The Construction Advantage

Material Suppliers Keep Payments When The General Contractor Goes Bankrupt

When a party receives payments from a soon-to-be bankruptcy debtor within 90-days before the filing of the Bankruptcy Petition, the Bankruptcy Trustee may seek to recover those payments for the benefit of the bankruptcy estate as “preferences.” When the entity receiving payment was party to a construction project and still possessed valid lien rights, there are defenses to the return of money, as recently demonstrated by a decision of the United States Bankruptcy Court for the District of Kansas in In re: WB Services, LLC, Case No. 16-10759 (Bankr. D. Kan. August 16, 2018).

The debtor, WB Services, LLC was a general contractor on a commercial construction project in Nebraska. The six defendants in the preference actions brought by the Chapter 7 Trustee were all material suppliers to the general contractor on the project.

Approximately two months before filing bankruptcy the general contractor requisitioned the owner for final payment on the project, promising to then issue checks to all unpaid suppliers and subcontractors on the project. The owner, feeling uncomfortable that the contractor would honor the promise, reached an agreement to issue checks payable jointly to the contractor and each supplier. After lien waivers were collected from the material suppliers, the balance of the contract was paid by the owner to the general contractor.

The Trustee sought recovery of the payments to the suppliers, and the defendants raised numerous defenses, arguing that the debtor/general contractor did not have an interest in the funds transferred to the suppliers. The Bankruptcy Court disagreed, finding that the debtor in fact did have an interest in these funds.

However, because the Prime Contract required the general contractor to deliver the project to the owner free of liens, and the owner was authorized to withhold payment as necessary to protect itself from claims raised by subcontractors and suppliers, the Bankruptcy Court held that the suppliers had a defense under § 547(c)(1) of the Bankruptcy Code because the payments were made in exchange for “new value given to the debtor.” Although it was the owner in this case that benefited from the release of liens on its property, the “new value defense” was available to the suppliers because there was an “indirect transfer” of value: The general contractor was required to deliver the project free of liens or face an offset, and the balance of the contract payment was released to the general contractor upon receipt of the lien waivers, providing a benefit to the debtor.

The Bankruptcy Court noted that while only one of the six suppliers had actually recorded a mechanic’s lien, the other five suppliers were all within the statutory deadline to do so. The court followed precedent that recognizes the construction industry would be substantially impaired if subcontractors were required to file mechanic’s liens to avoid later discouragement of payments if a struggling owner or contractor files bankruptcy. Given the typical practice of the exchange of lien waivers for payment, the acknowledgement of that waiver was of sufficient contemporaneous value to avoid a preference claim.

It is not unusual for financially compromised owners or contractors to make payments in the ordinary course of projects while bankruptcy looms. For a party receiving payment from a financially compromised entity, it is important to either make sure that a mechanic’s lien is recorded and in place prior to the deadline, or to affirmatively waive and release potential liens in exchange for payment within those deadlines to make sure that sufficient “new value” is provided. This will avoid the seemingly unfair result of repaying significant funds for work completed simply because payment was made within 90-days of the distressed party filing for bankruptcy, an event over which the party receiving payment ultimately has no control.

Carefully Crafted Contract Provision Avoids Anti-Indemnity Prohibition in Georgia

Indemnification provisions, also known as hold-harmless agreements, are designed to transfer some or all of an incurred liability from one party, who is known as the “indemnitee,” to another, who is known as the “indemnitor.” Many states have enacted anti-indemnity statutes to curtail indemnification provisions in construction contracts that go against public policy. These anti-indemnity statutes vary by state and generally limit the enforceability of agreements that seek to indemnify the indemnitee for its own negligence. Careful drafting helps to avoid limitation of liability provisions (which are typically enforceable) from being characterized as indemnity provisions, as the parties in US Nitrogen, LLC v. Weatherly, Inc., No. 1:16-CV-00462, 2018 WL 4509532 (N.D. Ga. Sept. 19, 2018) experienced.

In US Nitrogen, the plaintiff, US Nitrogen, LLC, hired the defendant, Weatherly, Inc., to provide engineering services related to the construction of an ammonium nitrate solution plant. Constructing the plant cost more money and took longer than the parties initially anticipated. After construction was complete, US Nitrogen discovered cracks in the concrete foundations of the compressor plants. Weatherly made certain recommendations to repair the cracks, but two independent firms hired by US Nitrogen recommended that the repairs would be inadequate. The two independent firms recommended removing and redesigning the compressor plant.  At around the same time, US Nitrogen determined that Weatherly’s design for piping systems within the plan were incomplete and erroneous. US Nitrogen hired another company to complete the piping work.

US Nitrogen sued Weatherly for breach of contract, professional negligence, negligent or fraudulent misrepresentation, bad faith and breach of express warranty. Weatherly asserted its right to limit its liability pursuant to the contract governing the relationship. The contract contained a provision stating as follows:

“Weatherly’s total aggregate liability to [US Nitrogen], except with respect of Weatherly’s cost of performing the Work under the Contract, for all causes including defects, Weatherly defaults, default of any warranties, or guarantees, patent infringement, or otherwise, shall not exceed fifteen percent (15%) of the Price.”

US Nitrogen argued that the provision was an indemnification provision that violated Georgia law. Weatherly argued that the provision was a simple limitation of liability provision that was enforceable under Georgia law.

Georgia has, like many other states, an anti-indemnification statute that prevents a building contractor, subcontractor, or owner from contracting away liability caused by their own negligence. The Georgia Supreme Court stated that the intent of the statute was to prevent a party from relieving another party to that contract from liability to third parties. A hallmark of these indemnification provisions that the statute seeks to prohibits is the obligation of one party (the indemnitor) to indemnify, hold harmless or otherwise defend the other party (the indemnitee) from a third party liability caused by the negligence of the indemnitee.

The US Nitrogen court, after carefully reviewing the language of the provision, found compelling the fact that the provision did not obligate US Nitrogen to indemnify or hold harmless Weatherly for third party liability created by Weatherly’s negligence. The provision only limited Weatherly’s exposure to US Nitrogen. Accordingly, the provision was not within the purview of the Georgia anti-indemnification and unless otherwise prohibited, the provision was enforceable. Finding that no other statute otherwise prohibited the provision, the US Nitrogen court ruled in Weatherly’s favor.

ME, unlike Georgia, does not have an anti-indemnification statute on its books. However, in ME, indemnification provisions that indemnify a party for its own negligence are “looked on with disfavor by the courts” and are only upheld where unequivocal language reflects an intention to provide such broad indemnification. See Emery v. Waterhouse Co., 467 A.2d 986 (Me. 1983). Accordingly, indemnification provisions are enforceable in ME so long as the parties make their intent to shift the risk clear. Conversely and for comparative purposes, even where their intent is clear, such risk-allocation is impermissible in Georgia.

Parties seeking to shift the risk of third party liability from one party to another in ME – and beyond – should pay careful attention to the jurisdiction that will govern the agreement and the distinction between indemnification provisions and limitation of liability provisions. If you have concerns or questions related to indemnification or limitation of liability provisions in your contract, we can help.