General Contractor’s Bankruptcy Voids New Jersey Construction Liens
As a contractor seeking payment on a construction project, one of the greatest weapons in your arsenal is a construction lien or mechanics’ lien claim. In most states, the lien is a security interest that attaches to the owner’s real estate and serves to cloud title on the real estate until payment is made. As a result, a lien is a powerful method to facilitate payment owed on a project.
Nevertheless, there are limits on the ability to file a lien. For instance, in Pennsylvania, a contractor cannot file a mechanics’ lien claim where the project is one for a “purely public purpose.” And similarly, in New Jersey, a contractor cannot file a lien on a public project owned by the state or any state agency.
Recently, the United States Court of Appeals for the Third Circuit, whose territory includes both New Jersey and Pennsylvania, established another limit in a contractor’s ability to file a construction lien in New Jersey: where the party who has failed to make payment has filed for bankruptcy prior to the claimant’s filing of the lien.
In In re Linear Electric Co., Inc., Cooper Electric Supply Co. and Samson Electrical Supply Co., Inc. (the “Suppliers”) sold electrical materials to Linear Electric Co., Inc. (“Linear”) for use in several construction projects in New Jersey. As of July 1, 2015, the project owners had not fully paid Linear and Linear had not fully paid the Suppliers. On that same date, Linear filed for Chapter 11 bankruptcy. Two weeks later, the Suppliers filed construction liens against the projects. Linear then filed a motion with the Bankruptcy Court to have the liens discharged for violating the automatic bankruptcy stay.
The Bankruptcy Court held that the construction liens violated the bankruptcy stay and were void. The Suppliers appealed to the United States District Court for the District of New Jersey and that court affirmed. The Suppliers then took a further appeal to the Third Circuit.
The Third Circuit considered the question of “whether a supplier can file a construction lien under New Jersey law when the contractor has filed a petition for bankruptcy.” The court held that the supplier cannot. In making this determination, the Third Circuit analyzed the interplay between the New Jersey Construction Lien Law and the federal Bankruptcy Code.
Under the Lien Law, a contractor is entitled to lien for the value of work or services performed, and that lien attaches to the interest of the owner of the real property. An owner is able to discharge a lien by paying into a lien fund, out of which the claimant recovers what it is owed. Importantly, the owner has a complete defense under New Jersey law if, however, it has fully paid the contractor for work performed.
Meanwhile, under the Bankruptcy Code, commencing a bankruptcy creates a bankruptcy estate consisting of all of the debtor’s property. Filing a bankruptcy petition automatically stays “any act to create, perfect, or enforce any lien against property of the estate.”
Considering this interplay, the Third Circuit determined that the construction liens were filed against property of the bankruptcy estate; specifically, Linear’s accounts receivable owed from the owner. In effect, if the owners made payment to the Suppliers, then they would be transferring a portion of an asset of the bankruptcy estate to the Suppliers. This would be inconsistent with the purpose of the automatic stay in that it would place the Suppliers in a position of advantage over other creditors. As a result, the Suppliers’ filings to perfect their liens violated the automatic stay.
In rendering the decision, the Third Circuit distinguished prior cases pertaining to mechanics’ liens under Pennsylvania law where courts had held that filing a mechanics’ lien in Pennsylvania did not violate the bankruptcy stay. Unlike in New Jersey, on Pennsylvania projects for new construction, the filing of the mechanics’ lien relates back to the commencement of work on the project; meaning that the lien would be considered filed prior to the bankruptcy petition and would not violate the automatic stay.
The Third Circuit’s Linear decision will likely have a substantial impact on lower-tier contractors and suppliers. Notably, once a bankruptcy has been filed, a subcontractor or supplier owed payment can no longer file a construction lien claim without violating the bankruptcy stay. Because the Bankruptcy Code provides significant protection to debtors, bankruptcy judges may award sanctions for violating a bankruptcy stay that can be severe, including punitive damages and attorney’s fees. It is, therefore, imperative not to file a construction lien claim in this instance.
In light of this case, we offer the following recommendations to contractors. First, you should perform greater due diligence into the financial condition of the party for whom you will be performing work to determine if there is any likelihood of a future bankruptcy filing. Second, you can insist upon a personal guaranty by that party’s principals in the event of a bankruptcy. Third, you should find out whether there is a payment bond posted in connection with the project. On projects where a payment bond is posted, you may be able to proceed against the payment bond regardless of whether there is a bankruptcy filing.
Separate and apart from these recommendations, there is also the possibility that, in light of this decision, efforts may be made by the New Jersey legislature to amend the Construction Lien Law to include a “relation back” provision similar to that in Pennsylvania and other jurisdictions. However, unless and until the legislature revises the Construction Lien Law, Linear is the controlling law, and you should avoid filing a construction lien claim in New Jersey once the party owing money has filed for bankruptcy.
