance of statutory liens, and the hospital would not have been able to avoid the lien under that section because the lien would have been effective prior to the bankruptcy and would have been perfected and enforceable against a bona fide purchaser of the property at the commencement of the case.  The court further noted that if the contractor was treated as fully secured in a hypothetical Chapter 7, it would have been entitled to a distribution in the full amount of its claim.

So, the question was whether the fact that the contractor received full payment, and thus no longer had any basis for filing a statutory construction lien, meant that it would be worse off than if it had rejected payment and filed a lien before accepting payment.  Relying on old Second Circuit case law, the bankruptcy court held that payments made during the preference period at a time when the contractor could still have perfected the lien under relevant state law and the perfection would not otherwise have been avoidable, are not themselves avoidable since it did not allow the contractor to receive more than it would have received in a chapter 7 liquidation – in essence giving the contractor the benefit of the mechanic’s lien that it could have filed.

Theoretically a contractor should be able to avoid the dilemma presented in this case by filing construction liens early and often.  However, that is not a practical suggestion since there are likely to be strong objections (to put it mildly) to what will be viewed as unnecessary lien claims.  Among other things, a project owner is likely to be concerned that a filed construction lien could trigger a default under its financing documents.

Although there is no assurance that other bankruptcy courts will take the same position as this court, the argument would not even have been an option if payment occurred when it would have been too late to file the construction lien.  So, at a minimum, a contractor allows its construction lien rights to lapse at its peril, and should consider filing a lien claim before the applicable deadline.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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