Joint-check and direct-payment agreements are the two mechanisms most often used by contractors to minimize their risk of unwarranted payment bond claims In joint-check arrangements, the contractor makes a check jointly payable to the subcontractor and the lower-tiered entity and forwards the check to the subcontractor to endorse and pass on to the lower-tiered entity. In a direct-payment scenario, the contractor simply issues a check directly to the lower-tiered entity and deducts the amount of that payment from amounts due the subcontractor.

But what happens when an unbonded subcontractor endorses and delivers a joint check to a lower-tiered entity, and within the following 90 days the subcontractor files for bankruptcy? A substantial risk exists that such payment will be deemed a “preference” payment that the lower-tiered entity will have to forfeit to the bankruptcy estate so that those funds may be shared equally among all of the subcontractor’s creditors. This becomes a problem for the contractor because the lower-tiered entity, which is now unpaid, may file a claim under the contractor’s payment bond. As most contractors are aware, payment by the contractor to the subcontractor is not a valid defense to a payment bond claim by a lower-tiered entity.

Preferential treatment

There are a number of cases in which joint checks have survived the attacks by bankruptcy trustees. Many such cases involve written agreements between the parties. Some contractors rely on oral agreements, or simply issue joint checks. This informality saves time and money in the short run but carries additional risk. However, even a written agreement will not always carry the day.

In re R.J. Patton, 348 B.R. 618 (Bankr. D.Ct. 2006), a bankruptcy court held that a general contractor’s joint payments endorsed by its subcontractor and also payable to the subcontractor’s material supplier, made within 90 days of the subcontractor’s petition for bankruptcy, were preferences and thus had to be forfeited. After a subcontractor’s financial condition worsened, the contractor and subcontractor entered into an agreement under which the contractor made out joint checks to the subcontractor and a supplier. After the subcontractor filed for bankruptcy, the bankruptcy trustee sought to recover the payments from the material vendor. The supplier argued that although the payments it received were technically monies due to the bankrupt subcontractor, they were not preferences, because the agreement between the contractor and subcontractor created an independent duty on the part of the contractor to pay the vendor.

The court acknowledged the agreement and the independent duty of the contractor to pay the vendor, but held that the payment nevertheless constituted a preference. The result in the case may have been different had the contractor and subcontractor entered into the written joint-check payment agreement earlier than 90 days before the bankruptcy filing—even if the actual payment were made within 90 days of the subcontractor’s bankruptcy filing.

Consequently, contractors must be alert to signs that their subcontractors are experiencing financial distress and must work to enter into joint- or direct-payment agreements as early on as possible. Better yet, contractors might consider including provisions in their subcontracts that allow them to make joint or direct payments where, in the sole discretion of the contractor, it is prudent to do so.

The existence of either a written agreement with the subcontractor before the 90-day preference period or a provision contained in the subcontract that expressly permits joint or direct lower-tiered payments may go a long way to ensuring that vendor payments are not voided. This, in turn, will ensure contractors and their sureties are not made to pay twice for the same work.