By: Martha B. Chovanes, Partner, and Laurie A. Stanziale, Partner, Fox Rothschild LLP.
August 16, 2022

While contractor bankruptcies have long been an issue in the construction industry, in the aftermath of COVID-19 and the resultant labor, material and supply-chain delays, contractor bankruptcies are of even greater concern. Many construction contracts attempt to protect the upstream party from a bankruptcy filing of its contractor or subcontractor by providing for an automatic right to terminate a contract, referred to as “ipso facto” clauses.  However, such clauses are generally unenforceable as bankruptcy laws, specifically Section 365(e) of Title 11 of the United States Code, protect the party filing for bankruptcy (the “Debtor”) from unilateral termination of the contract by the non-Debtor party.

What is an “Ipso Facto” clause?  An ipso facto clause is a provision in an agreement which permits its termination by one party due to the bankruptcy, insolvency or financial condition of the other party.

Bankruptcy Code section 365(e)(1) prohibits enforcement of ipso facto clauses in executory contracts and unexpired leases[1] and provides as follows:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

11 U.S.C. § 365(e)(1).

The purpose behind 365(e) and disallowing automatic termination of contracts is that defaults contemplated by ipso facto provisions are usually impossible to cure; a Debtor cannot easily cure insolvency, the filing of a bankruptcy case, or an assignment for the benefit of creditors. Enforcement of ipso facto clauses would mean that the Debtor or trustee could almost never assume ongoing contracts or leases which would prevent Debtors from performing under beneficial contracts that otherwise would have terminated automatically or would have been terminated by the other contracting party. Enforcement of ipso facto clauses therefore undermines public policy promoting Debtor rehabilitation. Thus, the general rule against the enforceability of ipso facto clauses protects Debtors, and by extension, their creditors.

Although it is relatively common for a construction contract to contain an ipso facto clause, unbeknownst to many, you cannot rely on the ipso facto clause in the contract to terminate the contract of a Debtor once it has filed for bankruptcy protection. Any unilateral termination of the contract is a violation of the automatic bankruptcy stay of section 362(a). The automatic bankruptcy stay prohibits actions against the bankruptcy estate, including actions to collect against the Debtor or to recover property of the Debtor, and halts any previously filed lawsuits and collection actions against the Debtor. With certain exceptions not generally relevant in the construction industry context, no action can be taken against the Debtor without bankruptcy court approval. In fact, any violation of the stay, especially a knowing violation, may result in a significant monetary penalty to the party who ignores the stay.  You can, however, seek bankruptcy authorization to terminate the contract, which is discussed below.

The ConsensusDocs 200 Standard Agreement and General Conditions Between Owner and Constructor attempts to properly address a bankruptcy filing and states in Section 11.3.3:

If Constructor files a petition under the Bankruptcy Code, this Agreement shall terminate if: (a) Constructor or Constructor’s trustee rejects the Agreement; (b) a default occurred and Constructor is unable to give adequate assurance of required performance; or (c) Constructor is otherwise unable to comply with the requirements for assuming this Agreement under the applicable provisions of the Bankruptcy Code.

Section 10.2.1 in the ConsensusDocs 750 (Standard Agreement Between Constructor and Subcontractor) reads the same as the 200 Document.

Subsections (a) and (c) above accurately describe how the Bankruptcy Code would apply as discussed further below but subsection (b) above is a little unclear and could be unenforceable as it does not describe the nature of the default and the connection to the Bankruptcy proceeding.

How can you avoid the aforesaid bankruptcy scenario? And, if you find yourself in this scenario what can you do?

Prior to the Debtor’s bankruptcy

Ask for and assess the financial statements and condition of the contractor or subcontractor prior to executing a contract and ask for periodic updates. During a significant project with a long project schedule, the financial health of the downstream party may change through the project term and requesting periodic financial information is recommended.

Confirm that the downstream party is making timely payments to its subcontractors, sub-subcontractors and suppliers during the project. Obtaining lien waivers and/or paid receipts with each requisition for the prior payment application is helpful to make sure the downstream party is not experiencing financial hardships and “borrowing”, albeit improperly, the upstream party’s funds for other projects and operating expenses to stay afloat.

