The courts are split on whether the “contemporaneous exchange for new value” defense of Section 547(c)(1) of the Bankruptcy Code applies when a creditor foregoes perfecting a mechanic’s lien in exchange for payment. The identical issue exists in the context of Section 547(b)((5) of the Bankruptcy Code.
Waiving Mechanic Lien Rights Is Not A Defense:
Precision Walls, Inc. v. Crampton, 196 B.R. 299 (E.D.N.C.1996), stands for the proposition that compliance with a state’s statutory requirements for perfection of a mechanic’s lien was a prerequisite for obtaining secured creditor status. Therefore, with respect to a preference claim, the subcontractor was not entitled to secured creditor treatment based on its contention that it would have perfected a mechanic’s lien, but chose not to after receiving the payments. The court stated that the subcontractor failed to perfect its lien under state law by filing a notice with the obligor and, under statute, only perfection could vest a creditor with priority over others.
In In re Globe Manufacturing Corporation, 2008 WL 11449037 (N.D.Ala.), the payments at issue resulted from a contract between debtor and defendant which called for the defendant to install a chiller plant at the debtor’s textile plant. The parties agreed that the work performed by the defendant constituted an improvement to real property within the meaning of the mechanic’s lien provisions of Massachusetts law. However, the defendant’s status as a creditor was at issue in the bankruptcy proceeding because the defendant did not take any of the statutorily-required steps to create or perfect a mechanic’s lien in the subject real estate. The defendant explained that it did not take the statutorily-required steps because it got paid.
The court ruled that the defendant’s failure to perfect its mechanic’s lien because of payment was not a defense to the preference payments. It noted that under Massachusetts law, a mechanic’s lien does not exist under until the contractor records a “notice of contract” in the registry of deeds for the county in which the property is located. Further, Massachusetts courts have made clear that strict compliance with the requirements of the statute is required to create and enforce a mechanic’s lien. Id. at *4. The court stated that “[b]ecause [the defendant] failed to record a notice of contract in connection with its work at [the debtor’s] Massachusetts plant, it does not have a statutory mechanic’s lien.
The defendant argued that it had an “equitable mechanic’s lien.” However, the court stated that regardless of the public policy justifications supporting the concept of an equitable mechanic’s lien, this court must take the law of Massachusetts as it finds it, and the Supreme Judicial Court of Massachusetts has refused to recognize the existence of an equitable mechanic’s lien. Id. at *5. See also, In re Pameco Corp., 356 B.R. 327, 339-40 (Bankr.S.D.N.Y.2006) (finding no influx of new value from waiver of lien.)
Waving Mechanic Lien Rights Is A Defense:
A different conclusion was reached in In re Rand Energy Co, 259 B.R. 274 (Bankr.N.D.Tex.2001). In this decision, the court held that in construing a hypothetical Chapter 7 liquidation, with the assumption that the transfer was not made, the court must assume that the lienor would have “acted in a commercially reasonable manner.” Under the facts of Rand Energy, the court held that the lienor would have presumably perfected its statutory lien had it not been paid. Then, at the time of filing of the bankruptcy case, the creditor would have been secured, requiring the court to analyze the creditor’s secured claim under 11 U.S.C. §506(a). If the value of the collateral covered the claim, the creditor would have been paid in full in the Chapter 7 liquidation, just as the creditor would have been paid in full with the transfer. The transfer would not thereby be avoidable. Id. at 278
In In re ML & Associates, Inc., 301 B.R. 195 (Bankr.N.D.Tex.2003) the trustee of a bankrupt debtor-contractor attempted to avoid payments made to a subcontractor which performed excavation work on a publicly-funded commercial construction project. With respect to this project, Texas law required the debtor to obtain performance and payment bonds. The court first noted that the bonds did not turn the subcontractor into a secured party. While the bonds effectively assured the subcontractor that it would be paid, without the existence of a security agreement, the bonds did not convert the subcontractor’s claim into a secured claim. Id. at 203.
But as to the question of whether the payment was avoidable as a preference, the secured or unsecured status of the subcontractor begged the question.
The court must construct a hypothetical Chapter 7 liquidation on the petition date, assuming the transfer had not been made. Upon the filing of the bankruptcy petition, the court could apply 11 U.S.C. §§ 501 and 502 to determine claims against the bankruptcy estate. T&R would have had two unpaid draws or invoices totaling $68,182.44. The payment of the invoices would have been assured by the performance and payment bond. In construing a hypothetical Chapter 7 case, the court must assume that persons would act in a commercially reasonable and businesslike manner. Had ML & Associates not paid the invoices, T&R would have asserted its claim against the bond. Hartford would have paid the claim. The T&R invoices would have been paid in full, albeit by Hartford. Hartford would thereupon have an unsecured claim to assert under §501. But T&R would not have a basis to file a claim under §501. T&R would have been paid 100% of its two invoices. T&R would have received no payment from the estate in a hypothetical Chapter 7 case, 11 U.S.C. §547(b)(5)(C). T&R will receive no payment from the actual estate. T&R was paid 100% by the transfer. T&R would have been paid 100% without the transfer, albeit by Hartford and not by the debtor. The trustee has not established that T&R received more than it would have received had the transfer not been made. As a result, §547(b)(5) has not been met.
