What do you do about your Mechanics’ Lien When the Developer Files Bankruptcy?

William L. Porter Founder & President Specializing in Construction Law, Business Law and Labor Law
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The California mechanics’ lien is a powerful tool for contractors, subcontractors and material suppliers to secure payment of unpaid construction related debts.  The goal of the mechanics’ lien is to force a sale of the real property where the work was performed in order to obtain the funds necessary to pay the delinquent debt.  Under the usual procedure, the first step is the recording of mechanics’ lien in the chain of title to the property at the County Recorder’s office.  A lawsuit must then be filed in state civil court within ninety days after the mechanics’ lien is recorded.  The goal of the lawsuit is to foreclose on the mechanics’ lien.  A successful foreclosure lawsuit will result in a court mandated sale of the property.  The proceeds of the sale will be used to pay the unpaid construction debt originally secured by the recording of the mechanics’ lien.  While this may seem an oversimplification, it is necessary to grasp this basic process in order to understand the complications discussed below.

One complication that arises from time to time begins when the developer that owns the property on which a mechanics’ lien has been recorded files a “Petition in Bankruptcy” in federal Bankruptcy Court.  When the developer files a bankruptcy petition after the mechanics’ lien was recorded but before the claimant has had the opportunity to file a foreclosure lawsuit, a number of important legal concepts must be considered.  These are rather tricky issues and any legal practitioner facing such issues would do well to consult current legal treatises and case law before committing to a course of action.  In general, the following concepts must be considered when the owner of the property subject to a mechanics’ lien files a bankruptcy petition:

The Bankruptcy “Proof of Claim:  A bankruptcy begins when a debtor files a “Petition in Bankruptcy” in the Bankruptcy Court.  Those to whom the bankrupt party owes money (“creditors”) will usually be listed as creditors of the bankrupt party on the schedules filed with the Petition in Bankruptcy.  The Bankruptcy Court will then usually send a “Proof of Claim” form to each of the creditors listed in the schedules.   Each of the creditors must then fill out and sign the Proof of Claim form and attach to the form appropriate documentary proof of the claim (contract, final unpaid invoices, mechanics’ liens, etc.).

In a Chapter 11 Bankruptcy (often referred to as a “reorganization”) the Proof of Claim form sent by the Bankruptcy Court to the listed creditors also usually contains a listing of a specific “bar date”.   This bar date represents the deadline by which the creditor must file with the Bankruptcy Court the completed Proof of Claim form and attachments in order to preserve the right to assert the claim against the bankrupt party.  Missing the bar date is usually fatal to a claim.

The Proof of Claim form also generally comes with detailed instructions for the creditor to follow in filling out the form.  For purposes of mechanics’ liens, it is important for the claimant to note when filling out the Proof of Claim form that the debt secured by the mechanics’ lien must be categorized on the Proof of Claim form as a “secured claim”.  This is done by checking the correct box, listing the correct debt amount and attaching a copy of the mechanics’ lien and other supporting documents to the Proof of Claim before filing it in the Bankruptcy Court.  The completed and signed Proof of Claim form and attachments must be filed in the Bankruptcy Court before the bar date arrives.  Once the Proof of Claim has been filed, the debtor will receive documents from the Bankruptcy Court and from other parties from time to time regarding the administration of the bankruptcy estate.    

The Bankruptcy Code Automatic Stay:  A very important legal concept which must be considered when a property owner files a bankruptcy petition is the U.S. Bankruptcy Code section 362 “automatic stay.  This Bankruptcy Code section addresses the fact that federal bankruptcy laws often conflict with state laws.  For our purposes, 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 would be “automatically stayed” (or suspended) until the Bankruptcy Court makes certain determinations.  Despite the foregoing, there still remain a few avenues to circumvent the automatic stay and pursue the mechanics lien to completion (or “perfection”) through sale of the property in question.  In order to achieve such circumvention however, certain procedures must first be followed.  These procedures are described below.