Your contract should also prevent the assignment of receivables to a factor or other party.   Learning of such an assignment, whether permitted by the contract or not, is generally a sign of financial hardship and an indication that the contract counterparty has diminished liquidity.

In the event financial strains become evident, exercising a right to terminate the contract before a bankruptcy filing is the best way to avoid the bankruptcy stay. The contract may (and should) contain a right to terminate for convenience and/or a right to terminate if there is evidence of financial instability and/or failure to make timely payments to downstream parties.

Protecting the non-Debtor after the Debtor Files for Bankruptcy Protection

The Automatic Stay

Once the Debtor has filed for bankruptcy, which invokes the automatic stay of section 362, any termination rights (whether for convenience or cause) will be unavailable to the non-Debtor without the approval of the Bankruptcy Court.  Further, in a Chapter 11 case, the Bankruptcy Court will rarely require a Debtor to decide to assume or reject a contract early in the case because it is assumed that a Debtor needs time to determine how it will reorganize and whether its various executory contracts are a benefit or a burden to the Debtor.

In a Chapter 7 case, the Chapter 7 trustee may assume or reject executory contracts.  However, the trustee is required to assume or reject an executory contract within 60 days after the order for relief is entered (usually the date of the filing of the voluntary bankruptcy petition) or such additional time as the court allows, or it is deemed rejected.

The Debtor’s Schedules

As a first step, the non-Debtor should check to see if its contract with the Debtor is listed in the Debtor’s schedules as a creditor or an executory contract counterparty. If the contract does not appear, this may have been an intentional, although improper, omission on the Debtor’s part.  Sometimes Debtors do this if they are seeking to perform the contract work under a different company name. In such instance, it would be risky to engage with a “new” Debtor affiliated company to do the work and that ‘new” party is not the counterparty to the original contract.  Further, a newly formed company may not be bondable or be able to obtain proper insurance and licenses required for the work. Contacting counsel for the Debtor and finding out why the company and the agreement are not listed on the Schedules is a recommended course of action.

Proof of Claim           

Regardless of whether the debt owed is listed on the Schedules, the non-Debtor should file a proof of claim, with support, if the Debtor owes you money under the contract because of overpayment, failure of the Debtor to pay subcontractors or suppliers with the non-Debtor’s funds and/or defective work that requires the non-Debtor to hire someone else to repair/replace. The Bankruptcy Court will set a deadline for filing proofs of claim, but it is always best to file as soon as possible to not miss the deadline, even if the full amount of the claim is not known, as the claim can be amended.

Rejection of the Contract

If desired, reach out to the Debtor to seek rejection of the Contract. If the Debtor agrees, the rejection can be achieved by stipulation between the Debtor and the creditor, which should be submitted to the Bankruptcy Court for approval. Once approved, the non-Debtor would then be able to contract with a different contractor/subcontractor to complete the outstanding work of the rejected contract. If the Debtor will not agree to terminate the contract and takes no action to assume or reject it, the non-Debtor may also file a motion with the Bankruptcy Court to require the Debtor to assume or reject the contract. However, as noted above, the Court is likely to grant the Debtor a significant amount of time to determine whether to assume or reject the contract, so such a motion should not be filed at the beginning of the Chapter 11 case.

Joint Checks

If monies are owed to the Debtor at the time of the bankruptcy, ask the Debtor to agree to allow payment via joint checks payable to the Debtor and its subcontractors or suppliers to ensure that all parties are being paid.

In sum, best practices to consider:

  • Vet the downstream party’s financial health prior to executing the contract and throughout the project
  • Include contract language that allows for termination for convenience and/or termination for evidence of financial weakness (and not just the filing of bankruptcy) and consider termination of the contract if the counterparty has financial concerns prior to bankruptcy filing
  • If the contractor files for bankruptcy, take prompt action to determine whether your contract is listed on the Schedules; file your proof of claim if you are owed money or expect to have any damages, and determine whether the contract will be assumed or rejected.

[1] An executory contract is a contract under which unperformed obligations remain on both sides..

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The  views expressed in this article are not necessarily those of ConsensusDocs. Readers should not take or refrain from taking any action based on any information without first seeking legal advice