Fall-09 Kobbe paper - Workshop H (00315270).DOC

I. Introduction

The last three years have been a chaotic and unsettling time for the construction and real estate industries. What began as a slowdown in 2006 quickly turned into a meltdown by 2008. The factors that have impacted the industries are by now well known: plummeting real estate values and sale prices; increasing and excessive inventory; high vacancy rates; a sharp reduction in construction starts; dramatic decreases in revenues for homebuilders and other construction‑related companies; a sharp drop in consumer confidence and spending; the subprime meltdown; a massive de-leveraging by companies in all sectors of the economy; an unprecedented tightening of the credit markets leading to an absence of liquidity both for new projects and for the completion of financially distressed projects; a significant increase in pricing and equity necessary for the financing of projects (in the limited instances where financing has been available); and a surge in mortgage defaults and foreclosures.

The crisis in the construction and real estate industries has led to increasing numbers of bankruptcy filings by real estate developers, homebuilders and other construction-related companies. According to a study issued in February of this year by a major accounting firm, the number of homebuilders that filed bankruptcy in 2008 was nearly double the number of homebuilders that filed bankruptcy in 2007.[1] The same study, which was based on a review of the 33 United States homebuilders with more than $10 million in annual revenues, estimates that more than 30 percent of homebuilders in the United States are in financial distress and in danger of filing bankruptcy.[2]

The number of bankruptcy filings has not slowed in 2009. To the contrary, bankruptcy filings by real estate developers, homebuilders and other construction-related companies have continued at a steady pace.[3] Given the fact that bankruptcy generally is considered to be a lagging indicator of the economic times, the steady pace of bankruptcy filings by developers, homebuilders and other construction-related companies should continue through 2009 and beyond the date of the ultimate recovery of the economy.

As might be expected, bankruptcy filings have been particularly high in the southern and western parts of the United States, including Arizona, southern California, Florida and Nevada. These markets (and, in particular, southern California and Florida) are believed to be the key markets to watch for evidence of a national turnaround.

It should be emphasized that not all financially distressed companies end up in bankruptcy court. For many real estate developers, homebuilders and other construction-related companies with limited balance sheet strength and no realistic prospect of post-petition financing, there frequently is no good reason to even attempt to reorganize through a bankruptcy. Rather than incur the expense and reputational risk associated with bankruptcy (and, in some instances, to protect guarantors from exposure under springing guaranty agreements), many companies (and, in particular, smaller companies) simply cease business operations and surrender their assets to their lenders. Given this reality, tracking the volume of bankruptcy filings tells only part of the story of how the global financial crisis has impacted the construction and real estate industries.

The purpose of these materials is twofold. First, these materials are intended to provide the non-bankruptcy practitioner with a brief overview of bankruptcy law and process, together with a description of how bankruptcy changes the landscape for the interested parties to a construction project. Second, in discussing how bankruptcy changes the landscape, these materials are designed to highlight areas that are of interest to construction practitioners.

II. Brief Overview of Bankruptcy

A. Purpose of Bankruptcy Code

The underlying purpose of the United States Bankruptcy Code (the “Bankruptcy Code”)[4] is to provide debtors burdened by debt (both individuals and businesses) with a “fresh start” and to facilitate the orderly liquidation of debtors whose assets should be liquidated and the orderly reorganization of debtors whose financial affairs should be reorganized. To facilitate the fresh start, the Bankruptcy Code employs two significant concepts: (1) the automatic stay that arises upon the filing of a bankruptcy petition, which halts, among other things, all collection actions of creditors; and (2) the discharge of debts that arose before the bankruptcy filing.

