Bankruptcy in the Construction Setting
When bankruptcy strikes a construction project, all members of the project delivery system are affected. A party filing for bankruptcy in the construction setting can either liquidate its assets (Chapter 7 under the Bankruptcy Code; see Section IV.A, below)1 or reorganize (Chapter 11 under the Bankruptcy Code; see Section IV.B, below)2 its business and get a fresh start by eliminating certain debts and obligations. The bankruptcy process can be complicated and frequently has a negative impact on a construction project.
A basic understanding of the law can benefit the construction professional when a project faces the bankruptcy of a key participant.
The Bankruptcy Code is a federal statute. Thus, many of the cases that interpret its provisions are decisions of the United States bankruptcy courts and federal courts of appeal. The characterizations of property interests are usually matters of law; however, for this reason, results can vary from jurisdiction to jurisdiction.
This chapter addresses the effects of bankruptcy on three vital areas of a construction project: (1) the status of contracts with the debtor, (2) the status of materials in the debtor’s possession at the time of bankruptcy, and (3) the status of contract funds and alternate sources of funds.
To understand how bankruptcy works in a construction setting, it is essential to be familiar with the key “players” in a typical liquidation or reorganization proceeding.
- 1. Debtor. This is the party filing for bankruptcy and can include the owner, general contractor, subcontractors, or suppliers.3
- 2. Debtor in possession. This is the party filing for bankruptcy (Chapter 11) that maintains control and continues operating its business through the reorganization process.4
- 3. Trustee. This is the “overseer” of a bankruptcy case who looks out for the creditors’ interests and is either appointed by the court (Chapter 7) or may be a debtor in possession (Chapter 11).5
- 4. Bankruptcy estate. This means the debtor’s assets that become part of “the estate” upon the filing of bankruptcy and can be used to pay off creditors.6
- 5. Creditor. A creditor is an entity that has a claim against a debtor (or the debtor’s estate) that arose at the time of, or before, an order for relief was entered in the debtor’s favor in a bankruptcy case.7
- 6. Secured creditors. These are the entities whose claims or interests (i.e., a valid lien claim on property) are part of the bankruptcy estate.8 Secured creditors have many advantages in a bankruptcy case, such as being allowed to use the full amount they are owed by the debtor to bid on any collateral securing the debt during a bankruptcy sale.9
- 7. Unsecured creditors. These are the entities whose claims or interests are not part of the bankruptcy estate.10 Unfortunately, in many bankruptcy cases unsecured creditors are only able to recover pennies on the dollar of the amount they are owed by the debtor (if anything at all).
- 2. Debtor in possession. This is the party filing for bankruptcy (Chapter 11) that maintains control and continues operating its business through the reorganization process.4
In addition to knowing the “players,” it is also helpful to be familiar with some basic bankruptcy terms as listed below:
- 1. Claim. A claim is a right to payment held by a creditor against a debtor and can be in the form of a judgment, can be liquidated (with a dollar amount owed being certain), unliquidated (with the amount owed to be decided by the court), contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.11
- 2. Debt. A debt is defined as a liability on a claim held by a creditor against a debtor.12
- 3. Insider. An insider includes relatives of the debtor, the debtor’s business partners, officers and directors, or any person or entity with control over the debtor or its assets.13
- 4. Insolvent. Generally, a debtor is insolvent if the debtor’s liabilities exceed the value of the debtor’s assets.14
- 5. Joint check agreement. A joint check agreement is an agreement (usually in writing) requiring a general contractor to issue checks payable to both a subcontractor and the subcontractor’s supplier on a construction project. Joint check agreements provide assurances to the supplier that it will be paid for the materials it provides to a subcontractor and assures the general contractor that the materials needed for a project will be delivered.
