There is something dispiriting about the sight of a preference demand letter received or complaint filed by the debtor, seeking the return of a payment (or payments) received for a prior job well done.
But, all is not lost—the payment may not be recoverable by the debtor’s estate.
A prime contractor working on a construction project under the terms of the contract with the owner (the same scenario could be a subcontractor working for the prime contractor) signs a lien waiver, or the bank will not agree to fund the payment draw. The contractor has no idea that the owner is contemplating filing for bankruptcy protection, and signs the lien waiver to get paid.
Then, two years later, the contractor receives a demand letter to return the payment received. The letter references a bankruptcy and a preference. As it turns out, the owner filed for bankruptcy after paying the contractor.
- The demand letter alleges that the debtor can recover the payment as a preference because the transfer was to or for the benefit of a creditor.
- The transfer paid for or satisfied an existing debt (the contractor’s outstanding invoices).
- The payment was made while the debtor was insolvent (this is presumed).
- The payment was made within 90 days before the bankruptcy was filed.
- The creditor received more than it would have if the debtor were liquidated.
The first four elements of the demand likely will be proven by the debtor with little difficulty (although the third element, insolvency, is sometimes contested). However, in the context of preference claims in an owner bankruptcy case against contractors and subcontractors, the fifth element might be a shield to protect the contractor from having to return any money.
The Debtor Might Not Be Able to Meet All of the Elements of Its Claim
Depending on where the debtor filed its bankruptcy case, the mechanics’ lien rights the contractor waived in exchange for the payment received might protect him from having to return any payment received. The fifth element of a preference payment is that the creditor received more by receiving that payment than it would have received if the debtor were liquidated. In almost every bankruptcy case, that standard will be met because general unsecured creditors usually are not paid in full. However, creditors with lien rights (mechanics’ lien rights) might be treated differently. Some courts have determined that if the contractor was not paid even though he signed a lien waiver, the contractor still might have been able to assert his mechanics’ lien rights (the ones that were otherwise waived when the contractor signed the lien waiver).
Asserting those mechanics’ lien rights might make the contractor a secured creditor in the event the owner is the debtor. And, as a secured creditor, the contractor could argue that the debtor cannot meet the fifth element because, as a secured creditor, he would have been paid in full anyway.
A very simplistic example is if the property is worth $1 million and, at the time the contractor was paid, there was a $500,000 mortgage and $200,000 in mechanics’ liens on the property. Had the contractor been paid pursuant to the lien waiver, the lien rights would be gone. However, some courts have determined that if the contractor executes a lien waiver but is not paid, then that lien waiver is ineffective. Therefore, the contractor might still have lien rights in the property. If the lienable amount is less than $300,000, the contractor would have been paid in full. Because the contractor had been paid in full, the last element is not met and the payment would not be a preference payment.
Defenses to a Preference
Even if the debtor can meet all five elements, all is not lost. The Bankruptcy Code provides defenses that might let the contractor keep the money he received. While there are a number of these defenses, mechanics’ lien rights implicate two of them:
- the “contemporaneous exchange defense;” and
- the “new value defense.”
Depending on where the debtor filed for bankruptcy, one or both of these defenses might be available based on the right the contractor had to file a mechanics’ lien, but which he gave up in exchange for payment.
The contemporaneous exchange for new value and the new value defense are similar because both require that the contractor provide value to the entity that paid him after he received the payment. Some courts have found that releasing the mechanics’ lien constitutes that new value. These courts determine that because the contractor could have asserted a mechanics’ lien on the property, the fact that the contractor released the mechanics’ lien in exchange for the payment constitutes value for the payment. This analysis differs if the debtor is the owner, a lessee or the prime contractor, because the owner is the only one with an ownership interest in the property and therefore the only party against which the contractor might have lien rights). Also, if the contractor continues to work on the project, any unreleased mechanics’ lien rights might constitute new value. Similarly, any work that was done on the project since the last payment, whether or not lienable, might also be new value.
Waiver or release of mechanics’ lien rights during the course of a construction project might be a defense to a preference demand. The analysis is based on the facts of each case and depends on where the debtor filed its bankruptcy case. However, the contractor should not automatically repay a preference demand without first considering the issues with bankruptcy counsel who are experienced in construction project bankruptcies.