Treatment of Mechanic’s Liens in the Wake of Construction Failures

The collapse of a commercial construction project may result in reorganization or liquidation through an insolvency proceeding overseen by a bankruptcy trustee or receiver. As part of the wind-down process, following the liquidation of assets the fiduciary has an obligation to equitably distribute any remaining and recovered assets to the estate’s creditors. Consequently, in order to properly allocate the assets, the fiduciary has a duty to analyze all creditor claims, including statutory lien claims.

Mechanic’s Lien Validity

The first step in examining the validity of statutory lien claims is to gather and evaluate the supporting documentation for each claim of lien. Inadequate documentation can present its own unique challenges, and the trustee or receiver may be obligated to object to a claim, even if it is listed on the debtor’s bankruptcy schedules as undisputed, in order to obtain supporting documentation.[1]

The following construction documents are examples of those commonly evaluated by a fiduciary in analyzing mechanic’s lien claims: (1) contract or subcontract agreements, (2) change order requests, (3) invoices, (4) purchase orders, (5) applications and certificates for payment, (6) continuation sheets, (7) waivers and releases for progress payments, and (8) support to show that the lien has been properly perfected under state law. This review process can be time-consuming and burdensome, as the documentation is often voluminous.

Issues may arise while reviewing construction records to determine the validity of the claim and the authenticity of the dollar amount of the statutory lien claim. The reviewer should diligently evaluate the records received to confirm that the claims are supported by proper documentation and that the claim amounts match the support submitted. One must also consider how the claim was recorded in the debtor’s books and records.

While it is ultimately up to the fiduciary to decide the procedures by which statutory lienholder claims are analyzed, the following are some helpful guidelines. First, the contract or subcontract agreement should be reviewed. Then, the reviewer should confirm that all change orders included in the claim amount had been approved by the debtor prior to performance. The fiduciary might object to claim amounts for unapproved change orders. The mechanic’s lien should only be for work actually performed and completed under the contract. The reviewer should check for documentation that confirms that the work was completed. Finally, confirm that the claim amounts match the lien amounts. If any issues arise, the trustee or receiver may decide that a reduction or rejection of the statutory lienholder claim is necessary.

Another key issue for consideration is whether or not the claimant was properly licensed to perform the work. Generally, a professional license is required to establish a valid mechanic’s lien.

Occasionally, a lienholder will sell its claim at a deep discount to another party. The laws surrounding the transfer or assignment of claims should be considered, since the transfer of claims may not be valid based on the laws in certain states. Because a lien claim is an asset, most states will allow it to be assigned. There are, however, a few states that do not authorize the assignment of a mechanic’s lien claim.[2]

Perfection

Generally, construction liens must be properly perfected in order for the lienholder to have a valid secured claim. Proper timing and notices are imperative to perfecting liens. The general requirements for the perfection of mechanic’s liens include the recordation and service of (1) notice of right to lien, (2) notice of lien and (3) lien foreclosure. Mechanic’s liens are governed by specific statutory provisions in each state.[3] Whether a lien is properly perfected is an issue that a trustee or receiver must consider.

First, the notice of right to lien, sometimes called a notice of commencement, should be delivered in person or by certified mail to the property owner. The timing requirements depend on state statute. Then, the contractor or subcontractor must record the notice of lien and deliver it to the owner within a certain number of days after the notice of right to lien. The notices typically have strict service requirements, with state law prescribing the exact form of each notice and the manner in which they must be served to the property owner. A lien is only effective for a certain amount of time after the notice of lien has been recorded, unless a lawsuit has been commenced to foreclose or the parties agree to extend it.

When a debtor files for bankruptcy, an automatic stay under 11 U.S.C. § 362 bars nearly all creditor actions against the debtor and/or the debtor’s property, including perfecting a lien, unless the bankruptcy court grants relief from the stay.[4] There is an exception that allows a creditor to properly perfect its construction lien without violating the automatic stay. Section 546(b)(1) permits the post-petition perfection, maintenance or continuation of perfection of a property interest, such as a mechanic’s lien, that arose prior to a debtor’s bankruptcy filing, to be effective against any third party that acquired rights in the property prior to the date of perfection, and/or the date of any act to continue or maintain perfection of the lien.[5]

Who Is Entitled to a Mechanic’s Lien?

A unique issue that may arise in the review of mechanic’s lien claims is the duplication of sub-tier lienholder claims. In a construction project, contracts flow down from the owner to the general contractor to the subcontractors to the suppliers. This structure may create confusion as to whom debts are due. A claim for the same work should only be paid once. For example, if the debtor retained a general contractor who subcontracted with other parties to provide services, both the general contractor and the subcontractor might record a mechanic’s lien claim relating to the same work contracted and completed. Since this results in two separate claims for the same work, the trustee or receiver will likely object to duplicated claims.

The process of identifying the duplication of sub-tier claims may become further convoluted as subcontractors hire sub-subcontractors who may then use multiple material-suppliers or laborers, and so on and so forth. This creates a web that must be untangled. The trustee or receiver might request that the contractor or subcontractor who did not perform the work release its duplicate claim so that the proper party can be paid. The fiduciary must be very cautious in making sure that statutory liens are not duplicated in order to equitably distribute available funds.

Priority

If there is not enough value in the secured asset to pay all security interests, who gets priority? According to § 506(a) of the Bankruptcy Code, an allowed secured claimant of an undersecured property will be entitled to a secured claim up to the value of the secured property and an unsecured deficiency claim for the balance of the debt.[6] Often the value of the collateral is not sufficient to treat all secured creditors as fully secured, and this may lead to a fight over priority.

Sometimes claimants will object to other lienholders’ claims in an attempt to ensure that the value in the collateral is preserved for their own interests. The objecting parties may identify potential issues with other lienholders’ claims, such as documentation issues, licensing issues, or perfection filing, timing and service issues. The trustee or receiver will investigate these concerns objectively.

When there is not enough money to make the various statutory lienholders whole, there are many rules that play into determining priority. In bankruptcy court, priority is determined based on state law. Examples of secured priorities that must also be considered include taxes, mortgages and lines of credit.

Conclusion

In construction project collapses, trustees and receivers are tasked with the duty of equitably distributing funds to mechanic’s lien-holders. This process may be challenging and time-consuming, as the fiduciary must consider lien priorities and ensure that the mechanic’s liens are valid, properly perfected and not duplicated. Construction service providers should be sure to properly perfect their security interest, maintain adequate supporting documentation for potential claims, and claim only the amount they are entitled to.