What to do if a general contractor files bankruptcy mid-project: legal and financial steps

Immediate Triage: Decoding Bankruptcy Type and the Invisible Legal Freeze

When a general contractor files for bankruptcy, the immediate legal reality is not just financial—it’s a fundamental shift in the rules of engagement. The type of bankruptcy dictates whether you’re chasing a dissolving entity or negotiating with a debtor trying to survive. More critically, the automatic stay—a court order that halts all collection activities against the debtor—creates an invisible barrier. Violating it, even unknowingly, can result in sanctions and kill your recovery chances. This isn’t about debt collection; it’s about navigating a federally supervised process where timing and procedure are everything.

The Chapter 7 vs. Chapter 11 Reality Check

Most articles state the difference but miss the tactical implications for a construction project.

• Chapter 7 (Liquidation): This is a controlled demolition. A court-appointed trustee’s sole job is to liquidate the contractor’s non-exempt assets to pay creditors. The project is dead. The trustee has no obligation to complete it and will likely reject the executory contract (the agreement with the homeowner or project owner). Your goal shifts from project completion to maximizing your share of a shrinking pie.
• Chapter 11 (Reorganization): This is a high-stakes negotiation. The contractor (now “debtor in possession”) aims to restructure and stay in business. They may assume (keep) or reject contracts. This creates a perverse incentive: they might assume profitable contracts and reject unprofitable or burdensome ones (like yours if it’s behind schedule or has disputes). Your leverage comes from your ability to object to their reorganization plan.

The automatic stay (11 U.S.C. § 362) freezes all actions against the debtor. You cannot call demanding payment, file a lawsuit, or—crucially—initiate or perfect a mechanic’s lien against the property if the lien claim is against the bankrupt contractor’s interest. However, a critical and often-overlooked nuance exists: if your lien rights are against the property itself (the homeowner’s interest) for work performed, some courts have allowed perfection to continue, as it doesn’t seek payment from the debtor’s bankruptcy estate. This is a razor-thin distinction requiring immediate legal counsel. Furthermore, the stay does not stop you from pursuing a surety bond claim or a claim against your own insurance, as these are against third parties.

The Hidden Leverage in Executory Contracts and Site Access

What 99% of articles miss is the power dynamics around “executory contracts” (like your subcontract) and site access under Section 365(d)(3) of the Bankruptcy Code. The debtor must timely pay for all “post-petition” (post-bankruptcy-filing) goods and services received. If you are asked to continue work by the trustee (in Chapter 7) or debtor (in Chapter 11), you have an administrative claim for that new work, which is a higher priority for payment. More strategically, if utilities or rent for the job site are unpaid, the debtor’s right to access that site can be terminated. This can force the project owner’s hand to step in and can be a point of leverage in negotiations for subcontractors with critical, unfinished work.

Subcontractor Survival Guide: The Two-Track Payment Pursuit

For subcontractors, the contractor’s bankruptcy triggers a simultaneous, two-track legal race. Track one is the state-law path to secure a claim against the property (lien rights). Track two is the federal bankruptcy path to file a claim against the contractor’s estate. Success requires running both tracks in the correct order. Relying solely on one is the single biggest financial mistake a sub can make. This process is about converting your work and materials into a legally recognized, prioritized IOU from a bankrupt entity.

Step 1: Preserve Lien Rights (The State Law Anchor)

Your state mechanic’s lien rights are your most powerful tool, but they operate on strict, non-negotiable deadlines that are not paused by the bankruptcy filing for pre-petition work. You must perfect your lien according to state law (e.g., pre-lien notices, recording the lien) for work done before the bankruptcy petition date. This lien, once perfected, can become a “secured” claim in the bankruptcy, putting you ahead of unsecured creditors. The contractor bankruptcy impact on subs is most severe when subs ignore this step, thinking the bankruptcy court will handle everything. It won’t.

Critical Overlap: If you are holding retainage, your lien rights for that amount are typically crystal clear. This retained fund is a direct claim against the property owner, and your lien secures it. In bankruptcy, this can make your claim for retainage more defensible.

Step 2: File a Proof of Claim (The Federal Mandate)

Filing a proof of claim in the bankruptcy case is mandatory to get paid anything from the estate, period. Even a perfectly perfected lien must be presented to the bankruptcy court via this form. The bankruptcy clerk will set a “claims bar date”—a firm deadline. Missing it extinguishes your claim forever, even if you have a lien on the property. This step is purely administrative but fatal to miss.

