THIRD CIRCUIT COURT OF APPEALS ADDRESSES WHETHER CONSTRUCTION LIENS UNDER NEW JERSEY LAW VIOLATE THE BANKRUPTCY STAY
The Third Circuit Court of Appeals on March 30, 2017 issued an opinion that two New Jersey construction suppliers who had filed liens violated the bankruptcy automatic stay. The construction liens, in typical fashion, had been filed by the material suppliers against the owners of the two developments where the prime contractor had installed the materials. The owners had not fully paid the prime contractor for the work on the projects and the contractor, in turn, did not pay the suppliers for their materials. Several weeks after the prime contractor filed for Chapter 11 Bankruptcy, the two suppliers of construction materials filed liens on the properties owned by the developers. The prime contractor filed a motion in bankruptcy court to discharge the liens.
The bankrupt entity (the prime contractor) argued that the bankruptcy’s automatic stay prevented the material suppliers from filing their liens. The court accepted the prime contractor’s argument that the liens were, in fact and in part, filed against the prime contractor’s property inasmuch as the liens could assist them in collecting against the prime contractor’s accounts receivable that was arguably due from the developers. In so holding, the court rejected the supplier’s argument that a filed lien is solely attached to the property interest of the developers/owners.
Rather, the court accepted the argument that the lien could be satisfied by payment of an asset of the bankrupt’s estate to the lien holder (i.e. paying off the lien and deducting the monies due the prime contractor) and, therefore, the lien is essentially against the property of the bankruptcy estate.
The uniqueness of this case (Linear Electric Co., Inc. v. Cooper Supply Co. and Samson Electric Supply, Third Circuit Court of Appeals, March 30, 2017) appears to be related to New Jersey’s Construction Lien Law. Specifically, the court focused upon New Jersey’s “Lien Fund,” which in general, states that an owner discharges a lien by paying into a lien fund from which claimants recover what they are owed. No lien fund can exist if at the time of service of a copy of the lien, the owner has fully paid the prime contractor for the work performed or services, materials, or equipment provided. Further, a claimant’s claim is limited to the “unpaid portion of the contract price of claimant’s contract for the work, services, materials or equipment provided.”
Applying the debtor’s logic, under New Jersey Law, if the lienors were fully paid, the amount that the prime contractor would be owed from the owners would be reduced accordingly. The Third Circuit concluded that this fact directly impacted the prime contractor’s “accounts receivable” which is clearly an “asset” of the debtor under the Federal Bankruptcy Laws.
In the end, the court, following numerous cases involving bankruptcy and lien filings, concluded that if the lienors, under these facts and under New Jersey Law, were allowed to receive full payment by virtue of the liens, the prime contractor would conceivably receive less as a result. In that situation, there would be less money for the bankrupt entity to put into a plan of repayment and, therefore, other creditors of the bankrupt entity would suffer. Thus, the lien filings improperly circumvented the federal bankruptcy laws.
In practical terms, it is interesting to note that the Third Circuit Court of Appeals did not address the well-accepted exception to the bankruptcy code’s automatic stay (Section 362(b)(3)), that permits an exception for mechanic’s liens. Further, the decision will significantly impact the construction industry in New Jersey inasmuch as many suppliers and lower-tier trade contractors rely upon the filing of a lien to protect their entitlement to get paid especially in the event of a bankruptcy filing by upper-tier general prime contractors. Without lien protection, often regarded under bankruptcy law as having some priority, the suppliers of construction materials would become unsecured creditors, forcing them to accept less money on their claim as is common with unsecured creditors.