B. Bankruptcy Court Jurisdiction and Venue

The bankruptcy court is an adjunct of the United States District Court. Bankruptcy judges are appointed by the United States Circuit Courts of Appeal and serve for a term of 14 years.[5]

Bankruptcy courts are courts of limited jurisdiction. In general, bankruptcy courts have jurisdiction to enter final judgment on all matters which arise under the Bankruptcy Code or arise in a case under the Bankruptcy Code. These are called “core” proceedings.[6] Bankruptcy courts also may hear all non-core matters that are related to the bankruptcy case, but may only enter a final judgment in such matters if the parties consent. If one of the parties in a non-core related proceeding does not consent, then the bankruptcy court will enter proposed findings of fact and conclusions of law for use by the district court in determining a final order.[7]

Venue for a bankruptcy case generally rests in the district where the domicile, residence, principal place of business or principal assets for the debtor has been located for 180 days before the filing of the petition. It also lies where there is a pending bankruptcy case involving the debtor’s affiliate, general partner or partnership. Venue of a core proceeding or non-core proceeding rests in the district where the bankruptcy is pending. A party may seek a change of venue of a bankruptcy case or adversary proceeding to another district in the interest of justice or for the convenience of the parties.[8]

C. Availability of Chapters 7, 11 and 13

Depending on a particular debtor’s circumstances, a voluntary petition may be filed under one of various chapters of the Bankruptcy Code, the most common of which are Chapters 7, 11 and 13. An involuntary petition may only be filed under Chapters 7 or 11.

Most individuals file bankruptcy under either Chapter 7 or Chapter 13 of the Bankruptcy Code. Under Chapter 7, a trustee is appointed to investigate the financial affairs of the debtor and to liquidate any non-exempt assets (including the pursuit of litigation claims) in order to make a distribution to creditors. Under Chapter 13, the debtor repays his debts to his creditors under a repayment plan that is administered over a period of 48 or 60 months by a Chapter 13 trustee. Under certain circumstances, an individual can file a Chapter 11 case.

Businesses (including corporations, partnerships and other types of business entities) file bankruptcy under Chapter 7 or Chapter 11 of the Bankruptcy Code. A Chapter 7 case is filed by a business that no longer intends to operate but rather chooses to permit a Chapter 7 trustee to liquidate its assets. Chapter 11, on the other hand, is the chapter of the Bankruptcy Code used by businesses seeking to remain in possession of their assets and to either reorganize their financial affairs or conduct an orderly liquidation of their assets.

D. Adversary Proceedings and Contested Matters

There are the two types of proceedings that arise within a bankruptcy case: adversary proceedings and contested matters.

An adversary proceeding is essentially a lawsuit within a bankruptcy case. An adversary proceeding is initiated by the filing of a complaint and, once filed, a separate adversary proceeding number is assigned by the clerk of the bankruptcy court. Adversary proceedings are governed by Part VII of the Federal Rules of Bankruptcy Procedure (the “Bankruptcy Rules”). Bankruptcy Rule 7001 identifies various matters which must be litigated through an adversary proceeding, including a proceeding to recover money or property and a proceeding to determine the validity, priority or extent of a lien or other interest in property. All preference actions and fraudulent transfer actions are adversary proceedings.[9]

Contested matters include a broad range of proceedings that commonly arise in bankruptcy cases. Contested matters tend to be less formal than adversary proceedings, and they are generally initiated by the filing of an application, motion or objection.[10] Some examples of contested matters include proceedings to obtain relief from the automatic stay, proceedings to authorize the use of cash collateral, proceedings to sell assets and proceedings to assume or reject executory contracts and leases.

E. Sources of Bankruptcy Law

In addition to the Bankruptcy Code, practitioners must be familiar with the following:

· Federal Rules of Bankruptcy Procedure;

· Federal Rules of Civil Procedure (which generally apply in both adversary proceedings and contested matters and are incorporated by reference in many of the Federal Rules of Bankruptcy Procedure);

· Federal Rules of Evidence (which, pursuant to Bankruptcy Rule 9017, apply in bankruptcy proceedings);

· Local Rules of the applicable bankruptcy court in which a case is pending (each bankruptcy court, just like each federal district court, has its own Local Rules); and

· Various federal statutes that govern bankruptcy-related matters.[11]

In addition, bankruptcy courts frequently address claims and issues that are governed by federal and state substantive laws. Some examples of areas that commonly arise in bankruptcy proceedings include contract law, employment law, mechanic’s lien law, real estate law and tax law. Bankruptcy practitioners frequently work with practitioners with expertise in these and other areas of the law.

