Dealing with third-party bankruptcy?

April 3, 2012
So let's review some of the more important things to keep in mind if a company you are dealing with files for bankruptcy.

Sometimes companies just go out of business. This is rarely a good thing, but it is easily understood. So are your options for dealing with this situation if the unlucky company is a customer or supplier. Not so when a company files for bankruptcy. Then the rules change.  Federal bankruptcy law takes over. And, if you aren’t careful, you can get yourself or your company into serious trouble. So let's review some of the more important things to keep in mind if a company you are dealing with files for bankruptcy.

The first thing to remember is that as of the moment of filing everything stops, or is supposed to stop by law. The federal bankruptcy law imposes what is known as the Automatic Stay, which freezes everything in the position it was as of the time of filing. The Automatic Stay is taken very seriously, and any action taken that violates it is punishable by stiff fines, which bankruptcy courts are not at all hesitant to impose. This means, for example, you can get in trouble for trying to enforce a contract with a party in bankruptcy unless you have received permission from the bankruptcy court.

Many people think that until they get an official notice from the bankruptcy court, they can continue to take steps to protect their interests. This is not correct. If you are aware that someone has filed you are considered bound even without official notice, and will be subject to those penalties mentioned above if you don't get court permission before acting. So if you hear that a company you are doing business with has filed bankruptcy, you better confirm whether this is true or not before you attempt any further business with that company.

If it turns out to be true, the company that filed bankruptcy (also called the debtor) may no longer have any say in what happens to your contract or business relationship. This is because a trustee is usually appointed to collect the assets and pay the bills of the debtor. Sometimes this person can be the debtor itself (called a debtor in possession "DIP"), but not always. Either way, everything the trustee or DIP does with the bankrupt still has to have approval of the bankruptcy court. You cannot take the word of the debtor that anything is or is not possible without also getting court approval.

The situation can get quite complicated if you have an ongoing, or executory, contract with a company in bankruptcy because it can't be simply cancelled. An executory contract is one that has not yet been fully performed, and the bankruptcy law says that the debtor's right to perform that contract is an asset of the bankruptcy estate that can't be taken away without the court's permission. The result of this rule is often extremely harsh on contractors. Of course, in order to hold onto the contract, the DIP or trustee will have to be able to prove that the debtor is capable of curing past defaults and performing as called for in the contract (which is generally unlikely, or the firm wouldn't be in bankruptcy), but the process can take a long time. Before a bankruptcy is filed, however, you are free to terminate contracts (provided that you otherwise have the right to do so), so it is very important to verify whether someone has actually filed. 

Keep in mind that the courts make a distinction between payments on account and actual purchase of goods. If you have bought specific items that can be identified by serial number or markings, you can (with court permission) take possession of them. If you have just made payments but don't yet "own" specific goods, you will be considered as just another creditor, in line to receive your portion of any assets left of the bankrupt company. For this reason, it really helps to have a bill of sale showing that title to equipment has transferred to you, and a means of identifying that equipment.          

Perhaps the most costly impact to doing business with a company that files bankruptcy is the risk of having to return payments you received for your work or products.  This happens because it is common for people on the brink of financial disaster to pay off some debts and not others – to repay family members or loans that they have personally guaranteed, for example. To assure that all creditors are treated fairly, the bankruptcy code says that all payments on past debts made within 90 days of filling bankruptcy are improper "preferences," which have to be returned to the bankruptcy estate.  The nit may or may not be returned to you; and if it is returned, expect only pennies on a dollar. For this reason, it is important to keep accounts current.

Timing is also a concern. While bankruptcy proceedings often drag on for many years, it is possible to get emergency hearings and expedited relief. An experienced bankruptcy lawyer who understands construction can often get hearing to "lift" the Automatic Stay and allow a contract to be rejected by the court (allowing you to terminate it and move forward) within a few days of filing. It is absolutely worth it to find the right lawyer to represent you in such a situation.

The most important thing to remember about bankruptcy is to be vigilant. If you encounter a situation where a company you conduct business with files for bankruptcy, you need to get expert advice as soon as possible to minimize the impact on your company.

Michael Callahan is a partner at Stinson Morrison Hecker LLP (the same firm as long-time columnist Susan McGreevy) where he assists clients with all aspects of their construction law needs, including litigation. Contact him at [email protected].

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