by Quenda Behler
There you are, just trying to make an honest living as a
contractor, when all of a sudden somebody you're doing business
with declares bankruptcy. How will this affect you?
Answering that question is difficult — but I can
guarantee you the news will not be good. Exactly what happens
to you depends on the kind of bankruptcy and whether you are a
How Bankruptcy Works
To declare bankruptcy, an individual, company, or corporation
files papers with a federal bankruptcy court. The court
appoints a trustee and notifies the creditors that a bankruptcy
is taking place. The trustee's job is to collect "nonexempt"
assets from the debtor, arrange for their sale, and use the
proceeds to pay creditors. (A nonexempt asset is one that can
be attached — or seized — during bankruptcy.)
Exempt assets. The rules vary from state to
state, but in most cases personal assets (such as clothing),
work tools, and vehicles are exempt from attachment. Many
states have homestead exemptions that protect all or part of
the debtor's equity in his home.
Secured creditors. An asset used as collateral to
secure a loan is typically exempt from bankruptcy because the
lender has a lien on it; the same may be true for a home that
secures a mortgage, an auto that secures an auto loan, or any
property with a lien on it. A secured creditor, lender, or
lien-holder can get at these assets by repossessing or
foreclosing on them, but a bankruptcy trustee usually
The trustee can attach and liquidate any assets that are not
exempt. However, by the time someone files for bankruptcy,
there will be few if any nonexempt assets left to seize.
Types of Bankruptcy
There are three kinds of bankruptcy: Chapter 7, Chapter 11, and
Chapter 13. From the creditor's point of view, Chapter 11 and
13 are preferable to Chapter 7 because they make it harder for
debtors to escape their debts.
Chapter 7. In a Chapter 7 bankruptcy,
the bankrupt individual, company, or corporation is saying,
"Sorry, I can't pay." The debtor's assets are liquidated by the
trustee and the proceeds are used to pay the creditors, who may
receive all or part of what the bankrupt party owes them. Once
the process is complete, the debts are "discharged," which
means they legally cease to exist, even if the creditor
received only pennies on the dollar.
An individual who files Chapter 7 will still be around when the
process ends; but when a company files Chapter 7, it goes out
of business and is effectively "dead."
Chapter 11. A Chapter 11 bankruptcy is filed by a
business that hopes to survive. The idea is to give the company
some breathing room while it comes up with a court-approved
plan to pay its debts. Once the papers have been filed, the
court tells creditors to step back and leave the company
In the end, some of the company's debts may be partially
discharged, but until then, creditors are barred from taking
steps against the debtor without the court's permission.
Chapter 13. Although Chapter 13 is
similar to Chapter 11, it applies to individuals rather than
companies or corporations. It is a personal-debt reorganization
that involves temporary protection from creditors while the
bankrupt person tries to get his financial act together. The
upshot is usually a court-mandated payback scheme and partial
discharge of the debts.
When a Vendor Declares
Let's start with a rather unpleasant example: You're doing a
whole-house remodel and the stone fabricator requires a $5,000
deposit so that he can buy material and begin making granite
countertops for the kitchen and baths. You write him a check
for $5,000, and he uses it to buy some granite slabs —
but before he begins work on the counters he declares Chapter 7
You paid for the materials, but they're not yours. Can you go
to his shop, pick them up, and take them to another fabricator?
No. Even if the fabricator gives you permission to take those
slabs, you can't. Moreover, this is true even if the
countertops are finished and the debtor was ready to deliver
them. If you were to take them, a U.S. marshal could come after
you to get them back.
How is this possible? You paid for the stuff! Well, yes, you
did, but you didn't take delivery — so, barring some
complication, that material still belongs to the debtor. It's a
nonexempt asset that can be sold to somebody else to raise
money to pay off creditors.
The meager good news is that you are a creditor, there's no
question about that. You paid the fabricator money and he
didn't deliver, so he owes you $5,000.
Can you expect a check in the mail? Not very soon, and not for
the full amount. Why? Because you're just an unsecured
creditor, which means you are last in line to collect and you
will probably be doing well to collect 10 cents on the
If someone who owes you money files for
bankruptcy, you'll receive a notification form that looks
something like this document. To protect your ability to
collect, follow up by filing the correct documents with the
The rest of the bad news is that if your customer advanced you
the money to pay the deposit, then you owe him either $5,000 or
granite countertops. (Maybe you can buy yours at the bankruptcy
When a Customer Declares
Let's consider a different example now, one that's not quite as
awful to contemplate: You just submitted the bill for final
payment on a construction job, but before you can collect, the
customer declares Chapter 7. Are you simply out of luck? Maybe.
All you can collect of the debt is what the trustee in
bankruptcy gives you from the bankrupt party's assets. That
debt is history.
But even though it has legally ceased to exist, all is not
lost. The good news is that if you have protected your lien
rights, you will probably still be able to eventually enforce a
lien. A lien on the property turns you into a secured creditor:
You can't collect the debt, but you can foreclose on the
property and get paid that way.
Tougher rules for individual debtors.
However, let's say your customer isn't a corporation. Personal
bankruptcy is a somewhat different ball game than it used to
be, thanks to the new bankruptcy act. If your customer is a
consumer — as opposed to an incorporated business —
he may not be eligible for Chapter 7 bankruptcy. The new act
has a "means test" intended to determine which individuals are
"worthy" of relief through Chapter 7.
The means test is calculated by comparing the debtor's average
income for the past six months with the median income for
households of the same size in the debtor's state of residence.
The debtor's income must be less than or equal to the state
median income, or he won't be allowed to declare Chapter 7 and
must instead go into a Chapter 13 reorganization.
How is this better for the contractor? In Chapter 13, the debt
is not usually discharged, so the debtor will have to pay the
contractor with future income.
What to Do
What kind of advice do I have for you? The first thing you need
to do if you get a bankruptcy notice is decide whether the debt
is large enough to pursue. Collecting a debt costs time and
money; in some cases it may be cheaper to let it go or file
your creditor's claim and rely on whatever the trustee can do
If the amount is large, though, call your lawyer right away.
Don't delay, because there are deadlines involved and
bankruptcy and lien laws are complicated.
As a contractor, the main thing you want to do is protect your
lien rights, because they turn you into a secured creditor. If
you lose your lien rights — something that happens
frequently in bankruptcies — you become an unsecured
creditor and have to get in line with everyone else. Protecting
your lien rights is very technical stuff; you're going to need
professional help to do it.author of The Contractor's Plain-English
Legal Guide, has practiced and taught law for more than 25