Contractor’s Inchoate Lien Defense Defeats a Preference, Most Courts Hold

A contractor with the right to file a lien for uncompensated work and materials cannot receive a preference, according to Bankruptcy Judge Stacey G.C. Jernigan of Dallas, who adopted the position of the majority.

A contractor agreed to construct a building on the owner’s property for $480,000. Still owed $290,000, the contractor signed a “final payment lien waiver” and received the $290,000 two months later. Three weeks after the payment, the owner filed a chapter 11 petition that later converted to chapter 7.

The chapter 7 trustee sued the contractor, alleging that the $290,000 payment was a preference under Section 547.

The contractor filed a motion for summary judgment, contending that the payment was not a preference as a matter of definition because it held an inchoate lien. The parties agreed that the contractor had a right to file a lien, that the lien would have been valid, and that the lien itself could not have been avoided as a preference.

In her June 4 opinion, Judge Jernigan granted the contractor’s motion for summary judgment and held that the $290,000 payment was not a preference.

Among the five elements of a preference, the only dispute involved Section 547(b)(5) and the question of whether the contractor received more than it would have realized in a chapter 7 liquidation. The contractor argued there was no preference, as a matter of law, because the inchoate lien meant it would have been paid in full in a hypothetical chapter 7 liquidation.

Conceding that the contractor had an inchoate lien under North Carolina law, the chapter 7 trustee argued that the contractor waived the lien and only had a general unsecured claim when it signed the lien waiver. As a result, the trustee contended that the payment on the unsecured claim was a preference.

Judge Jernigan focused on the language of the lien waiver signed by the contractor. It said, “In consideration for the final payment . . . , the undersigned Contractor hereby . . . waives and releases any and all liens . . . .”

Judge Jernigan said that the “plain language” of the document “expressly conditioned” the waiver of lien “upon its receipt of the final payment.” The waiver, she said, did not become effective until the payment was actually received.

“There was simply no other commercially reasonable interpretation,” Judge Jernigan said. “To adopt the Trustee’s view would be to conclude that [the contractor], for a reason not disclosed in the record, waived its inchoate lien rights while still owed [$290,000].”

Having established that the contractor did not waive its inchoate lien rights until it was actually paid, Judge Jernigan next ruled that the contractor was not required to have perfected its lien before bankruptcy to avoid having received a preference.

On that issue, Judge Jernigan said, the courts are divided. A “small minority” hold that the failure to perfect the lien classifies the contractor as an unsecured creditor, making the payment preferential. The “majority,” she said, “focus on the facts that existed at the time of payment. If the creditor could perfect the lien under state law at the time payment is made, and the perfection of the lien is not avoidable under the Bankruptcy Code, then the payments are not recoverable.”

Quoting Bankruptcy Judge Allan L. Gropper of New York, Judge Jernigan said that the inchoate lien defense to Section 547(b)(5) avoids the “‘unreasonable Hobson’s choice between accepting payment (with the attendant risk that it could be avoided if the payor enters bankruptcy) or taking the commercially unreasonable step of declining payment in order to perfect an inchoate statutory lien.’” Official Comm. of Unsecured Creditors of 360Networks (USA), Inc. v. AAF–McQuay Inc. (In re 360Networks (USA), Inc.), 327 B.R. 187, 195 (Bankr. S.D.N.Y. 2005).

The opinion concludes with a discussion of the allocation of the burden of proof and Section 547(g), which places the burden on the trustee of proving the elements of a preference under Section 547(b).

Regarding the hypothetical recovery by the contractor in chapter 7, the property had been sold before conversion to chapter 7. The sale contract put a $430,000 value on the property built by the contractor.

The trustee argued that $430,000 was the going concern value. According to the trustee, the contractor had not proven that a chapter 7 liquidation would have generated more than $290,000, to make the contractor fully secured.

Judge Jernigan said that the trustee overlooked Section 547(g), which required the trustee to prove what the contractor would have received in a hypothetical chapter 7 liquidation. In the absence of any “probative evidence” regarding liquidation value, she said the contractor was entitled to summary judgment.