Insite Corp. v. Walsh Constr. Co. Puerto Rico, 906 F.3d 139 (1st Cir. 2018) –

A debtor subcontractor sought to recover progress payments it claimed were due from a general contractor. The general contractor argued that the debtor did not have any interest in the withheld funds. The bankruptcy court agreed with the general contractor, the district court affirmed, and the debtor appealed to the First Circuit.

The general contractor (Walsh) contracted with the debtor to provide concrete and masonry work for an addition to a government building. The debtor in turn had contracts with a number of suppliers. The debtor was entitled to progress payments if certain conditions were met. Among other things, it was required to remain current with its suppliers.

In December 2011 Walsh issued a notice of default to the debtor alleging that it had breached their contract by failing to pay its suppliers. As provided in the contract, the letter gave the debtor 72 hours to cure its default.

In response the debtor filed bankruptcy, which blocked Walsh from terminating the contract. Walsh then notified the debtor’s surety of the defaults. However, the surety claimed it had no obligation to perform until Walsh formally terminated its contract with the debtor.

With the surety refusing to work, the debtor continued to do at least some work on the project. It submitted several applications for progress payments totaling ~$592,000. However, Walsh was dissatisfied with the debtor’s performance and continued to send letters accusing the debtor of defaulting. Since the debtor was in default, Walsh contended that it was not entitled to progress payments.

The debtor sought and obtained court approval to assume the contract. It then notified the general contractor that its cash flow was getting critical so that it was imperative that it be paid. In response Walsh sent a letter advising that it refused to make any payments to the debtor, although it did make some direct payments to the debtor’s suppliers. This caused the debtor to stop work, which led Walsh to begin exercising its right to take corrective action and complete the work.

At this point the debtor filed an adversary action seeking to recover the unpaid progress payments, arguing that they were part of the bankruptcy estate and that Walsh violated the automatic stay by withholding payment. Further, it contended that Walsh breached the contract since the debtor’s breaches were immaterial and did not justify the actions taken by Walsh.

The court began with a detailed review of the contract. This clearly demonstrated that under the terms of the contract the debtor was in material breach and Walsh was entitled to take the steps that it did. In particular, Walsh was entitled to withhold and use progress payments to cure defaults and complete the debtor’s work.

As a general matter, the critical threshold question was whether the unpaid progress payments were property of the bankruptcy estate. Walsh argued that, under the Pearlman doctrine (derived from Pearlman v. Reliance Insurance Co., a Supreme Court case), in the context of a construction project funds do not become property of the estate until the debtor completes its work and fully complies with all payment obligations to its suppliers.

The First Circuit agreed that “it has been widely held that a defaulting subcontractor does not have a property interest in funds withheld by a general contractor to cover cure and completion costs.” The Pearlman case involved the competing claims of a contractor’s bankruptcy trustee and a surety that was subrogated to the owner’s right to funds. The court noted that its prior decisions made clear that Pearlman applied regardless of whether the defaulting debtor was a general contractor or subcontractor, and regardless of whether the withheld funds were retainages or unpaid progress payments. The court had further determined that the applicable state law (Puerto Rico) on ownership of withheld funds was consistent with Pearlman. (This was important since bankruptcy courts generally look to state law to determine property rights.)

Thus, the court agreed that the debtor had no interest in the funds (1) based on contract rights and (2) to the extent the funds were required to cure defaults and complete the project. However, this left open the question of whether the debtor might have an equitable claim to any excess funds. Accordingly, the First Circuit remanded for consideration of these issues.

This case is a reminder that there are special rules applicable in construction and disputes involving construction payments are often messy. Issues can become even more messy if statutory or common law builders trust fund claims are added into the mix.

Vicki R Harding, Esq.