When a Sub-Tier Files for Bankruptcy

Though bankruptcy is somewhat “sacred,” it is not beyond comprehension.

By Anthony D. Whitley

The American author John Updike once said, “Bankruptcy is a sacred state, a condition beyond conditions, as theologians might say, and attempts to investigate it are necessarily obscene, like spiritualism.” While Updike provided poetic commentary on the sanctity of bankruptcy, our intent is to investigate it from a practical perspective on projects dealing with a sub-tier’s bankruptcy.

Anthony Whitley, an attorney with Ford, Nassen & Baldwin (fordnassen.com) in Dallas, focuses his practice on construction law. He may be reached at 214-523-5132.

Automatic Stay Once a debtor files for bankruptcy, certain actions against the debtor or its property based on events arising prior to the date of bankruptcy are stayed, including: lawsuits; enforcement of judgments; actions to obtain possession of the debtor’s property; set-off, or “back-charge,” against monies owed to the debtor; actions to collect a debt against the debtor; and any act to create, perfect or enforce a lien against the debtor’s property. The Bankruptcy Code carves out an exception for mechanic’s liens, allowing the perfection after the filing of the petition for bankruptcy. Any attempt to foreclose on the claim is forbidden.

Understanding what belongs to the estate is first. A contractor must know if the debtor owes it monies or damages. Real and personal property in the debtor’s name are property of the estate and the Bankruptcy Code prohibits any action to recover damages against such property. A payment or performance bond issued by a surety naming the debtor as the principal is not property of the estate, so claimants can sue the surety on such bonds without violating the automatic stay.

A Cause for Termination? Often, contractors insert provisions in their subcontracts that allow the contractor to terminate the subcontract should the subcontractor become insolvent or file for bankruptcy protection. Such provisions are unenforceable. They may hamper a debtor’s ability to reorganize or continue performing under the contract. Even with cause to terminate, the stay prevents any unilateral act against the property of the estate, so the contractor must petition the court for relief from the automatic stay.

Ongoing ContractsCourts, for the most part, will be sensitive to a contractor’s rights to receive the benefit of its bargain under a subcontract that is ongoing when a bankruptcy petition is filed. The Code requires the debtor or trustee to assume, assign or reject the subcontract. If the debtor was in default at the time it filed, it will have to cure the default at the time it assumes the contract.

It may take a while for the debtor to decide which contracts it wants to assume or reject. Project schedules do not account for such time, so the contractor is often left with two options. The first assumes the parties want to maintain the relationship under the subcontract, and the contractor allows the debtor to continue performing while waiting for the debtor to obtain court approval to assume the contract. This is risky. If the debtor later rejects the contract or defaults and causes the contractor damages, the contractor is relegated to an unsecured creditor and all other pre-bankruptcy creditors.

The better option involves requesting the court’s approval of the assumption, assignment or rejection of the contract. A compelling reason may be needed to explain why the debtor should make its decision sooner, since the purpose of a bankruptcy and the automatic stay is to provide breathing room for the debtor. However, the nature, and state of the project and the potential for damages to the contractor and other third parties, and the possibility that the value of the subcontract, and therefore the estate, may be reduced are reasons a court may consider in the assumption or rejection of a contract.

The Texas Trust Fund Statute Affect This Act requires contractors and owners to first use monies received on a construction project to pay for material and labor on that project before using the monies for other purposes. A contractor owing money to a debtor in bankruptcy should take great care in how it disburses money to the debtor or trustee. If the subcontract contains language establishing a trust fund, courts have held that such funds are no longer property of the estate. In either case, a contractor should seek guidance from the court as to whom it should pay subcontract proceeds, either by motion or by an adversary proceeding in the bankruptcy case.