When Construction Contracts Go Sideways in Bankruptcy
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The contractor on a project files a bankruptcy case. How should the property owner and subcontractors proceed? When a party to a contract files bankruptcy, the other party’s actions are constrained by the bankruptcy code.
Types of Bankruptcies
The typical bankruptcy case involves a chapter 7 complete liquidation, chapter 13 reorganization for an individual, or a chapter 11 reorganization or liquidation. In a chapter 7 the business ceases to operate and a panel trustee is appointed immediately upon the filing of the case. The chapter 7 trustee’s duties are to liquidate assets for the benefit of creditors and to prosecute litigation that can result in assets for the creditors. In a chapter 13, the individual debtor continues to operate, and there is a trustee, but the trustee’s roll is limited to reviewing the chapter 13 plan and making sure that the plan is performed. In a chapter 11, the debtor retains control of its assets and continues to operate its business until a plan is confirmed. During the chapter 11 period before a plan is approved, the debtor will decide which contracts it wants to assume or reject, all while operating the company and preparing a plan.
Benefits of Bankruptcy for the Debtor
Bankruptcy laws replaced debtor’s prison. The bankruptcy filing stops all actions against the debtor because immediately upon the filing an automatic stay is imposed. In addition to stopping litigation and collection efforts, the automatic stay prevents set off of debts. Another benefit is that a debtor can eliminate contracts that are burdensome and minimize the financial impact of getting out of those contracts. Of course, the ultimate goal of the debtor is to reduce the amount that creditors are paid.
Benefits of Bankruptcy for the Creditor
There can be little good news when someone who owes you money files bankruptcy. However, the silver lining is that in bankruptcy any creditor can ask the debtor for financial information related to the debtor. Creditors can look at past transfers and can look to see if insider’s received inappropriate distributions. If needed, a creditor can ask the court to appoint a trustee to protect assets. If nothing else, creditors will be assured that all creditors are receiving the same distribution, and the debtor is not paying favorites more money.
Executory Contracts
Under the Bankruptcy Code, contracts that have performance due by both parties to the contract are considered executory contracts, and the debtor can choose whether to assume (keep the contract) or reject the contract (end its ongoing obligations). Parties to contracts that are rejected will have an unsecured claim in the case like all of the other creditors who have pre-petition claims. If the debtor assumes a contract, the debtor must cure defaults at the time the Court authorizes the debtor to assume (or the debtor must prove that the cure can happen soon), and the debtor must establish that it can provide adequate assurance of future performance under the contract going forward.
Executory contracts can be assumed and assigned to third parties unless they are not assignable under non-bankruptcy law. For example, personal contracts cannot be assigned under California state law. If a construction contract involves Jill performing a service, it cannot be assumed. However, if the contract is with the Hill, LLC, it may be assumable. If the contract expired before the bankruptcy case commenced, then it cannot be assumed. Provisions in contracts that terminate the contract upon the filing of a bankruptcy or other insolvency proceeding are called ipso facto clauses and are not enforceable by the bankruptcy court (but may be enforceable outside of the bankruptcy court). It is important to note, that in the Ninth Circuit, a debtor is considered to be a different legal entity from the entity that existed before the filing, and it is required to assume contracts that it wants to continue to use. Although a contract may not be assumable under the Bankruptcy Code, the parties are free to consent to have the contract assumed.
If a contract is assumed by the debtor and the debtor breaches that contract, the damages will be treated as an administrative claim, which will entitle the creditor to be paid before the unsecured creditors.
Read every pleading sent by the debtor. If the debtor is asking the court for permission to assume your contract you should:
- Determine if there is a default and make sure that the debtor can prove that it is going to have the funds or the ability to cure the default;
- Make sure that the debtor proves that it can perform under the contract going forward;
- If the contract is being assumed and assigned to a third party, make sure that the third party will be able to perform.