- 6. Lien. A lien is an encumbrance on the debtor’s property to secure payment of a debt or the performance of an obligation.15
- 7. Security. Security in a bankruptcy setting can include, among other things, notes, stocks, bonds, certificates of deposit, securities, royalties, and other investment assets.16
- 8. Security agreement. A security agreement is a contract between a lender and borrower whereby the borrower pledges certain property or assets as collateral for a loan with the lender obtaining a superior interest to the collateral as against other creditors especially if steps are taken to “perfect” the security agreement.17
- 9. Payment bond. A payment bond is issued by a surety generally guarantying that covered subcontractors and suppliers providing labor and materials for a construction project will be paid upon making a timely claim against the bond.18 Payment bonds may also be issued on subcontractors. (See Chapter 16.)
- 10. Performance bond. A performance bond is issued by a surety generally guarantying that if the general contractor defaults on its contract that the owner’s project will still be completed.19 Performance bonds may also be issued on subcontractors. (See Chapter 17.)
- 11. Proof of claim. A proof of claim is filed by a creditor in a bankruptcy case to assert a claim against the debtor’s estate for the amount the creditor is owed by the debtor.20 The trustee will usually set a deadline as to when a proof of claim must be filed with failure to do so resulting in the creditor’s claim being barred.
- 12. Retainage. Retainage is the money withheld by an owner or general contractor from a general contractor or subcontractor to ensure that the work for a construction project will be completed and that repairs will be made.21
- 13. Uniform Commercial Code (U.C.C.). The U.C.C. is a series of statutes designed to simplify and harmonize the laws relating to commercial transactions and sales in all 50 states.22 (See Chapter 8 for a review of the significance of the U.C.C. to purchase orders and contracts with suppliers/vendors for materials and equipment used in construction.)
- 2. Debt. A debt is defined as a liability on a claim held by a creditor against a debtor.12
Bankruptcy laws are contained in the United States Bankruptcy Code (the Code), which is codified in Title 11 of the United States Code. The Code provides for two types of business bankruptcies, Chapter 11 (Reorganization) and Chapter 7 (Liquidation), both of which may be encountered on a construction project.23
A. Chapter 11—Reorganization
Under Chapter 11, the debtor remains in control of its business and property as a “debtor in possession” unless there is a good reason for a trustee to be appointed by the court to control the debtor’s property. A debtor in possession has considerable discretion and authority to continue operating its business. The debtor, however, must develop and obtain court approval of a plan of reorganization that includes payments to creditors. Once the plan is approved, the debtor emerges from bankruptcy with a fresh start. However, failure by a Chapter 11 debtor to comply with the terms of its plan of reorganization can result in the matter’s being converted to a Chapter 7 liquidation.24
B. Chapter 7—Liquidation
The other form of bankruptcy often encountered on a construction project is Chapter 7 liquidation. Under Chapter 7, the debtor’s assets are liquidated, creditors are paid a pro rata share of the proceeds of the liquidation, and the debtor corporation then ceases to operate. In a Chapter 7 liquidation, the bankruptcy court appoints a trustee to handle the liquidation and winding up of the business. It is possible that during a Chapter 7 proceeding it may be determined that the debtor can reorganize its business and avoid having all of its assets liquidated. In this situation, the trustee or other interested party can file a motion with the court asking that the proceeding be converted from a Chapter 7 to a Chapter 11 (reorganization) proceeding.25
Whether in a Chapter 11 reorganization or a Chapter 7 liquidation, the basic goal of the bankruptcy process is to give the debtor relief from debts that no longer can be paid in the ordinary course of business.26 In fact, the purpose of the Bankruptcy Code is to provide a “fresh start” to honest but unfortunate debtors.27 Under Chapter 7, a corporate debtor is not discharged from its debts, but all assets obtained from the liquidation are distributed and the corporate debtor ceases to exist.
From a creditor’s standpoint, a basic premise of bankruptcy law is that creditors in the same class should be treated equally. As mentioned, in most bankruptcies, there are several different classes of creditors, including secured creditors and general unsecured creditors. Within each class, creditors should receive equal treatment so that no one creditor receives more than its fair share of money or other assets from the debtor. Assets of the debtor are protected in various ways to facilitate an orderly gathering and distribution of funds to all creditors.
