Project Bankruptcy Protection

Does belly up mean they’ll still pay up?

Construction related bankruptcies are on the rise. In order to protect their interests, a general understanding of creditors’ rights and remedies in bankruptcy court will assist contractors, subs and suppliers in dealing with an insolvent project or development, or perhaps a struggling general contractor.

The following is a basic discussion of the critical areas that those involved in any construction project should understand in the event that it ends up in the bankruptcy court.

The Difference between Chapter 7 & 11
Bankruptcy is a governed by federal law. The idea behind the bankruptcy laws is to provide the insolvent entity an opportunity to reorganize or liquidate, and to treat all similarly situated creditors equally in the process. There are several kinds of bankruptcies, but construction projects usually file for protection under Chapter 7 or Chapter 11 of the U.S. Bankruptcy Code.

Chapter 11 allows the debtor an opportunity to reorganize its financial affairs and, hopefully, return to economic viability. In Chapter 11 reorganization, the debtor intends to continue to operate the business under the close eye of the bankruptcy court. Once the bankruptcy is filed, the debtor becomes what is known as a “debtor-in-possession” (DIP). The DIP remains in possession of the debtor’s assets and business.

In a Chapter 7, the debtor does not reorganize. The goal of a Chapter 7 bankruptcy is to marshal the debtor’s assets, liquidate those assets and pay the creditors. A trustee is appointed to manage the liquidation process. Creditors are paid according to the priority of their claim.

Generally, creditors receive the following priority:

• secured creditors receive their collateral or the proceeds of the sale of that collateral
• expenses incurred in the administration of the estate (including attorney’s fees, and other professional consultant fees)
• pre-petition wage claims
• priority taxes
• generally unsecured claims

Often in a Chapter 7, there are no assets remaining and recovery for unsecured creditors is minimal at best.

The Automatic Stay
As soon as a bankruptcy is filed, all collection actions against the debtor are barred by the automatic stay. Section 362 of the U.S. Bankruptcy Code acts as an injunction against any collection activities to collect a pre-bankruptcy debt from the debtor. The automatic stay stops anyone from trying to collect a debt — meaning no repossessions, foreclosures, collection calls, garnishments or lawsuits to collect on a debt. In the construction context, the automatic stay also prohibits any actions that could adversely affect property of the debtor’s “estate,” such as a construction project.

Upon filing the petition, an “estate” is created by law which consists of the entire debtor’s property. The estate holds all legal and equitable interest that the debtor holds. Therefore, the estate’s property includes all the debtor’s real estate, personal property, accounts receivables, equipment, machinery, intellectual property, licenses and insurance policies. No action may be taken against any property of the estate without court approval.

The automatic stay may be lifted by the bankruptcy court for cause. Specifically, if there is a showing that the creditor is not adequately protected, or that there is no equity available for the creditor and the property is not necessary to an effective reorganization, the court may lift the stay and allow an action against the debtor’s property to commence. The decision as to whether or not to seek relief from the automatic stay should be made on the advice of counsel and on a case-by-case basis.

It is important to note that when the stay is lifted by the bankruptcy court, it is lifted only as to the party seeking relief from the stay — not to all creditors. Each creditor must bring its own request for relief from the automatic stay, and establish the merits on an individual basis. It is important to note that the automatic stay does not apply to non debtors. Thus collection activities may proceed against guarantors, sureties or non-bankrupt property owners. Also, a bankruptcy filing does not effect an action directly brought to recover under a bankrupt entities bond.

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