The Intersection of Lien Laws and Federal Bankruptcy Law

Gregory J. Wartman
Published June 6, 2017

This update relates to one of the most fascinating and widely studied areas of the law—the intersection of state construction lien law and federal bankruptcy law. Okay, so maybe this is not the most interesting legal topic, but a recent decision in this area from the Court of Appeals for the Third Circuit has important implications for the respective construction lien rights and obligations of subcontractors and contractors in New Jersey.

In Re: Linear Electric Company, Inc. presented the Court with the question of whether subcontractors that filed construction liens against the real property where their materials were incorporated violated the automatic stay imposed as part of the general contractor’s Chapter 11 bankruptcy. The subcontractors, Cooper Electrical Supply Co. and Samson Electrical Supply Co., sold electrical materials to Linear Electric Company. Linear incorporated those materials into several construction projects in New Jersey but failed to pay Cooper and Samson for their materials. On July 1, 2015, Linear filed for Chapter 11 bankruptcy in federal bankruptcy court. Two weeks later, the two unpaid subcontractors filed construction liens under the New Jersey Construction Lien Law against the developments in which their materials were incorporated. Shortly thereafter, Linear filed a motion with the bankruptcy court to discharge the liens on the grounds that they violated the automatic stay that flowed from its bankruptcy filing.

The Bankruptcy Court ruled that the liens violated the automatic stay. The District Court affirmed, and on appeal—the Court of Appeals for the Third Circuit also affirmed. The Court recognized that under federal law, the filing of a bankruptcy petition automatically stays, among other things, “any act to create, perfect, or enforce any lien against property of the estate . . . .” The Court ruled that although Cooper and Samson’s liens encumbered real property owned by developers, the liens violated the automatic stay nonetheless. In arriving at this conclusion, the Court reasoned that under New Jersey’s construction lien claim payment process, Cooper and Samson are second tier claimants, and payment of their lien claims would reduce any balance owed by the developers to the contractor. In other words, on Linear’s balance sheet, its accounts receivable would be reduced by the amounts that the third-party developers had previously owed to Linear for Cooper and Samson’s materials, which would now be paid directly to Cooper and Samson to satisfy their construction lien claims (bypassing Linear). Because Linear filed for bankruptcy, Cooper and Samson’s liens would be paid by transferring part or all of Linear’s asset—its accounts receivable—from the bankruptcy estate directly to Cooper and Samson. Because an asset was in effect reduced by the filing of Cooper and Samson’s construction liens, the Court determined that this violated the stay.

The subcontractors contended that the automatic stay did not apply because the liens attached to the real property owned by third-parties—and not to Linear’s property interests. The Court disagreed, ruling that “the stay applies to any lien ‘against’ Linear’s interests in property, not solely those that ‘attach’ to Linear’s interests in property, and the Construction Lien Law expressly contemplates that a lien may be against something to which it does not attach.” In other words, the construction lien can be against a contractor’s accounts receivable in addition to the real property owned by a third-party.

The Court also rejected the lien claimants’ argument that the liens might not have been against Linear’s interests in property because Linear may have had no interests in the debts of the developers. Although the contracts between Linear and the developers were not part of the record, the lien claimants reasoned that those contracts might state that Linear’s payment to its suppliers was a condition precedent to its right to payment for its work. They contended that the existence of such provisions would mean that Linear would have no property interest in anything from the developers, and the automatic stay would not have been violated. The Court noted, however, that if such provisions existed and Linear had no right to payment from the developers, then the value of the lien claim would be zero.

Because construction/mechanics’ lien laws vary significantly from state to state, contractors and owners should consult with legal counsel about whether the ruling in Linear would apply to the mechanics’ lien laws in their states.

The case is In Re: Linear Elec. Co., Inc., 852 F.3d 313 (3d Cir. 2017).