Bankruptcy and Insolvency In The Construction Context

 

The primary goal of all participants in most construction projects is to make money, and nothing interferes with that goal more than a bankruptcy of one of the participants – especially if it is one of the participants high up the contractual chain (e.g., an owner or general contractor).

 

The goal of this paper is to provide a basic overview of bankruptcy and insolvency law as it relates to the construction industry, and to provide some indication of the impacts on various participants in a construction project depending on which project participant becomes bankrupt.  

 

Insolvency, and the legal status of bankruptcy which can result from insolvency, is a complex area of law in which different issues arise depending on the particular factual circumstances of each case. Therefore this paper, which is intended to provide a basic overview of just some of the principles that apply, is necessarily incomplete and should not be relied on as a substitute for legal advice with respect to real life problems that may arise.

 

 

 

Unlike “bankruptcy”, which is a legal status, insolvency is not a formal legal status but is merely a recognition of a debtor’s ability to pay debts.

 

There are two forms of insolvency: insolvency arising from cash flow problems (this is classed as commercial insolvency); and insolvency resulting from having a negative net worth (this is classed as legal insolvency). These two forms of insolvency are recognized in the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3 which provides as follows:

 

Insolvent person means a person who is not bankrupt and who resides, carries on business or has property in Canada, whose liabilities to creditors provable as claims under this Act amount to one thousand dollars, and

(a)    who is for any reason unable to meet his obligations as they generally become due,

(b)   who has ceased paying his current obligations in the ordinary course of business as they generally become due, or

(c)    the aggregate of whose property is not, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all his obligations, due and accruing due; 

(Bankruptcy and Insolvency Act, R.S.C., 1985, c. B-3, s. 2, emphasis added).

 

As indicated by the opening words of the above definition, a person may be insolvent but not bankrupt.

 

Note that insolvency does not require that the debtor have no assets, but just that the debtor’s liabilities exceed its assets, or that the debtor’s cash flow does not allow its debts to be paid in the ordinary course of business. Similarly, a bankrupt does not necessary have no assets, but has more liabilities than assets.

 

 

Bankruptcy can result in a number of different ways, and the first two listed below are the most common:

(a)    A debtor making a voluntary assignment into bankruptcy (Bankruptcy and Insolvency Act, s. 49). If there is little value in the estate, the debtor making an assignment will generally be required to provide the trustee in bankruptcy with a retainer to fund the administrative work required by the bankruptcy. 

(b)   The debtor committing an “act of bankruptcy” (most commonly “he ceases to meet his liabilities generally as they become due”) and being petitioned into bankruptcy by a creditor (ss. 42 and 43).

(c)    The creditors voting against a proposal of the debtor under Division 1 of the Bankruptcy and Insolvency Act (s. 57).

(d)   The debtor not abiding by the terms of an approved Division I Proposal and the trustee or a creditor then applying to court to have the debtor deemed bankrupt (s. 63).

 

 

 

Generally, the property of the bankrupt vests in the trustee as a result of the bankruptcy:

 

On a bankruptcy order being made or an assignment being filed with an official receiver, a bankrupt ceases to have any capacity to dispose of or otherwise deal with their property, which shall, subject to this Act and to the rights of secured creditors, immediately pass to and vest in the trustee named in the bankruptcy order or assignment, and in any case of change of trustee the property shall pass from trustee to trustee without any assignment or transfer.

(Bankruptcy and Insolvency Act, s. 71, emphasis added).

 

The liabilities of the bankrupt related to the property also vest in the trustee, and this is confirmed by the definition of “property” in the Bankruptcy and Insolvency Act:

 

“property” means any type of property, whether situated in Canada or elsewhere, and includes money, goods, things in action [which includes claims under contract, or the right to sue someone], land and every description of property, whether real or personal, legal or equitable, as well as obligations, easements and every description of estate, interest and profit, present or future, vested or contingent, in, arising out of or incident to property;

(Bankruptcy and Insolvency Act, s. 2, emphasis added).

