Third Circuit Decision Denying Supplier’s Attempt to Secure Payment Through Mechanics’ Lien Emphasizes the Need for Careful Planning

The U.S. Court of Appeals for the Third Circuit recently provided guidance to practitioners representing suppliers and materialmen looking to secure their otherwise unsecured debt through the filing of a mechanic’s lien following the bankruptcy of a contractor. In its March 30, 2017, opinion in In re Linear Electric Company,[1] the Third Circuit Court of Appeals held that a creditor’s perfecting of a mechanic’s lien after the commencement of the contractor’s bankruptcy case violated the automatic stay, and upheld the bankruptcy court’s decision invalidating the lien. To avoid such a result, counsel for a creditor with mechanic’s lien rights should be familiar with the governing state lien law, and take steps early in the representation to better protect the client’s rights to payment.

In Linear Electric, two suppliers (collectively, the “suppliers”) sold electrical materials to Linear Electric Co. Inc. (the debtor), who in turn incorporated the materials into several construction projects owned by third-party developers (the owners). The debtor failed to pay the suppliers for their materials and subsequently commenced a chapter 11 case in the U.S. Bankruptcy Court for the District of New Jersey. Subsequent to the filing, the suppliers filed mechanic’s liens under New Jersey law against the properties where the work had been performed. The suppliers reasoned that their liens attached only to the properties, which were owned by the non-debtor owners, and not to any assets of the debtor’s estate. Accordingly, the suppliers believed that their liens did not violate the automatic stay.

The debtor disagreed, however, and filed a motion to discharge the liens as violating the automatic stay. The bankruptcy court agreed with the debtor, held that the mechanic’s liens violated the stay and were therefore void ab initio, and ordered the suppliers to discharge the liens. The district court affirmed the bankruptcy court’s decision, and the suppliers appealed to the Third Circuit Court of Appeals.

The question presented on appeal was whether the suppliers’ filing mechanic’s liens under New Jersey law violated the automatic stay of the contractor/debtor. The appeals court agreed with the two courts below and held that the suppliers’ filing of the liens against the debtor indeed had violated the automatic stay, because under New Jersey law a mechanic’s lien attaches not only to the property under development, but also to the accounts receivable owed to the contractor by the owner. So in the case at hand, the suppliers’ liens had violated the stay because they had attached to the receivables owed to the debtor by the owner, which were undoubtedly property of the debtor’s estate.

The court of appeals explained that an important distinction exists between New Jersey’s lien law, which provides that mechanic’s liens are effective as of the filing date, and the laws of certain other states, such as Pennsylvania, which provide for retroactive effect. For example, Pennsylvania’s statute gives mechanic’s liens retroactive effect back to the visible commencement of work at the site. If the governing law gives a lien retroactive effect to a time prior to the petition date, then the lien would fall under a certain exception to the stay set out in § 362(b)(3) of the Bankruptcy Code permitting perfection of lien interests where the applicable law provides that the lien would be effective retroactively to a date prior to the commencement of the bankruptcy case.[2] However, because New Jersey’s lien statute does not provide for retroactive effect, a mechanic’s lien filed under New Jersey’s law does not fall within that exception to the automatic stay. Accordingly, a post-petition mechanic’s lien filing under New Jersey law will violate the automatic stay if it attaches to any property of the debtor’s estate.

The Linear Electric decision serves as a reminder to counsel that they must be aware of state law, as well as the Bankruptcy Code, in representing clients with mechanic’s lien rights. Counsel must be able to determine whether (1) under the applicable statue a mechanic’s lien would impact property of a contractor’s bankruptcy estate, and (ii) the lien would fall outside of the scope of the stay exception applicable to liens having retroactive effect.

In the event that a mechanic’s lien filing would both impact property of the contractor and fall outside of the § 362(b)(3) exception to the automatic stay, creditors with lien rights against a potentially insolvent contractor should file their liens as promptly as possible with the applicable state office to try to get their rights on file prior to the contractor’s commencing a bankruptcy case. Once the contractor commences a bankruptcy case, the automatic stay becomes applicable.

If the creditor is too late and has failed to file its lien prior to the contractor’s commencing a bankruptcy case, the creditor may still wish to file its lien so that it can at least obtain its rights as a mechanic’s lien holder with respect to the owners and any other applicable nondebtor parties. To do so, the creditor would need to seek relief from the automatic stay prior to filing its lien. In this situation, counsel should be aware that in many states, mechanic’s liens are subject to strict filing deadlines under state law. Accordingly, a creditor requiring automatic stay relief prior to asserting a lien should seek relief as promptly as possible so that the delays attendant to seeking relief do not cause the creditor to miss the state law filing deadline.