Preference Suits: Giving Back What You Earned

A subcontractor’s reward after successfully completing a job is a final payday. After the headaches, change orders and other hardships, the contractor tenders payment in exchange for a release of lien signed by the subcontractor. Imagine the surprise and dismay when, after several months have expired, the subcontractor learns that the contractor has filed for bankruptcy, and the debtor-in-possession or the bankruptcy trustee is suing to recover that payday as a “preferential transfer” made within ninety days preceding the bankruptcy filing. This type of preference lawsuit is especially frustrating as the subcontractor, had he not received that payment, would have been able to file a construction lien on the project where the work was performed.Does the subcontractor have any defenses to this sort of lawsuit or does he have to turn over his hard-earned pay?

The U.S. Bankruptcy Code provides certain relief to parties who are sued for receiving preferential transfers. However, before considering whether any defenses apply, the subcontractor should first argue that the payment does not even qualify as a preferential transfer under the Bankruptcy Code. One of the requirements for qualification is that a payment would entitle the creditor to receive more than if the case were a straight liquidation under Chapter 7 of the Bankruptcy Code. The subcontractor should argue that it could have been paid in full had it exercised its lien rights against the project. Therefore, the payment is not a preferential transfer. This is an argument that may be difficult to prove but could be more effective if the subcontractor actually forgave some amounts due and still released its lien rights for the entire amount of its claim.

If the argument that the payment is not a preferential transfer fails, one defense to raise is that the tender of the release of lien provided new value to the contractor-debtor. In essence, the subcontractor can argue that by tendering the release, the contractor was freed up to collect monies due to it by the owner or other contractor on the job. This argument has succeeded before certain bankruptcy courts. However, it was rejected by the Eleventh Circuit Court of Appeals that maintains jurisdiction over a good part of the Southeast region of the United States. Courts that reject this argument generally state that the release served to operate as consideration to the owner-not to the paying contractor. Therefore, no “new value” was provided to the debtor-contractor.

Another defense is that the payment was made to the subcontractor during the ordinary course of business between the subcontractor and paying contractor, and was made according to ordinary business terms. This defense has greater “teeth” when payments are made during regular intervals. If, for example, the subcontractor routinely sent monthly invoices to the contractor, and the contractor routinely paid the entire amount of the invoice by the 10th of each month, such course of dealing would most likely qualify under the ordinary course of business defense. If payments are made during non-routine intervals, it will be necessary to first show the court the course of dealing in the industry as well as between the parties, and then to show that the payments at issue were consistent with such conduct and made according to ordinary business terms—difficult, but not impossible.

Defending such lawsuits can be a costly proposition. If there are issues of fact that are not easily resolved, the subcontractor may have difficulty recovering attorney’s fees, even if prevailing in the litigation. Therefore, very often, the best strategy for the subcontractor is to raise its defenses in a pleading filed with the court, and then attempt to negotiate an early settlement. Bankrupt debtors often are more likely to be in an especially compromising mood in the earlier stages of litigation. It keeps their costs of litigation down. Better yet, from the debtor’s viewpoint, settlement proceeds received at the beginning of litigation can be used to fund other cases.

Unfortunately, no easy solutions are readily available to subcontractors who are served with such lawsuits. The best course of action is to carefully examine the facts of the actual case. After this is done, the subcontractor will be in a better position to determine whether the matter is worth the good fight or whether an early settlement is warranted.

Construction Business Owner, August 2008