Homebuilder Bankruptcy Cases - What You Need To Know

Friday, February 1, 2008 - 00:00

With the recent decline in housing and real estate generally, companies in the homebuilding and construction markets face serious challenges. Some projects have already been forced into Chapter 11, and others will almost certainly require either a bankruptcy filing or out-of-court restructure. In the event a bankruptcy is filed, vendors, contractors, subcontractors and other interested parties should be aware of the impact of important bankruptcy code provisions on their relationship with troubled companies.

Automatic Stay

Upon the commencement of a bankruptcy case, Section 362 of the United States Bankruptcy Code stays the commencement or continuance of any action against the debtor or its property subject to limited exceptions. This is generally referred to as the "automatic stay." Accordingly, a creditor that has filed a lawsuit prior to the filing of a bankruptcy petition cannot continue that suit unless the bankruptcy court grants "relief from the stay." Similarly, any foreclosure is also stayed and creditors are prohibited from perfecting liens post-petition except as discussed below. The automatic stay is extremely broad in scope and is the most important protection afforded to a debtor under the Bankruptcy Code. It becomes effective immediately, without prior notice. Violation of the automatic stay by a creditor may result in sanctions being imposed by the court. Accordingly, parties are well advised to seek counsel prior to taking any actions against the debtor or its property that might fall within the scope of the automatic stay.

However, the automatic stay does not prevent a creditor from taking actions against non-debtors absent a further order of the court. For instance, in the event of a bankruptcy filing, a creditor is well within its rights to proceed against a guarantor, letter of credit or a surety for payment of amounts owed. In certain limited cases, the bankruptcy court may order that the automatic stay be extended to non-debtor entities.

Joint Administration And Substantive Consolidation

Homebuilders sometimes form special-purpose entities for each particular project. These entities are often but not always operated as limited liability companies that each own one development. These companies may have separate funding mechanisms and lenders. Accordingly, a homebuilder bankruptcy may actually be several bankruptcy cases that are administered together. So-called "joint administration" is not intended to affect the substantive rights of parties. However, creditors are typically required to file claims against a specific debtor or debtors. In addition, joint administration would not prevent a group of related debtors from each being considered a single-asset real estate case. Single-asset real estate cases are required, among other things, to proceed more quickly than other bankruptcy cases.

In certain instances, the bankruptcy court may order "substantive consolidation" of a group of bankruptcy cases. Substantive consolidation results in the merger of all of the assets and liabilities of related debtor entities. Consolidation can significantly impact the rights of creditors that may have relied upon the assets and credit of a particular entity in lending money, and is not the preferred method of administering a group of bankruptcy cases. For example, creditors of a profitable development would not want their claims combined with those projects that did not have the resources to even pay secured claims.

Construction/Materialman's Liens

Contractors and subcontractors providing homebuilding services may have liens under applicable state statutes for amounts owed prior to the bankruptcy case. The priority and effect of these liens is determined under state law. Accordingly, with respect to a homebuilder that operates in several states, the practical impact on these claims may vary. In addition, these liens may be referred to as "construction liens," "materialman's liens," "mechanic's liens," "artisan's liens," or by another name depending upon the particular services provided and the relevant state. Typically the amount of the lien is based upon the value of the goods or services provided. The state laws in this regard are often very technical, and a party asserting lien rights is well advised to seek experienced counsel.

In addition, Section 546(b) of the Bankruptcy Code provides an important mechanism for enforcing lien rights. This section limits the rights of the debtor (or bankruptcy trustee) by authorizing post-petition perfection of an interest in property if applicable state law permits perfection. Similarly, the maintenance or continuation of a perfection of a lien or other property interest is generally allowed if applicable state law provides for such maintenance or continuation of perfection. However, the applicable law must provide that perfection (or maintenance or continuation of perfection) relates back in time to a pre-petition period to be effective. The specific facts and circumstances of a contractor's relationship with the debtor must be evaluated in order to determine with specificity whether Section 546(b) provides protection to that contractor.

Section 503(b)(9) Claims

Section 503(b)(9) provides administrative priority for "the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor's business." Administrative priority claims are paid before any other unsecured claims in a bankruptcy case and must be paid in full in order for a Chapter 11 plan to be confirmed. Where a company has provided goods to the debtor pre-petition, it should carefully evaluate its rights under this section. In many instances, the bankruptcy court will establish procedures for asserting such claims as well as reclamation claims, which also involve the pre-petition provision of goods to the debtor. Creditors should pay attention to any notices received regarding such procedures and be sure to file any Section 503(b)(9) claims before the applicable deadline, which may or may not be the same as the general claims bar date depending upon the case.

