The U.S. Court of Appeals for the Third Circuit’s recent decision in Linear Electric Company Inc. vs. Cooper Electric Supply Co. and Samson Electrical Supply Co. Inc. significantly increases risk for New Jersey construction subcontractors seeking to collect on claims for materials sold or services provided to construction contractors that file bankruptcy prior to paying for those materials or services.
Generally, under New Jersey’s construction lien law, when a supplier sells materials on credit to a contractor who then incorporates those materials into property located in New Jersey that is owned by a third party, the supplier can file a lien which “attaches” to the owner’s property for the amount the contractor owes the supplier for those materials. The supplier can then directly recover from the property owner on its claim for unpaid supplies—but only in an amount equal to the account receivable owed to the contractor by the owner. In other words, the supplier can collect the debt the owner owes to the contractor to satisfy its own account with the contractor. Given this statutory framework, suppliers selling materials on credit outside the bankruptcy context have a significant added source of recovery, knowing their accounts are secured by construction liens on the property of the owner (who does not want its property subject to liens).
Under bankruptcy law, when a contractor files bankruptcy, there arises an automatic stay which protects the contractor/debtor from any actions by creditors to collect a debt, including the creation or enforcement of liens “against” property of the debtor. Prior to the Third Circuit’s decision in Linear Electric, it was not clear whether the filing of a construction lien under New Jersey’s construction lien law after a contractor filed for bankruptcy constituted a violation of the automatic stay. Since the construction lien “attaches” to the property of the owner—not the property of the contractor—there is a reasonable argument that the filing of the lien would not violate the automatic stay, because such property is not property of the contractor’s estate.
In Linear Electric, however, the Third Circuit, affirming decisions of the Bankruptcy Court and the United States District Court, held just the opposite. The Third Circuit held that the act of perfecting a construction lien after a contractor’s bankruptcy filing violated the automatic stay. The court emphasized that although the liens “attached” to the real property of a non-debtor owner, the recovery by the supplier on account of the construction lien is, as a practical matter, from the accounts receivable owed to the contractor by the owner. The court concluded, therefore, that the lien was “against” property of the contractor (the accounts receivable) and the act of filing the lien violated the automatic stay and was void. In short, the court determined that although a construction lien under New Jersey law attaches to the property of the owner, it is also “against” property of the contractor within the meaning of the Bankruptcy Code.
The Third Circuit’s decision restricts the ability of suppliers who provide goods or services to projects in New Jersey to secure their accounts with construction liens after their contractor has filed bankruptcy. On the flip side, it provides contractors who file bankruptcy with the ability to collect accounts receivable owed by the project owner (to the extent the owner does not otherwise have valid defenses) and improves the prospects that the contractor can reorganize its financial affairs. While suppliers could formerly seek solace in the exact argument advanced by the suppliers in Linear Electric, the Third Circuit’s decision confirms that the concept of property of the bankruptcy estate is, indeed, a far-reaching one, providing the utmost protection to the debtor’s estate. In light of this decision, suppliers to construction contractors in New Jersey should consider taking the following steps to reduce their risk:
(i) Reduce accounts receivable turnover ratio by adopting more conservative policies on credit extension;
(ii) closely monitor the creditworthiness of contractors to avoid unexpected bankruptcy issues and, particularly, so that a construction lien can be obtained and perfected prior to bankruptcy; and
(iii) if choosing to deal with a contractor whose financial situation is questionable, request adequate assurance of payment for the services or materials provided.
– Paul Kizel, Esq., is a partner and Nicole Fulfree, Esq., is an associate at Lowenstein Sandler LLP’s Bankruptcy, Financial Reorganization & Creditors’ Rights Department. Lowenstein Sandler represents the Official Committee of Unsecured Creditors in the Linear Electric Co. Inc. Chapter 11 case.