C. Automatic Stay
A fundamental element of the bankruptcy system is the automatic stay, a rigidly enforced prohibition against taking any steps that are hostile to the debtor or that affect the debtor’s property.28 The automatic stay, however, only protects the debtor and not “related” third parties of the debtor such as family members, business partners, shareholders, or officers.29 Once a debtor has filed for bankruptcy, all actions against the debtor by its creditors are automatically brought to a standstill.30 Any action taken against the debtor in violation of the automatic stay is void.31 The automatic stay allows the debtor in possession or trustee the necessary breathing space to determine what steps to take in order to reorganize or liquidate the company while holding off creditors.32 The automatic stay also prevents any one creditor from obtaining more money or property than other creditors.33
The automatic stay prohibits almost all creditor attempts to collect debts or property from the debtor. The stay prohibits such actions as:
- Filing a lawsuit or demanding arbitration against the debtor34
- Advancing a lawsuit or arbitration against the debtor35
- Enforcement of a judgment against the debtor36
- Seizing the debtor’s materials, tools, equipment, or supplies37
- Filing or foreclosing a lien against the property of the bankruptcy estate38
- Filing or foreclosing a lien against the debtor’s property39
- Recovering the debtor’s property or claims40
- Reconciling amounts owed to the debtor with amounts the debtor owes creditors41
- Advancing a tax proceeding against the debtor42
The stay is “automatic” because no court order is necessary to implement it. Instead, the stay is legally in effect from the moment the bankruptcy petition is filed.43
D. Sanctions for Violation of Automatic Stay
The automatic stay is enforced by the bankruptcy court, which may impose sanctions against a creditor for violating the automatic stay.44 Such sanctions may include imposition of administrative penalties and attorneys’ fees.45 Any individual injured by reason of the violation may recover actual damages, costs, attorneys’ fees, and, in some instances, punitive damages against the violator.46 Violation of the automatic stay in connection with a contract, such as terminating the contract for default, may be treated as a breach of contract by the party terminating the contract. The automatic stay does not, however, stop time or prevent a contract from expiring under its terms.47 The automatic stay also does not preclude a defaulting party from having a contract canceled if proper notice is given.48 Because the consequences of violating the automatic stay can be severe, before a creditor takes any action against a debtor, the creditor must determine whether the planned action violates the stay.
E. Relief from the Automatic Stay
A creditor is not, however, without an avenue for relief from the impact of the automatic stay, particularly with regard to efforts to obtain secured property held by the debtor or to determine amounts owed by the debtor in a litigation or arbitration forum. The United States Bankruptcy Code provides that a creditor may petition the bankruptcy court for relief from the automatic stay to allow the creditor to proceed against the debtor or the debtor’s property.49 The term “petition” usually requires that a motion be filed with the court seeking such relief.50 A court may grant relief from the automatic stay when the property against which the creditor seeks to take action is of no value to the bankruptcy estate because the debtor does not have any equity in the property. Creditors can request that the automatic stay be in some way altered.51
For example, a debtor lacks equity in certain property when the value of the property is less than the security interest in the property; or a debtor may have, pre-bankruptcy, pledged a piece of earthmoving equipment as security for a bank loan. If the amount of the bank’s security interest exceeds the value of the equipment, the bank could move for relief from the automatic stay on the ground that the debtor has no equity in the property. Because the debtor has no equity, the property would have no value to the bankruptcy estate or to other creditors, and therefore the bank should be permitted to foreclose its interest.
Other circumstances may justify relief from the automatic stay “for cause.”52 For example, a common problem in a construction setting is the failure of the debtor to maintain insurance on equipment. A creditor with a security interest in the equipment could move for relief from the automatic stay to allow foreclosure if the debtor is not adequately protecting the security interest by maintaining insurance. Relief from the automatic stay may be justified if the debtor fails to maintain or secure materials or equipment.
