Industry leaders agree that the economy has turned the corner and private construction projects are on the uptick.  Banks have eased lending requirements and there is more private equity money on the streets.  Inexperienced developers are entering the arena and experienced developers are less guarded and taking on more risk.  On the flip side, small general contractors are growing into large construction managers and those guys who worked from their pickup trucks a few years back are now “reputable” trade contractors bidding on multi-million dollar subcontracts.  All of these ingredients are a recipe for a project bankruptcy.

This article is the first in a series that will examine the implications of a bankruptcy filing by an owner, a construction manager and subcontractor from the perspective of both a construction manager and then an owner.  This article addresses the owner’s filing for bankruptcy during the construction phase of a project from the construction manager’s perspective.

As a construction manager, the starting point for protecting your company from an owner bankruptcy is the construction contract itself.  Many states including New York, Massachusetts and Connecticut have significant statutory schemes protecting a contractor’s right to payments and providing for lien rights and maximum retainage withholding on most large private construction projects, among other protections.

Prudent construction managers will negotiate the most favorable payment terms possible; and once the work commences they won’t get too far ahead of the payments.  Payment terms should be no more than thirty days and many states have statutes mandating the timing of payments.  Construction managers should seek the right to suspend work for non-payment and the ability to collect interest on late payments.  Retainage should be limited to the statutory minimum but in no case greater than 10%.  Provisions that provide for the early release of retainage, including payment of retainage upon completion for those large subcontractors who perform and complete their work early (e.g. site work, concrete etc.) will reduce the amount of earned contract proceeds at risk should a bankruptcy be filed.  The standard AIA clause providing the construction manager with the right to reasonable evidence of the owner’s financial ability provides added security if warning signs of financial trouble appear.  Construction managers should carefully review lien waivers ensuring proper carve-outs for change orders and other claims.  Finally, a strong form subcontract with “paid if paid”, and trust fund language will protect your company against subcontractor claims in the event of an owner bankruptcy.

If an owner bankruptcy is in fact filed the construction manager should immediately determine its lien rights and to the extent permitted under state law file or perfect a mechanic’s lien against the property.  If the owner leases the building or land an investigation should be made to determine what extent a lien can be filed against the fee simple owner in addition to the project owner’s leasehold interest.  In most states like New York and Connecticut, if it can be established that the fee simple owner consented to the performance of the work a lien can be filed against the fee simple owner who is not in bankruptcy and will probably be quite motivated to obtain a release of that lien.  Once liens are filed most states require their perfection which typically requires a bankruptcy court notice or bankruptcy court intervention.  To foreclose upon a lien, a construction manager would need to obtain relief from the automatic stay.

Next, track down the retainage.  Remember, retainage monies are earned contract proceeds which arguably are not the property of the owner or its bankruptcy estate.  To the extent these funds were segregated a good basis might exist to obtain the release of these monies from the estate.  Several states including New York have strong trust fund statutes that provide added protection for earned contract proceeds and strengthen the construction manager’s ability to recover these funds including retainage in bankruptcy.

Although most subcontracts contain some form of a “paid if paid” or “paid when paid” provision, the enforceability of which is questionable depending upon where the project is located, contact subcontractors and attempt to negotiate liquidating agreements.  Such an agreement recognizes the costs associated with pursuing an owner for contract funds and retainage and allocates the associated costs and risks up front.  Most of these agreements provide the subcontractor with a right to participate in the process and a seat at the table for any mediation or settlement discussions.  Importantly, to be effective, a liquidating agreement should limit the construction manager’s liability to the amount actually recovered from the owner for the subcontractor’s work less costs and fees.

Other bankruptcy considerations for construction managers include considering whether a 503(b)(9) claim can be asserted, which can provide payment for materials furnished to the project in the twenty days leading up to the bankruptcy filing at a priority payment above that of general unsecured creditors.  Also investigate the possibility of finishing any uncompleted project under a new or existing agreement.  The construction manager of record brings to the table knowledge of the work in place, budget, subcontractor relationships and other points of leverage.  These might be used to negotiate full or partial payment for the work in place in exchange for an agreement to finish the project.

While most bankruptcies are unexpected at the start of a project, the ingredients tend to appear like warning signs as the work progresses.  Take notice and react accordingly.  Note that while this article sets out general observations, the actual circumstances encountered will dictate what actions or strategies should be employed and a construction manager should always consult their attorney before taking any action.