JUNE 2007
N a t i o n a l A s s o c i a t i o n o f C r ed i t M a n a g ement
T h e P u b l i c at i o n F o r C r ed i t & F i n a nce P ro f e s s i o n a l s
$ 7. 0 0
credit colu m n
Bruce Nathan, Esq.
Recent Favorable Preference
Rulings for Construction
Material and Service Suppliers
F
or suppliers of goods and services on construction projects, like other trade creditors,
there is nothing more dreaded than their general contractor’s or subcontractor’s bankruptcy filing. It
is bad enough that the supplier might have an outstanding claim against the general contractor or subcontractor. But, what about the preference risk arising from the
debtor’s payments to the supplier within 90 days of the
bankruptcy filing? And, what if the supplier accepted
the payments in exchange for a waiver of mechanics’
lien rights against the project? And does it make a difference whether the creditor waived unasserted “inchoate”
lien rights? Finally, what if the waived lien rights are
against non-debtor property?
Well, two recent bankruptcy court decisions offer
guidance in answering these questions. In In re Philip
Services Corp., the United States Bankruptcy Court for
the Southern District of
Texas ruled that a debtor/
What about the preference general contractor’s payment of approximately
risk arising from the $937,000 to a subcontractor within 90 days of
debtor’s payments to the
bankruptcy, in exchange
supplier within 90 days of for the subcontractor’s release of its filed mechanthe bankruptcy filing?
ics’ lien, was not a preference based upon the
section 547(c)(1) contemporaneous exchange for new
value defense. And in In re J.A. Jones, Inc., the United
States Bankruptcy Court for the Western District of
North Carolina ruled that the section 547(c)(1) contemporaneous exchange defense might protect a sub1
Business Credit June 2007
contractor from preference exposure where the subcontractor had waived unasserted inchoate mechanics’
lien rights in exchange for the preference payments. In
both cases, the subcontractors waived mechanics’ lien
rights against construction projects owned by third
parties and not the debtor. What new value did the
debtor/general contractor receive from the subcontractor’s waiver of lien rights against third party property to justify invocation of the contemporaneous exchange defense? Read on for the answer!
The Elements of a Preference Claim and the Contemporaneous Exchange for New Value Defense
Section 547 of the Bankruptcy Code governs preferences. A bankruptcy trustee can avoid and recover
a preference by proving all of the following: (1) the
debtor transferred its property (such as making a
payment) to or for the benefit of a creditor (section
547(b)(1)); (2) the transfer was made on account of
existing indebtedness owing by the debtor
to that creditor (section 547(b)(2)); (3)
the debtor was insolvent at the time of the
transfer (i.e., liabilities exceeded assets,
which is presumed during the 90-day preference period) (section 547(b)(3)); (4) the
transfer was made within 90 days of the
bankruptcy filing for non-insider trade
creditors, and within one year of the filing for payments to insider creditors, such
as a debtor’s officers, directors, controlling
persons and certain affiliated companies
(section 547(b)(4)); and (5) the creditor obtained a greater recovery from the
transfer than it would have received in a
Chapter 7 liquidation had the transfer
not occurred (section 547(b)(5)). section
547(b)(5)’s “greater than Chapter 7 liquidation recovery requirement” is always
satisfied unless the debtor’s unsecured
creditors receive full payment of their
claims; the creditor receiving the payment
is fully secured by the debtor’s assets; or
the payment came from the proceeds of
the creditor’s collateral.
release or waiver of their mechanics’ lien
rights against non-debtor property.
with a wire transfer in the identical amount
of $936,741.35.1
In Re Philip Services Corp.Case
Philip Environmental Services Corp.
(“PESC”) had entered into a contract to
construct a powerhouse for Ford Motor Company and Rouge Steel Company
(“Ford/Rouge”). The powerhouse was to
be constructed on real property owned by
Ford/Rouge in Wayne County, Michigan
(the “Ford/Rouge Real Property”).