Perfecting Your Mechanics’ Lien in Bankruptcy:  As historical background, for some time, many legal practitioners considered the obligation to file a state court action to foreclose on the mechanics’ lien to be an exception to the bankruptcy automatic stay rule.  This belief arose because Bankruptcy Code section 546(b) generally provides that the rights and powers of the Bankruptcy Trustee 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.  Since a mechanics’ lien is an interest in property under the generally applicable California laws and since the claimant acquired such right to the property before the date the claimant sought to perfect that right by filing a lawsuit to foreclose on the mechanics’ lien, it would seem permissible under section 546(b) to bring a lawsuit in the state civil court to foreclose on the lien (and avoid missing the California Civil Code section 8460 ninety day deadline for filing a state court mechanics’ lien foreclosure suit).  This would seem to be the proper course under section 546(b).  However, at least one federal court (our own 9th Circuit) has ruled that this is not the proper course.  The court has made statements which eventually evolved into a procedure which is now used to perfect a mechanics’ lien when bankruptcy becomes an issue.  This procedure and others are described below.

Bankruptcy “Notice of Perfection of Mechanics’ Lien:  In 1999 the United States Bankruptcy Appellate Panel for the Ninth Circuit disagreed with the perception that a state court mechanics’ lien lawsuit could be filed where a bankruptcy automatic stay was in effect.  See, In re Baldwin Builders, Village Nurseries v. David Gould, Trustee (9th Cir. 1999) 232 B.R. 406.  Specifically, the Baldwin Builders court disapproved of the practice of filing state lien foreclosure lawsuits and failing to give any additional notice to the Bankruptcy Court. The court cited the 1994 amendments to section 546(b) when Congress added ”maintenance or continuation of perfection” to the section 546(b) exception as well as its decision in the case of In re Hunters Run Ltd. (9th Cir. 1989) 875 F.2d 1425, 1427-1429.  The Ninth Circuit in Baldwin Builders addressed this point as follows:

”We see nothing ambiguous in the words ‘maintenance and continuation of perfection,’ nor anything incoherent or inconsistent in enforcing the notice requirement. Under California law, the filing of a foreclosure suit, an enforcement action, is required to maintain the perfection of a lien: if no suit is timely filed, the lien becomes void. Section 546(b) unambiguously mandates that, if commencement of an action is required to maintain or continue perfection, notice shall be given instead.”

The Baldwin Builders case thus seems to require that when a bankruptcy has been filed, rather than foreclosing on a mechanics’ lien in state court, the lien claimant must instead give some other form of notice to those participating in the bankruptcy process.  Despite this decision, legal practitioners are nevertheless understandably extremely uncomfortable about failing to file a state law mechanics’ lien foreclosure action within 90 days as required by California Civil Code section 8460.  Under customary state practices the right to sue on the mechanics’ lien is irretrievably lost if a lawsuit is not brought to foreclose on the mechanics’ lien within ninety days.  Legal practitioners are thus torn between the fear of violating the Ninth Circuit’s Baldwin Builders interpretation of Bankruptcy Code section 362 and missing the very short ninety day California deadline for filing a mechanics’ lien foreclosure lawsuit found in Civil Code section 8460.

Take the case of Village Nurseries v. Greenbaum, (2002) 101 Cal. App. 4th 26, 123 Cal. Rptr. 2d 555.  In Village Nurseries the Court of Appeals referred to the above Baldwin Builderscase and noted that pursuant to section 546(b) of the Bankruptcy Code, where state law requires the commencement of an action to accomplish perfection, or maintenance or continuation of perfection of an interest in property and the action has not been commenced pre-bankruptcy petition, perfection of such interest shall be maintained or continued by giving “notice” within the time fixed by law for such commencement.

“Notice” pursuant to Village Nurseries and Baldwin Builders cases and Section 546(b) has since those cases were decided been achieved by filing with the appropriate Bankruptcy Court a document commonly entitled a “Notice of Perfection of Mechanics’ Lien [11 U.S.C. 546(b)(2)(A)]”.  Included within the body of the notice are citations to the relevant California mechanics’ lien statutes, including Civil Code section 8460 and its ninety day statute of limitations.  Also included in the body of the notice are references to the “automatic stay” rule of Bankruptcy Code section 362 as well as references to the Village Nurseries and Baldwin Builders cases, cited above.