III. How Bankruptcy Changes the Landscape

A bankruptcy filing will immediately change the landscape for all interested parties to a construction project. Although a bankruptcy filing will bring new burdens and risks to both the debtor and other parties in interest (including expense, delay, risk of loss of control of the project and competitive disadvantage), it also may bring benefits that were not available outside the context of a bankruptcy proceeding (including the ability of the debtor to bring an immediate halt to hostile creditor actions that jeopardize the project, the ability to restructure obligations to help ensure that the project is completed, the ability to preserve favorable contracts and to terminate unfavorable contracts and, where necessary, the ability to liquidate assets in an orderly manner designed to maximize value).

The notable consequences of a bankruptcy filing involving a construction project are described in the sections below.

A. The Automatic Stay

A bankruptcy filing will immediately trigger an automatic stay that prohibits creditors from taking action against the debtor or the debtor’s property.[12] The automatic stay is effective against all creditors regardless of notice.

The automatic stay serves a dual purpose. First, the stay protects the debtor from the pressure and harassment of creditors seeking to collect or enforce their claims. The stay thus provides the debtor a “breathing spell” to focus its efforts on the reorganization of its financial affairs. Second, the stay protects creditors by preventing the assault on the debtor’s assets by individual creditors. This promotes the bankruptcy goal of equality of distribution among the debtor’s creditors.

Section 362(a) of the Bankruptcy Code identifies eight broad categories of actions which are “automatically stayed” upon the filing of a bankruptcy petition. As a general matter, any action traditionally taken by a creditor to enforce its rights will fall within the scope of the automatic stay. Certain exceptions to the automatic stay are set forth in Section 362(b) and elsewhere in the Bankruptcy Code. One notable exception for construction practitioners is that the perfection of a mechanic’s lien after the commencement of a bankruptcy case generally is excepted from the automatic stay.[13]

The protection of the automatic stay is not normally extended to non-debtor third parties. In some instances, however, courts have extended the stay to protect guarantors and/or general partners who are involved in the day-to-day operations of the debtor or who have committed to contributing funds to assist the debtor’s reorganization.[14] In granting this relief, courts have relief on the broad language of Section 105(a) of the Bankruptcy Code, which empowers the court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”[15]

Courts hold that creditors have an affirmative duty to comply with the stay, and that actions taken against the debtor’s property without knowledge of the stay are void (or, at least, voidable upon request of the debtor or another party in interest).[16] Innocent violations of the stay generally do not result in the imposition of sanctions. Knowing violation of the stay, however, may result in the imposition of a variety of sanctions, including damages or the equitable subordination of a creditor’s claim. Under Section 362(h) of the Bankruptcy Code, an individual damaged by a willful violation of the stay may recover actual damages, including costs and attorneys’ fees, and punitive damages.[17]

The automatic stay is probably the most common source of litigation in bankruptcy cases. A creditor may move for relief from the automatic stay pursuant to Section 362(d) of the Bankruptcy Code, which specifies two grounds for terminating, annulling, modifying or conditioning the automatic stay: (1) cause, including lack of adequate protection; and (2) with respect to the stay of an act against property, lack of equity in the property and lack of need for the property in an effective reorganization.[18] Under Section 362(e) of the Bankruptcy Code, the bankruptcy court is required to hold a hearing within 30 days from the date on which a motion for relief from stay is filed. Such hearing may be a preliminary hearing, provided that a final hearing is concluded within 30 days of the preliminary hearing, unless extended by consent of the parties or by an order of the court upon a showing of compelling circumstances. Thus, absent compelling circumstances, the court must conclude the hearing on a motion for relief from stay within a maximum of 60 days from the date of filing.[19]

Bankruptcy cases involving distressed construction projects frequently involve relief from stay litigation, as the lender is pressing to obtain immediate control over the project to liquidate its collateral through foreclosure. In such cases, the success of the bankruptcy frequently hinges on the outcome of the lender’s motion for relief from stay filed in the early stages of the bankruptcy case.

