A contractor, subcontractor or supplier who properly performs its agreed contract and gets paid for its labor or materials expects to keep its hard-earned money. Imagine having to give it back! If the payee files for bankruptcy protection within ninety days of making the payment, that is exactly what can happen.
One of the policies of the Bankruptcy Code is to foster equality of distribution among creditors of the debtor. Any creditor that received a greater payment than other similarly situated creditors is required to disgorge so that all may share equally. Section 547(b) of the Bankruptcy Code gives the bankruptcy trustee power to “avoid” or demand back any payment (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made within 90 days before the date of the filing of the petition; and (5) which would enable the creditor to fare better than it would fare in a Chapter 7 liquidation. The debtor is presumed to be insolvent during the 90 days prior to the filing (meaning, the payee has the burden of proving otherwise). If these conditions are met, the payment is deemed “preferential” and subject to disgorgement, leaving the payee in the position of an unsecured creditor who will be lucky to get pennies on the dollar.
There are some exceptions to this avoidance power, chief among them the “contemporaneous exchange for new value” exception―but if the payee had to wait for its money beyond the normal payment turnaround time (and that is normally the case; chances are that someone who is about to file bankruptcy hasn’t been paying his debts on time!) this exception won’t apply. The common practice of creditors applying payments to the oldest open invoice tends to exacerbate this problem.
Worse, it’s almost certain that any mechanic’s lien rights will have expired by the time notice of the bankruptcy is received, leaving the creditor without an alternative way to get paid. The argument sometimes raised by creditors that giving up their lien rights in exchange for payment counts as “contemporaneous exchange for new value” has fared ill in the courts. Even if a lien was actually filed and then released in exchange for payment, most courts refuse to apply the exception, particularly were the debtor is not also the land owner and thus any “new value” in the form of a lien discharge was not given to the debtor. The outcome is different, however, if at the time of the lien discharge the owner still owed money to a now-bankrupt general contractor and could have set it off against any lien. In that case, “the subcontractor’s release of lien rights against the owner causes ‘a coincident release of the owner's [secured] claims against debtor, thereby creating new value to the debtor.’” In re Charwill Const., Inc., 391 B.R. 7, 12 (Bkrtcy.D.N.H. 2007).
When the debtor happens to be the land owner, however, a filed lien released in exchange for payment might protect the payment from preference attack on a different basis: if the lien would have resulted in full payment to the creditor in a Chapter 7 liquidation (because secured creditors get first dibs), there is no preference. That approach won’t work when the debtor is the general contractor or a lower tier contractor, since any mechanic’s lien wouldn’t be on the debtor’s property.
Unlike some states, New Hampshire law does not automatically provide that owners’ payments to general contractors or generals’ payments to subcontractors are “trust funds” for the payment of lower tiers. If such payments were trust funds in the hands of the debtor, they would not be considered the debtor’s property, and a preference attack would falter (assuming the payments have been segregated and can be traced). Some general contracts and subcontracts have language which imposes such a trust on payments – so if you are a sub or lower tier, before you swallow hard and write the bankruptcy trustee a check, make sure to check the language of the contract governing the tier above you.
One of the policies of the Bankruptcy Code is to foster equality of distribution among creditors of the debtor. Any creditor that received a greater payment than other similarly situated creditors is required to disgorge so that all may share equally. Section 547(b) of the Bankruptcy Code gives the bankruptcy trustee power to “avoid” or demand back any payment (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made within 90 days before the date of the filing of the petition; and (5) which would enable the creditor to fare better than it would fare in a Chapter 7 liquidation. The debtor is presumed to be insolvent during the 90 days prior to the filing (meaning, the payee has the burden of proving otherwise). If these conditions are met, the payment is deemed “preferential” and subject to disgorgement, leaving the payee in the position of an unsecured creditor who will be lucky to get pennies on the dollar.
There are some exceptions to this avoidance power, chief among them the “contemporaneous exchange for new value” exception―but if the payee had to wait for its money beyond the normal payment turnaround time (and that is normally the case; chances are that someone who is about to file bankruptcy hasn’t been paying his debts on time!) this exception won’t apply. The common practice of creditors applying payments to the oldest open invoice tends to exacerbate this problem.
Worse, it’s almost certain that any mechanic’s lien rights will have expired by the time notice of the bankruptcy is received, leaving the creditor without an alternative way to get paid. The argument sometimes raised by creditors that giving up their lien rights in exchange for payment counts as “contemporaneous exchange for new value” has fared ill in the courts. Even if a lien was actually filed and then released in exchange for payment, most courts refuse to apply the exception, particularly were the debtor is not also the land owner and thus any “new value” in the form of a lien discharge was not given to the debtor. The outcome is different, however, if at the time of the lien discharge the owner still owed money to a now-bankrupt general contractor and could have set it off against any lien. In that case, “the subcontractor’s release of lien rights against the owner causes ‘a coincident release of the owner's [secured] claims against debtor, thereby creating new value to the debtor.’” In re Charwill Const., Inc., 391 B.R. 7, 12 (Bkrtcy.D.N.H. 2007).
When the debtor happens to be the land owner, however, a filed lien released in exchange for payment might protect the payment from preference attack on a different basis: if the lien would have resulted in full payment to the creditor in a Chapter 7 liquidation (because secured creditors get first dibs), there is no preference. That approach won’t work when the debtor is the general contractor or a lower tier contractor, since any mechanic’s lien wouldn’t be on the debtor’s property.
Unlike some states, New Hampshire law does not automatically provide that owners’ payments to general contractors or generals’ payments to subcontractors are “trust funds” for the payment of lower tiers. If such payments were trust funds in the hands of the debtor, they would not be considered the debtor’s property, and a preference attack would falter (assuming the payments have been segregated and can be traced). Some general contracts and subcontracts have language which imposes such a trust on payments – so if you are a sub or lower tier, before you swallow hard and write the bankruptcy trustee a check, make sure to check the language of the contract governing the tier above you.
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