Bankruptcy and mechanic’s liens: What creditors need to know

As a credit manager, you are likely familiar with the sinking feeling you get after learning a customer has filed for bankruptcy. Whether they are aiming to reconstruct or liquidate their business entirely, customers filing for bankruptcies can send even the most experienced credit managers scrambling.  

Why it matters: Mechanic’s liens are the bedrock of a strong credit strategy in the construction industry. When it comes to bankruptcies in construction projects, it’s important that credit managers understand their ability to file and perfect mechanic’s liens.  

Federal bankruptcy laws say that the filing of a bankruptcy operates as a stay, applicable to all entities, of any act to create, perfect or enforce against property of the estate. However, courts have carved out exceptions to this law to help mechanic’s lien claimants.  

When someone is involved in a construction project you’re supplying materials or labor to files for bankruptcy, the first thing you must determine is who filed for bankruptcy and where, because laws differ by state. Mechanic’s lien rights differ from state-to-state and depend on whether it was the customer, general contractor, owner or lender who filed. 

“Just because they file bankruptcy doesn’t mean you lose your rights. You still have a mechanic’s lien, so long as you meet your prerequisites,” said Michael Murray, attorney at Lanak & Hanna, P.C. (Orange, CA). “Depending on who files, whether it’s the subcontractor, contractor, owner or lender, you may be able to record a lien or file a lawsuit to collect on your mechanic’s lien. Bankruptcy may have no impact on your lien rights at all.” 

If your customer filed for bankruptcy, you are precluded from collecting from your customer, but you are not prevented from enforcing your mechanic’s lien rights against the owner of the property because that property is not part of the bankruptcy.  

“The reason mechanic’s liens exist, one of their real values, is they give you a second person or entity to recover debts from,” Murray said. “Without a mechanic’s lien, if my customer files for a Chapter 7, no asset bankruptcy, I probably should take that account and throw it in the trash.” 

This process might look different if your customer is the general contractor because they have some interest in the property and in some states, you are required to name all other mechanic’s lien claimants.  

“Per the rules I have to name the general contractor, but I can’t because they’re in bankruptcy,” Murray said. “I wouldn’t be able to file my lawsuit yet because one of the parties, my customer who also has a lien, is in bankruptcy. So, if you’re in a state that requires you to name everyone, when you go to file your lien, pull a title report, and review it to check whether any party is in bankruptcy.” 

You may still be able to foreclose on your lien, but some states limit the amount of the mechanic’s lien to the amount due the general contractor, so the general contractor’s bankruptcy could have a direct impact on your ability to foreclose on your lien. If there is a dispute between the owner and the general contractor over what is owed, the dispute is stayed by the general contractor’s bankruptcy, meaning your lien is, likewise, stayed until a determination can be made as to what is owed.   

If the owner files for bankruptcy before you’ve recorded your lien, almost all states allow a lien claimant to record their lien, because liens relate back to when work first commenced, which is before the bankruptcy. If the owner files for bankruptcy after you’ve recorded your lien, you’re largely unaffected but, in many states, the automatic stay will keep you from foreclosing on your lien. In many of these states, the statute of limitations to file your lawsuit doesn’t start until the property is released from bankruptcy.  

The bottom line: It’s important that you familiarize yourself with the lien laws of any state in which you are operating. Bankruptcies are unpredictable, but you can ready your defenses by learning exactly what your lien rights are in any given circumstance.