Claim Type	What It Covers	Priority & Likely Recovery
Administrative Claim	Goods/services provided after the bankruptcy filing, if authorized.	Highest priority (after secured). Near-full recovery likely.
Secured Claim	Amount backed by a perfected mechanic’s lien or other collateral.	Paid from collateral’s value. Better recovery than unsecured.
Unsecured Priority Claim	Certain wages or employee benefits (limited amounts).	Paid after secured/admin claims, but before general unsecured.
General Unsecured Claim	All other pre-bankruptcy debts (e.g., unpaid invoices for completed work).	Lowest priority. Often receive pennies on the dollar, if anything.

The Strategic Interplay and Overlooked Trade-offs

The unique insight is how these tracks inform each other. The strength of your secured claim (from your lien) in bankruptcy is dictated by how well you followed state lien laws. Furthermore, consider this counterintuitive truth: aggressively perfecting your lien can sometimes prompt the property owner to settle with you directly to clear their title, even while the bankruptcy proceeds. This is especially true for residential projects. However, the trade-off is cost—legal fees for lien perfection are immediate out-of-pocket expenses with an uncertain return.

For experts, the complexity deepens with issues like “pay-if-paid” clauses. In bankruptcy, such clauses are often scrutinized and may be deemed unenforceable as against public policy, potentially allowing a sub to claim payment from the general contractor’s estate even if the owner never paid the GC. This is a nuanced but critical legal argument. Your action plan must be concurrent: 1) Immediately consult a construction attorney to assess lien deadlines, 2) Monitor the bankruptcy docket (PACER) for the claims bar date, and 3) Document every communication and invoice to support both your lien and your bankruptcy claim. This is not just about filing paperwork; it’s about building a fortified, multi-jurisdictional argument for payment.

Project Continuity: Navigating Completion When Your Contractor Goes Bankrupt

When a general contractor files for bankruptcy, the immediate fear for a project owner is total abandonment—a half-built structure and a depleted bank account. The standard advice to “just hire a new GC” is financially naive and legally perilous in this context. The path forward is dictated by the type of bankruptcy filing and requires a strategic choice between two fundamentally different completion pathways, each with profound cost and timeline implications.

The Trustee’s Gamble: Can the Bankruptcy Estate Finish Your Project?

In a Chapter 11 reorganization, the debtor (the contractor) often remains in possession of the business. Here, a rarely discussed but critical possibility emerges: the bankruptcy trustee or debtor-in-possession may seek to assume the executory construction contract under Section 365 of the Bankruptcy Code. WHY this matters is twofold. For the trustee, a profitable, near-complete project represents an asset to sell or complete for the benefit of creditors. For you, the owner, it presents a paradoxical chance for continuity but with zero control.

HOW it works is a high-stakes negotiation. The trustee must cure all defaults (e.g., unpaid subcontractor bills causing liens) and provide “adequate assurance” of future performance. In practice, this is where most assumptions fail. The contractor is bankrupt; its bonding is likely exhausted, and subs won’t return without cash upfront. The unique insight is that an astute owner can leverage this moment. You might negotiate to fund the cure amount directly to critical subs (securing lien releases) in exchange for the trustee’s agreement to assign the contract to a new GC of your choice, a maneuver that can bypass costly re-procurement. However, this requires deft legal navigation of the bankruptcy court’s oversight.

WHAT 99% of articles miss is the cost-benefit analysis of this route versus termination. The math isn’t just about completion costs. It includes the “soft cost” of delay damages from the automatic stay (which halts all collection actions), the risk of the trustee rejecting the contract later, and the administrative priority claims that may arise. Completing in-place with a new GC under a trustee assignment might save 10-15% on material waste and remobilization, but if it adds 90 days of legal limbo, the net loss may be greater.

The Termination Pathway: Scorched Earth or Strategic Reset?

When assumption isn’t viable or in a Chapter 7 liquidation, your primary right is to terminate the contract for cause. This triggers the immediate activation of your financial safeguards: surety bonds and any applicable insurance. The critical, counterintuitive choice you now face is between completion-in-place and tear-out/restart.

