Bankruptcy or even the threat of it, whether of an owner, contractor, or supplier, can have significant repercussions on a construction project.  At the whiff of insolvency, an owner may terminate the contract and take an assignment of subcontracts.  Mechanic’s liens and payment disputes become more complex and potentially uncollectible.  Insurer’s payment of third-party claims may require court oversight.  Understanding these impacts may allow you to prepare a shelter before the bankruptcy storm hits.

1.    Assignment of Subcontracts

Many contracts, particularly those modeled after the American Institute of Architects (AIA) family of documents, allow for the owner to take an assignment of subcontracts if the general contractor defaults.  

The problems begin, as they often do, with payment.  The owner typically gets wind of a general contractor’s liquidity issues when subcontractors and suppliers file notices of intent to lien for unpaid work or materials.

Under the AIA Document A201, General Conditions of the Contract for Construction, the architect may withhold or nullify certification of a contractor’s payment application if certain conditions exist.  Among those conditions are:

• • The contractor fails to make payments properly to subcontractors or suppliers; or
  • If reasonable evidence exists that the contractor cannot finish the work for the unpaid balance of the contract amount.

The owner, in its sole discretion, can decide whether to joint check the general contractor and its subcontractors or suppliers. The owner may also opt to terminate the general contractor for cause if the general contractor fails to make payments to subcontractors or suppliers.  

If the contract is terminated for cause, the owner is entitled to an assignment of each subcontract subject to prior rights of the surety, assuming a bond was procured for the project.  The owner accepts the assignment by notifying the general contractor and subcontractor.  

2.    Liens

General contractors, subcontractors, and suppliers often seek to secure payment by filing lien affidavits against the improvements or property.  But what happens to those liens in bankruptcy court?

In Texas, mechanic’s liens for general contractors are creatures of statute and the State Constitution.  For subcontractors and suppliers, liens are creatures of statute, only.  The typical enforcement mechanism for lien is to file suit to foreclose on the liened property.  Bankruptcy complicates matters.  

Filing for bankruptcy triggers an automatic stay which includes enforcement of actions for any liens against the property of the debtor.  To pursue a lien foreclosure action, the contractor must obtain leave of the bankruptcy court or show that the property is not part of the bankruptcy estate.  Given that real property is often considered a valuable asset of the bankruptcy estate to which superior secured interests may already attach, even a contractor with a properly and timely filed lien affidavit may find itself without much monetary relief.

3.    Third-Party Claims

Bankruptcy can also have profound impacts on claims regarding completed construction projects.  If the bankrupt entity is a contractor or supplier, the only asset worth pursuing may be an insurance policy.  Although the insurance policy may be used to satisfy a third-party claim involving a construction project, it remains an asset of the estate subject to the automatic stay.

Relatively recent case-law from the federal Fifth Circuit Court of Appeals makes clear that where multiple claims threaten the debtor’s estate over and above the policy limits, the insurance proceeds are classified as property of the estate. So, while a bankruptcy court may allow the separate construction dispute to proceed to determine allocation of responsibility, the bankruptcy court may retain power to determine equitable distribution of the insurance policy limits.  

In determining how to proceed when an owner, contractor, subcontractor, or supplier is default, insolvent or bankrupt, it is always advisable to consult with legal counsel.  The attorneys in our Austin and Dallas offices are available to answer any questions you may have.

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