Bankruptcy preference and state mechanic's lien laws: is the subcontractor protected from the preference?(CREDIT COLUMN)

A fundamental responsibility of a credit executive is assessing a debtor's credit risk. For credit executives employed by subcontractors and material suppliers, states have created special protections to these vendors to reduce or eliminate credit risk through mechanic's lien laws. However, what is the effect of the state lien laws where the general contractor files bankruptcy? Are payments made to the subcontractor and materialman during the preference period recoverable by a bankruptcy trustee, or do the states' lien laws protect the vendors from the preference risk? A recent bankruptcy case that considered the interplay of the state lien law and federal Bankruptcy Code's preference provision is considered.

The Bankruptcy Preference

The Bankruptcy Code vests the debtor (or trustee, if one is appointed) with far-reaching powers to recover payments to vendors within 90 days of the bankruptcy filing. The power to avoid preferential transfers is one of the most powerful weapons a trustee has. The bankruptcy preference is part of the Bankruptcy Code, which is a federal law that applies to all states uniformly. The purpose of the preference provision is two-fold.

First, unsecured creditors (or undersecured creditors, e.g., those creditors whose collateral is valued at less than their debt) are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain unsecured creditors by the requirement that any unsecured creditor that receives a greater payment than similarly situated unsecured creditors disgorge the payment so that like creditors receive an equal distribution of the debtor's assets.

Not all transfers made within the preference period are avoidable. To protect those transactions that replace value to the bankruptcy estate previously transferred, the Bankruptcy Code carves out seven exceptions or defenses to the trustee's recovery powers. The most commonly asserted exceptions by vendors are the contemporaneous exchange defense, the subsequent advance defense and the ordinary course of business defense.

Mechanic's Liens

State mechanic's lien laws ensure payment to vendors extending credit for supplying labor and materials that improve property, by allowing the vendors to look to the owner of the property for payment. Many states provide for a payment bond in lieu of a mechanic's lien.