 

The trustee only takes the interests that the bankrupt has in property and therefore, for example, property held in trust by the bankrupt is prima facie exempt from the bankrupt’s estate:

 

The property of a bankrupt divisible among his creditors shall not comprise property held by the bankrupt in trust for any other person;

(Bankruptcy and Insolvency Act, s. 67(1)(a)).

 

Therefore, to the extent that the trust provisions under the Builders Lien Act establish a valid trust, then such trust property will not form part of the bankrupt’s estate. 

 

 

The trustee in bankruptcy selected by the bankrupt, or appointed by the court, is responsible for administering the bankrupt estate. The primary duty of the trustee is to the creditors of the bankrupt estate. The duties of the trustee include an obligation to collect in the property of the bankrupt, review and assess the claims of creditors against the bankrupt estate, and share out the wealth in the estate according to the scheme defined in the Bankruptcy and Insolvency Act. The trustee also has the right to sue in the name of the bankrupt to realize additional value to be shared out amongst the creditors of the bankrupt estate.

 

 

Secured creditors (creditors with an security interest in some or all of the assets of the bankrupt) are to a large extent unaffected by bankruptcy and may recover against the property they have security in, but may also submit a claim in the bankruptcy to the extent that the security they hold is insufficient to cover the debts owed to them.

 

“Preferred creditors” (including CRA for source deductions, employees for a limited amount of wages, and various other groups) have priority to payment out of the bankrupt estate, and only after those creditors are paid amounts due under the preferred creditor provisions will residual funds from the bankrupt estate be available for pro rata sharing to the general creditors (and such group of general creditors may include persons who were partially paid relying on secured creditor or preferred creditor rights).  

 

 

Whether the bankrupt is petitioned into bankruptcy or makes an assignment, upon bankruptcy there is an automatic stay of proceedings against the bankrupt:

 

69.3 (1) Subject to subsections (1.1) and (2) and sections 69.4 and 69.5, on the bankruptcy of any debtor, no creditor has any remedy against the debtor or the debtor’s property, or shall commence or continue any action, execution or other proceedings, for the recovery of a claim provable in bankruptcy.

(Bankruptcy and Insolvency Act, s. 69.3, emphasis added).

 

The broad nature of the stay is confirmed by the broad wording of s. 121(1) of the Bankruptcy and Insolvency Act:

 

All debts and liabilities, present or future, to which the bankrupt is subject on the day on which the bankrupt becomes bankrupt or to which the bankrupt may become subject before the bankrupt’s discharge by reason of any obligation incurred before the day on which the bankrupt becomes bankrupt shall be deemed to be claims provable in proceedings under this Act.

(Bankruptcy and Insolvency Act, s. 121(1)).

 

The primary purpose of the stay of proceedings that applies upon bankruptcy is to ensure that the trustee has control over all of the assets of the bankrupt's estate so that those assets may be distributed in an orderly manner.

 

Although there are some exceptions, the stay of proceedings generally only applies to unsecured creditors, and secured creditors may proceed to realize upon their security without interference by the trustee (s. 69.3(2)).

 

Although the stay prevents most claims from proceeding against the bankrupt, there are some claims that, as a matter of public policy, Parliament has determined are debts that should not be released by bankruptcy. These exceptions include fines imposed for offences, civil liability for sexual assault, and liability for alimony. One of the exceptions that may arise in the construction context is:

 

[A]ny debt or liability resulting from obtaining property or services by false pretences or fraudulent misrepresentation, other than a debt or liability that arises from an equity claim;

(Bankruptcy and Insolvency Act, R.S.C., 1985, c. B-3, s. 178(1)(e)).

 

For example, where a developer obtains a loan, or procures the services of a contractor, by intentionally making false statements about its financial means, a claim for fraudulent misrepresentation may be available.  

 

Where a claimant wishes to proceed with a court action against the bankrupt despite bankruptcy, a court order permitting the claim to proceed must first be obtained.