A creditor also may seek relief from the automatic stay to allow arbitration or litigation to proceed to determine the amount of a debt owed by the debtor.53 In this instance, the creditor would not be allowed to proceed to judgment and collection; however, the alternate forum (which presumably would be more familiar with construction cases) would be permitted to determine the amount of the debt. The creditor’s pro rata share of the proceeds of the bankruptcy liquidation or reorganization then would be calculated according to the amount of the debt established by the arbitration or litigation proceeding.
In order to obtain relief from the automatic stay, a creditor must file a motion with the bankruptcy court having jurisdiction over the debtor’s case.54 The court must take some action on the motion within 30 days after the motion is filed or the stay is automatically terminated as to the moving party.55 Although the court may simply set the motion for a hearing within that 30-day time limit, the time limitation allows a creditor to shorten what otherwise could be a lengthy process.
F. Preferential Transfers
The Code allows a trustee to void a pre-bankruptcy transfer of property or money by the debtor to a creditor.56 The purpose for this rule is to prevent debtors from showing favoritism by paying one creditor at the expense of others.57 Debtors that make payments 90 days before filing for bankruptcy run the risk that such will be viewed as suspect and rescinded by the trustee.58 Under the Code, debtors are considered to be insolvent 90 days before filing:59 as such, the trustee may question how creditors were paid during this prefiling period.60 Beyond the 90-day period, the trustee bears the burden of establishing that the debtor was insolvent in regard to any transfers (or payments) which were made to creditors.61
- Benefiting a creditor64
- For an antecedent debt of the debtor65
- Made by an insolvent debtor66
- Made within 90 days before the date of bankruptcy or one year before the date of bankruptcy if the creditor was an “insider”67
- The transfer allows a creditor to receive more than it would have received under a Chapter 7 liquidation68
A transfer that satisfies all of these five criteria is voidable even if the payment to the creditor was a lawfully made payment of a preexisting debt.69 Such transfers are termed “preferential” transfers, even though no intent to defraud other creditors is necessary. Simply stated, a preferential transfer is voidable to prevent favoritism among creditors even if the creditor’s increased share was obtained before the debtor filed for bankruptcy.
While the Code does not define “debtor’s property,” such includes all assets that could have been used by the debtor to pay creditors, had the assets not been improperly transferred.70 Assets not available to pay creditors usually are not considered part of the estate and are not subject to being reclaimed by the trustee.71
Preferential transfers may include payments made by third parties to a debtor’s creditors where the debtor controls the transaction,72 payment to a supplier in exchange for dismissal of an involuntary bankruptcy petition,73 exchanging an obligation for a preexisting duty,74 and garnishment of funds owed to the debtor.75 A mechanic’s lien that becomes effective before the debtor’s insolvency or bankruptcy filing is generally not considered a preferential transfer because the Code excludes statutory liens.76
G. Exceptions to the Preferential Transfer Rule
The Code provides that under certain circumstances, a debtor can transfer assets without such being considered preferential.77 The eight exceptions to the preferential transfer rule include:
- Transfers made for new value contemporaneously given to the debtor78
- Payments made in the ordinary course of business or under ordinary business terms79
- Loans made to the debtor for the purchase of property secured by new value with the property serving as collateral80
- Transfer benefiting the creditor whom gave new value to the debtor and was proper81
- Secured interest in inventory or receivables82
- Valid statutory liens83
- Domestic support and consumer-type debt payments84
- Avoided transfers made to non-insiders to benefit insiders are considered avoided only as to the insiders85
- Secured interest in inventory or receivables82
1. “New Value” Exception
Perhaps the most important exception to the preferential transfer rule is the contemporaneous exchange of property for new value.86 Under this exception, a transfer of new value going to the debtor’s estate will make up for any outgoing payments such that creditors will not be cheated out of available assets.87 For example, a release of lien or bond rights in exchange for a payment of past-due amounts may be considered as an exchange for new value so that the payment is not a voidable preference.88 However, a discount on the amount owed given to a debtor may not constitute “new value” under the Bankruptcy Code.89
Although a waiver and release of lien or bond rights is not universally held to be an exchange for new value,90 a contractor or supplier receiving a payment from an owner or another contractor in shaky financial condition can improve its chances of keeping the payment even if the payor files for bankruptcy within 90 days of the payment. The contractor or supplier receiving the payment should document that any lien or bond rights that are waived or released as a result of the payment are being given up expressly in exchange for the funds received. The waiver or release language also should be worded carefully to state that the waiver or release is contingent upon actual receipt of the funds.
