Bankruptcy doesn’t always bust a business relationship

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Understanding the landscape can help both sides work through problems

Bankruptcy is an ever-present feature of the business landscape.

Unsurprisingly, there are more bankruptcy filings when the economy, local or national, deteriorates. But even in a healthy economy, one should expect filings from businesses seeking to take advantage of the Bankruptcy Code’s powerful reorganization and restructuring tools. Following is a brief summary of what to expect when either a client or a subcontractor files for bankruptcy.

It’s important to understand the difference between the two primary types of bankruptcy filings: liquidation or reorganization. Liquidations are known as chapter 7s, and business reorganizations are chapter 11s.

Under liquidation, the business debtor is taken over by a trustee-in-bankruptcy, who tries to sell assets in order to pay off debts. Under reorganization, the business debtor generally continues to operate under prebankruptcy management, as a “debtor-in-possession,” and tries to save itself from insolvency by reorganizing its debts and assets.

The first, and perhaps most important, effect of a bankruptcy filing is the automatic stay. Once an individual or a business – the debtor – files for bankruptcy, the Bankruptcy Code requires that all attempts to collect or enforce any pre-existing obligations or debts against the debtor be halted.

The automatic stay is broad and significant. It covers all sorts of actions – exercising a right to set off, perfecting a security interest, continuing a lawsuit already filed – and a violation of the stay can result in fines from the bankruptcy court. This is an area where it generally is better to be safe than sorry, and a quick legal consultation can prevent significant problems.

Related to the collection of debts is the idea of a “preference.” Generally speaking, when a debtor made payments or transfers in the 90 days immediately before filing bankruptcy, a bankruptcy court can reverse, as preferential, those payments or transfers in certain situations.

There are exceptions to this rule, including for payments made in exchange for goods received at the same time as or after the payment, and for payments made in the ordinary course of business. An attorney can help determine any exposure or defenses to this kind of liability when a client or subcontractor files for bankruptcy.

Another effect of a bankruptcy filing is the right to assume or assign an open contract even if after a default on that contract. Generally speaking, that means that the debtor-in-possession or trustee-in-bankruptcy has a right to cure any default and then continue to perform on the contract. In that situation, the other party must accept the cure and continued performance, notwithstanding any contractual provision that would terminate the relationship upon bankruptcy.

Even more surprising is that, after curing and assuming a contract, the debtor or trustee can, subject to a few narrow exceptions, sell or assign its rights under the contract to some other person or entity – even if the contract forbids assignment.

In practical terms, this can be a good thing; for example, where the debtor is the buyer of construction services, the contractor can, upon assumption, continue to enjoy the benefit of the construction contract. On the other hand, when the debtor is a subcontractor, the general contractor may have to wait before hiring a replacement subcontractor.

Fortunately, in the construction industry, many defaults are uncurable. This is another area where legal professionals can determine whether the debtor or trustee might have a right to cure and assume its contract.

If the debtor or trustee does have that right, an attorney can help force a more expeditious decision, thereby minimizing the period in which the non-debtor has to wait to see what will happen. Alternatively, an attorney may advise whether it would be beneficial to terminate – and thereby eliminate any right to assume or assign – a contract before an insolvent and defaulting subcontractor files for bankruptcy.

If a debtor or trustee does not assume its contract, the contract generally is deemed rejected, the court will estimate damages for contractual breach, and the innocent party will be left to file a general unsecured claim for the amount of its damages. That means that the innocent party will collect only a portion of its damages, sharing any payout pro rata with all other unsecured claimants.

Usually, this means pennies on the dollar, or nothing at all. That is why an unsecured position is unfavorable. A secured position is more favorable and generally will produce a larger payment on a claim.

One good option for obtaining secured status is through statutory liens such as construction liens. When state law allows the creation of liens for work performed or goods provided, the Bankruptcy Code allows creation and perfection of those liens even after the bankruptcy filing imposes an automatic stay. The law regarding such liens varies from state to state, and an attorney can help determine which types of statutory liens are available and whether they may be perfected after the bankruptcy filing.

A bankruptcy filing can complicate a business relationship, but it does not always disrupt it. Key issues to watch for include recent payments received from the debtor, any ongoing attempts to collect money from the debtor, any active contracts with the debtor, and any opportunities to obtain statutory liens to secure money owed by the debtor.

Peenesh Shah is an attorney in the Portland, Ore., office of Schwabe, Williamson & Wyatt. He focuses his practice in the areas of bankruptcy and creditor’s rights, commercial litigation, and corporate insolvency and restructuring.