Generally, the automatic stay remains in effect until the bankruptcy case is closed, the case is dismissed, or, in the case of an individual debtor in a Chapter 7 or a case under Chapter 11 or 13, when a discharge is granted or denied.[20]

B. Disclosure of Financial Information

Bankruptcy is designed to be a transparent process, and an important part of the process is the public disclosure of financial information. This disclosure is designed to provide a level playing field by providing all creditors and interested parties with adequate information to make decisions regarding their course of action in the bankruptcy case.

A debtor must file with the court detailed schedules of assets and liabilities, as well as a statement of financial affairs that requires the debtor to disclose additional detailed information. In addition, all Chapter 11 debtors must file with the court monthly operating reports that identify all financial transactions.

The Office of the United States Trustee (an arm of the Department of Justice that oversees the administration of bankruptcy cases in most jurisdictions) typically will monitor Chapter 11 cases to ensure that debtors comply with their reporting obligations. In most jurisdictions, the Office of the United States Trustee will seek to convert or dismiss the bankruptcy case if the debtor has not fulfilled its reporting obligations.

At the outset of every bankruptcy case, usually within 30 days of the commencement of the case, a representative of the debtor must testify under oath at a meeting of creditors.[21] This meeting is an opportunity for interested parties to obtain “free discovery” in the early stages of the case. Interested parties also may seek authority to conduct a broad range of discovery pursuant to Bankruptcy Rule 2004, which permits the examination of “any entity” with respect to “the acts, conduct, or property or . . . the liabilities and financial condition of the debtor, or . . . any matter which may affect the administration of the debtor’s estate, or . . . the debtor’s right to a discharge.”[22]

Finally, the various traditional discovery devices that are available in state and federal court litigation (including depositions, interrogatories, requests for production of documents and requests for admissions) are all available to interested parties in both adversary proceedings and contested matters that arise in connection with a bankruptcy case.

C. The Debtor in Possession Concept

A Chapter 11 debtor typically retains control over its assets and financial affairs, and its management typically remains in place.[23] The salaries of the debtor’s officers, however, may be subject to review. Moreover, the debtor and its officers are fiduciaries bound to act in the interests of the bankruptcy estate.

In bankruptcy cases involving construction projects, there frequently are allegations of mismanagement and/or breach of trust by the debtor’s management. For example, when a general contractor files bankruptcy, subcontractors frequently allege that the general contractor failed to pay trust funds that were received from the project owner. Likewise, where a real estate developer files bankruptcy, lenders frequently alleged that the developer has improperly commingled or otherwise failed to properly use project funds.

Under certain circumstances, “including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case,” the debtor’s management may be ousted by the court in favor of a trustee.[24] The court also has the authority under certain circumstances to order the appointment of an examiner “to conduct such an investigation of the debtor as is appropriate, including investigation of any allegations of fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor of or by current or former management of the debtor[.]”[25]

D. Single Forum

The bankruptcy court generally has jurisdiction over all property of the debtor’s bankruptcy estate (which, under Section 541 of the Bankruptcy Code, is broadly defined to include all property of the debtor, wherever located and by whomever held) and all matters that affect the debtor’s financial affairs.[26] As a result, there is a single forum available for the resolution of disputes (including all types of issues relating to the adjudication of claims and other issues relating to the debtor’s operations) and, if appropriate, to supervise the liquidation of the debtor’s assets. In addition, claims or causes of action that relate to a debtor’s bankruptcy case may be removed to the district where the bankruptcy case is pending.[27]

