May 11, 2006

Savvy subcontractors and suppliers understand the importance of protecting their lien rights. Two new cases highlight the importance of just having lien rights at the time of payment, even if paperwork is not filed to perfect the lien. This approach may provide a defense to a later action to recover the payment as an "avoidable preference" brought by a bankruptcy trustee.

Sometimes extraordinary collection efforts are required if an owner or general contractor has financial problems. If an owner or general contractor files a bankruptcy proceeding, subcontractors and suppliers may get a nasty surprise: a bankruptcy trustee may demand return of payments received by the subcontractor or supplier within 90 days before the bankruptcy. These are so called "preferential transfers".

A preferential transfer is a payment made to or for the benefit of the subcontractor or supplier, a creditor of the debtor, on account of work previously performed. The check cashed by the subcontractor or supplier must clear the account of the debtor within the 90 days before the petition was filed, and the payment must have been made with the debtor was insolvent. The transfer must enable the creditor to receive more than the creditor would have received through the bankruptcy distribution had the transfer not been made.

In the two recent cases, suppliers of construction materials successfully defended themselves. The suppliers argued that at the time of the payment, they had the right to file a lien but had not done so.

The first case arose in bankruptcy proceedings of 360 Networks (USA), Inc. in New York. A group of suppliers argued that they each had the right to file a lien against a construction project for materials at the time of payment from the debtor. Because of this lien right, the payment did not "prefer" them over other unsecured creditors. The bankruptcy judge agreed that the existence of these "inchoate" lien rights enabled the suppliers to successfully defeat the preference claims of the bankruptcy trustee.

The decision in the case of 360 Networks (USA) was subsequently followed with approval in the bankruptcy case of Electron Corp. in Colorado. The bankruptcy trustee brought suit to recover $14,967 from JCOR Mechanical, Inc. on the ground that JCOR had received avoidable preferences. The bankruptcy court originally rejected the argument of the supplier creditor that it would have filed a lien had it not been paid. This decision was reversed on appeal, and the supplier creditor won. The Bankruptcy Appellate Panel held that the supplier had a good defense even if the lien was not actually filed.

Each of the suppliers in these cases still had to prove that their mechanic's lien rights were valid under state law at the time they received payment. Also, the property must have sufficient value to support the lien. In other words, to use this defense, the supplier or subcontractor has to show that it had satisfied all statutory pre-requisites to perfecting a lien prior to the time they receive payment. This means that subcontractors and suppliers must take care to preserve their rights by providing a preliminary notice in states that require this. A guide to what is necessary to preserve your lien rights in each state is available from ASA in the CD/ROM publication "Lien and Bond Claims in the 50 States."

These cases again highlight the importance of taking all the preliminary steps required under state law to perfect a subcontractor or supplier mechanic's lien. Even if the lien is not filed, the fact that the right to lien existed at the time of payment may prove useful in defeating a claim to avoid the transfer. This means that the subcontractor or supplier may retain the hard-won account receivable.