Bankruptcy and Business Contracts: Effects on Existing Agreements
When a business declares bankruptcy, it not only affects its financial standing but also has significant implications for its existing contracts. Whether it's a supplier agreement, a lease, or a service contract, these legal obligations are often disrupted by the bankruptcy process. Understanding how bankruptcy affects existing business contracts is essential for both the party filing for bankruptcy and its business partners, as it determines the fate of their ongoing contractual obligations.
Types of Bankruptcy: Chapter 7 vs. Chapter 11
Before diving into how bankruptcy impacts contracts, it's important to distinguish between two common types of bankruptcy filings for businesses: Chapter 7 and Chapter 11.
Chapter 7 Bankruptcy involves liquidation. The business shuts down, and its assets are sold off to pay creditors. In this scenario, contracts are usually terminated or left unfulfilled, as the company ceases operations.
Chapter 11 Bankruptcy focuses on reorganization. The business continues to operate under court supervision while it restructures its debts and obligations. Contracts may be renegotiated or canceled as part of the restructuring process, but the business usually aims to maintain key relationships while becoming solvent again.
The Bankruptcy Code and Executory Contracts
One of the key concepts in bankruptcy law is the handling of executory contracts. An executory contract is one in which both parties still have significant, ongoing obligations to fulfill. For example, if a business has a multi-year service contract with a supplier, and both sides still have performance obligations, that contract is considered executory.
Under the U.S. Bankruptcy Code, a debtor in Chapter 11 has the power to either:
- Assume the contract, meaning the debtor will continue to fulfill the contractual obligations.
- Reject the contract, which essentially allows the debtor to cancel or terminate the agreement.
In Chapter 7, the trustee overseeing the liquidation decides whether to assume or reject contracts. If a contract is rejected, the non-debtor party may file a claim for damages, but it will likely be treated as an unsecured claim, which typically receives lower priority for repayment.
What Happens to Contracts During Bankruptcy?
Assumption of Contracts
- When a business undergoing Chapter 11 bankruptcy assumes a contract, it commits to fulfilling its obligations under the contract moving forward. This often involves "curing" any past defaults (e.g., paying overdue amounts) and providing adequate assurance that it can continue to meet future obligations.
- For the non-debtor party, this can mean that business continues as usual, with the possibility of renegotiating more favorable terms as part of the reorganization process.
Rejection of Contracts
- If a contract is rejected during bankruptcy, the debtor is essentially relieved of its future obligations under that agreement. The non-debtor party, in turn, has the right to file a claim for damages caused by the rejection of the contract.
- Importantly, any claim arising from the rejection of a contract is typically treated as an unsecured claim. This means that it falls behind secured claims (such as debts backed by collateral) and is often paid at a significantly reduced rate, if at all, during the bankruptcy process.
Automatic Stay and Contractual Actions
- When a business files for bankruptcy, an automatic stay goes into effect. This stay temporarily halts most actions against the debtor, including attempts to enforce contracts, collect debts, or repossess property. For business contracts, this means that the non-debtor party cannot immediately terminate the agreement or take legal action for non-performance due to the debtor's financial situation.
- The automatic stay provides the debtor with breathing room to assess its financial state, reorganize under Chapter 11, or prepare for liquidation under Chapter 7.
Intellectual Property Agreements
- Special rules apply to intellectual property (IP) contracts in bankruptcy. If a company rejects an IP contract during bankruptcy, the non-debtor party may choose to either terminate the agreement or continue to use the IP under the original contract terms, provided they meet their payment obligations. This is a unique provision designed to protect licensees who rely on intellectual property for their business operations.
Leases in Bankruptcy
- Leases, whether for real estate or equipment, are common types of executory contracts in bankruptcy. A debtor may assume or reject a lease depending on whether it's advantageous to continue using the leased property.
- If a lease is rejected, the landlord or lessor may file a claim for damages, which, again, will likely be treated as an unsecured claim. However, certain caps exist on claims for damages related to lease rejection, limiting how much a landlord can recover.
Impact on Non-Debtor Parties
Businesses that contract with a company going through bankruptcy may find themselves in a difficult position. Whether they are suppliers, customers, or service providers, their options are limited once bankruptcy is declared. Some key considerations for non-debtor parties include:
Increased Risk of Payment Delays: Even if a contract is assumed, payment delays are common as the bankrupt business reorganizes or secures financing. Non-debtor parties may need to negotiate payment schedules or other terms to ensure they are compensated.
Uncertainty About the Future of the Contract: Until a contract is assumed or rejected, the non-debtor party must continue fulfilling its obligations. For example, a supplier might still be required to deliver goods even if it's unclear whether the contract will be honored long-term. Breaching the contract during this period could open the supplier to liability.
Damages from Rejection Are Limited: If a contract is rejected, the non-debtor party is left with a claim for damages. However, because these claims are often treated as unsecured, the amount recovered might be only a fraction of the actual loss, especially in cases where the business's assets are insufficient to cover all claims.
Renegotiation Opportunities: On the positive side, bankruptcy can sometimes provide an opportunity for non-debtor parties to renegotiate more favorable contract terms. The debtor may be motivated to maintain key business relationships and could offer better payment terms or concessions as part of the reorganization process.
Conclusion
The intersection of bankruptcy and business contracts creates a complex landscape for both debtors and their contractual partners. For the business filing for bankruptcy, the ability to assume or reject contracts is a powerful tool that can help facilitate restructuring efforts or the orderly liquidation of assets. For the non-debtor party, the process involves a delicate balance between risk mitigation and maintaining business continuity.
Understanding the rights and obligations under bankruptcy law can help businesses navigate this uncertain terrain, protecting their interests while finding ways to work with financially distressed partners. Whether you are a debtor seeking to reorganize or a business partner with contractual ties to a struggling company, knowing the rules of bankruptcy can make the difference between recovering your investment and facing a significant financial loss