Where the debtor is involved with one or more distressed construction projects, a single forum can be an efficient mechanism for the centralized resolution of all disputes. In some instances, however, litigation claimants may seek relief from the automatic stay to liquidate their claims against the debtor or the debtor’s property in a non-bankruptcy forum. The factors that should be considered in deciding whether “cause” exists for modification of the automatic stay to permit the prosecution of litigation against the debtor in another forum are: “(1) whether the issues in the pending litigation involve only state law, so the expertise of the bankruptcy court is unnecessary; (2) whether modifying the stay will promote judicial economy and whether there would be greater interference with the bankruptcy case if the stay were not lifted because matters would have to be litigated in bankruptcy court; and (3) whether the estate can be protected properly by a requirement that creditors seek enforcement of any judgment through the bankruptcy court.”[28]

A related issue is the post-bankruptcy enforceability of arbitration provisions in construction contracts. A bankruptcy filing by a party to a contract does not extinguish the enforceability of the arbitration provision in the contract, and in fact the courts have recognized that the presumption in favor of arbitration continues to exist despite post-bankruptcy. Bankruptcy courts generally do not have discretion to refuse to enforce arbitration provisions in non-core matters because the presumption in favor of arbitration will usually trump the lesser interest of bankruptcy courts in adjudicating non-core matters.[29] In core matters, however, bankruptcy courts have discretion to refuse to enforce arbitration provisions where the dispute is based on provisions of the Bankruptcy Code and arbitration would conflict with the purposes of the Bankruptcy Code.[30]

E. Restrictions on Debtor’s Activities

Once a bankruptcy case is filed, the debtor’s ability to use, sell or lease property is restricted to “ordinary course of business” transactions.[31] Moreover, the debtor may not incur new debt without court approval, and a secured lender is under no obligation to extend additional credit.[32] Similarly, the debtor may not use a secured lender’s “cash collateral” without first obtaining either the lender’s consent or court approval.[33]

The effect of these provisions is that the bankruptcy court must be actively involved in (and creditors and other interested parties must be given notice of and an opportunity to object to) any action by the debtor that is outside the ordinary course of business. As a result, the debtor must be able to justify non-ordinary course actions as being reasonable and in the best interests of the bankruptcy estate.

The Bankruptcy Code, the Bankruptcy Rules and/or case law will dictate the standard which must be met for the debtor to justify a particular type of non‑ordinary course action. For example, the bankruptcy cases of homebuilders and other construction-related companies frequently involve litigation settlements. In approving a proposed litigation settlement, the court must determine that it is “fair and equitable” and in the best interests of the estate. In addition, the court generally will consider the following factors: (1) the probability of success in the litigation to be settled; (2) the difficulties, if any, to be encountered in collecting a judgment if the estate prevails in litigation; (3) the complexity of the litigation involved, including the expense, inconvenience and delay attending to further proceedings; and (4) the paramount interests of the creditors, with appropriate deference to their reasonable views.[34]

Given the detailed nature of the court’s inquiry, the debtor has a strong disincentive to propose any litigation settlement that cannot be justified as being in the best interests of the bankruptcy estate.

F. Appointment of Committees

In most Chapter 11 cases, a committee of unsecured creditors is appointed and, in larger cases, additional committees may be appointed (for example committees of equity holders or committees of tort claimants).[35] Committees engage their own professionals who provide a watchdog function and bring a heightened level of scrutiny to any action taken by the debtor and by secured creditors. Committees also add an additional layer of expense and bureaucracy to bankruptcy proceedings.

Although service on a committee can be a good way to obtain access to information, it also may require a significant investment of time. Also, because committee members are fiduciaries, there is some litigation risk in serving on a committee.

G. Sale of Assets

Bankruptcy courts have the authority under certain circumstances to approve the sale of all or part of a debtor’s assets free and clear of all liens, claims, encumbrances and other interests.[36] Many bankruptcy cases are designed and carried out as fast-moving vehicles for the liquidation of substantially all of the debtor’s assets. Furthermore, many bankruptcy cases that are at the outset intended to be reorganizations, quickly turn into liquidations due to lack of funding or a variety of other issues (and sometimes at the direction of post-petition lenders whose court-approved loan documents may require that various actions, including in some instances the confirmation of a plan of reorganization, be taken or completed by the debtor pursuant to an accelerated schedule).