Completion-in-Place: You hire a new GC to finish the existing work. This seems efficient but is riddled with risk. The new contractor inherits all latent defects and incomplete systems of the bankrupt predecessor, often demanding hefty contingency allowances and refusing to warranty prior work. It requires a meticulous, legally binding audit of the work completed to date—a process where tools for admissible digital evidence in construction disputes become invaluable.

Tear-out/Restart Under Bond or Insurance: This radical option is sometimes the most financially sound. If investigation reveals widespread shoddy work or mis-installed systems, completing over them is a long-term liability. A performance bond surety, when presented with clear evidence of fundamental breach, may financially prefer a controlled demolition and fresh start to assuming endless warranty claims. Similarly, a builder’s risk policy with an “inherent defect” exclusion might still cover the resulting physical loss from a collapse caused by that defect.

The table below contrasts these pathways on key dimensions:

Pathway	Speed to Resume Work	Cost Predictability	Quality/Warranty Control	Best Suited For
Trustee Assumption & Assignment	Slow (Months of negotiation)	Low (Unknown court/admin costs)	Very Low	Large projects where original GC has unique expertise/subs.
Completion-in-Place with New GC	Moderate (Weeks for bid/negotiation)	Moderate (Contingency for hidden defects)	Moderate (Limited to new work)	Projects with simple, easily verified construction (e.g., standard framing).
Tear-out/Restart Under Bond Claim	Slow (Requires surety investigation/approval)	High (Fixed-price bid for entirely new scope)	High (Full warranty on all work)	Complex projects (MEP systems, structural) with evidence of poor workmanship.

Unlocking Financial Safeguards: The Bond and Insurance Claim Playbook

Surety bonds and insurance are not automatic payouts; they are complex contractual obligations that require precise, adversarial claims processes. Most owners and subs fail to recover fully because they treat a claim like a polite request rather than a structured legal demand. The bankruptcy of the contractor alters the strategic landscape for both.

Surety Bond Claims: Performance vs. Payment in a Bankruptcy Context

WHY the distinction between a Performance Bond and a Payment Bond matters becomes stark at bankruptcy. The performance bond guarantees the project’s completion; the payment bond guarantees that laborers and material suppliers are paid. In bankruptcy, unpaid subs will file claims against both the bankruptcy estate and the payment bond, creating a race for limited funds.

HOW the surety bond claims process works requires immediate, parallel action. For an owner, the steps are:

1. Formal Default Declaration: Notify the surety in writing, declaring the contractor in default under the bond, citing the bankruptcy filing as the triggering event.
2. Demand the Remedy: Invoke the bond’s terms—typically, the surety has the option to complete the work, re-tender it, or pay the penal sum.
3. Facilitate the Tender: Provide the surety with all project documents, a detailed status report, and access to the site. Cooperate, but do not relinquish your rights under the bond.

For subcontractors, the process to file a proof of claim on the payment bond is separate from the bankruptcy claim. You must send a formal notice to the surety, often within a strict timeframe (e.g., 90 days from last furnishing labor/materials), detailing the amount owed. WHAT most miss is the surety’s common tactic of demanding a “release of lien rights” as a condition for payment. In bankruptcy, this is dangerous. Your lien rights are a critical lever; never release them globally in exchange for a partial bond payment. Instead, offer a release specific to the bond claim amount.

Insurance Realities: The Gap Between Expectation and Coverage

Builder’s Risk or Course of Construction insurance is for physical loss from named perils like fire or wind—not for contractor incompetence or insolvency. However, a sophisticated claim can sometimes bridge this gap. WHY this matters is that insurance may be the only recovery for an owner without a bond or for certain consequential losses.

HOW to navigate it involves understanding policy exclusions and triggers. For example, if a subcontractor, unpaid due to the GC’s bankruptcy, removes installed equipment (theft), that may be a covered physical loss. The insurer will then subrogate against the bankrupt estate, but your claim is paid. The major pitfall is the ubiquitous “cooperation clause.” Insurers may deny your claim if you settle with the surety or contractor without their consent, arguing you compromised their subrogation rights. Advanced strategy for mitigating financial loss requires a coordinated, legally-managed claims strategy across all fronts—bankruptcy, bond, and insurance—to avoid these traps.

