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Tools to Protect Construction Businesses from the Effects of a Third Party Bankruptcy
Tools to Protect Construction Businesses from the Effects of a Third Party Bankruptcy

As we near the mid-point of 2023, the economic outlook continues to remain uncertain at best. The Federal Reserve continues to raise interest rates, sending ripple effects throughout the markets. While the employment data continues to be strong in most sectors, inflation has only subsided minimally, leaving many to wonder what the remainder of 2023 will bring.

Amidst this uncertainty, the number of bankruptcy filings has – not surprisingly – increased significantly. According to the American Bankruptcy Institute (ABI), the April year-over-year statistics for chapter 11 and subchapter V bankruptcy cases - the two types of bankruptcy cases most often used by businesses – showed increases of 32% and 81%, respectively. Subchapter V bankruptcy offers a particularly attractive option for small businesses to reorganize, as it is faster, less costly, and more flexible than a traditional chapter 11 bankruptcy.

While we have seen waves of retail and restaurant filings in recent years, anecdotal evidence suggests that the construction sector may be next. Because the construction industry relies on a web of suppliers, subcontractors, and general contractors, the bankruptcy of one construction-related business can have wide-ranging effects on the various parties to a construction project, including owners, contractors, and even municipalities.

Contractors and suppliers have statutory and contractual protections to help protect their business. However, the extent to which a contractor can take advantage of these protections can change drastically once the debtor entity files for bankruptcy. Here are some things to watch out for:

  • Mechanic’s Liens – Virginia, Maryland, and DC all provide for a statutory lien as a means of securing payment for contractors, subcontractors, suppliers, laborers, architects, engineers, etc. Whether you can take action to perfect a mechanic’s lien once the target files for bankruptcy depends in part on the location of the project, as local law will determine when the lien arises. If the lien arose under state law prior to the bankruptcy filing, you may be able to perfect the lien while the bankruptcy is pending without violating the automatic stay that arises under the Bankruptcy Code.
  • Insurance – If your contract requires subcontractors to purchase insurance for stored materials, make sure that each time you make an advance, you get an insurance certificate which states with specificity the materials being insured. If the subcontractor files for bankruptcy and you do not have a valid insurance certificate with a specific list of covered materials, it will be difficult if not impossible to recover on a claim filed against the insurance company.
  • Surety Bonds – A surety bond is generally not considered property of the bankruptcy estate. Once a bankruptcy is filed, you can still pursue a claim against the surety without violating the automatic stay. Upon validation of the claim, the surety will pay you the amount of the claim and will then “step into your shoes” to pursue your claim against the bankruptcy estate. The surety may avail itself to any of the legal remedies to which you were entitled. For example, the surety can assert that a claim is nondischargeable or is entitled to priority treatment.

Mechanic’s liens, proper insurance coverage, and surety bonds are all tools to minimize the impact of a third-party bankruptcy on your construction projects and business. Bankruptcies can, however, have wide-ranging effects and can be treacherous to navigate without the advice of experienced bankruptcy counsel. If your business is affected by a bankruptcy filing (or is considering filing bankruptcy itself), the Hirschler construction practice and bankruptcy and creditors’ rights team is ready and able to help.

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