Many homebuilder cases in recent years have ended in liquidation. One of the significant advantages of the bankruptcy sale process is that purchasers receive the comfort of a court order authorizing the sale of assets free and clear of all liens, claims, encumbrances and other interests. Because distressed construction projects are frequently burdened with mechanic’s liens and other claims, the prospect of a sale “free and clear” makes the bankruptcy process attractive to purchasers who otherwise would be reluctant to bid on assets due to concerns about title and lien issues. In a recent case involving a Florida homebuilder, for example, the bankruptcy court approved the sale of residential lots free and clear of a restrictive covenant in a housing development plan that required a minimum sale price for the lots.[37] Outside the context of a bankruptcy case, the restrictive covenant could not have been extinguished.

H. Executory Contracts and Unexpired Leases

Under Section 365 of the Bankruptcy Code,[38] executory contracts (which generally are defined as contracts under which both the debtor and the non-debtor party have material unperformed obligations at the time of the bankruptcy filing) and unexpired leases may be “assumed” or “rejected” by the debtor.[39] If an executory contract or unexpired lease is assumed, the debtor is required to accept all of its benefits and burdens; if an executory contract or unexpired lease is rejected, the debtor generally has no obligation to perform and, subject to certain limitations, the non-debtor party is awarded an unsecured claim in the debtor’s bankruptcy proceeding for the damages it will sustain as a result of the rejection.

The debtor’s decision to assume or reject any executory contract or unexpired lease is subject to court approval based on the deferential business judgment standard. If the debtor’s business judgment has been reasonably exercised, the court will approve the proposed assumption or rejection.[40] If an executory contract or unexpired lease is assumed, the debtor generally is required to cure all curable defaults that existed as of the commencement of the bankruptcy proceedings and to provide adequate assurance of its future ability to perform under the executory contract or unexpired lease.[41]

The right to reject burdensome contracts and leases is a key benefit of bankruptcy to debtors. Many bankruptcy cases, including retail cases involving large numbers of real estate leases, are largely precipitated and driven by the need to restructure executory contracts and unexpired leases. Moreover, the right to reject executory contracts and unexpired leases provides the debtor with a favorable platform to negotiate significant concessions, particularly concessions to real estate leases during a down market.

In bankruptcy cases involving distressed construction projects, construction contracts are likely to be considered “executory contracts” within the meaning of Section 365 of the Bankruptcy Code that may be assumed or rejected by the debtor. In a Chapter 11 case, the debtor has until the confirmation of a plan of reorganization to decide whether to assume or reject an executory contract, unless the non-debtor party to the contract requests that the court compel the debtor to decide sooner. The debtor, however, is required to perform its post-bankruptcy obligations under the executory contract, which creates a strong incentive for the debtor to decide quickly if it wants to assume or reject the executory contract.

I. Ipso Facto Clauses

Most construction contracts include a default and/or termination provision that is triggered by a party’s insolvency or bankruptcy filing. For example, construction subcontracts frequently empower the general contractor to terminate in the event of a bankruptcy filing by a subcontractor. This type of provision, which generally is referred to as an ipso facto clause, is not enforceable in bankruptcy.[42] Any post-bankruptcy attempt to terminate a contract based on an ipso facto clause likely will be viewed as ineffective and, further, likely will be viewed as a violation of the automatic stay.

J. Bankruptcy Causes of Action

The Bankruptcy Code provides for various causes of action, including the avoidance and recovery of various transfers (e.g., preferential transfers, fraudulent transfers and unauthorized post-petition transfers).[43] These causes of action are typically investigated and pursued by the debtor (or a trustee, if appointed), the creditors committee or a post-confirmation agent appointed for the purpose of pursuing litigation claims. As a result, all interested parties are at risk that claims may be asserted against them for the avoidance and recovery of transfers.