The findings of the Bankruptcy Appeal Panel in Village Nurseries and Baldwin Builders thus indicate that rather than filing a foreclosure action in state civil court, filing the “Notice of Perfection of Mechanics’ Lien” in federal Bankruptcy Court pursuant to section 546(b) is the proper method under federal bankruptcy law by which to perfect a mechanic’s lien where the owner of the property burdened by a mechanics’ lien files bankruptcy before the claimant has the opportunity to file a state out suit to foreclose on the mechanics’ lien.  Such a Notice of Perfection of Mechanics’ Lien must be filed in Bankruptcy Court within the same period of time as would apply to the state court action, which is within ninety days after the mechanics’ lien was recorded, as required by Civil Code section 8460.  The main difference is that instead of filing a mechanics’ lien foreclosure lawsuit in state court, the practitioner would file a Notice of Perfection of Mechanics’ Lien in Bankruptcy Court within the same ninety day time period.  This would avoid losing the right to a mechanics’ lien foreclosure action by virtue of passage of the ninety day deadline for filing such a lawsuit.

Danger of Using the “Notice of Perfection” Only:  There is however a danger to consider when using the Village Nurseries and Baldwin Builders Section 546(b) “Notice of Perfection” provision.  If such a notice is filed with the Bankruptcy Court and the claimant does not also file a state court mechanics’ lien foreclosure lawsuit the claimant may become exposed to loss of mechanics’ lien rights when events occur in the bankruptcy proceeding which the claimant and its attorney do not understand or as to which no notice is received.  For example, if the Bankruptcy Trustee officially abandons the real property on which the mechanics’ lien was recorded or if the Trustee or the Court grants another interested person’s request for relief from the automatic stay, and the mechanics’ lien claimant does not learn of this, the right to foreclose on the mechanics’ lien may quickly be lost.

For example, in Sawyer Nurseries v. Galardi (1986) 181 Cal. App.3d 663, 226 Cal.Rptr. 502, the court held that a contractor’s action to foreclose a mechanics’ lien against the beneficiaries of deeds of trust executed by the bankrupt property owner was barred when the automatic stay was lifted at the request of the holders of the deed of trust.  When the automatic stay was lifted by the bankruptcy court the mechanics’ lien claimant should have then filed a lawsuit to foreclose on the mechanics’ lien on the property, but unfortunately did not attempt to do so until it was too late.   The mechanics’ lien was recorded in February 1981.  Soon thereafter, bankruptcy was filed and the “automatic stay” went into effect, thereby preventing the filing of the state court lien foreclosure lawsuit.  However, unbeknownst to the lien claimant, the bankruptcy automatic stay was lifted by the court two years later.  The mechanics’ lien foreclosure action was not filed until ten months later when legal counsel first realized that the automatic stay had been lifted.  Under these circumstances the court held that the mechanics’ lien claimant’s filing of its secured creditor’s claim in the Bankruptcy Court did not relieve it from its obligation to comply with the state requirements for foreclosure of mechanics’ liens after the automatic stay had been lifted by the court. When the Bankruptcy Court granted another claimant’s request for relief from the automatic stay to foreclose on the deed of trust to the property, the property ceased being property of the bankrupt’s estate. The automatic stay against collection or enforcement of claims against the bankrupt terminated, and the “tolling” (or hold) on the Civil Code section 8460 ninety day statute of limitations ended.  The claimant did not know this had occurred and unfortunately missed the deadline to file a state court lawsuit to foreclose on the mechanics’ lien.

Request for Special Notice:  Please note that this result might have been avoided had the claimant served and filed a “Request for Special Notice” with the Bankruptcy Court.  Had the claimant done so, the claimant would almost certainly have received notice that the Bankruptcy Court was considering lifting the automatic stay or that the Bankruptcy Trustee was considering abandoning the property in question.  Receipt of such notice would certainly have put the claimant on notice that it would need to take at least some action to continue to protect its right to a mechanics’ lien.