WHAT is almost always overlooked is the potential to claim soft costs under a builder’s risk policy. While default itself isn’t covered, if a covered event (e.g., a collapse due to unshored excavation after the bankrupt GC’s crew abandons the site) causes a delay, the resulting extended financing, architectural, and rental expenses might be recoverable. Proving this causal chain is difficult but possible with meticulous documentation, turning a partial recovery into a more complete one.

Ultimately, recovering from a contractor bankruptcy is a triage operation. Your first move is to secure the site and notify all guarantors. Your strategic advantage lies in understanding that the bankruptcy filing is not an end, but a redistribution of liabilities among the bond surety, insurers, and the estate—and your actions determine who ultimately bears the cost. For a deeper dive on the foundational business planning that can help avoid such catastrophic partnerships, review our guide on writing a construction business plan, which stresses financial resilience and vetting key partners.

Advanced Recovery Strategies: Maximizing Value in the Bankruptcy Estate

Filing a proof of claim is just the admission ticket. The real fight for recovery happens in the strategic navigation of the bankruptcy estate—the pool of the contractor’s remaining assets. While average recovery for unsecured creditors in Chapter 7 can be as low as 5-10%, proactive parties can leverage specific, underutilized legal mechanisms to significantly improve their position.

Strategic Use of Lien Rights in Bankruptcy Proceedings

Why it matters: A secured claim is infinitely more powerful than an unsecured one. In bankruptcy, lien rights don’t simply vanish; they transform. The timing and perfection of your lien dictate whether you hold a secured interest in the project’s real property, giving you priority over general unsecured creditors. This is the single most impactful lever for subs and owners alike.

How it works: Upon a bankruptcy filing, an automatic stay halts all collection activities, including foreclosing on a lien. However, you can file a “Motion for Relief from Stay” to ask the bankruptcy court for permission to proceed with foreclosure. Success is not guaranteed but is more likely if the debtor has no equity in the property. More commonly, your perfected lien attaches to any funds held by the owner or in the project account, segregating that asset from the contractor’s general, unsecured estate. The trustee must respect this secured status during asset distribution.

What 99% of articles miss: The critical interplay between lien waivers and bankruptcy. Signing an unconditional lien waiver in exchange for a check that then bounces can permanently extinguish your lien rights, leaving you as an unsecured creditor. An conditional lien waiver, which is only effective upon actual payment clearing, is a non-negotiable risk mitigation tool. Furthermore, many overlook investigating “lien stripping” opportunities—if the contractor’s bankruptcy estate includes receivables from other, solvent projects, your lien may attach to those funds as they are traced, a concept explored in depth regarding lien rights for extra work.

Investigating the Estate and Challenging Improper Transfers

Why it matters: The bankruptcy trustee’s primary duty is to the estate, not to you. Creditors who actively monitor and challenge the trustee’s actions can prevent the dilution of assets through improper sales or recover assets for the pool.

How it works: You have the right to scrutinize the debtor’s schedules and statements. Look for:

• Preferential Transfers: Payments made to certain creditors (like favored suppliers) within 90 days before bankruptcy can be clawed back into the estate. If you see one, you can prompt the trustee to act.
• Undervalued Asset Sales: If the trustee proposes selling equipment or vehicles below fair market value in a “fire sale,” you can file an objection. Providing independent appraisals can force a better sale process.
• Executor Contracts: The trustee may assume (continue) or reject (cancel) the contractor’s ongoing contracts. If your project is rejected, it crystallizes your claim. If it’s assumed and sold to a new contractor, you may have leverage to ensure your claim is addressed as part of the sale.

What 99% of articles miss: The power of the creditors’ committee. In larger Chapter 11 cases, an official committee of unsecured creditors is formed. Serving on this committee gives you direct insight into estate operations, negotiation leverage with the debtor, and a voice in the plan of reorganization. It’s a resource-intensive but high-reward strategy for major claimants.

Structuring Settlements Based on Estate Liquidity

Why it matters: A claim for $100,000 means little if the estate only has $20,000 in liquid assets after secured claims and administrative costs. Realistic recovery is based on projected liquidity, not face value.

