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Potential Issues Faced by General Contractors when a Subcontractor Files for Bankruptcy

Bankruptcy is governed by Federal law.  The goal is to treat similarly-situated creditors equally so that one is not treated better than another.  This is achieved either through liquidation of the debtor’s assets or by a plan of reorganization negotiated with the creditors, under which the debtor continues operating.

TYPES OF BANKRUPTCY:

A general contractor faced with subcontractor’s bankruptcy filing will be involved in a Chapter 7 or Chapter 11 case.  A Chapter 7 case is the easiest:  Chapter 7 is a straight liquidation.  At the outset, an interim trustee will be appointed.  If no trustee is elected by the creditor body at the first meeting of creditors, the interim trustee will “succeed” as permanent trustee for the case.

A Chapter 7 trustee’s duties are simple:  gather all the assets of the debtor, liquidate them into cash, and, if there are sufficient funds available, distribute those funds to the creditors according to the priority scheme in the Bankruptcy Code.

A Chapter 11 is a reorganization of the business with the intent to preserve the economic value of the business as a going concern, in order to provide greater returns to creditors than a trustee’s rapid sale of assets for cash.  Implicit in Chapter 11 is the idea that the debtor and creditors will negotiate terms of how the creditors’ claims will be treated.  A debtor operating in a chapter 11 is referred to as a “debtor-in-possession.”  With certain exceptions, a debtor-in-possession has all the rights, powers, and duties, and is required to perform all of the functions, of a bankruptcy trustee.  11 U.S.C. § 1107(a).

In a Chapter 11, existing management of a debtor-in-possession will maintain control, unless the Bankruptcy Court appoints a trustee for “cause.”  Appointment of a Chapter 11 trustee is an unusual remedy, generally due to malfeasance of the debtor’s management.  “Cause” includes “fraud, dishonesty, incompetence or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause.”  11 U.S.C. § 1104(a)(1).  In addition, a trustee can be appointed if the court determines that doing so is “in the best interests of creditors, any equity security holders, and other interests of the estate.”  11 U.S.C. § 1104(a)(2).  In practice, courts generally find that it is in the best interests of creditors to allow existing management, which is experienced and familiar with the debtor’s operations and needs, to continue in place.

AUTOMATIC STAY ISSUES:

The automatic stay is a powerful protection against diminution in value of the debtor’s estate.  The filing of a bankruptcy petition acts as an immediate stay, applicable to all entities, of any attempt to collect or enforce a debt.  It also stops attempts to enforce termination provisions of subcontracts.  In the middle of a construction project, it may be crucial for a general contractor to replace a subcontractor in order to finish a project within the time frame called for by the contract.  The general contractor must take immediate action to protect its right to terminate the subcontract and to replace the debtor subcontractor with another subcontractor.  This can be done one of two ways:  a motion to compel the debtor to reject the subcontract (discussed below), or a motion for relief from the automatic stay.  The facts that justify the court’s entry of an order granting relief from the automatic stay are basically the same as those that must be proved in order to obtain an order compelling the debtor’s rejection of the subcontract.  The motion for relief from stay may be quicker, since the Bankruptcy Code contains strict requirements for scheduling hearings on relief from stay motions within 30 days of the date the motion is filed, 11 U.S.C § 362(e)(1), and requires that relief from stay motions must be decided within 60 days of the filing of a motion for relief from the stay, 11 U.S.C. § 362(e)(2)(B)(i), unless that period is extended either by agreement of the parties or by order of the court.  To extend the stay beyond the 60-day period, the court must set a specific time, and set forth good cause for the extension in findings made by the court.  11 U.S.C. § 362(e)(2)(B)(ii).

ASSUMPTION/REJECTION ISSUES:

A construction subcontract is an “executory contract.”  This simply means that the contract is not completely fulfilled; that there is some performance due under the contract by either or both parties.  The Bankruptcy Code permits a trustee or debtor-in-possession to assume or reject an executory contract.  In a Chapter 7, the trustee must assume an executory contract within 60 days of the date of the order for relief (usually the date the bankruptcy case is filed, but may be later in an involuntary case filed by creditors against the debtor).  11 U.S.C. §365(d)(1).  In a Chapter 11, the debtor-in-possession or trustee has until the confirmation of a Chapter 11 plan to assume an executory contract, but the court may, upon request of any party to the contract, direct the debtor-in-possession or trustee to make the decision to assume or reject within a specified period of time.  11 U.S.C. § 365(d)(2).

Many construction contracts contain clauses by which the contractor may terminate the contract if the subcontractor becomes insolvent or files a bankruptcy petition.  If this right has not been exercised prior to the filing of the bankruptcy petition, it may not be exercised after.  The Bankruptcy Code prohibits the enforcement of such provisions.  11 U.S.C. § 365(e)(1)(B).

PREFERENTIAL TRANSFER ISSUES:

Under the Bankruptcy Code, payments made to creditors within the 90-day period before a bankruptcy is filed can be recovered from the payee and included in the bankruptcy estate.  11 U.S.C. § 547. General contractors must be aware of this threat and make preparations immediately upon becoming aware of a subcontractor’s bankruptcy.  In a subcontractor’s bankruptcy, this doesn’t usually apply to the general contractor, as the general contractor is usually paying the subcontractor.  But, for example, if the general contractor has requested reimbursement of a prior overpayment and received that reimbursement within the 90-day period prior to the subcontractor’s bankruptcy filing, the payment may be at risk.

CLAIMS ISSUES:

If there will be a distribution to creditors in a Chapter 7 case, the trustee will request that the court set a deadline for filing claims.  The court or trustee will send out notices of the deadline.  While the general practice in Chapter 7 cases is that the court’s Notice of Bankruptcy Filing form will tell creditors not to file a proof of claim until a notice of claim deadline is received, prudent practice suggests that a claim be filed in the case as soon as notice of a bankruptcy filing is received.  While a filed claim can always be amended to reflect corrected amounts owed, a late-filed claim almost certainly precludes a creditor’s participation in distributions by a trustee or under a Chapter 11 plan.  The risk to creditors is that a notice of claims deadline received many months after the bankruptcy case is filed may be overlooked or ignored, especially because the creditor may have been receiving numerous notices in the case that do not directly affect the creditor and the creditor’s mail-review persons may have gotten in the habit of ignoring notices in the case.

By: Mark Moburg

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