One Possible Solution or a Violation of Bankruptcy Law?  After giving due consideration to all of the above and more, one of the leading California legal treatises on the subject of mechanics’ liens commented on the above state of affairs and reached a conclusion as to a possible course of action.  Unfortunately, the stated course seems to contrary to the holding of Village Nurseries and Baldwin Builders.  The legal treatise states that the Sawyer Nurseries case points to “the advisability of simply filing complaint on the lien within 90 days after recordation to perfect the lien (as noted above) even though further steps are stayed until the bankruptcy is terminated or an order is obtained vacating the stay.”  The treatise also states:

”Nevertheless, we believe that the only safe procedure is to file the foreclosure complaint within the 90-day period following recordation of the notice and claim of lien to avoid the bar of Civil Code Section 3144 (now 8460), in reliance upon the provisions of the bankruptcy law which provides that the automatic stay does not operate as a stay of any act to perfect an interest in property under any generally applicable law that requires commencement of an action to accomplish such perfection (see 11 U.S.C. section 362(b)(3) and section 546(b).”  See also, Village Nurseries v. Greenbaum (2002) 101 Cal. App. 4th 26, 123 Cal. Rptr. 2d 555 and Wells v. California Tomato Juice, Inc. (1941) 47 Cal. App. 2d 634.  See, CAL. MECHANICS’ LIEN LAW 6th Ed. Issue 4 (2000), section 4.57.

Following the above course of action would seem to be contrary to the holding of the Village Nurseries and Baldwin Builders cases.  Faced with the difference of opinion which seems to color the issue of how to deal with an unperfected mechanics’ lien in the bankruptcy context, the legal practitioner would do well to consult current legal sources for further direction before deciding on a specific course of action.  Consulting with the Clerk of the Bankruptcy Court and the Bankruptcy Trustee before reaching a decision might also be advisable.  There are also a few other viable options to consider:

Motion for Relief From the Automatic Stay:  Another common method of pursuing the foreclosure of a mechanics’ lien is by securing permission to remove the mechanics’ lien claim from the Bankruptcy Court and litigate the mechanics’ lien foreclosure cause of action in state civil court, much as if the bankruptcy had never been filed in the first place.  There are generally two methods of achieving this result.  The first of these is by filing with the Bankruptcy Court a “Motion for Relief from the Automatic Stay” to seek Bankruptcy Court approval to proceed to enforce the mechanics’ lien in state Superior Court.  Under Bankruptcy Code section 362 the motion generally requires demonstration to the Bankruptcy Court that either “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 title report would generally accompany the motion.  Another option is as follows:

Stipulation for Relief From the Automatic Stay:  A simpler and less expensive method of addressing the automatic stay is by negotiating with the bankrupt party and thereafter file with the Bankruptcy Court an agreed “Stipulation for Relief from the Automatic Stay”.  Such a stipulation is generally the result of cooperation between the parties and takes the form of agreement which is signed by the claimant’s attorney and by the attorney for the bankrupt party allowing the claim to leave the Bankruptcy Court and be determined in state court.  All interested parties (other bankruptcy creditors) are also served with the proposed stipulation and given an opportunity to object.  If such an agreement can be reached between the parties and if there is no viable objection, an “Order Granting Relief from the Automatic Stay” is then usually signed by the Bankruptcy Court Judge.  The parties who can use this process instead of filing a motion to obtain relief from the automatic stay usually benefit by saving the time and expense which would be incurred to draft and argue a motion in Bankruptcy Court.  Where the stipulation can be negotiated, this is often the most favorable and cost effective means of circumventing the bankruptcy automatic stay and foreclosing on the mechanics lien.

Dealing with a mechanics’ lien foreclosure after the owner of the property files bankruptcy can be a tricky business.  Costly errors are not uncommon.  When considering how best to address these issues, retaining legal counsel who specializes in construction law but also has practical Bankruptcy Court experience is recommended.  If legal counsel selected does not understand the rules of pursuing a mechanics’ lien after the developer files bankruptcy, costly mistakes may result in loss of mechanics’ lien rights.  Always select legal counsel who has the knowledge and experience to best protect your interests.

Article revised by William L. Porter, Esq. in 2014. Mr. Porter is a principal in The Porter Law Group, Inc. in Sacramento, California. He can be reached by phone at (916) 381-7868.

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