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Must Payment to Customer in Bankruptcy Be Returned?
by John S. Mrowiec
Consider this scenario. A contractor provides lienable construction
services to a customer, whether a tenant, developer or owner.
The customer pays the contractor, whether prompt or not, and
then the contractor pays its subcontractors.
Let's say that unknown to the contractor, within 90 days of
the payment check clearing the bank, the customer files a
Chapter 7 (liquidation) or Chapter 11 (reorganization) petition
in bankruptcy under the United States Bankruptcy Code. Up
to two years later, the bankruptcy trustee or, if Chapter
11, the debtor-in-possession, sues the contractor for return
of the payment as an "avoidable preference." Must
the contractor return the payment? The answer is maybe. It
depends on the facts of the situation.
Some basics of bankruptcy law will set up the problem. A trustee
in bankruptcy, or a debtor-in-possession, has "avoiding
powers." These "avoiding powers" exist to permit
the undoing of those types of pre-bankruptcy transactions,
which Congress has determined are antithetical to the goals
of bankruptcy policy.
A central policy of bankruptcy is equality of distribution:
"creditors of equal priority should receive pro rata
shares of the debtor's property." Therefore, one type
of pre-bankruptcy transfer, "preferential transfers,"
can be set aside in bankruptcy "to prevent debtors who
are tottering toward bankruptcy from playing favorites among
their creditors, trying to keep alive a little longer by placating
the most importunate ones" In
re Freedom Group, Inc., 50 F.3d 408, 410 (7th Cir.
1995).
Section 547(b) of the Bankruptcy Code defines preferential
transfer. Many readers may be familiar with the generic concept
that transfers made within 90 days before filing of the bankruptcy
petition might be an avoidable preference.
Actually, any transfer of an interest in property may be avoided
if the transfer satisfies five requirements:
To or for the benefit of a creditor
For or on account of an antecedent debt owed by the
debtor before such transfer was made
Made while the debtor was insolvent
Made on or within 90 days before the date of the filing
of the petition
· Enables the creditor to receive more than such creditor
would receive if the case were a case under Chapter 7, the
transfer had not been made, and the creditor received payment
of such debt to the extent provided by the provisions of the
Bankruptcy Code (11 U.S.C. §547(b)).
If, within 90 days of the owner's bankruptcy, an owner pays
the contractor who uses the payment to pay subcontractors,
must the contractor return the payment?
The same questions would arise in a prime contractor's bankruptcy
regarding a prime contractor's payment to a subcontractor
or in a subcontractor's bankruptcy regarding a payment to
a sub-subcontractor or supplier.
Case Illustration
A recent case holds that mechanics lien rights can determine
whether a transfer is an avoidable preference, Golfview
Developmental Center, Inc. v. All-Tech Decorating Co. (In
re Golfview Developmental Center, Inc.), 2004
Bankr. LEXIS 642 (Bankr. Ct. N.D. Ill. May 11, 2004).
The Golfview
bankruptcy court held after a trial that because the contractor
still had valid, unexpired mechanics lien rights as of the
time of the payment, the contractor was not required to
repay the payment. That was true even though the contractor
had not asserted its mechanics lien rights as of the time
of the payment (but those rights had not expired). The contractor
need not return the payment even though the contractor signed
a mechanics lien waiver after receiving the payment, because
the contractor still had unexpired lien rights at the time
of payment, Golfview,
2004 Bankr. LEXIS 642, *19.
In Golfview,
All-Tech was a painting contractor. The debtor, Golfview
Developmental Center Inc., was the tenant under a lease
for a nursing home for developmentally disabled adults in
Des Plaines, Ill. The landlord was Golfview Realty Partnership
Inc., an entity related to the debtor.
A principal of the landlord sought bids for interior painting.
The contractor submitted a bid to the tenant, and the bid
did not contain payment terms. The tenant accepted the bid.
The contractor began in July 2001 and substantially completed
the work in September. The punch list work continued into
December.