 

 

The following considers the implications of bankruptcy for various participants in construction projects, depending on which project participant goes bankrupt. The discussion assumes the common project delivery model of using a general contractor to construct a project under a design-bid-build mode of delivery; i.e., an owner hires a general contractor to construct a fully designed project and the general contractor is responsible for substantially all of the work, but subcontracts portions of it out to subcontractors, who may in turn contract with sub subcontractors and material suppliers. Other project delivery models (e.g., construction management) are not considered, and indeed it bears reiterating that this paper is not exhaustive and other rights or obligations may apply depending on the facts of the individual case.

 

Since most owners, contractors, and subcontractors are limited liability entities (typically corporations) it is assumed that each project participant is a corporation. It is also assumed that the “owner” of the project owns the project lands. 

 

 

Bankruptcy of an owner is generally very disruptive to a construction project because it typically results in the flow of funds down the contractual chain being abruptly cut off.

 

Owner bankruptcy in and of itself may, or may not, constitute a fundamental breach of the general contract giving the general contractor the right to terminate the contract. However, even if the bankruptcy itself does not give rise to termination rights, the subsequent non-payment by the bankrupt owner of amounts due to the general contractor will generally constitute a fundamental breach entitling the general contractor to terminate the contract.

 

Depending on the degree of completion of the project, the additional cash input required to complete the project, the value to be realized from project completion, and the resources generally available to the trustee, the trustee may seek to finance the remainder of the project to realize additional value for the bankrupt estate. However, in many cases the various factors required to make this happen will not come together and the owner’s bankruptcy will result in termination of the general contract and the end of the construction project so far as the existing project team is concerned.

 

Because of the stay of proceedings that applies under the Bankruptcy and Insolvency Act, the general contractor will be prohibited from suing the owner for breach of contract, but that does not mean that the contractor, and those below the contractor, will be without any remedy at all. The following options for recovery (albeit likely quite limited) generally apply.

 

 

The general contractor can rely on its contractual claim against the owner to prove a claim in the bankruptcy of the owner. Such a claim would typically be as an unsecured creditor and there is typically low recovery on such claims (e.g., 10 cents on the dollar, and in many cases 0 cents on the dollar). Subcontractors would not be able to file claims in the bankruptcy of the owner as they have no right to payment directly from the owner.

 

 

The general contractor, and all persons otherwise generally entitled under the Builders Lien Act, SBC 1997, c. 45 to file liens against the land, can do so.  Claims of lien are not claims against the owner personally, but are claims against an asset (in this case land) owned by the owner. Being claims against property of the owner, lien claims are provable in bankruptcy, and lien claimants are considered secured creditors of the owner: Taylor Ventures Ltd. (Re) (Trustee of), 2002 BCSC 699 at para. 59.

 

Claims of lien may be filed even after the date of the owner bankruptcy. The normal (short) time limits for filing claims of lien apply and so claimants should act quickly. Liens under the Builders Lien Act are only for the value of work done, and so, for example, a general contractor cannot include in a claim of lien amounts on account of lost profit on work not completed.

 

 

The lien claim of the contractor will be for the value of work done for the owner by the general contractor, directly or through its subcontractors.  If a claim of lien is filed by a person engaged by the owner then the land will, under the Builders Lien Act, be charged with payment of the full amount actually owing to the general contractor and the land may be sold to secure payment of that amount. However, mortgage lenders will generally rank ahead of lien claimants, and depending on the value of the land given the partially completed project, there may not be sufficient equity in the land to fully compensate the mortgage lender and the general contractor advancing a claim under the Builders Lien Act.

 

Keep in mind that funds realized by the general contractor by way of its lien claim against the land will be trust funds which must be used to cover expenses incurred by the general contractor in respect of that particular project; i.e., the trust provisions of the Builders Lien Act apply as usual. However, this does not mean that all subcontractors will be paid, and indeed the general contractor can apply trust funds to pay its own labour and materials cost in respect of the project before directing any amounts received to payment of subcontractors.

