A fundamental responsibility of a credit executive is assessing a debtor’s credit risk. For credit executives employed by subcontractors and material suppliers, states have created special protections to these vendors to reduce or eliminate credit risk through mechanic lien laws. However, what is the effect of the state lien laws where the general contractor files bankruptcy? Are payments made to the subcontractor and materialman during the preference period recoverable by a bankruptcy trustee, or do the states’ lien laws protect the vendors from the preference risk? A recent bankruptcy case which considered the interplay of the state lien law and federal Bankruptcy Code’s preference provision is considered.

The Bankruptcy Preference

The Bankruptcy Code vests the debtor (or trustee if one is appointed) with farreaching powers to recover payments to vendors within 90 days of the bankruptcy filing. The power to avoid preferential transfers is one of the most powerful weapons a trustee has. The bankruptcy preference is part of the Bankruptcy Code, which is a federal law that applies to all states uniformly. The purpose of the preference provision is two-fold.

First, unsecured creditors (or undersecured creditors, e.g. those creditors whose collateral is valued at less than their debt) are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain unsecured creditors by the requirement that any unsecured creditor that receives a greater payment than similarly situated unsecured creditors disgorge the payment so that like creditors receive an equal distribution of the debtor's assets.

Not all transfers made within the preference period are avoidable. To protect those transactions which replace value to the bankruptcy estate previously transferred, the Bankruptcy Code carves out seven exceptions or defenses to the trustee's recovery powers. The most commonly asserted exception by vendors is the contemporaneous exchange defense, the subsequent advance defense, and the ordinary course of business defense.

Mechanic’s Liens

State mechanic’s lien laws ensure payment to vendors extending credit for supplying labor and materials that improve property, by allowing the vendors to look to the owner of the property for payment. Many states provide for a payment bond in lieu of a mechanics lien.

The subcontractor must give preliminary notices to the property owner and ot hers, depending on the state statute. The time limit is generally connected with the last date on which the goods or services have been supplied to a particular job. The subcontractor must also record a claim of a lien in the county filing office. The mechanic’s lien attaches to property immediately when the claimant supplied the labor or materials. The claimant must initiate a legal proceeding by filing a complaint for a foreclosure and records a notice of lis pendens. The vendor must be mindful that each state’s lien law may vary in terms of notice requirements and protection afforded the vendor.

Interplay of Federal Bankruptcy Preference Law and State Lien Law

Whether a vendor who is protected under a state’s lien law, must return preference payments when the general contractor files bankruptcy raises the doctrine of preemption. A state’s lien laws are created by the state legislature, while the bankruptcy laws are created by Congress and are a federal statutory scheme.

Preemption may exist if Congress passes a federal law that is intended to block enforcement of a state law, here the lien laws. While Congress crafted the Bankruptcy Code to cover most aspects of debtors and their creditors, there a number of state laws that also govern these rights.

Where a court is requested to interpret whether a state law, here the lien law, is preempted by a federal law, here the Bankruptcy Code, the inquiry is whether the state law conflicts with the federal law. In a recent decision, the bankruptcy court in In re IT Group, Inc., considered whether the bankruptcy laws preempted a state’s lien, thereby opening the door for vendor to face a preference claim.

Preference and the Subcontractor

In In re IT Group, the debtor’s creditors’ committee sued two of its material suppliers for payments received during the preceding 90 days the debtor’s bankruptcy filing (preferences). The suppliers sought to have the preference actions dismissed as the transfers were trust property under state lien law and thus was not property of the estate.

In opposition to dismissal of the preference action, the creditors’ committee contended that the preference provision was intended to ensure equitable distribution to all the creditors. The material suppliers cited to cases wherein courts found that funds held in trust under state law for the benefit of subcontractors and material suppliers was not a preference.

The bankruptcy court concluded that the material supplier and subcontractor were entitled to judgment in their favor because the state lien law created a statutory trust. The funds were not property of debtor’s bankruptcy estate because the funds received by the general contractor for the improvement of real property is to be held in trust for the benefit of the subcontractors. The court noted that the preference defendants provided labor, services, and materials in connection with the prime contracts and therefore the preference actions should be dismissed. The court observed that the Bankruptcy Code did not preempt the state lien law.

Conclusion

The IT Group decision encourages the subcontractor and material supplier to continue supplying their financially struggling general contractor. While the IT Group court underscores that the particular state’s lien law protects the vendor from a preference claim, be mindful that the state lien laws are statutory and thus may vary from state to state. Vendors may use the IT Group ruling as a means to negotiate a dismissal or reduction in the preference demand, depending on the state lien statute.