Construction Contracts

Contracts for the construction of incomplete developments will almost certainly exist in any homebuilder bankruptcy. Under Section 365 of the Bankruptcy Code, these contracts will likely be found to be executory contracts which the debtor may typically assume or reject. Generally, courts allow the debtor to exercise its business judgment in determining whether to assume or reject these contracts. If the debtor decides to assume the contract, it must, among other things, pay all pre-petition amounts due in full.

Unless the court orders a faster timeline, the debtor has until confirmation of a plan to determine whether to assume or reject a contract. In the interim, the counter-party to the contract is typically required to render performance despite the bankruptcy case. However, depending upon the facts and circumstances of a particular case, a contractor may be able to convince the court that the debtor should be required to quickly determine whether to assume or reject a particular contract. Indeed, the possibility that a contractor may be required to invest substantial sums in order to perform with no assurance of assumption may persuade the court to require an earlier decision.

Contracts For The Sale Of Homes And Deposits

Any homebuilder filing for bankruptcy protection is also likely to be a party to a number of contracts for the sale of homes. Typically, homebuyers will have paid a deposit on or about the time they entered into the contract with the debtor. The bankruptcy filing itself is generally insufficient to allow a party to cancel its contract to purchase a home. Rather, the debtor typically has until confirmation of a reorganization plan to assume or reject the contract. Assuming the debtor has sufficient funds to operate post-petition, construction of at least some developments is likely to continue. Unless the debtor breaches the contract post-petition, purchasers may be required to wait several months before knowing what will happen to both their deposit and the home they may still hope to purchase. As real estate values have fallen, customers may actually desire rejection of their contract and may be willing to forego their deposits.

However, in the event the debtor does reject a contract for the sale of a home, the purchaser may have a secured claim for any deposit paid. Pursuant to Section 365(j) of the Bankruptcy Code, "a party whose executory contract to purchase real property from the debtor is rejected and under which such party is not in possession, has a lien on the interest of the debtor in such property for the recovery of any portion of the purchase price that such purchaser or party has paid." However, the security interest granted under this section may be subordinate to pre-existing liens. To the extent the relevant property is already encumbered, a Section 365(j) lien may be worthless. In addition to a lien under Section 365(j), a purchaser may also have a vendee lien under applicable state law.

Home Warranties

Homebuyers that purchased homes prior to a bankruptcy filing may have a warranty protecting the newly built home. However, such warranties may not survive a bankruptcy filing. Typically, warranties are treated as contingent and unliquidated pre-petition general unsecured claims in a bankruptcy case. Accordingly, unless the debtor makes special provisions for these claims in a plan of reorganization, purchasers holding home warranties may be placed at risk. Moreover, in the event a defect subject to warranty coverage does not manifest until after the conclusion of the bankruptcy case, the homebuyer may not even have filed a claim based upon the warranty. While many homebuilders provide private warranty insurance, in the absence of such insurance, the value of a purchaser's warranty may be insignificant.

Avoidance Actions

Under Sections 547 and 548 of the Bankruptcy Code, a debtor may seek to avoid any transfers of an interest in property made within ninety (90) days or one year of the bankruptcy case, depending upon the specific circumstances of a particular transfer. Transfers that may be avoided include not only payments made by cash, check or wire, but also, in some instances, the grant of a lien or mortgage.

One of the defenses to these actions that may be specifically applicable in homebuilder cases is found in Section 547(c)(6). This provision of the Bankruptcy Code protects against avoidance transfers that are the fixing of a statutory lien. In certain jurisdictions, mechanic's and similar liens are statutory. Thus, the debtor may have difficulty avoiding such a lien as a preference. In addition, at least one court has held that a payment made by a debtor which resulted in the creditor not taking steps to perfect a statutory lien came within this defense. Of course, Defendants in these cases may also rely on the traditional defenses to an avoidance action, including the defense that the transfers were made in the ordinary course of business.

Conclusion

This article discusses only a few of the many issues that may arise in the bankruptcy case of a homebuilder. In the coming months, additional homebuilders are likely to be forced into Chapter 11. Those in the construction industry should prepare themselves for this unfortunate set of circumstances and be prepared to seek advice from counsel and take an active role in the bankruptcy proceeding in order to protect their rights.

H. Jason Gold is the Chair of Wiley Rein LLP's Bankruptcy & Financial Restructuring Group and has more than 25 years of experience counseling clients on restructuring and insolvency matters. Mr. Gold can be reachedat 703-905-2825. Associate Dylan G. Trache represents debtor and creditor clients on a variety of bankruptcy and insolvency issues in bankruptcy courts throughout the country and can be reached at 703-905-2829.

Please email the authors at jgold@wileyrein.com or dtrache@wileyrein.com with questions about this article.