By Joseph B.C. Kluttz, K&L Gates, Charlotte

“God looks out for drunks, fools and construction lawyers.”

— with apologies to Otto von Bismarck

Many contractors and non-bankruptcy practitioners are generally aware that upon the filing of a bankruptcy petition a variety of collection impediments spring into existence, including indignities like the “automatic stay,” lien-trumping provisions and “preferences.”

Many involved in the construction industry may be unaware, however, that because of special provisions and exemptions applicable to mechanics’ liens in bankruptcy, a contractor (or subcontractor) may be able to improve its position dramatically on the eve of — or even after — the filing of a bankruptcy petition by a counterparty.  That could become increasingly important as clouds of economic and political uncertainty continue to gather on the horizon.

First, a little background (statutory references are to the “Bankruptcy Code,” Title 11, U.S.C.):

Mechanic’s Liens, Generally.  Mechanic’s lien statutes in most states provide, of course, that if the lien is properly perfected it can “relate back” to a specified time in the past, in many cases to the time as of which the lien creditor first began to provide goods or services to the property being improved.  Statutes usually require affirmative steps– typically the recording of a written notice– for initial perfection of the lien.

Preferences.  Under §547(b), and subject to certain statutory defenses and exceptions, the representative of the bankruptcy estate (for purposes of this blog post, the “trustee”) generally may “avoid” any “transfer” of “an interest of the debtor in property” made within ninety days (one year where the transferee is an insider) prior to the filing of the bankruptcy petition in respect of a preexisting debt, which has the effect of improving the transferee’s position against the debtor relative to other creditors.  A common type of preference might be a simple payment to a vendor on an unsecured thirty-day invoice.  Importantly, the statute is not limited to payments and expressly refers to any “transfer,” which includes the perfection of a lien.

Automatic Stay.   §362(a) states that the mere filing of a bankruptcy petition “operates as a stay, applicable to all entities” of a litany of acts by which a creditor might otherwise improve its position against the party filing the petition.  Included is an express prohibition of “any act to create, perfect, or enforce any lien against property” owned by the petitioner.  Courts jealously guard the automatic stay, and are quick to sanction violations.

Strong Arm” Lien.   Upon the filing of a petition, under §544(a) the trustee automatically has a “strong arm” lien on all property of the debtor’s estate, generally subject only to liens and security interests that are properly perfected and unavoidable as of the time of the filing.

All other things being equal, therefore, a contractor asserting a mechanic’s lien against an entity in bankruptcy could have a lien set aside as a preference if perfected within the applicable period prior to the filing of the petition; could run afoul of the automatic stay if the lien weren’t perfected under state law as of the time of the filing; or even if perfected post-petition, could wind up junior in priority to the trustee because of the “strong arm lien.”  Luckily for contractors, however, protections and exemptions exist that give a mechanic’s lien creditor an important leg up in bankruptcy, including the following:

Preference Exemption.   §547(c)(6) exempts from preference attack the fixing of a statutory lien that is not avoidable under § 545; and section  §546(b)(1)(A) in turn states that the rights of the trustee to avoid a transfer under §545 are “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.”  In other words, if upon perfection under state law a mechanic’s lien relates back to give the lien creditor priority over an entity that acquired rights in the property prior to the perfection, the lien is not subject to avoidance, even if perfected during the preference period.

Stay Exemption.  After the litany of prohibited acts in §362(a), §362(b) prescribes an even longer list of actions expressly exempted from the automatic stay.  Included is §362(b)(3), which affirmatively states that the automatic stay does not apply “… to any act to perfect, or to maintain or continue the perfection of an interest in property to the extent that the trustee’s rights and powers are subject to such perfection under Section 546(b)…,” which includes the express exception for preference avoidance described in the foregoing paragraph.  A mechanic’s lien creditor therefore is generally free to take action after the filing of a petition to perfect the lien under state law and allow it to relate back to a time prepetition.

Strong Arm Exemption.  But if the lien is perfected post-petition, what about the trustee’s intervening “strong arm” lien?– §546(b)(1) conveniently states that §544’s strong arm lien is subject to “any 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.”  In other words, so long as upon perfection post-petition the lien relates back to a time prior to the filing of the petition, the perfected mechanic’s lien will trump the trustee’s strong arm lien.

In short, whether an act to perfect a mechanic’s lien is taken within the applicable preference period prior to the filing of the bankruptcy petition or must be taken after the petition, so long as a construction or mechanic’s lien under applicable state law fits the description of the Bankruptcy Code sections above (as many do), the contractor or subcontractor can proceed with impunity, secure in the knowledge that the lien should survive in the bankruptcy proceeding.

A few important caveats:

First, while many state law mechanic’s lien statutes qualify for the exemptions described above, in each case care must be taken to ensure that that in fact is the case.  A few courts have held, for example, that under a given state’s statute perfection doesn’t merely cause the lien to relate back to a prior period but has the effect of creating the lien in the first instance, and the above exemptions therefore do not apply.

Second, because of the exemptions, in the case of construction or mechanic’s liens courts generally hold that nothing in the Bankruptcy Code extends any of the time periods prescribed under applicable state law– a contractor must proceed carefully to ensure full compliance with all applicable deadlines and other requirements of the statute in question.

Third, the exemptions generally refer to clerical acts — such as the filing of a notice of lien — taken to perfect a lien in the first instance.  There is no statutory exemption for the enforcement of the lien, and relief from the automatic stay must be obtained from the bankruptcy court before any act is taken to enforce the lien.  That can be especially important in the case of statutes that require, for example, that in order to maintain the perfection of the lien an action must be filed to enforce it within a further specified time.  In that case there is yet another special protection: under §546(b)(2),  if a statute requires “seizure of such property or commencement of an action to accomplish such perfection, or maintenance or continuation of perfection,” then such interest “shall be perfected, or perfection of such interest shall be maintained or continued, by giving notice within the time fixed by such law for such seizure or such commencement.”

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