Due to the prohibition on seeking payment from a debtor in bankruptcy – called the automatic stay – a bankruptcy filing by a single construction project participant can cause a chain reaction, leading to financial distress, impacts to project payment systems, project completion schedules, and/or bankruptcy for other participants.To add insult to injury, the bankrupt company (Debtor) or a court-appointed trustee (Trustee) has the ability to demand the return or "clawback" of all payments made by the Debtor to third parties in a 90-day period prior to date the Debtor's bankruptcy case began. These are often referred to as "preference demands."
Non-bankruptcy project participants can be understandably upset when they learn about this aspect of bankruptcy law. The bankruptcy filing of a construction project participant will likely lead to payment stoppages and project disruptions, and on top of that, a Trustee can seek to clawback partial payments received by other contractors, subcontractors, or suppliers from the Debtor. These demands often take the form of the letter from the Debtor's or Trustee's attorney (sometimes years after the bankruptcy was filed) and can be followed by a lawsuit filed in the bankruptcy court if the payment demand is not resolved in the Debtor's bankruptcy case.
The good news is that non-bankrupt project participants have several defenses that may reduce or completely eliminate liability in connection with preference demands. Many of these defenses are available to all payment recipients, and there are particular defenses that specifically apply to project participants given the unique contractual relationships among these parties. Below is a discussion of strategies on how project participants are able to address preference demands that are often overlooked in these disputes.
Preference claims are becoming a regular occurrence as Trustees hunt for funds available to pay creditors. The general rule is that a Trustee or Debtor may seek the return, or clawback, of funds paid by the Debtor to third parties in the 90 days prior to the Debtor's bankruptcy filing. This preference period is extended to one year if the payments were made to an "insider" such as a family member of the Debtor's owners or certain business affiliates. See 11 U.S.C. § 547. The policy behind this bankruptcy law is that a Debtor should not be permitted to "prefer" one creditor over its other creditors, and any amounts paid out immediately prior to bankruptcy should be brought back into the bankruptcy estate for a more even distribution among the Debtor's entire list of creditors.
The Bankruptcy Code recognizes that, in many cases, payments within the 90-day preference window were not preferential in nature, giving rise to various defenses that one can raise to a preference demand. Most common among these are the ordinary course of business defense (payments were made according to ordinary business terms and the historical practice of the parties), and the new value defense (e.g., after receiving the preference payment, the non-debtor provided new goods or services to the Debtor, offsetting the preference payment). However, these common defenses can be subjective in nature, and they rarely convince the Trustee to fully drop its preference demand.
Fortunately, there are unique defenses available to non-debtor project participants which, in certain circumstances, may result in an objective defense that no liability exists in connection with a preference demand. For example, as discussed further below, the non-debtor participant may be the holder of a statutory lien right in association with its contractual project obligation to provide labor, materials, or services as it relates to the Debtor contractor, as well as the non-debtor's right to receive payment. In this instance, the non-debtor may fall under the umbrella of a statutory lienholder, and will be recognized by the bankruptcy court as a secured creditor that is entitled to the full value of amounts due under the applicable construction contract and the amounts due to be paid prior to the bankruptcy filing or amounts, which were in fact paid during the 90-day preference period. In such a situation, the Debtor's or Trustee's attempt to clawback the alleged preference payments is improper and inconsistent with mechanic lien law and bankruptcy law principles, for the reasons set forth
Under the Bankruptcy Code, a Trustee can recover preferential transfers made from the debtor's estate if the transfer was 1) made to a creditor, 2) for a debt owed by the Debtor, 3) made while the Debtor was insolvent, 4) within 90 days prior to the Debtor's filing of its bankruptcy and 5) enabled the creditor to receive more than it would have received in the Chapter 7 liquidation of the Debtor. Most notable is the fifth element and its applicability to mechanic lien holders. It is well-settled law that, in a Chapter 7 liquidation case, if a creditor is fully secured, it should receive the full value of its claim. See Golfview Developmental Ctr., Inc. v. All-Tech Decorating Co., 309 B.R. 758, 768 (Bankr. N.D. Ill. 2004).