Seeking Perfection: Can a Subcontractor Protect its Lien Rights After its General Contractor Files Bankruptcy?

North Carolina law has long protected the right of subcontractors to payment for the labor and materials provided to a project by granting them the right to place a lien upon funds owed to their upper-tier contractors on that project. Indeed, subcontractors' liens upon funds are entitled to super-priority — they defeat even prior perfected secured creditors. But, what happens to these powerful lien rights when an upper-tier contractor files bankruptcy before the subcontractor perfects its lien?

In two recent decisions, the Bankruptcy Court for the Eastern District of North Carolina prevented subcontractors from perfecting a lien upon funds without first obtaining stay relief -- in other words, subcontractors could lose their super-priority status and become general unsecured creditors if they fail to perfect their lien rights before the bankruptcy filing.

North Carolina's mechanics' lien statute, Chapter 44A, establishes two categories of construction liens. First, contractors who deal directly with a property owner can assert a lien on the real property. These liens are perfected upon filing, but they relate to and take effect from the time of the first furnishing of labor or materials (G .S. §§ 44A-10, 44A-11).

Subcontractors, who do not deal directly with the property owner, can file a lien upon funds owed to an upper-tier contractor. Although a subcontractor is entitled to a lien upon funds, a lien upon funds is not effective until the obligor receives notice of the lien. A subcontractor also has, pursuant to its subrogation rights, the right to assert a lien on the obligor's real property, but only if that subcontractor has first perfected its claim of lien upon funds (G.S. § 44A-18(6)). When a contractor files bankruptcy, the automatic stay immediately halts the commencement, continuation, or enforcement of a range of actions against the contractor, including "any act to create, perfect, or enforce any lien against property of the estate." (11 U.S.C. § 362(a)(4)).

However, Bankruptcy Code § 362(b)(3) allows a creditor to perfect an interest in property if a bankruptcy trustee's rights and powers are subject to such perfection under Bankruptcy Code § 546(b). Under that section, the trustee's powers are subject to "any generally applicable law that permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection." Funds owed to a debtor are property of its bankruptcy estate. Thus, whether a lien on funds may be asserted postpetition without violating the automatic stay depends upon when the subcontractor obtains an interest in those funds under North Carolina law.

According to the Eastern District Bankruptcy Court's decisions in In re Harrelson Utilities, Inc. and In re Mammoth Grading, Inc., a subcontractor does not obtain an interest in funds owed to its upper-tier contractor until the subcontractor provides the statutorily required notice of lien upon funds. The Bankruptcy Court concluded that "the lien on funds is empty, imprecise, indeterminate and illusive, and in essence, it does not exist until notice is served on the obligor." Thus, under those decisions, a claim of lien upon funds does not fall within the § 362(b)(3) exception to the automatic stay. Consequently, a subcontractor's postpetition claim of a lien on real property was invalid and could not be enforced if the subcontractor failed to perfect its claim of lien upon funds pre-petition.

Both Harrelson and Mammoth Grading have been appealed, but those appeals have not yet been decided. No other North Carolina federal court has decided whether § 362(b)(3) permits a subcontractor to perfect a lien upon funds post-petition, but the issue is arising. First, in In re Canco Construction NC, Inc. pending in the Middle District, Judge William L. Stocks noted from the bench that he found Harrelson persuasive. Western District Bankruptcy Court Judge J. Craig Whitley, however, stated from the bench in In re Newbold Corporation that he might disagree with the Harrelson outcome. Although not specifically addressing the issue of whether a lien upon funds may be perfected post-petition, the Fourth Circuit recently seemed to endorse the view in Harrelson that a subcontractor's interest in property does not arise until it actually files its lien claim. United Rentals, Inc. v. Angell, 2010 U.S. App. LEXIS 1451, *19-20 (4th Cir. Jan. 22, 2010).

Unless Harrelson and Mammoth Grading are reversed, and until the Middle and Western Districts have decided the issue, subcontractors in North Carolina are well-advised to assume that they will not be permitted to perfect their lien rights post-petition under the § 362(b)(3) exception to the automatic stay. Accordingly, subcontractors must at least consider serving a notice of lien on funds immediately upon delivery of materials or labor to a project; otherwise, they risk becoming an unsecured creditor if an upper-tier contractor files bankruptcy.

On the other hand, a tendency to file protective liens will delay projects, freeze the payment process, and may result in conscientious subcontractors gaining a "bad" reputation, hindering their ability to get work. Even attentive subcontractors can be caught off-guard by an upper-tier contractor's bankruptcy filing. In that situation, the subcontractor should immediately move for relief from the automatic stay on an expedited basis to perfect their liens. Of course, if the owner and bankruptcy trustee (or debtor-in- possession) agree to a final payment on the project or sign a final lien waiver before the motion is decided, the subcontractor's lien rights likely will be extinguished.

Subcontractors will have to weigh the benefits and risks of these alternatives on a case-by-case basis, but the decisions in Harrelson and Mammoth Grading certainly incent subcontractors to keep a closer eye on the financial condition of their upper-tier contractors and to assert liens upon the slightest sign of concern.