 

However, subcontractors (and sub subcontractors and suppliers) can file their own claims of lien and compete with the general contractor (and other lien claimants) for the available equity in the land. Their claims will have priority over the claim of the general contractor under section 36 of the Builders Lien Act.

 

 

Other liens available under the Builders Lien Act (e.g., against holdback held by parties up the contractual chain and against materials on the land), also remain available despite the bankruptcy of the owner.

 

 

Section 81.1 of the Bankruptcy and Insolvency Act allows unpaid suppliers of goods to demand the return of the goods from the trustee in bankruptcy. There are strict conditions that must be met to invoke this remedy, including that the goods must have been delivered within 30 days of the bankruptcy, must be in their original state, must not have been comingled with other goods, and must not have been re-sold to an arm’s length purchaser. As well, the supplier must deliver the prescribed form of notice to the trustee within 15 days of the bankruptcy. Meeting all of the requirements can be very challenging, but it is a worthwhile remedy to consider for suppliers of valuable equipment which is readily recoverable and reusable; e.g., an air conditioning unit not yet installed.

 

 

 

Absent clear pay if paid clause in the subcontract, general contractors may remain liable to subcontractors for work they performed for the general contractor even though the general contractor may not have been fully paid by the owner. Where the general contractor is substantial, the loss to subcontractors resulting from an owner bankruptcy may not be significant.    

 

 

A general contractor bankruptcy impacts the owner who hired the contractor, as well as the subcontractors below the general contractor. The following discusses the impact on those two affected parties / groups.

 

 

Generally, the primary rights of an owner against the general contractor are:

 

In the event of the bankruptcy of the general contractor, right #1 (which is the most basic and general right of the owner against the general contractor) is lost; it is barred by the stay of proceedings that applies during bankruptcy – although the owner can claim as an unsecured creditor in the bankruptcy.

 

Interesting strategy considerations, or consequences, can arise for owners in cases of general contractor bankruptcy. Certainly the owner will be inclined to make no further payments to the general contractor, even if payment is (in the mind of the owner) actually due. The trustee has the right to advance a claim against the owner for payment due to the general contractor, but such claims can be factually complex and therefore expensive to litigate and the trustee may not pursue such a claim. Further, issues such as the value of work done by the general contractor prior to bankruptcy impact the amount of the owner’s liability under the Builders Lien Act to subcontractors, and in addition owners who have not followed the proper procedures in retaining the required holdback face increased liability. In the case of bankruptcies of sizeable general contractors in the business of single family home construction, the home owners (who are not professional developers) who hired the now bankrupt general contractor can find themselves on the receiving end of a barrage of lien actions filed by unpaid subcontractors of the now bankrupt general contractor, and this can be very unsettling for upstanding members of the community who have never been involved in court proceedings.

 

As noted, theoretically the trustee in bankruptcy of the contractor should pursue the owner for amounts due to the contractor, but trustees may not do so for a variety of reasons (e.g., the trustee assumes that the lion’s share of the amount due to the general contractor will be due to subcontractors and so may see little incentive to pursue the claim for the general benefit of the creditors of the bankrupt, the trustee may not be able to justify or afford the cost of pursuing such claims, which can be factually complicated, etc.). See discussion below about the right of creditors of the bankrupt general contractor to step into the shoes of the general contractor to advance such claims if the trustee refuses to do so.

 

Another issue that arises in general contractor bankruptcy situations is how the project will be completed. In some cases the owner may look to hire the trades (who were subcontractors to the now bankrupt general contractor) directly to finish the project, and in other cases the personnel who were the “management” of the general contractor and who have knowledge of the project may look to form a new company to be hired by the owner to complete the work. Depending on the state of accounts between the owner and the general contractor, various complications can arise in these situations.

 

 

Subcontractors to a bankrupt contractor will lose the right to claim against the contractor directly for breach of contract, but a number of options, discussed below, may be available to such subcontractors.

 

 

Subcontractors owed amounts by the now bankrupt general contractor can submit a claim in the bankruptcy of the contractor - this will be an unsecured claim and likely provide little recovery. 