In jurisdictions where a waiver and release are not considered new value, the contractor or supplier still may preserve lien or bond rights by entering into an agreement with the debtor that the waiver and release are contingent upon the paying party not filing for bankruptcy within 90 days after the payment is made.91 Although the payment still could be treated as a voidable preferential transfer, the contractor or supplier would at least retain its lien or bond rights. Depending on the notice and filing requirements in the jurisdiction, however, it may be necessary to proceed with perfecting lien or bond rights during the 90-day preference period to avoid losing such rights for failure to comply with applicable time limits.
2. Ordinary Course of Business Defense
A second exception to the voidable preference rule relevant to the construction industry involves payments for work or supplies made in the “ordinary course of business” or under “ordinary business terms.” The Trustee cannot rescind such payments.92 A subcontractor receiving a payment from a general contractor shortly before the general contractor filed for bankruptcy must prove that such was made through normal business dealings.93 To invoke this exception, the creditor must establish that the “ordinary business terms” comported with industry standards.94 In deciding if a payment was made in the ordinary course, courts will consider how long the transfer took, if the method or amount of payment deviated from prior transactions, whether any questionable payment or recovery practices were used, and if the creditor unjustly benefited from the debtor’s unfortunate circumstances.95 In deciding if a payment was ordinary, the date the debtor sent the check is more telling than when it was cashed or deposited.96
The rationale for this exception is that payments in the ordinary course of business neither drain funds from the bankruptcy estate nor treat other creditors unfairly because the debtor has received something of value, that is, short-term credit. No hard and fast rule is applied when determining whether a transfer from one entity to another was made in the “ordinary course of business”; instead, the courts examine the circumstances surrounding each individual case.97
Courts will look to the parties’ past dealings to determine whether the payment at issue is consistent with those past dealings.98 When there is no history between the parties to use as a baseline to determine what is normal, the courts will look for transactions that generally “raise a red flag.”99
The ordinary course of business exception should apply to a progress payment made to a contractor or subcontractor in accordance with the contract payment terms or other terms established by the course of dealings between the parties. Payments made by a bankrupt subcontractor to a supplier that appear from the invoice to be late still may have been made in the ordinary course of business.100 The closer that a payment is to the ordinary business dealings between the parties, the more likely it is that the court will treat it as an exception to the preferential transfer rule.
At the conclusion of a bankruptcy case, the debtor’s plan is approved, the debtor is discharged, and the automatic stay ceases.101 The automatic stay is replaced with a permanent injunction that prevents recovery of dischargeable debts, but nondischargeable debts can be collected.102 The discharge order does not specify which debts fit into each category.103 Instead, such a determination usually is made in a different adjudication.104
The discharge is accomplished by a court order that bars the debtor’s liability on most claims.105 Creditors can be penalized for purposely ignoring the injunction.106 In a Chapter 7 liquidation, an individual is discharged from liability for prepetition debts.