On June 2, 2003, just a few weeks after
PESC’s wire transfer to Homrich, PESC
and its affiliates filed Chapter 11 in the
United States Bankruptcy Court for the
Southern District of Texas. The case ended
up as a liquidating Chapter 11 and a trustee
was appointed under a liquidating Chapter
11 plan to, among other things, prosecute
preference claims.
PESC then entered into a subcontract with
Homrich, Inc. (“Homrich”). Homrich had
agreed to demolish the existing building on
the Ford/Rouge Real Property. Homrich
The trustee commenced a lawsuit against
Homrich, seeking recovery of the sum of
$936,741.35 as a preference. Homrich disputed the preference on numerous grounds.
A preference defendant can reduce its exposure by invoking any one or more of
the defenses contained in section 547(c).
The section 547(c)(1) contemporaneous
exchange for new value defense excuses
any payment or other transfer that the
debtor and creditor had intended as a
contemporaneous exchange for new value
and that was, in fact, a substantially contemporaneous exchange. This defense,
like the other preference defenses, is supposed to encourage creditors to continue
doing business with, and extending credit
to, financially troubled companies. A
creditor that provides new goods and/or
services substantially contemporaneously
with the payment or other transfer replenishes the debtor and should not be
forced to return the transfer. In the absence of the contemporaneous exchange
for new value and other preference defenses, creditors would not have any incentive to continue providing goods and/
or services to troubled companies, thereby precipitating their bankruptcy.
completed the demolition work by the end
of February 2003, when most of the subcontract price was still outstanding. On
May 9, 2003, Homrich filed a Claim of Lien
in the amount of $1,279,758.89 against the
Ford/Rouge Real Property in the records of
the Wayne County Register of Deeds and
also served notices of non-payment on
PESC and Ford/Rouge.
This article addresses two recent cases where
the courts applied the section 547(c)(1)
contemporaneous exchange defense to general contractors’ payments to material/service providers, in exchange for the latters’
This defense, like the other preference defenses,
is supposed to encourage creditors to continue
doing business with, and extending credit to,
financially troubled companies.
The contract between Ford/Rouge and
PESC allowed Ford/Rouge to withhold
payment from PESC if an unpaid subcontractor, like Homrich, had filed a mechanics’ lien against the Ford/Rouge Real Property. In addition, Ford’s general conditions
for construction and installation required
PESC to keep the job free of liens and again
allowed Ford to withhold payment from
PESC in an amount sufficient to pay off
any filed lien.
On May 22, 2003, PESC hand delivered a
check in the amount of $936,741.35 to
Homrich. In exchange for the check, Homrich executed and delivered to PESC a
written waiver of construction liens, conditioned on the availability of sufficient
funds for full payment of the check. The
check ultimately bounced due to insufficient funds. PESC replaced the bad check
First, Homrich claimed that section
547(b)(1) (payment from property of the
debtor) was not satisfied because the payment was from trust funds held by PESC
under a statutory trust fund created under
the Michigan Building Contract Trust
Fund Act, Mich. Ret. Stat. § 570.151-53
(the “MBCTFA”)2 and not from property
of PESC. The MBCTFA is similar to certain other state statutes that create builders
or construction trust funds in favor of suppliers of material and labor with claims
against a general contractor or subcontractor. The trust arises without the necessity
for any notice or filing, as is the case for
mechanics’ liens, and includes the sums
payable by the project owner to the general
contractor, or sums payable by the general
contractor to a subcontractor, for the benefit of material and labor suppliers. The
suppliers/trust beneficiaries have a right to
payment of these sums, as trust funds held
for their benefit, prior to payment to the
general contractor (or subcontractor where
applicable) and its creditors, including its
secured creditors.
Trust law generally requires the trust beneficiary to trace the funds at issue to the
original trust fund. The MBCTFA is silent
on whether builders trust beneficiaries
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must trace funds they are claiming to the
original trust fund. The bankruptcy court
required Homrich to trace the alleged preference payment to trust funds paid by
Ford/Rouge to PESC on account of the
project as a necessary condition for rebutting the trustee’s claim that the payment
was from PESC’s property. However, Ford/
Rouge was not the source of the alleged
preference payment. PESC made the payment from funds borrowed from its secured lender, Foothill. PESC had control
over, and the discretion to use, funds borrowed from Foothill as part of PESC’s business operations. Therefore, PESC’s payment to Homrich was from PESC’s
property, satisfying section 547(b)(1).