In bankruptcy cases filed by general contractors, preference claims frequently are asserted against subcontractors and suppliers that received payments within the 90-day period prior to the date of the bankruptcy filing.[44] If a subcontract or a supply contract has been assumed, there is no risk of preference liability because the Bankruptcy Code requires a debtor to cure all curable defaults and to otherwise perform under the subcontract or supply contract (and, as a result, there can be no argument that the subcontractor or supplier received any payment that it was not entitled to receive). If a subcontract or a supply contract has been rejected, however, preference claims may be asserted.

The Bankruptcy Code identifies various technical elements that must be established to sustain a preference claim,[45] as well as various defenses that may be used to defeat all or part of a preference claim.[46] In some cases, subcontractors have defeated preference claims by arguing that they provided new value to the debtor (one of the defenses to a preference claim expressly recognized under the Bankruptcy Code) through the release of lien rights that, but for their receipt of payment, would not have been released.[47] In doing so, subcontractors have been able to distinguish themselves from general unsecured creditors that have no lien rights to release in exchange for payments. In other cases, however, courts have rejected the new value defense on grounds that the subcontractor’s lien rights had no value at the time the preferential payments were made.[48]

K. Mechanic’s Liens

A mechanic’s lien is treated by the Bankruptcy Code as a statutory lien that may be avoided under certain circumstances, including for defects in the perfection of the lien.[49] Pursuant to Sections 362(b)(3) and 546(b)(1) of the Bankruptcy Code, a mechanic’s lien may be perfected after the commencement of a bankruptcy case without violating the automatic stay if applicable state law permitted the relation back of the lien.[50] According to a recent homebuilder case, “the net effect of these two provisions [i.e., Sections 362(b)(3) and 546(b)(1) of the Bankruptcy Code] is to authorize an entity to perfect an ‘interest in property’ after the filing of a petition to the extent state law provides for perfection to relate back to the pre-petition interest.”[51]

In addition, Section 546(b)(2) of the Bankruptcy Code provides that, where perfection of a mechanic’s lien requires the seizure of property or the commencement of a lien foreclosure action, the mechanic’s lien claimant may perfect by filing a notice with the court in lieu of seizure of the property or the commencement of a lien foreclosure action.[52]

Mechanic’s lien issues turn on the application of state law, and each state has different technical requirements for the assertion and perfection of mechanic’s liens (including different requirements regarding when a lien arises and whether it relates back to the date of the occurrence of an event specified by a statue such as the filing or service of a lien notice).[53] Given the differences in state mechanic’s lien laws, practitioners should review the law of the particular state within which a construction project is located in determining the effect of a bankruptcy filing on the rights of mechanic’s lien claimants.

L. Single Asset Real Estate Cases

The Bankruptcy Code includes special provisions that govern cases involving single asset real estate entities, including provisions that limit the duration of the automatic stay. Because so many construction projects involve single asset real estate entities, the provisions governing these cases are of interest to construction practitioners.

The Bankruptcy Code defines a “single asset real estate” as “real property constituting a single property or project, other than residential real property with fewer than four residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental [thereto].”[54] Prior to the 2005 amendments to the Bankruptcy Code, single asset real estate cases were limited to those involving debtors whose property value did not exceed $4 million. The amendments thus greatly expanded the number of potential single asset real estate cases.

Examples of single asset real estate debtors include those who own apartment buildings, strip shopping centers and office buildings. In a recent case, a court has held that a homebuilder and its affiliated companies were single asset real estate debtors. In doing so, the court found that the debtors’ activities of purchasing and developing real estate, planning and building homes and marketing and selling homes were “incidental” to the debtors’ main purpose of selling real estate and that no one could reasonably expect to generate income from those activities without the sale of the real estate.[55] Moreover, courts have broadly interpreted the “single project” requirement from the definition of “single asset real estate” to include a detached group of properties with a common plan or scheme involving their use.[56]