Id. at 202-03.
A similar conclusion was reached in In re Golfview Development Center, Inc., 309 B.R. 758 (Bankr.N.D.Ill.2004). Applying Illinois law the court noted that the Illinois Mechanics Lien Act requires certain procedural steps to be taken to enforce and perfect a mechanics lien. A mechanic who has met the prerequisites for bringing a lien claim has merely acquired an inchoate right to a lien that attaches as of the date of the contract; it must then be perfected in accordance with the requirements set forth in the Act. In Golfview, the mechanic had, in fact, met all of the prerequisites for bringing a lien claim and thus had its inchoate right to a valid mechanics lien. The defendant was then paid in full within two months of completing the work and thus had no need to give written notice or record a verified claim for lien, or file suit to enforce and foreclose its mechanics lien. The court noted that “indeed, to take any of those steps after being paid in full would have violated the Illinois statute and improperly clouded the title to the property.” Id. at 769.
The court also noted that had the defendant not been paid, and had the defendant perfected its statutory lien prior to the petition date, it would have been effective against the Debtor’s estate pursuant to Section 547(c)(6) of the Bankruptcy Code. Alternatively, if the defendant had not been paid but perfected the lien subsequent to the petition date, the lien would likewise be effective against the estate because Illinois law provides that a mechanics lien relate back to the date of the contract when the inchoate lien arose. Because of these facts, and given the court’s interpretation of Illinois law, the court concluded that the defendant had a secured claim that was required to be paid in full, even though that claim was inchoate.
In In re 360Networks (USA) Inc., 327 B.R. 187 (Bankr.S.D.N.Y.2005), the court noted that because neither the filing nor the enforcement of a mechanic’s lien would have constituted a preference, payment of the debt obtained without filing the lien could not be challenged as a preference. The court reasoned that payment itself should not be less secure than the lien which could have secured it, and held that payment is not preferential where the payment merely avoids the bite of a lien which the trustee could not have successfully attacked.
In In re Carney, 396 B.R. 22 (Bankr.N.D.Iowa 2008), the court dealt with Iowa law. Here, it noted that under Iowa law, a mechanic’s lien attached to the property on the date the mechanic commenced work. For 90 days after the work was finished, this lien is valid against all other subsequent liens or interests. After 90 days, if unperfected, the lien would remain valid against all other interests, except those of good faith purchasers or encumbrancers for value without notice.
In this case, the debtor paid the mechanic on the 90th day after he finished his work on her furnace. At that time, the mechanic’s lien was valid against all subsequent liens and interests without the need for him to file a statement with the Iowa District Court. The mechanic could have filed a mechanic’s lien statement on that date had the debtor failed to pay him in full. Such perfection of a statutory lien would have been excepted from preference avoidance under §547(c)(6). If the debtor had paid the mechanic on the 91st day or later, without a lien statement being filed, the mechanic’s rights would be subordinate to the trustee, who possessed the rights of a hypothetical good faith purchaser under the Code.
The court stated that the trustee failed to prove the sixth element of preference avoidance, i.e., that the mechanic was better off from receiving the payments during the preference period than he would have been if he had to assert his secured claim in a Chapter 7 liquidation. The court noted that the trustee offered no evidence regarding the value of the property to which the lien attached. “Thus, nothing in the record prevents the Court from finding that [the mechanic] would have been entitled to full payment of his secured claim in a hypothetical Chapter 7 liquidation if he had not received payment during the preference period.” Id. at 27.
A similar conclusion was reached in Betty’s Homes, Inc. v. Cooper Homes, Inc., 411 B.R. 626 (W.D.Ark.2009). Here the court noted that in Arkansas, a materialman’s lien arises by statute on the date construction begins, and it remains inchoate until it is perfected or expires by failure to timely perfect. Upon perfection, it relates back to the date construction began. Id. at 632.
On the date of the $200,000 transfer in this case, Copper had inchoate materialman’s lien on several of Betty’s properties – as to which the time to perfect was running out but had not expired. No party contends that these liens were not later timely perfected. The filing of Betty’s bankruptcy petition did not terminate Cooper’s rights to timely perfect its materialman’s liens and, upon perfection, the liens were not avoidable under the Bankruptcy Code. Under the In re Electron Corp. analysis, this state of affairs places Copper in the category of a secured creditor. That being the case, the transfer of $200,000 from Community First Bank to Cooper was a transfer from one secured creditor to another – which falls within the parameters of the earmarking doctrine. It was, thus, not an avoidable transfer as defined in 11 U.S.C. §547(b).
