As the structure of the U.S. economy changes in response to COVID-19, many bankruptcy filings are affecting the construction industry. At its core, federal bankruptcy laws are about debtor rehabilitation and fair and efficient treatment of the debtors’ liabilities. However, often those doing business with a company that declares bankruptcy are left by the wayside due to the hurdles and confusing procedure that accompanies a bankruptcy.
Most of the literature on this topic is “debtor focused,” meaning that it explains what to do to prepare if your company is filing bankruptcy. However, there is little practical guidance for contractors that are financially healthy but face a situation in which a customer, subcontractor, or vendor is entering bankruptcy. Completing a project on time while one of your vendors or subcontractors has just entered bankruptcy can be tricky for contractors that do not know the bankruptcy rules.
This article offers a practical explanation of how bankruptcies work, what common pitfalls arise for contractors if their customer or vendor enters bankruptcy, and how to handle these situations quickly and efficiently. It will also provide practical considerations and an understanding of bankruptcy in general terms. However, be mindful that there is usually a substantial interplay between bankruptcy law and substantive state law on issues that vary by jurisdiction (e.g., commercial and contract law, mechanic’s liens, and claims against company management). Be sure to check with your legal counsel on matters discussed in this article.
Automatic Stay
When a bankruptcy is filed, much of the debtor’s world comes to a halt, and an orderly process is attempted to address the debtor’s obligations in a way that preserves the value of the debtor’s business or assets. Thus, a bankruptcy automatic stay, which has the force of a federal court order, prevents creditors from engaging in collection actions or lawsuits against the debtor, contract terminations, and any actions that may be adverse to the property of the bankruptcy estate.1 It even prevents mechanic’s liens from being filed in certain states.2 For example, according to In re Draper, sending informational invoices with a return payment envelope is a violation of the automatic stay.3
In the normal creditor-debtor scenario, the automatic stay is an inconvenience and one of many disappointing events in a commercial relationship in which one party has performed its obligations and the other party has not. But, in construction, consequences may be more urgent. You may have performance obligations on an existing construction project, face delays as well as liquidated damages, experience shortages in available labor or material, or encounter work orders that have a long lead time. Finding out that one of your project partners is not going to perform requires a swift response.
Bankruptcy Basics
When a debtor files for bankruptcy under the Bankruptcy Code, it chooses between reorganization (Chapter 11) and liquidation (Chapter 7). In a reorganization, the debtor’s management usually stays in control of the business. They are given time to propose a plan that would allow the bankruptcy debtor to pay certain minimum thresholds to its creditors. The company would then emerge from the bankruptcy as a reorganized company that is unburdened by many of the pre-filing obligations. In a liquidation, a bankruptcy “trustee” is appointed by the court to sell and distribute all assets of a company to creditors.4
This distinction is important if you have contracts with a bankrupt entity; usually, if the debtor is attempting to reorganize, then it will have some plans in place to continue performing under its contracts. After all, what will be left to reorganize if the debtor loses the confidence and trust of all of its customers and key vendors during the bankruptcy process? In a liquidation, the motives and interests of the debtor are not as much about preserving a future business as they are about an orderly wind-down.
However, not all Chapter 11 filings have a reasonable hope of successful reorganization. Because an “11” can always be later converted to a “7,” it is not unusual that a case may be filed as an “11” merely for the added benefit that the debtor stays on as management for the initial stages of the bankruptcy. Owners of construction companies have a business concern that most other business owners do not have — personal liability in the form of an indemnity (or personal guarantee) on their performance and payment bonds and perhaps some of their supplier agreements. There are benefits to company owners staying on as management through the initial stages of a bankruptcy — some of which have nothing to do with the actual reorganization.
First Day Filings/Schedule of Assets & Liabilities
The first day of a bankruptcy is often the most telling in terms of assessing the debtor’s intentions toward pre-petition obligations. A well-organized set of bankruptcy filings is an indication that the debtor will truly reorganize. A “crash landing” filing that lacks any indication of advance planning likely signifies no real path toward reorganization, even if the debtor commences the proceeding as a Chapter 11 reorganization.
Exhibit 1 presents some common and useful examples of what may be included in first day filings and what that tells about the debtor’s plans.
Supplementing, Descoping, or Back Charging a Non-Performing Bankruptcy Debtor
The fact that a debtor files bankruptcy is not grounds to terminate a contract, regardless of your contract terms.5 With that being said, construction contracts typically provide rights to supplement, accelerate, and issue change directives, including the right to “descope” a lower-tier contractor. These provisions generally survive a bankruptcy filing, and a non-debtor is permitted to the benefit of contract terms that do not violate bankruptcy principles.
Violating the Automatic Stay
Typically, the mere act of supplementing or issuing a change directive will not violate the automatic stay. But be mindful of the fine line between continuing performance under a contract and taking actions that affect property of the bankruptcy of the estate in violation of the automatic stay.
For example, as displayed in In re Sixteen to One Mining Corp., the notice of default on a lease was not a violation of the automatic stay so long as it did not demand possession (9 B.R. 636 (Bankr. D. Nev. 1981)). Make sure to get the advice of legal counsel that understands bankruptcy and construction law so you don’t unintentionally violate the automatic stay.