Bankruptcy Preference and State Mechanic’s Lien Laws: Is the Subcontractor Protected from the Preference?

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 law 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, which considered the interplay of the state lien law and federal Bankruptcy Code’s preference provision, is considered.

Interplay of Federal Bankruptcy Preference Law and State Lien Law
Whether a vendor who is protected under a state’s lien law must return preference payments when the general contractor files bankruptcy falls under the doctrine of preemption. A state’s lien laws are created by the state legislature, while the bankruptcy laws are created by Congress and are a federal statutory scheme. Preemption may exist if Congress passes a federal law that is intended to block enforcement of a state law, here the lien laws. While Congress crafted the Bankruptcy Code to cover most aspects of debtors and their creditors, there are a number of state laws that also govern these rights. Where a court is requested to interpret whether a state law, here the lien law, is preempted by a federal law, here the Bankruptcy Code, the inquiry is whether the state law conflicts with the federal law. In a recent decision, the bankruptcy court in In re IT Group, Inc., considered whether the bankruptcy laws preempted a state’s lien, thereby opening the door for the vendor to face a preference claim.

Preference and the Subcontractor
In In re IT Group, the debtor’s creditors’ committee sued two of its material suppliers for payments received during the preceding 90 days of the debtor’s bankruptcy filing (preferences). The suppliers sought to have the preference actions dismissed as the transfers were trust property under state lien law and thus were not property of the estate. In opposition to dismissal of the preference action, the creditors’ committee contended that the preference provision was intended to ensure equitable distribution to all the creditors. The material suppliers cited cases wherein courts found that funds held in trust under state law for the benefit of subcontractors and material suppliers was not a preference. The bankruptcy court concluded that the material supplier and subcontractor were entitled to judgment in their favor because the state lien law created a statutory trust. The funds were not property of the debtor’s bankruptcy estate because the funds received by the general contractor for the improvement of real property is to be held in trust for the benefit of the subcontractors. The court noted that the preference defendants provided labor, services and materials in connection with the prime contracts and therefore the preference actions should be dismissed. The court observed that the Bankruptcy Code did not preempt the state lien law.

The IT Group decision encourages the subcontractor and material supplier to continue supplying their financially struggling general contractor. While the IT Group court underscores that the particular state’s lien law protects the vendor from a preference claim, be mindful that the state lien laws are statutory and thus may vary from state to state. Vendors may use the IT Group ruling as a means to negotiate a dismissal or reduction in the preference demand, depending on the state lien statute.
Source: Blakeley & Blakeley, LLP

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