TRANSACTIONAL: Bankruptcy: Contractor Insolvency Issues in Large Project Transactions

by King & Spalding

An issue that is often overlooked, but should be considered in the context of large project transactions, is the potential insolvency of contractors and subcontractors. A bankruptcy proceeding involving a key contractor can cause headaches and costly delays, particularly if title to goods or work completed has not been transferred to a project owner. Accordingly, anticipating these types of issues and accounting for them in negotiating construction and supply contracts is an important step in any large project transaction.

The timing of when title to work is transferred from a vendor or contractor to the project owner is an important consideration in mitigating insolvency risk. In a situation where a contractor files for bankruptcy (the “debtor”), whether title to the work was transferred prior to the filing date impacts the debtor’s interest in the property and the rights that may be exercised by each party. Upon filing a bankruptcy petition, “all legal or equitable interests of the debtor in property” as of that date become “property of the estate.” [1] In addition, an automatic stay takes effect, prohibiting the exercise of most remedies against the debtor. [2]

If the project owner takes title to work prior to the bankruptcy petition date, under applicable state property law and the United States Bankruptcy Code, the work will typically not be deemed property of the bankruptcy estate. As a result, the project owner may avoid a number of potentially difficult issues. Conversely, if the project owner has not taken title to work prior to the petition date, then the following issues may arise: (i) the work will be subject to the automatic stay and, potentially, claims of other parties, including secured creditors, with consensual or non-consensual liens, like mechanic’s and materialman’s liens; (ii) the automatic stay could prevent the project owner from accessing the work or taking actions such as removing component parts or hiring replacement contractors; and (iii) the bankrupt party may “reject” the contract and cease performance prior to any transfer of title of the work to the project owner.

Under the first concern, unpaid subcontractors may assert their state law lien rights against the work. In Texas, for example, these state law rights may include a mechanic and materialman’s lien that has priority to other liens. [3] If the subcontractor can establish that it supplied materials that can be removed from the work without material injury to the work, the land, or the materials themselves, its mechanic and materialman’s lien is superior to other liens and could result in the subcontractor removing its materials from the work.

Under the second concern, the project owner who is prevented by the automatic stay from accessing the work or taking other actions with respect to the project, would have to obtain relief from the automatic stay by filing a motion with the bankruptcy court. Such motions can be expensive to prosecute and are subject to a “for cause” standard that makes the probability of success hard to predict. [4]

Finally, in the third issue raised, the bankrupt entity has a statutory right either to assume or reject the construction or supply contract as an “executory contract.” [5] The bankruptcy court’s review of the debtor’s decision to assume or reject is highly deferential to the debtor, and is premised on the business judgment rule. [6] Depending on the factual circumstances, the project owner’s interest may be either in favor of assumption or rejection—but the decision is left in the hands of the bankrupt contractor. In a Chapter 11 case, the debtor is not obligated to assume or reject many executory contracts prior to confirmation of the plan. While the project owner could move the court to compel the debtor to make a decision on assumption or rejection, such relief is considered on its own factual circumstances, often in a light most favorable to the debtor.

During the time prior to assumption or rejection, if the bankrupt is able to convince the bankruptcy court that it can complete performance under the contract, the project owner cannot terminate the contract based on a pre-petition breach or the fact that the contractor filed bankruptcy. Additionally, the contractor might even be allowed to assign the construction contract to a third party even if the contract prohibits such assignment. [7] The contractor would have to provide adequate assurance of the assignee’s ability to perform under the contract, but the project owner’s consent to the assignment might not be required.

In sum, the bankruptcy considerations of whether to take title to the work “early” or “late” suggest that early delivery of title, for a number of reasons, may be preferable in the context of a contractor bankruptcy filing. The later the project owner takes title, the greater the risk of being faced with the various bankruptcy issues set forth above. While other factors, such as tax or liability issues, may influence the analysis a different way, the ability to avoid the pitfalls and delays occasioned by a bankruptcy of a contractor or other contract party is worth serious consideration.

[1] 11 U.S.C. § 541.
[2] 11 U.S.C. § 362.
[3] See Tex. Prop. Code § 53.021.
[4] 11 U.S.C. § 362(d)(1).
[5] 11 U.S.C. § 365(a).
[6] Id.
[7] 11 U.S.C. § 365(f).

Mark W. Wege
+1 713 751 3246

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Eric M. English
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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