How it works: Before settling a claim for pennies on the dollar, demand to see the trustee’s preliminary asset liquidation analysis. Focus on:

Estate Asset	Liquidation Timeline	Estimated Net Value (After Costs)
Accounts Receivable	6-12 months	Often 50-70% of face value due to collection difficulty
Equipment & Vehicles	3-6 months	Auction value, often 30-50% of book value
Real Property (if any)	12+ months	Market value minus liens and selling costs
Retainage Held by Project Owners	Subject to dispute	May be contested if project is incomplete

What 99% of articles miss: The timing of distributions. Administrative expenses (trustee fees, legal fees) and priority claims (certain taxes, employee wages) are paid first. Your settlement should account for this waterfall. A structured settlement that pays out as the trustee liquidates specific assets can yield a higher total recovery than a low, immediate cash buyout.

Proactive Defense: Mitigating Financial Loss Before Bankruptcy Hits

Reactive strategies are a salvage operation. Proactive defense is about engineering financial firewalls into your standard operating procedures. This requires moving beyond checking a contractor’s license to understanding the nuanced financial and contractual indicators of impending failure.

Financial Health Red Flags Beyond Late Payments

Why it matters: By the time payments are chronically late, the contractor is often in a deep cash flow crisis. Earlier signals provide a crucial window to protect yourself.

How it works: Implement a monitoring protocol that looks for:

• Rapid Expansion: Taking on multiple large projects simultaneously without a demonstrable increase in overhead or bonding capacity, a classic overextension scenario.
• Change in Material Suppliers: Switching from established, credit-based suppliers to cash-on-delivery (COD) vendors indicates credit lines have been cut.
• Frequent Use of “Paid When Paid” Clauses: While common, an insistence on this as a blanket term for all subs, especially for projects where the owner has paid, signals the contractor is using subs as a bank. Understand the severe risks of “pay-when-paid” vs. “pay-if-paid” clauses.
• Subcontractor Churn: A rotating door of subs on a site can indicate that previous tradesmen were not paid and walked off.

What 99% of articles miss: The predictive value of public records. Regular searches of the county recorder’s office for mechanics’ liens filed against your general contractor (not just by them) on other projects is a free, real-time distress signal. A contractor facing multiple liens elsewhere is a severe risk.

Contractual Firewalls: Preserving Rights from Day One

Why it matters: Your contract is your primary shield. Once bankruptcy is filed, it’s too late to add protective language. These clauses must be in place at signing.

How it works: Mandatory clauses for any construction agreement include:

1. Joint Checks: For key subcontractors and suppliers, require that payments be made via joint checks payable to both the GC and the sub/supplier. This prevents the GC from diverting funds intended for your project.
2. Payment Bond Requirement: A requirement for a 100% payment and performance bond from a reputable surety is the gold standard. It shifts the credit risk from the contractor to the bonding company. Know the role of a surety bond and how to verify its validity.
3. Right to Request Lien Waivers: Contractually obligate the GC to provide signed lien waivers from all subs and suppliers as a condition of receiving each payment application. This creates a paper trail and exposes non-payment.
4. Direct Payment Clause: If the GC fails to pay a sub after owner payment, the contract should allow the owner to pay the sub directly and deduct that amount from sums owed to the GC.

What 99% of articles miss: The importance of the “flow-down” clause in subcontracts. For subs, ensuring the prime contract’s protective provisions (like bonding requirements and dispute resolution) flow down to you is critical. This is especially vital in federal construction subcontracts.

Structuring Payments to Preserve Leverage

Why it matters: How you pay is as important as what you pay. A structured payment application process creates verifiable milestones and preserves lien rights for all parties in the chain.

How it works: Implement a payment process that:

• Uses AIA-style G702/G703 Application and Certificate for Payment forms or equivalents. These standardized forms require a detailed breakdown of work completed, stored materials, and a schedule of values, making diversion of funds more difficult.
• Requires Conditional Waivers Upon Payment Application: With each application, collect conditional lien waivers for the amount billed. This waives rights only if the check clears.
• Requires Unconditional Waivers Upon Payment Clearance: Once the GC’s payment check has cleared your bank, require unconditional waivers for that payment period before releasing the next draw. This systematic approach, coupled with a robust understanding of essential financial tracking, builds a defensible position.

What 99% of articles miss: The strategic use of retainage. While typically 5-10%, increasing retainage on a contractor showing red flags (with proper contract modification) can create a crucial financial reserve to complete the project or pay claimants if the contractor fails. This must be balanced against state retainage laws which may cap amounts or dictate release schedules.