Protecting and Perfecting Your Mechanics’ Lien when the Owner/Developer Files Bankruptcy

William L. Porter Founder & President Specializing in Construction Law, Business Law and Labor Law
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Introduction/Overview of the Mechanics’ Lien Law

The California mechanics’ lien is a powerful tool for contractors, subcontractors and materials suppliers to secure payment of unpaid construction-related debts. A contractor, subcontractor or materials supplier is allowed a lien on real property, based on the value they add to the property during the construction process.

The mechanics’ lien gives the claimant the right to force a sale of the improved real property and thereby obtain the funds necessary to pay the delinquent debt. Under the usual procedure, the first step is the recording of mechanics’ lien with Recorder’s office in the County where the property is located. A lawsuit to foreclose the lien must then be filed in the County Superior Court within 90 days after the mechanics’ lien is recorded. The goal of the lawsuit is to obtain a judgment for foreclosure on the mechanics’ lien by way of a forced sale of the property. The net proceeds of the sale will be used to pay the unpaid construction debt secured by the recorded mechanics’ lien, assuming that sale proceeds exceed the amount of senior liens and encumbrances.

Generally, if the claimant does not file the lien foreclosure lawsuit within 90 days after recording the mechanics’ lien, the lien becomes void and unenforceable.

Owner/Developer insolvency is a growing problem in the construction industry. Changes in real estate market conditions have led large and small developers to default in paying their obligations, and we are seeing developer bankruptcies in increasing numbers. It is anticipated that this trend will continue until the market improves.

A bankruptcy does not automatically negate a mechanics’ lien. It is important to understand certain issues and procedures in order for the contractor to protect itself in the event of an owner/developer’s bankruptcy filing.

Bankruptcy Overview/Types of Bankruptcies

Chapter 7 – Liquidation

Chapter 13 – Individual Debt Repayment Plan

Chapter 11 – Reorganization

Secured creditors hold significant advantages over unsecured creditors in nearly all bankruptcy cases. A contractor holding a valid mechanics’ lien is treated as a secured creditor, entitled to full payment, provided that the property securing the lien has value in excess of prior liens and encumbrances.

The Bankruptcy Code Automatic Stay

U.S. Bankruptcy Code section 362’s “automatic stay” acts as an injunction, effective on the date the bankruptcy is filed, that prohibits lawsuits and all other acts by creditors to collect on a prepetition debt or enforce claims against the debtor’s property. Section 362 sets the rule that no state court lawsuit may be filed against a bankrupt party without first obtaining permission from the Bankruptcy Court. The automatic stay thus automatically prohibits the filing of a state court lawsuit to foreclose on the mechanics’ lien without first obtaining Bankruptcy Court approval. In addition, any state court lawsuit already on file against the bankrupt party is “automatically stayed” (or suspended) until the Bankruptcy Court grants relief to allow the plaintiff to proceed with the action.

Case authority holds that state court lawsuits filed against a bankrupt debtor after the bankruptcy filing are void and of no effect. Therefore, a mechanics’ lien foreclosure action filed against a debtor after it files bankruptcy will very likely not preserve the mechanics’ lien.

The automatic stay prohibits the contractor/subcontractor from filing an action to foreclose its lien. If the mechanics’ lien is recorded but no lawsuit is filed to foreclose the lien within 90 days of recording, the contractor stands to lose its rights as a secured creditor. Luckily, the Bankruptcy Code offers an alternate remedy that allows for protection of mechanics’ lien rights, without the need to file a lawsuit.

Protecting Your Mechanics’ Lien in Bankruptcy

Bankruptcy Code section 546(b) generally provides that the rights and powers of the Bankruptcy Trustee/Chapter 11 debtor in possession 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 such perfection.

Section 546(b) provides that if a law requires commencement of an action to accomplish perfection, maintenance or continuation of perfection of an interest in property, and such an action has not been commenced before the date of the filing of the petition then:

“such interest in such property shall be perfected, or perfection of such interest shall be maintained or continued, by giving notice within the time fixed by such law for such seizure or such commencement.”

A mechanics’ lien gives rise to an interest in property that the claimant acquires when the lien is recorded, and before a lawsuit to foreclose is filed. Section 546(b) allows the mechanics’ lien holder to file a “notice of perfection of lien” with the bankruptcy court as an alternative to filing an action to foreclose, provided the notice is filed within the statutory 90 day period after the lien is recorded. In addition, the claimant should file a proof of claim with the bankruptcy court, using the approved form, and noting that the claim is a secured claim.

Danger of Using the “Notice of Perfection” Only

The automatic stay prohibiting mechanics’ lien lawsuits terminates if: 1) the Bankruptcy Trustee abandons the real property subject to the mechanics’ lien; 2) the bankruptcy case is dismissed; or 3) the Court grants another interested person’s request for relief from the automatic stayIf one these occur, the claimant may lose the right to foreclose on its mechanics’ lien if the claimant does nothing further to protect its interests and the statutory time period to act elapses.

The Federal Rules of Bankruptcy Procedure includes a provision giving creditors the right to request special notice of papers filed in the court, including orders dismissing the case and orders for relief from stay or abandonment of property.

Once the mechanics’ lien claimant learns that the automatic stay is lifted, it should then proceed in state court with an action to foreclose its mechanics’ lien, keeping in mind that it could lose its rights if it fails to act promptly.

Motion for Relief from the Automatic Stay

A mechanics’ lien claimant may consider filing a motion for relief from stay to allow the mechanics’ lien foreclosure action to proceed in state court. Under Bankruptcy Code section 362, the motion requires demonstration to the Bankruptcy Court that “cause” for granting the relief exists, including lack of adequate protection (e.g., default in prior security, which threatens extinction of claimant’s lien); or that there is no equity available for unsecured creditors and the property is not necessary to an effective reorganization. A sworn declaration and an authenticated appraisal report would generally accompany the motion for relief from stay.

The decision to proceed with a motion for relief from stay should be considered on a case by case basis. If the amount of prior liens and encumbrances exceed the property’s value, then proceeding with an action to foreclose the mechanics’ lien may be of no benefit, since the proceeds of a forced sale will not be sufficient to pay anything toward the mechanics’ lien claim.

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