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The Unique Challenges of Contractor Bankruptcies

October 2011

Published in the Daily Journal of Commerce and the Idaho Business Review

The last few years have been difficult ones, to say the least, for the construction industry in Oregon and throughout the United States, as numerous projects have stalled or failed.  In this climate, it is essential that owners and developers (and general contractors, who often face the same issues) understand the consequences of a contractor's or subcontractor's bankruptcy filing and take appropriate steps to protect themselves.

The Problem
It may not always be obvious that a contractor is approaching insolvency.  The contractor may be performing its work and may appear to be paying its subcontractors.  Then, suddenly, an owner discovers that its contractor has not only stopped working, but that the contractor also has failed to pass on the owner's timely progress payments to its subcontractors.  Now they, too, have stopped working, and even worse, have begun filing liens against the property. 

The owner faces an extremely difficult position.  The project is shut down, interest on the construction loans is accruing, and subcontractors are clamoring for payment even though they too have stopped working.

Upon the filing of a bankruptcy petition, an "automatic stay" comes into effect, preventing any party from taking any action to collect a debt or to exercise control over property of the debtor's bankruptcy estate.  This means an owner or developer cannot attempt to collect debts owed by the bankrupt contractor without a court order.  In practical terms, even an attempt to compel the contractor to turn over progress payments to subcontractors is impermissible, and may result in a court assessing punitive damages against the party making such an effort.

In addition, the contractor has the right to choose to "assume or reject" its construction agreement.  This means that the owner or developer cannot terminate or walk away from its contract with the bankrupt business without a court order.  Many contracts contain clauses providing that they will terminate automatically in the event of a party's bankruptcy filing, but these "ipso facto" clauses are generally unenforceable, and it is never safe to assume that a construction contract is automatically terminated by its own terms upon the event of a bankruptcy filing.

What can the owner or developer do?  It cannot take action against the bankrupt contractor without first obtaining permission from the bankruptcy court – a time-consuming process which may or may not yield positive results.  Similarly, it cannot unilaterally terminate its construction agreement with the bankrupt contractor and replace the contractor, and even if it could, there would still be the issue of the unpaid subcontractors.  Does the owner need to pay twice?  Even if it does, how can work continue if the owner remains bound to its agreement with a non-performing bankrupt contractor?

Strategies and Solutions
The first steps an owner or developer (or general contractor) takes should occur long before the contractor (or subcontractor) is hired.  A thorough background investigation should always be performed.  A search of the State of Oregon Construction Contractors Board web site can quickly reveal how long a contractor has been in business (under the same name), its disciplinary record, the complaints filed against it, any criminal convictions, and its bonding and insurance information, among other things.  As further protection against the risk of insolvency, an owner also should require references from banks regarding the contractor's financial condition and from suppliers or subcontractors regarding its payment history.  An owner also should obtain proof of insurance in an amount appropriate for the project (generally liability, workers compensation, automobile), and should be named as an additional insured in the policies of the general contractor and all subcontractors.  An owner also may require the contractor to obtain a performance or payment bond, or both.  Finally, an owner may consider requesting a personal guarantee from a contractor's principals.

When negotiating a construction agreement, an owner or developer may consider requesting provisions providing for direct payments to subcontractors or payments by joint check.  That way, if the contractor later becomes insolvent or actually files a bankruptcy case, the owner will have a contractual right to pay subcontractors, providing it with more flexibility to move forward without forcing it to decide whether to pay twice or risk a breach of contract claim by refusing to pay the general contractor and instead paying the subcontractor directly.  Although, as noted above, "ipso facto" clauses terminating contracts are unenforceable in bankruptcy, a provision that the contract will be terminated if certain benchmarks are not achieved or if work is stopped may be enforceable and should be considered.  An owner may also want to negotiate a provision allowing the owner to substitute another contractor in the event of the bankrupt contractor's non-performance, together with a contingent assignment of subcontracts.  It is also helpful to include provisions in a construction agreement requiring a general contractor to obtain at least conditional lien waivers from subcontractors and suppliers upon payment.

Finally, the contract should also contain explicit authorization for each party to set off mutual obligations, including liquidated or consequential damages caused by the contractor's breach.  In the event of a bankruptcy, this may provide a way for the owner to avoid paying any remaining amounts due, or even to recover money from the bankruptcy estate that would not otherwise be available, since owners are typically unsecured creditors who receive low priority in the bankruptcy distribution scheme (though such action would be subject to bankruptcy court approval).

After construction begins, the owner should demand copies of the lien waivers subcontractors issue when they are paid, and also should communicate with subcontractors directly to confirm that the payments are occurring and the lien waivers are authentic. 

Once a bankruptcy case is filed, an owner or developer can take additional steps even if it failed to plan in advance.  First, the filing does not relieve the bankrupt contractor from its obligations to continue performing under the construction agreement.  If the contractor appears unwilling or unable to do so, the owner can ask the bankruptcy court to compel the contractor to reject the construction agreement on an expedited basis.  Unless the contractor can convince the court that it can cure its existing defaults (including paying subcontractors) and can provide adequate assurance of its future performance, the court will order the contractor to reject the contract, at which point the owner will be free to proceed with a new contractor.

Even if the owner is able to mitigate its damages by successfully engaging a new general contractor, however, that will not resolve the problem of the unpaid subcontractors and their liens on the property.  Must the owner pay twice?  Not necessarily.  First, construction lien laws are very technical and a subcontractor's lien rights may not have been perfected if the subcontractor did not fully comply with state statutory notice and filing requirements.  Second, the bankrupt contractor's bond may be available to pay the claims of subcontractors.  Finally, if the bankruptcy estate still holds any of the funds paid by the owner, subcontractors may be able to assert a right to such funds in the bankruptcy case under a theory that the bankrupt contractor held them in trust for the subcontractors.  In any of these scenarios, the liens should be released.

Bankruptcy poses unique and difficult challenges in the construction context.  When a contractor files a bankruptcy petition mid-project, an owner can anticipate delays, uncertainty, and even the possibility of having to pay some debts twice.  Whether you are a developer overseeing a large project, an individual building a personal residence, or a general contractor hiring subcontractors, the best way to avoid these problems is to take every step possible to work with businesses that have established track records and strong financial backing and are unlikely to become insolvent, and then to negotiate construction agreements that provide flexibility in the event of bankruptcy.  If you find yourself dealing with a bankrupt contractor during a construction project, you should immediately consult with experienced bankruptcy counsel to help you mitigate any damages and take control of the situation.

Related Practice Areas

Business Restructuring & Bankruptcy

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