If the contract cannot be assumed under the law but you are willing to proceed with the debtor, use that opportunity to negotiate extra protections into the agreement going forward. These issues should be considered for pre-bankruptcy negotiations also.
- Identify specific milestones that must be met by some measure other than (and in addition to solvency) as a basis for terminating the contract if not met;
- If applicable, consider requiring joint checks be written to you and the debtor;
- Spell out grounds for termination, replacement for non-performance, and the right to set off funds otherwise due to the debtor.
Liens and Bonds
The bankruptcy code provides an exception to the automatic stay for parties to perfect their mechanic’s liens. There is a big difference between enforcing a lien and perfecting a lien. Enforcement is not allowed without applying to the court for permission. Also, the automatic stay generally only applies to the debtor. Therefore, if the contractor files a bankruptcy, and a lien holder has rights against a property owner, and that owner is not in bankruptcy, there is no automatic stay that prevents enforcement of the obligation. This applies to guarantors and bonds as well. A debtor can ask the court to intervene under some circumstances, but the automatic stay may not apply. If the demands on the bond exceed the value of the bond, it may be brought into the bankruptcy to resolve payment issues, if not otherwise resolved. As a property owner paying a subcontractor directly when a contractor is in bankruptcy, you want to make sure that you are making payments that you are compelled to make under the law so that the debtor does not come back and ask you to pay again. When in doubt, obtain an order from the bankruptcy court authorizing the payment.
Getting the Work Done
If the debtor is the contractor and has ceased working the project, a motion should be made in the bankruptcy court to compel the assumption or rejection of the contract so, if necessary, a new contractor can be brought in to finish the job. If the debtor is being replaced, bankruptcy court approval is necessary or you could be in violation of the automatic stay. The motion should ask the court to authorize the owner to deduct money from the holdback to pay the new contractor if necessary. Applying the holdback is a set off under bankruptcy law, therefore to avoid violating the automatic stay, the court must pre-approve the setoff. Setoffs can be done before the bankruptcy case is filed, if allowed under the contract. To avoid problems getting paid, the availability and reliability of payments sources should be clarified and memorialized in an order. Also, creditors should continuously monitor the bankruptcy case, as some cases can become administratively insolvent—meaning from a practical standpoint post-petition creditors may not get paid even though a court order says that they will be paid. Keep a very close eye on when and where the money goes. If the owner or contractor files bankruptcy, subcontractors need to obtain approval to stop performance by filing a motion to ask the debtor to reject or assume the contract and provide assurances of future performance.
Preferences
Payment made on or before 90 days of the filing can be clawed back under some circumstances. The claw back can only happen if the payment was on an antecedent debt, payment came from the debtor, the debtor was insolvent, and the creditor received more than it would have in a chapter 7 liquidation. There are defenses a creditor can raise, such as ordinary course of business, new value or contemporaneous exchange. However, if the payment is on a lien that encumbers the debtor’s assets, then there is no preference. A mechanics lien on property owned by someone other than the debtor does not assist the creditor as a preference defense, but may assist in obtaining payment. A timely made payment may fall within the ordinary course of business defense, but care should be taken when late payments are received. If given the choice between taking a possible preference that may be avoided or not getting paid, most creditors will accept the money and take their chances. Also, the clock on the 90 days starts running on the date that the check clears the debtor’s bank. This is reason to deposit all checks as soon as possible to get the time running, and consider holding off on releasing third parties or liens, if possible, until you are sure that there is no bankruptcy filing in the 90 day period after payment.
Doing Business with a Distressed Contractor
If it looks like a party with whom you are doing business may file bankruptcy and the party is in default, consider terminating the contract before the bankruptcy case is commenced in compliance with contract terms to avoid being caught up in the bankruptcy. Make sure that your contract includes protections such as requiring owners to write joint checks or, if applicable, to provide lien waivers. If you are working with a party on multiple projects, you may want to provide that a default on one contract is default on all contracts, and payments are subject to setoff.
California Construction Law Blog | Nomos LLP 
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