In re Linear Electric Co., 852 F.3d 313 (3rd Cir. 2017) –

After a general contractor filed bankruptcy, two of its suppliers filed construction liens against property of owners who had contracts with the contractor. The debtor sought a determination that this violated the automatic stay. The bankruptcy court concluded that the stay was violated; the district court affirmed; and the suppliers appealed to the Third Circuit.

Under applicable state law (New Jersey) if a supplier sells material on credit to a contractor that is incorporated into a project owned by a third party, if the supplier is not paid it can file a lien against the property. “In essence, the supplier can step into the shoes of the contractor and collect the debt owed to the contractor from the third-party property owner in order to recoup what the contractor owes to the supplier.”

The question was whether a supplier can file a lien after the contractor files bankruptcy without violating the automatic stay. The suppliers argued that their liens attached to interests of the property owners and not to the contractor’s receivables. The debtor countered that the liens were intended to allow the suppliers to collect a portion of the receivables owed to the debtor. So, filing the liens was an act against property of the bankruptcy estate.

The district court emphasized in its opinion that the value of the liens depended on both the amount the contractor owed the suppliers and the value of the contractor’s receivable. Since the receivable was part of the bankruptcy estate, and the supplier construction liens depended on the existence of the contractor’s receivable, filing the liens violated the automatic stay.

The Third Circuit noted that under state law a construction lien is limited to the amount the property owner agreed to pay for the project less payments made prior to the lien filing. The owner discharges the lien by paying into a lien fund from which claimants recover what they are owed. Claimants are split into different tiers, including a first tier (the contractor) and a second tier (subcontractors and suppliers). The value of the lien is determined at the time of filing and is not reduced by payments made by the owner after the filing.

The court further reviewed the limitations on payments and how the allocation process among tiers plays out. In particular, after lien funds have been allocated to a first tier claimant, its funds are further allocated to valid claims of second-tier claimants that have contracts with it. If the total claims exceed the owner’s liability or the allocation to a tier, allocations are reduced pro rata.

Given this background, when the debtor received payment in full from the owners after the supplier liens were filed, that payment did not reduce the amounts the suppliers were entitled to recover. Since the suppliers’ payments would be subtracted from the debtor’s receivable, their liens were in effect against the debtor’s property.

The court reviewed another Third Circuit construction lien filing case that did not find a violation of the automatic stay. However, there was a key difference. The liens in that case were filed in a different state (Pennsylvania) where the date of the lien filing related back to “the date of visible commencement upon the ground of the work of erecting or constructing the improvement” – which was prepetition. Since the lien related back to a time before the bankruptcy filing, it came within an exception to the automatic stay. The court interpreted the analysis in that case as confirming that if the filing date had not related back to a prepetition date, there would have been a violation of the automatic stay. The court also found support in cases analyzing lien claimants’ actions as enforcement of a lien (as opposed to creation or perfection of the lien).

The suppliers argued that their liens “attached” to the owners’ property, and not interests of the debtor. The court rejected this argument. Among other things, the liens were “against” interests of the debtor even if they did not “attach,” which was sufficient to trigger the automatic stay.

Accordingly, the Third Circuit affirmed the lower court decisions.

This case illustrates yet again the importance of involving local counsel. A real estate lawyer without knowledge of local law might be tempted to provide advice on whether a lien filing violated the automatic stay based on an assumption that the priority of construction liens relates back to commencement of the project – since that would be the case in many jurisdictions. And under section 546(b)(1)(A) of the Bankruptcy Code: “[The automatic stay is] subject to any generally applicable law that … permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection.” Unfortunately for the lawyer, that would be bad advice in states like New Jersey.

Vicki R. Harding, Esq.