The Bankruptcy Code provides that a secured creditor of a single asset debtor shall be entitled to relief from the automatic stay unless the debtor, within 90 days after the entry of the order for relief or such later date fixed by the court before the expiration of the 90-day period upon showing of cause, has either (a) filed a plan that has a reasonable possibility of being confirmed within a reasonable time, or (b) has commenced monthly payments to the secured creditor, which may be made from rents or income generated by the property, “in an amount equal to interest at the then applicable nondefault contract rate of interest on the value of the creditor’s interest in the real estate[.]”[57] The underlying purpose of this provision is to address perceived abuses by single asset real estate debtors in seeking bankruptcy relief in an effort to delay foreclosure, even where there is no realistic prospect for reorganization. The effect of this provision is to accelerate the pace of cases involving single asset real estate debtors.

M. Plan of Reorganization

The ultimate goal in a Chapter 11 bankruptcy is confirmation of a plan of reorganization. A plan is essentially an agreement between the debtor and its creditors pursuant to which the debtor’s obligations which existed prior to the commencement of the bankruptcy are extinguished and, in their place, new obligations are substituted.

Whether it provides for a reorganization or liquidation of the debtor, a plan will provide for, among other things, a proposed treatment of each class of creditor claims and a proposed means for implementation.[58] In developer and builder cases under Chapter 11, plans typically will provide for the disposition of remaining projects (either by way of completion or by way of transition to project lenders) and for the establishment and funding of a liquidating trust to pursue bankruptcy causes of action and to administer distributions to unsecured creditors. Also, it is common in developer and builder cases for lenders who will be involved in the completion of projects to be active in formulating and proposing plan.

A Chapter 11 debtor has the exclusive right to file a plan for a certain period of time.[59] Once the debtor’s “exclusivity” period has expired or otherwise terminated, creditors have the right to propose their own plan. In some cases, is the most drastic action a creditor can take is to propose its own plan providing for the immediate liquidation of the debtor.

IV. Conclusion

The foregoing is intended only as a summary of how bankruptcy impacts construction projects. It should be emphasized that no two bankruptcy cases involving construction projects are exactly alike. The outcome of each bankruptcy case, and the appropriate course of action for any interested party in responding to a bankruptcy filing, will depend on a number of issues, including the following:

· Which party to the project filed the bankruptcy (i.e., the owner, the prime contractor, a major subcontractor or a major supplier)?

· What type of bankruptcy has been filed (i.e., a Chapter 7, a liquidating Chapter 11 or a reorganizing Chapter 11)?

· Has a trustee been appointed (either by virtue of a Chapter 7 filing or by virtue of the appointment of a trustee in Chapter 11 due to the debtor’s fraud or mismanagement)?

· What is the status of the project at the time of the filing (i.e., has the project been suspended due to defaults under construction loans or due to refusal of contractors and suppliers to perform)?

· Has the project been delayed or otherwise impacted by external factors beyond the control of the debtor’s management (i.e., natural disaster or labor strike)?

· What is the debtor’s relationship with its project lenders (i.e., are the lenders cooperating in the debtor’s efforts, or are they seeking to immediately terminate the project in an effort to foreclose)?

· Is a bonding company or surety involved (and, if so, has the bonding company or surety become active in the completion of the project)?

· Does the debtor have the ability to fund the project going forward (either through post-petition financing or some other funding mechanism)?

· Will a bankruptcy filing address the fundamental problem(s) that have driven the debtor to financial distress (or does the debtor, like so many, have an unworkable business model or other restraints that will keep it from achieving profitability even if its capital structure is altered through a bankruptcy)?

These and other issues must be evaluated (and continually re-evaluated) in every single case. And because the bankruptcy process is deadline-driven and often fast-moving, these issues must be evaluated quickly. Where a construction project has value, and where the interested parties act quickly, bankruptcy can be the best way to preserve and maximize the value for the benefit of all interested parties. Where a construction project is of questionable value, or where there are internal and/or external restraints on the debtor’s ability to reorganize, bankruptcy is likely to result in liquidation.