The contractor issued three invoices: July 31, Aug. 31 and
Sept. 14, 2001, for $100,211.50. Not until Dec. 31 did the
tenant issue a check for that amount to the contractor.
On Jan. 4, 2002, Contractor gave a final waiver of mechanics
lien rights to the tenant.
On Jan. 7, the tenant's bank honored the check. The tenant
filed its Chapter 11 bankruptcy petition on Feb. 5, just
29 days after its bank paid the check.
On March 5, 2003, the tenant (now the debtor), filed an
adversary complaint against the contractor. The adversary
complaint sought to recover from the contractor the payment
as an alleged avoidable preference under sections 547(b)
and 550 of the Bankruptcy Code.
The tenant and contractor agreed that the first four elements
of a preference were satisfied. The contractor disputed
only that the contractor had received by the payment more
than what contractor would have been entitled to receive
in a Chapter 7 liquidation case if the payment had not been
made by the tenant.
The contractor's specific argument was that the contractor
was a "secured creditor" at the time of the payment
by virtue of mechanics lien rights. Therefore, according
to contractor, the payment did not enable the contractor
to receive more than what it would have received in a Chapter
7 liquidation.
Court's Response
The Golfview
bankruptcy court started with the proposition that "[o]rdinarily,
transfers to fully secured creditors are not preferential
unless they exceed the value of the creditor's security
interest" Golfview,
2004 Bankr. LEXIS 642, * 13 (citing cases). The key date
for making that determination is the date of the transfer.
State law governs whether a creditor is secured and the
value of that security. The contractor claimed its security
was the landlord's real estate and improvements to which
the contractor's mechanics lien would have attached if the
contractor had recorded a lien.
The Golfview
bankruptcy court noted that mechanics liens are state statutory
liens.
Under section 547(c)(6) of the Bankruptcy Code, mechanics
liens, because they are statutory liens, may not be avoided.
The tenant and contractor agreed that they entered into
an agreement, "knowingly permitted" by the landlord,
to perform the painting services and improvements to the
real estate and that the work was completed satisfactorily.
At the time of the transfer, the contractor's four-month
deadline under Illinois law to record a mechanics lien or
to file suit had not expired. Therefore, the contractor
would have had a valid, inchoate (not yet perfected) mechanics
lien right as of the date of the transfer. That interest
would have attached to the tenant's leasehold interest and
the landlord's "reversionary interest" as owner
of the fee interest in the real estate and improvements.
Accordingly, the contractor was a secured creditor.
But, the tenant argued, the contractor never perfected the
lien interest and, in fact, waived it by signing the final
waiver of mechanics lien rights.
No matter, said the Golfview
bankruptcy court: Contractor did what he was required to
do. Contractor "was paid in full and appropriately
gave a release of its lien prior to the time necessary
for any additional steps to be taken to perfect the lien"
Golfview,
2004 Bankr. LEXIS 642, * 21 (emphasis added). The holder
of an "inchoate lien" is a "secured creditor"
and, under Illinois law, that inchoate lien relates back
to the date of the tenant-contractor contract.
The tenant then argued that even if contractor was secured,
the value of its security was less than the amount of the
transfer. Although neither party submitted evidence of the
value of the leasehold (or, presumably, the landlord's fee
interest), the Golfview
bankruptcy court found that the value of the leasehold exceeded
the amount of the payment: The payment "was less than
two months worth of base rent reserved in the lease"
Golfview,
2004 Bankr. LEXIS 642, *24.
Therefore, the contractor was a secured creditor and the
value of its security equaled or exceeded the amount of
the payment sought to be avoided. Accordingly, the contractor
did not receive more than Contractor would have in a Chapter
7 liquidation if the payment had not been made. There was
no avoidable preference: The contractor could keep the payment.
John S. Mrowiec is a partner
with Chicago-based Conway & Mrowiec, a construction
and public contracts law and litigation practice. He may
be reached at (312) 658-1100. For information, go to the
firm's Web site at www.cmcontractors.com.
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