 

 

Subcontractors can file claims of lien against the land. The amount available to all lien claimants will be the greatest of:

 

a.          10% of the amount paid by the owner to the general contractor;

b.         10% of the value of work done by the general contractor for the owner; and

c.          the amount still owing by the owner to the general contractor.

 

Given this limited liability of the owner under the Builders Lien Act, recovery for lien claimants may be relatively small, especially on projects where the general contractor subcontracted a large portion of the work to be done under the general contract.

 

 

Subcontractors can also claim liens against the holdback held by the owner and against materials on the construction site and not yet incorporated into the improvement; i.e., all the usual lien remedies under the Builders Lien Act apply despite the bankruptcy of the general contractor.

 

 

Unless title to the goods has passed to the owner, subcontractors / suppliers who provided goods to the now bankrupt contractor may be able to rely on s. 81. 1 of the Bankruptcy and Insolvency Act (described above), which allows unpaid suppliers of goods to demand the return of the goods from the trustee in bankruptcy. However, as noted above, meeting all of the conditions for reliance on this remedy is often difficult.

 

 

If there is a labour and material payment bond in place, then subcontractors should claim under that bond as it can provide good recovery.

 

 

Subcontractors who are owed money by a now bankrupt general contractor may consider asserting trust claims (under the Builders Lien Act) against funds paid by the owner to the general contractor and still in the hands of the general contractor as of the date of bankruptcy. Such funds would generally be under the control of the trustee in bankruptcy immediately upon the bankruptcy of the general contractor, and the trustee may owe obligations to ensure such funds are preserved for the benefit of trust claimants under the Builders Lien Act.

 

There has historically been some controversy in the case law as to whether funds designated as trust funds under the Builders Lien Act (according to which payments received by a contractor are impressed with a trust for the benefit of those engaged by the contractor in respect of the particular project) are trust funds for the purposes of the Bankruptcy and Insolvency Act and so excluded from the pool of assets to be shared with the general creditors of the bankrupt. This controversy arose from the question of whether provincial legislation can create a trust which impacts the operation of federal legislation, since according to the doctrine of “paramountcy” provincial legislation (which is what the Builders Lien Act is) is generally inoperative to the extent that it impacts federal legislation (which is what the Bankruptcy and Insolvency Act is). The recently prevailing view in the case law is that so long as the statutory trust under provincial legislation (e.g., the Builders Lien Act) meets the common law requirements for creation of trusts (i.e., the three certainties: certainty of intention, objects and subject matter) then the trust will be valid for the purposes of the Bankruptcy and Insolvency Act and the trust funds will be held for the benefits of the trust claimants under the Builders Lien Act and not for the general creditors of the bankrupt, but the law in this area is evolving and not entirely clear.

 

 

Subcontractors can consider a claim for breach of trust against the directors of the general contractor for breach of trust.. If the directors of the general contractor participated in funds received from the owner being used to pay debts of the general contractor not related to the project in question, then the directors of the general contractor may be personally liable for such misappropriation, and the bankruptcy of the general contractor does not restrict the ability of any party to make claims against the directors of the general contractor.

 

Note that the claim described in the section above (“Claim to trust funds”) is a claim against monies held in trust (without there necessarily being an allegation that there was a breach of the trust) and so can only succeed if there are still, at the time the claim is made, identifiable funds which can be claimed to be trust funds. However, the claim described in the paragraph above is a claim that can be advanced even when there are no longer identifiable funds which can be claimed to be trust funds, and the essence of the breach of trust claim is that due to the wrongful conduct of those who were in charge of trust funds those funds were misappropriated, and so those wrongdoers should be personally liable.

 

 

This is a potentially powerful, and somewhat underused, provision of the Bankruptcy and Insolvency Act.