Businesses cease to exist under a Chapter 7 liquidation rather than being discharged. Pursuant to Chapter 11, the order confirming the plan usually relieves the debtor from obligations incurred before the confirmation.107
I. Nondischargeable Debts
Certain debts of an individual are not dischargeable.108 Such nondischargeable debts include: debts for money, property, or services obtained through false statements or fraud; debts obtained through false financial statements upon which the creditor relied and which the debtor provided with the intent to deceive; and debts arising from fraud while the debtor was acting in a fiduciary capacity.109
In the construction setting, a construction trust fund statute usually treats all parties having possession of the funds as “trustees.” Courts have reached conflicting results when deciding whether a construction trust fund statute creates a fiduciary duty on the “trustee” so that the breach of the fiduciary duty renders a debt nondischargeable.110 Whether a debtor’s violation of a construction trust fund statute results in a nondischargeable debt depends on the state construction trust fund statute and the particular bankruptcy court’s prior decisions interpreting the statute. Although federal law controls the creation of a fiduciary duty, state laws are considered to determine whether such a relationship creates a nondischargeable debt.111
If the bankruptcy court determines that a debt is nondischargeable, the debtor still is exposed to liability for suit and collection. Any debt owed by a debtor on a construction project should be investigated carefully to determine whether there is a basis for claiming fraud or a breach of a fiduciary duty.
A. Executory Contracts
When a party files for bankruptcy, all “executory” contracts remain in full force and effect.112 Under the Bankruptcy Code, an executory contract is one in which there are material obligations remaining to be performed by both parties.113 In determining whether a contract is executory, courts typically conclude that if the failure to complete performance by either party would constitute a material breach of contract, the contract is executory.114 Generally, a construction contract is considered executory before substantial completion.115 Considerable punch-list work remaining after substantial completion may, however, constitute a substantial remaining obligation on the contractor’s part. Likewise, payment of retainage may be considered a substantial remaining obligation. Therefore, under certain circumstances, even if substantial completion has occurred on a construction project, the underlying contract still may be treated as an executory contract.
The Code offers many protections for the debtor in possession or trustee to address the debtor’s executory contracts. For example, the Code prohibits termination of a contract solely because of the insolvency or bankruptcy of the debtor. A contract clause that gives the right of termination for insolvency or bankruptcy is known as an “ipso facto” clause and is usually deemed invalid.116 The Code does not recognize these clauses; instead it chooses to allow the debtor to maintain profitable contracts as a resource for funding the debtor’s operations and obligations.117
B. Affirmance or Rejection
Under the Code, a debtor in possession or trustee may affirm or reject an executory contract.118 In a Chapter 7 bankruptcy, the trustee has 60 days to affirm or reject an executory contract, or it is considered rejected.119 Under Chapter 11, the debtor in possession can affirm or reject a contract at any time up until the court approves the debtor’s plan of reorganization. When a Chapter 11 debtor neither declines nor accepts an executory contract, a “ride through” occurs and the agreement survives bankruptcy.120
A debtor in possession must use its “business judgment” when deciding which contracts to continue and which to abandon.121 The debtor should reject those contracts that are not profitable.122 Those contracts that are rejected are considered to be breached, and the other contracting party then has an unsecured claim for damages.123
If the debtor in possession or trustee decides to affirm a contract that is in default, any default first must be cured, and the other party must receive adequate compensation for damages incurred as a result of the default.124 The debtor also must give adequate assurance of future performance.125 As a practical matter, curing existing defaults and giving adequate assurance of future performance can be insurmountable obstacles if the bankruptcy estate is in a condition sufficient to warrant filing for bankruptcy.
If an executory contract is affirmed, performance of contract obligations by both parties can continue in the normal course of business. An affirmed contract creates additional obligations on the part of the debtor in possession or trustee and gives substantial rights to the other party to the contract.
