Canada: Construction Liens and Bankruptcy: How Contractors Can Protect Themselves

It is an unfortunate reality in the construction industry that bankruptcies can, and do, occur. An owner, general contractor or subcontractor may become insolvent and be unable to meet its financial obligations. In those circumstances, contractors need to know how you can best protect your rights and minimize potential losses. This article explains some of the rights and remedies available to contractors under insolvency legislation and under the Construction Lien Act of Ontario when you are confronted with the troublesome situation of a bankruptcy of someone in the construction pyramid.

Lien rights as set out in the Construction Lien Act are strictly interpreted and enforced by the courts. Even in the face of an insolvency, you should be aware that the time periods for preserving and perfecting a claim for lien are not suspended, nor are they extended. A contractor should preserve its lien within 45 days of its last supply to the project. Failing to do so will mean that your lien rights will expire and they cannot be revived. Failing to preserve its lien may also mean losing your right to receive a portion of the holdback funds being held for your benefit. These may be the only funds available to you in a bankruptcy-type of situation.

Typically in a bankruptcy or insolvency proceeding, the court will grant the insolvent company a form of protection by putting in place a "stay of proceedings." This means that creditors of the bankrupt company are forbidden by court order from commencing or continuing with a lawsuit against the insolvent party. Provisions of these orders may also indicate that construction liens are not to be registered. However, the courts have, on more than one occasion, amended their initial orders and lifted the stay on a limited basis. In these cases, they will permit lien rights to be preserved or perfected through the bringing of a motion or by getting the consent of the Trustee in Bankruptcy. However, the courts cannot bring back to life lien rights that have been lost by inaction or by the failure to enforce them.

Under Section 39 of the Construction Lien Act, a contractor is entitled to make a request for information and to receive it from the owner, general contractor or mortgagee. This information will set out the state of accounts, indicate the amount of the holdback fund, help to determine if a lien has priority over a building mortgage and will identify the existence of any labour and material payment bond. This information can prove very valuable in determining what course of action should be pursued. Knowing that a bond is in place can mean that recovery can be sought against the surety.

Contractors are also urged to contact the receiver or Trustee In Bankruptcy. Very often, this will provide you with some information on the insolvency of the debtor company and will get you on the list of people who are entitled to be notified of further proceedings that may affect your rights.

Sections 7 and 8 of the Construction Lien Act impose a trust on funds received by owners and contractors for the benefit of those who have supplied labour, services and materials on the project. If an owner or contractor uses the funds in a manner inconsistent with the trust (i.e., they have paid money to themselves and not to contractors, they have made a preferential payment to a creditor unrelated to the project, etc.), they may be guilty of a breach of trust. Section 13 of the Construction Lien Act empowers a claimant to personally sue the officers and directors of the insolvent company and can make them personally liable for the misused funds. The spectre of personal liability is a powerful tool in the contractor’s arsenal and should not be forgotten in situations involving an insolvent payor.

If an owner or general contractor has gone bankrupt, there is a danger that the value of the project could deteriorate if the work stops or is abandoned. Consider, for example, an unfinished subdivision project where only a portion of the underground services have been installed and several of the houses remain unfinished. Exposure to the elements, the risk of vandalism and general deterioration of the work are likely if the project comes to a standstill for a prolonged period.

Section 68 of the Construction Lien Act allows a lien claimant or person with an interest in the premises to apply to the court and request that a construction lien trustee be appointed to:

• Manage, mortgage or sell the property;
• Complete the improvement;
• Reserve the premises and do other things such as realize on the project assets, administer the trust funds and distribute the monies to entitled contractors and suppliers.

A lien trustee is a court officer who must act in a fair and equitable manner for the benefit of all affected parties.

If a mortgage was taken with the intention of financing the construction project, the mortgagee (i.e., the lender) may be liable for any deficiency in the holdback. If an owner has failed to maintain the 10% holdback fund, the mortgagee may be responsible to the contractors for any shortfall in the fund.

Under the Income Tax Act, the CRA asserts a "super priority" over the assets of the debtor company. The CRA’s claim arguably trumps the interest of lien claimants and other secured creditors. CRA even maintains its priority over the holdback fund.

Notwithstanding this priority, CRA will, in many instances, negotiate a sharing of the holdback monies with the valid lien claimants. This is especially true if it can be demonstrated that hardship would result to the lien claimants if CRA kept all of the money for itself in order to satisfy its claim for unpaid source deductions and GST.

A bankruptcy situation is often one where a contractor will not entirely recoup all you are owed. Knowing what remedies are available and initiating actions to preserve and protect your rights will ensure that you are putting yourself in the best position possible to maximize your potential recovery.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.