What Do You Do When One of Your Subcontractors Files for Bankruptcy Protection?

The bankruptcy of a subcontractor on a construction project can wreak havoc with a project and in some circumstances, can threaten a project in its entirety. This article addresses a few pertinent bankruptcy issues that all contractors should be familiar with.

Types of Bankruptcy Cases

Corporations basically have two available remedies under the federal Bankruptcy Code: liquidation under Chapter 7 and reorganization under Chapter 11.

Under Chapter 7, once a debtor files its bankruptcy petition, a trustee is appointed to collect and sell all of the assets of the business as quickly as possible. Once the assets are sold, the trustee pays the creditors in the following order:

• First, all creditors holding valid and enforceable liens on particular assets;
• Second, expenses associated with the administration of the Chapter 7 case and the claims entitled to special status under the Bankruptcy Code; and
• Finally from the remaining balance (if any), the general unsecured creditors are paid.

This is usually done on a pro-rata basis because there are rarely sufficient assets to completely pay the debtor’s general unsecured claims.

Chapter 11 is based on the economic theory that a business, even if it is currently unable to meet its financial obligations, can be restructured to enable creditors to receive more money from the continuation of the debtor’s business than they would if the business and its assets were liquidated. Chapter 11 is generally a long, involved process. The debtor negotiates with its creditors and then proposes and files a plan of reorganization with the bankruptcy court. The debtor’s plan of reorganization, once confirmed by the bankruptcy court, governs how the debtor will continue to conduct business and in what manner it will satisfy the claims of its creditors.

Most construction subcontracts contain an insolvency clause by which the general contractor may immediately terminate the subcontract if the subcontractor becomes insolvent or files for bankruptcy protection under the Bankruptcy Code. In bankruptcy parlance, the insolvency clause is known as an “ipso facto clause” and is not enforceable in a bankruptcy case.

The Automatic Stay Provisions of the Bankruptcy Code

Any termination of a subcontract with a debtor-subcontractor in accordance with an ipso facto clause or without bankruptcy court authorization could be seen as a violation of the “automatic stay” provisions of the Bankruptcy Code. This could result in the bankruptcy court’s assessing punitive damages against the offending contractor.

“The automatic stay” is basically a protection created when the debtor files a bankruptcy petition the purpose of which is to freeze the position of all creditors and to establish the bankruptcy court as the forum for all disputes regarding the debtor or its property. In this case the debtor’s property consists of its subcontract rights. The automatic stay acts as an injunction or a “force-field” which prohibits creditors from beginning or continuing litigation, collection activity, or in the case of a construction contract, a general contractor’s efforts to terminate the debtor’s subcontract.

In the circumstances described above, the subcontract between the debtor-subcontractor and general contractor is called an “executory contract” under the Bankruptcy Code. Since it constitutes property of the debtor’s bankruptcy estate, the general contractor cannot unilaterally terminate it without a bankruptcy court order authorizing such termination.

The Impact of the Stay Provisions

There is a notable impact of the automatic stay provisions of the Bankruptcy Code on a general contractor’s ability to terminate a subcontract with a subcontractor who has filed for bankruptcy protection. When a subcontractor who has filed for bankruptcy protection is unable to complete its obligations under a subcontract, it is imperative that the general contractor obtain bankruptcy court authorization to terminate the subcontract as quickly as possible.

The general contractor must take immediate and aggressive action to protect its right to terminate the subcontract and to replace the debtor-subcontractor with another subcontractor capable of completing the debtor’s work. In a chapter 11 context, a debtor-subcontractor can assume or reject the original (executory) contract at any time during the Chapter 11 proceeding. In a Chapter 7 case, however, executory subcontracts that require completion of work by the debtor-subcontractor, are usually rejected by the Chapter 7 Trustee.

A general contractor can pursue two types of motions to terminate an executory subcontract. The first is a Motion to Compel The Debtor’s Rejection of the Executory Subcontract. The general contractor needs to present the bankruptcy court with a fact pattern that shows that the debtor will be unable to complete its obligations under the subcontract. Specific facts about the debtor that the court will consider are the debtor’s inability to make payroll, to provide workers’ compensation insurance, to render payment to its material suppliers and equipment lessors, and most importantly, to perform its obligations under the subcontract. If the debtor can’t convince the court that it is able to meet its subcontract obligations, the bankruptcy court will enter an order forcing the debtor to reject the executory subcontract.

A general contractor may also seek bankruptcy court authorization to terminate a debtor-subcontractor by filing a Motion for Relief from the Automatic Stay. The general contractor must persuade the bankruptcy court that there is “cause” to justify its request to terminate the subcontract. The facts, which would justify the court’s entry of an order granting relief from stay, are essentially the same as must be presented to the bankruptcy court in order to obtain an order compelling the debtor’s rejection of a subcontract.

Working with a Debtor-Subcontractor

When a debtor-subcontractor continues to properly fulfill its contract obligations, a general contractor may want to continue working with the subcontractor despite the pending bankruptcy. In such a case, the general contractor should protect its rights and interests by requiring the debtor to file an assumption stipulation with the bankruptcy court assuming the “executory subcontract”. This will serve as an agreement apart from the original subcontract, by which the debtor will agree to assume its subcontract in accordance with a bankruptcy court order.

The stipulation will outline the terms of the existing subcontract, along with any defaults that may have occurred. It will also set forth the debtor’s agreement to comply with the requirements set forth in Section 365 of the Bankruptcy Code. This section of the Code provides that the debtor may assume the original contract only if it provides the general contractor with adequate assurance that it will promptly “cure” any existing defaults under the subcontract, including promptly compensating the general contractor for any actual pecuniary loss that resulted from the debtor’s prior defaults under the subcontract. Further, Section 365 also requires the debtor to provide adequate assurance to the general contractor that it will be able to perform all of its future obligations under the subcontract.

The General Contractor’s Rights

Under the terms of an assumption stipulation, a general contractor should require the following:

• The debtor to show a detailed schedule outlining the types and timing of all work to be performed by the debtor-subcontractor;
• The ability of the general contractor to pay the debtor and all of its laborers and material suppliers by joint checks;
• The ability of the general contractor to immediately terminate the subcontract if the debtor is unable to complete the work without further bankruptcy court intervention;
• The ability of the general contractor to replace the debtor-subcontractor on the project if the contractual conditions are not met; and
• The right to set off any liquidated and consequential damages cause by the debtor’s breach against any funds that may be due to the Debtor.

By entering into an assumption stipulation, a general contractor can avail itself of a wide range of advantages and protections if the debtor fails to perform its contractual obligations. By understanding its rights and remedies available under the Bankruptcy Code, a general contractor can plot a course to protect its general contract by terminating a non-performing debtor or to complete its contract with a performing debtor-subcontractor.

Construction Business Owner, October 2006