Second, Homrich argued that the trustee
could not satisfy section 547(b)(5)’s “greater than Chapter 7 liquidation recovery requirement” that Homrich had received
more from the alleged preference payment
than it would have received in the Chapter
7 liquidation of PESC without regard to the
payment. Homrich claimed that it was fully
secured as a result of its mechanics’ lien on
the Ford/Rouge Real Property and, therefore, would have received a 100% recovery
in PESC’s hypothetical Chapter 7 case.
The court ruled that Homrich could not
rebut section 547(b)(5)’s “greater than
Chapter 7 liquidation recovery” requirement because its mechanics’ lien was filed
against a third party’s property (the Ford/
Rouge Real Property) and not property
However, Homrich defeated the preference
claim by successfully invoking the section
547(c)(1) contemporaneous exchange for
new value defense. Homrich’s release of its
mechanics’ lien against the Ford/Rouge
Real Property resulted in Ford/Rouge’s simultaneous release of its indemnification
claim against PESC, which, in turn, was secured by Ford/Rouge’s right of set-off
against the accounts receivable owing to
PESC. This amounted to a contemporaneous exchange for new value that satisfied
section 547(c)(1).
Each subcontractor/preference defendant
had completed their work and submitted a
request for payment to one of the Jones
Companies. The Jones Companies paid
the subcontractors for their work in exchange for the subcontractors’ release of
their mechanics’ lien rights. Unfortunately
for the subcontractors, some of the payments fell within the 90-day preference
period. Unlike the Philip Services case, in
J.A. Jones, no mechanics’ liens were filed
against the projects.
Ford/Rouge had the right to withhold sums
due PESC as a result of Homrich’s mechanics’ lien on the Ford/Rough Real Property.
That was the functional equivalent of a lien
in favor of Homrich in the accounts receivable owed by Ford/Rouge to PESC. PESC’s
payment to Homrich and Homrich’s simultaneous waiver of its mechanics’ lien
against the Ford/Rouge Real Property resulted in a release of Homrich’s “lien rights”
against the Ford/Rouge receivable owing to
PESC. That created new value for PESC by
freeing up the Ford/Rouge receivable owing to PESC up to the sum of the alleged
preference
payment,
approximately
$937,000, for payment to PESC and distribution to its creditors.
Trust law generally
requires the trust
beneficiary to trace the
funds at issue to the
original trust fund.
The J.A. Jones Inc. Case
The J.A. Jones case takes the facts of Philip
Services one step further: what if the subcontractor accepted an alleged preference
payment in lieu of filing a fully-secured
What if the subcontractor accepted an alleged
preference payment in lieu of filing a fully-secured
mechanics’ lien on non-debtor property?
owned by PESC. The greater than Chapter
7 recovery test deals with whether the creditor would have received more from the
debtor’s estate in a Chapter 7 liquidation, as
a result of the alleged preference payment,
not the creditor’s recovery from a third
party. The trustee satisfied section 547(b)(5)
because Homrich was an unsecured creditor of PESC’s bankruptcy estate, notwithstanding Homrich’s likely receipt of full
payment by foreclosing its mechanics’ lien
on the Ford/Rouge Real Property.
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mechanics’ lien on non-debtor property?
J.A. Jones and several dozen subsidiaries
(the “Jones Companies”) had filed Chapter 11 between September 25, 2003 and
November 13, 2006 in the United States
Bankruptcy Court for the Western District
of North Carolina. Prior to their Chapter
11 filings, the Jones Companies were general contractors on numerous construction
projects owned by third parties. Each preference defendant was a subcontractor to
the Jones Companies on these projects.
Preference actions were commenced against
the subcontractors. The subcontractors
moved for dismissal of the lawsuits. They
claimed section 547(b)(5)’s “greater than
Chapter 7 liquidation recovery requirement” could not be satisfied because the
subcontractors’ unasserted inchoate mechanics’ lien rights, arising from their right
to file liens on the projects, made them fully
secured creditors of the Jones Companies.