All debts and expenses incurred by the debtor’s estate for an affirmed contract are considered as “administrative expenses” of the estate.126 “Administrative expense” is a term of art applied to expenses and debts incurred by the debtor during the administration of the bankruptcy estate.127
Typically, an expense or debt must be shown to benefit the debtor’s estate in order to be treated as an administrative expense.128 The expenses a debtor incurs in attempting to acquire assets, however, may not be administrative in nature.129 Since administrative expenses are given a priority, a party to an affirmed contract may have some assurances that the debts and costs associated with the affirmed contract may be given preference in the ultimate distribution of the debtor’s assets if such benefited the bankruptcy estate.130
Although the debtor in possession or trustee may assign an executory contract,131 adequate assurance of performance by the contract assignee must be given.132 If applicable state law or nonbankruptcy federal law provides that the other party would have to consent to an assignment of the contract, an executory contract cannot be assigned without such consent.133 Contracts that usually cannot be assigned (or assumed) frequently involve intellectual property rights.134
D. Minimizing the Impact on Executory Contracts
Because the trustee (or debtor in possession) can affirm or reject a contract,135 the other party to a contract with a debtor is effectively denied the freedom to exercise its contract rights against the bankrupt debtor. Most construction projects require quick decisions and aggressive actions to continue the work. If a party in bankruptcy continues to perform without difficulty, the bankruptcy may not have any impact. But if the debtor in possession or trustee ceases performance and fails to promptly reject the contract, the impact on the progress of construction can be immediate and severe. Fortunately, the nonbankrupt party to a contract can take certain measures to minimize the impact of a debtor’s executory contract on a construction project.
1. Terminate before Bankruptcy
In many cases, there are advance signs that a party on a construction project is about to file for bankruptcy. The problems inherent in having an executory contract with a debtor can be avoided by terminating the contract before the bankruptcy filing. Such termination, however, must be based on a default for some reason other than insolvency or impending bankruptcy, or the contract must contain a termination for convenience clause.136 For the termination to be effective, the terminating party must follow all applicable contract termination procedures. All required notice and cure periods must run in full before the bankruptcy filing. Otherwise, the termination cannot be made final because of the automatic stay.
The right to affirm or reject a contract does not apply if the contract has been terminated before the bankruptcy petition is filed or is in default.137 After termination, there is no valid contract to be affirmed or rejected.
2. Exercise Contract Rights
A typical construction contract includes a clause allowing an owner or general contractor (or a subcontractor in the case of a sub-subcontractor’s bankruptcy) to supply the necessary labor, materials, and equipment to complete the other party’s work in the event of a failure of performance. If a contractor or subcontractor files for bankruptcy and ceases performance, the other party to the contract could use such a clause to supplement the debtor’s forces without violating the automatic stay and without violating the right of the debtor in possession or trustee to affirm or reject the contract.138 Typically, such a contractual clause would permit the costs incurred for supplementing the debtor’s forces to be backcharged to the debtor in possession or trustee. Costs not recovered through backcharges become general, unsecured claims against the bankruptcy estate when a contract has been rejected, and administrative expenses of the bankruptcy estate when a contract has been affirmed.
3. Seek Relief from the Automatic Stay
If the debtor is in default of its contract, the other party may petition for relief from the automatic stay to allow termination of the contract. Such a request limits the period of uncertainty as to whether the debtor will affirm or reject the contract. The motion forces the debtor in possession or trustee to take a position on the contract, and the other party to the contract is assured that the bankruptcy judge will act within a reasonable time on the motion. A party that can demonstrate that the contract is seriously in default and has few hopes for a cure would likely establish good cause for lifting the stay.139 As a practical matter, if the debtor’s situation is hopeless, the debtor in possession or trustee may not oppose lifting the stay to allow termination, thereby agreeing to the requested relief.
4. Seek a Time Limit on Affirming or Rejecting the Contract
If the debtor continues performing the contract, and is not in default, there are no grounds for terminating the contract. As previously discussed, neither insolvency nor bankruptcy standing alone is a ground for termination. The Chapter 11 debtor that continues performance, therefore, has a prolonged period of time during which it may decide to affirm or reject the contract. As previously mentioned, an executory contract can be affirmed or rejected until the debtor’s reorganization plan is approved.140 Even if a contract is not in default, however, the Code allows the nonbankrupt party to petition the bankruptcy court to set a “reasonable” time limit on the debtor in possession’s or trustee’s choice to affirm or reject the contract even before the reorganization plan is confirmed.141 Although the question of what is a “reasonable” time depends on the circumstances of each case,142 where the contract is not in default, this request for a time limit to affirm or reject the contract is the only way to shorten the process.