The same conclusion was reached in In re Johnson Memorial Hosp., Inc., 470 B.R. 119 (Bankr.D.Conn.2012), in which the court quoted from 360Networks (USA) extensively, including the following:
[T]he question is whether the Debtors have satisfied §547(b)(5). Under §547(b)(5), a transfer to a fully secured creditor is immunized from preference attack because the creditor would have been paid in full in a hypothetical Chapter 7 liquidation by virtue of its realization on its collateral. The question is whether, as the Defendants argue, they could have been secured creditors and should be so treated; or whether, as the Debtors contend, the Defendants should be treated as unsecured creditors because they had not perfected any liens and were never secured at all.
The Bankruptcy Act case of Riccotta v. Burns Coal & Building Supply Co., 264 F.2d 749 (2nd Cir.1959), is decisive on this issue in the Defendants’ favor. In Riccotta, the preference defendant had provided a debtor with building supplies and as a result obtained an inchoate mechanic’s lien under New York Law. The defendant was paid in full during the preference period—prior to the expiration of its right to perfect its statutory lien. The debtor subsequently sued to avoid the payment as a preferential transfer. Reversing the decision below, the Circuit Court held that “neither the filing nor the enforcement of [a mechanic’s] lien would have constituted a preference” and that “had the liens been filed, payment merely discharging them … would likewise have been immune from attack.” Id. at 750. The Circuit Court . . . held that payment is not preferential where “the payment merely avoids the bite of a lien which the trustee could not have successfully attacked.” Id. at 750-51.
The Riccotta court based its holding principally on the logical and equitable premise that, . . . if the lien filing is not preferential, actual payment on the claim should not be so considered. . . . [A] majority of courts facing the precise issue under consideration here have held that Riccotta retains its vitality under the present law.
. . . A holder of an inchoate statutory lien cannot perfect the lien after accepting payment in satisfaction of the underlying claim. As the Court said in Riccotta, holders of inchoate statutory liens would be faced with an unreasonable Hobson’s choice between accepting payment or taking the commercially unreasonable step of declining payment in order to perfect an inchoate statutory lien. . . .
In re 360Networks (USA,), Inc., 327 B.R. at 190.
In In re BFN Operations, LLC, 2019 WL 2387168 (Bankr.N.D.Tex.), the debtor contracted with defendant for defendant to construct a nursery pad storage addition and loading dock on property the debtor leased in North Carolina. As defendant’s work progressed it submitted seven invoices to the debtor for payment which totaled $478,760.05. On March 25, 2016, while defendant was still owed $290,532.21, it executed a document titled “Final Payment Lien Waiver.” Defendant was then paid in full on May 25, 2016. The issue was whether this transfer could be avoided as a preference, a question which the court believed implicated §547(b)(5).
The court started its analysis by noting that under North Carolina law, the “claim of lien” related to, and took effect from, the time defendant first furnished labor or materials. Thus, according to defendant, had it not been paid in full prepetition, it would have acted in a commercially reasonable manner by perfecting its inchoate lien right, making it a secured creditor entitled to payment in full in a hypothetical liquidation. The trustee, in turn argued that the defendant released that right as of March 25, 2016 when it executed the Final Payment Lien Waiver. And, since the payments at issue were received by Defendant on and after that date, defendant held only a general unsecured claim and would not be entitled to payment in full in a hypothetical liquidation.
Examining the Final Payment Lien Waiver, the court found the plain language of this document to be clear and unambiguous. Defendant’s waiver of its inchoate lien rights was expressly conditioned upon its receipt of the final payment amount of $47,876.05. Once that payment was received, defendant’s waiver became effective as of March 25, 2016, the date the waiver was signed. Id. at *5. The issue was whether the defendant had to actually perfect its lien right prior to the Debtor’s bankruptcy. Here the court followed what it described as the majority rule, i.e., if the creditor could perfect the lien under state law at the time payment is made, and the perfection of the lien is not avoidable under the Bankruptcy Code, then the payments are not recoverable.
The Court finds the majority position persuasive. The inchoate lien defense to §547(b)(5) recognizes that, since the holder of inchoate lien cannot perfect its lien after being paid in full, a court’s refusal to protect such transfers from avoidance exposes the holder to “an unreasonable Hobson’s choice between accepting payment (with the attendant risk that it could be avoided if the payor enters bankruptcy) or taking the commercially unreasonable step of declining payment in order to perfect an inchoate statutory lien.”
Matthew T. Gensburg