Bankruptcy / 7 min read
You Just Found Out That Your Contract Counterparty Filed for Bankruptcy, Now What Happens?
First, from a bankruptcy point of view, it is important to understand the term "executory contract or lease." The Bankruptcy Code has an extensive section (Section 365) that deals with executory contracts and leases but nowhere in the Bankruptcy Code is the term "executory" defined. Instead, courts, including the U.S. Supreme Court, have adopted a definition that means that each party to the contract or lease – both the debtor and the non-debtor - still have material obligations outstanding to the other party on the date when the bankruptcy case was filed. For example, in a construction setting, if important work or services were still outstanding, including the payment for that work and services when the bankruptcy case was filed, that contract would be executory. However, if all the services or work required per the contract (and applicable change orders) was performed and the only obligation remaining was payment, that would not be an executory contract because only one party has a material outstanding obligation.
For a contract or lease to be "executory" for purposes of the Bankruptcy Code, that contract or lease must still be in existence and not have been fully terminated pursuant to the contract terms and/or applicable law. The contract will largely govern what steps and timing are needed for a termination to occur. If all the steps to terminate occurred before bankruptcy, including any applicable cure periods, then the contract is not "executory" in a bankruptcy filed by one of the contract counterparties.
Options for the Debtor or Trustee
With that very important foundation, what happens to your contract depends on which of three options the debtor or trustee exercises during the bankruptcy case. Generally speaking, the debtor or trustee can request a bankruptcy court to approve:
- an assumption of the contract;
- an assumption and assignment of the contract to a new third party; or
- rejection of the contract.
Assumption or Assumption and Assignment of the Contract
Often, having a client's contract assumed, or assumed and assigned, is the best outcome because it provides the only viable way to get paid on all outstanding obligations. An assumption or assumption/assignment provides a pathway for performance and/or payment of post-bankruptcy work. In order for a debtor or trustee to assume, or assume and assign a contract, all defaults must be cured or paid as part of the assumption, which includes curing any non-monetary defaults.
Many bankruptcy cases involve sales of assets and assumption, or assumption/assignment of contracts related to those assets to a third-party purchaser. The process for how the sale will occur is often put in place early on in a bankruptcy case via a motion to approve bid, sale and contract assumption procedures. If you find yourself in this circumstance it is critical that you contact us as soon as possible because the approval of a sale and contract assumption procedures largely dictate the end results. Importantly, the sale procedures set out the timing of filings including objections by the non-debtor contract counterparty to protect its rights. This timing is often short, so it is imperative that you are diligent in protecting your rights and claims.
A typical sale and contract assumption process provides for a debtor or trustee to file a schedule of all the debtor's executory contracts (or those contracts the debtor asserts are executory), along with a disclosure of what the debtor asserts is owed. This contract schedule is often filed before there are any bids made for a debtor's assets and before there is any information on whether a sale will actually occur and to whom.
One of the most important parts of any contract assignment process relates to responding to a debtor's schedule of "cure" amounts. Here, a typical contract assignment process will include a debtor filing a list of all of its executory contracts by title, name of counterparty, brief description of contract and the debtor's statement of outstanding payment amounts. Unfortunately, we see all too often generic contract descriptions, duplicate contract listings, and other issues along with zero-dollar cure amounts. This means that a contract counterparty must object and respond with what is owed (often times with a reservation that additional or continuing amounts are being incurred) otherwise, the amount owed will be zero. Again, it is important to know the deadline for filing objections to the listed "cure amount" because failure to timely object creates a serious obstacle to collecting what you are owed. If you believe there is no executory contract because performance has been completed or the contract has been terminated, it is important to assert that in an objection as well.
The next part of the bankruptcy sale process important to contract counterparties is the filing of a proposed purchase and sale agreement (PSA) which identifies the assets to be sold, the identity of the buyer, the price and importantly, what contracts the buyer wants assigned to it. Contract counterparties have essentially no say in whether a buyer should include a contract on the assumption/assignment schedule, it is the buyer's business judgment of whether it sees the contract as helpful or valuable to the assets it is purchasing. Here, we sometimes see a filed proposed PSA, but the contract assignment schedule is filed separately. In either event, the deadline to object to the assumption or assumption/assignment is often very short, ranging from seven to ten days. You have the right to know whether the proposed buyer is capable of paying the cure amount and has the financial and operational ability to perform on the contract going forward. If there are questions or issues on any of these, you have to file another objection.
The end of the sales process is a court hearing approving the sale and final PSA along with hopefully, clarifying any open contract issues. We often see a sale approved and a contract "provisionally" assigned even if there is a significant issue about (i) whether the contract is executory and capable of being assumed or assumed/assigned, (ii) the monetary cure amount, or some other non-monetary default, or (iii) the buyer's financial/operational ability to perform. At some point the parties will resolve any issues, or the bankruptcy court makes a ruling on any open issues and then the buyer either agrees to the ruling or elects to drop the contract from its PSA. Lastly, the Bankruptcy Code renders unenforceable contract language that (i) provides for default or termination upon the filing of a bankruptcy case, or (ii) precludes assignment of a contract. As you can see, the process is designed to help the debtor or trustee maximize value, it is not designed to protect your contract rights.
Rejection of the Contract
If the debtor or trustee seeks to reject your contract, it means that they will breach the contract by not performing the contract going forward. A rejection is not a termination of the contract but simply a breach. As such, you have the ability to file a claim for breach of contract damages. Unless there has been work performed post-bankruptcy, a rejection means you have a pre-bankruptcy unsecured claim (absent an ability to assert a mechanics' & materialman's lien). In most bankruptcy cases, unsecured claims receive little to no real recovery so rejection often means you will not receive payment on what was owed plus no recovery for what was supposed to get paid if the contract was fully performed. Because the results for rejection are often so difficult for contract parties, a debtor or trustee may use the possibility of rejection as leverage to attempt to re-negotiate contract terms. We work with clients in these circumstances to obtain the best commercial result possible. Ultimately, if your contract is rejected, you file your proof of claim by the applicable deadline and wait to see how much, if anything, is paid on account of your claim.
Bankruptcy cases involve a number of issues but can have an important effect on your contract and contract rights. Bankruptcy cases often move on quick timelines, so it is important to not only reach out promptly to understand your rights and options, but also to understand the time periods necessary to protect your rights. You often have rights to assert liens or have already asserted your liens and we work with you to protect those lien rights as we navigate the bankruptcy case.