 

As noted above, all assets of the bankrupt vest in the trustee, and this includes the right to advance claims to recover accounts receivable; e.g., claims against an owner who still owes money to a now bankrupt general contractor. Other claims of the contractor may also vest in the trustee; e.g., if the bankrupt contractor has an outstanding claim under an insurance policy then that claim would also generally be one which the trustee could pursue. However, trustees are sometimes reluctant to pursue such claims, and where the trustee is (for example due to lack of funds) unwilling to pursue such claims, any proven creditor of the bankrupt can obtain a court order under s. 38 of the Bankruptcy and Insolvency Act to allow it to “step into the shoes” of the bankrupt and advance such a claim against the third party. The creditor obtaining such a s. 38 order is required to give written notice to all other proven creditors of the bankrupt inviting them to join in on pursuing the claim, and all creditors who join in share pro rata in the cost of pursuing the claim, and share pro rata in recovery on the claim.

 

If the trustee of a bankrupt contractor is underfunded or otherwise reluctant to proceed with meritorious claims of the bankrupt contractor, then proceedings under s. 38 of the Bankruptcy and Insolvency Act can be a valuable option to unpaid subcontractors. For example, if the project for a particular owner was relatively close to completion and the owner had, based on the work done, short paid the general contractor, the subcontractors (who are familiar with the project) could band together, step into the shoes of the general contractor, and proceed under s. 38 of the Bankruptcy and Insolvency Act with a claim against the owner for all amounts due to the general contractor. Such a claim against the owner would not be limited to the value of work the subcontractors did (as is the case when subcontractors advance claims under the Builders Lien Act) but would be for the full value of work completed by the general contractor, including with its own forces (including the profit on such work).

 

 

The following considers impacts on the owner, the general contractor, and on sub subcontractors, of subcontractor bankruptcy.

 

 

From a strictly contractual point of view a subcontractor bankruptcy is not the owner’s problem and the owner can simply look to the general contractor for proper performance of the contract regardless of what problems the general contractor may be having with its subcontractors.  However, from a practical perspective, subcontractor bankruptcy may have significant impacts on an owner:

 

 

The general contractor is the party primarily affected by a subcontractor bankruptcy and is presumptively responsible for properly completing the project and delivering it to the owner despite the problems caused by the subcontractor bankruptcy.

 

An option that will always be available to the general contractor in such a situation is to file a claim in the bankruptcy of the subcontractor, but the recovery on such claim will typically be small.

 

Except on large projects with large subcontractor scopes of work, subcontractors will generally not provide performance bonds, but the option of the general contractor obtaining a personal guarantee from the principals of the subcontractor may provide some opportunity for recovery. Some measure of protection can also be obtained by including provisions in the contract between the general contractor and the subcontractor stating that in the event of subcontractor bankruptcy the general contractor can take possession of the equipment and tools (including, for example, scaffolding) of the subcontractor to better enable the general contractor to have the work of the subcontractor completed by others. However, the operation of such rights may be affected by the rights of third parties; e.g., secured creditors of the subcontractor, owners of tools rented to the subcontractor, etc.

 

Certainly, the sparse nature of the remedies that a general contractor will have against a bankrupt subcontractor emphasizes the importance of general contractors thoroughly investigating the history and financial strength of subcontractors before contracting with them.

 

 

The remedies for sub subcontractors in the event of subcontractor bankruptcy are essentially the same as for subcontractors in the case of a general contractor bankruptcy; see discussion above. 

 

 

 

The creditors of a party that goes bankrupt will generally suffer financial loss, but there will often be some limited recovery for the creditors if protections are put in place at the outset of the project and timely action is taken after the bankruptcy arises.

 

As indicated by the relatively long lists of remedies identified above for project participants in the context of bankruptcies on construction projects, a variety of options may be available to creditors depending on the factual circumstances of the case. Unfortunately, given the complexity of the various remedies, legal advice is often required to realize maximum recovery in the bankruptcy context. As with many other areas of law, prevention is often the best approach and thoroughly investigating the party you are contracting with before engaging with them, and drafting careful contracts, is always advisable. Thought should also always be given at the outset to what guarantees of performance (from credit worthy parties) are realistically available.