The subcontractors also argued that their
release of lien rights, in exchange for the alleged preference payments, was a contemporaneous exchange for new value that satisfied section 547(c)(1).
The court rejected the subcontractors’ section 547(b)(5) argument. Section 547(b)(5)
was satisfied because the subcontractors
held mechanics’ lien rights against projects
that were not owned by any of the Jones
Companies. As a result, the subcontractors
were unsecured creditors of the Jones Companies and received more from the payments than they would have received in the
Jones Companies’ Chapter 7 liquidation.
However, the subcontractors were not left
empty handed. The court ruled that their
forbearance from filing valid mechanics’
liens against the projects and the release of
their unasserted inchoate lien rights, in exchange for the alleged preference payments,
might, under certain circumstances, satisfy
The Jones Companies received new value in
exchange for the alleged preference payments,
justifying invocation of the contemporaneous
exchange defense.
the section 547(c)(1) contemporaneous
exchange for new value defense.
The J.A. Jones court took a similar approach to that taken by the court in Philip
Services. In the event any subcontractor
had filed mechanics’ liens against any
project, the owner would have been forced
to pay the subcontractor in order to protect the owner’s interest in the project. The
owner could then seek indemnification
from the applicable Jones Company, as
general contractor.
The subcontractor’s ability to invoke the
section 547(c)(1) defense is contingent
upon the existence of accounts receivable
owing by the owner to the Jones Companies that would, in turn, give rise to the
owner’s setoff rights to secure payment of
its indemnification claim against the Jones
Companies. The subcontractor’s waiver of
lien rights against the project, in exchange
for the alleged preference payments, resulted in a coincident release of the owner’s
indemnification claims against the Jones
Companies. That, in turn, made it unnecessary for the owner to exercise any setoff
rights against its receivable owing to the
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Jones Companies. As a result, the Jones
Companies received new value in exchange
for the alleged preference payments, justifying invocation of the contemporaneous
exchange defense.
A subcontractor could not rely on the section 547(c)(1) contemporaneous exchange
defense where the owner had no outstanding receivables owing to the Jones Companies. In that circumstance, the subcontractor’s waiver of lien rights, in exchange for
the Jones Companies’ payment, resulted in
the owner’s release of an unsecured indemnification claim against the Jones Companies. That would not have created any new
value for the benefit of the Jones Companies to justify invocation of the defense.
There were not sufficient facts before the
court to determine whether the project
owner’s indemnification rights against the
Jones Companies were secured by any setoff rights. The court left that determination
for a later day.
Conclusion
Material and labor suppliers on construction projects have additional protection
from preference risk based on their ability
to invoke state mechanics’ lien law rights.
They could rely on the section 547(c)(1)
contemporaneous exchange for new value
defense to reduce or eliminate preference
exposure where they had released or waived
asserted or unasserted mechanics’ lien
rights in exchange for the alleged preference
payments. Another win for the trade! n
1. In the event Homrich had delivered an unconditional lien waiver in exchange for a bad check that
was later replaced, Homrich would not have received the benefit of the section 547(c)(1) defense.
2. Mich. Rev. Stat § 570.151 Building Contract
Fund; status as a trust fund. Sec. 1. In the building
construction industry, the building contract fund
paid by any person to a contractor, or by such person or contractor to a subcontractor, shall be construed by this act to be a trust fund, for the benefit
of the person making the payment, contractors,
laborers, subcontractors or materialmen, and the
contractor or subcontractor shall be considered
the trustee of all funds so paid to him for construction purposes.
Bruce Nathan, Esq. is a partner in the New York
City office of the law firm of Lowenstein Sandler
PC. He is a member of NACM and is on the Board
of Directors of the American Bankruptcy Institute
and is a former co-chair of ABI’s Unsecured Trade
Creditors Committee. He can be reached at
[email protected].
This is reprinted from Business Credit magazine, a
publication of the National Association of Credit
Management. This article may not be forwarded
electronically or reproduced in any way without
written permission from the Editor of Business
Credit magazine.