Coping with the Insolvent Business Partner

Joint ventures and other modern forms of strategic partnerships have been criticized lately in the business media as being difficult to manage and ultimately difficult to unwind. In this age of constant change, the synergies obvious one year often become unfavorable "ties that bind" the following year. And the financial failure of the venture adds insult to injury and poses challenging legal issues and potential liability to the non-bankrupt partner. Understanding what the failing enterprise can do to its customers, partners and owners in the event of a Chapter 11 filing will provide these innocent parties the knowledge to effectively negotiate with the debtor before a filing and enable the innocents to best cope if and when the bankruptcy is eventually filed.

The Nature of the Problem

An insolvent business partner may default on its obligations and leave the solvent business partner (SVP) with unexpected losses, and creditors and others blaming the company for their losses. Even the perception or threat of a Chapter 11 filing can cause lasting damage to a business venture and all those associated with it.

In order to effectively evaluate the impact of a possible Chapter 11 filing by a co-venturor of a joint venture, it is critical to first obtain as much information as possible, financial and otherwise, as soon as you believe a bankruptcy filing is possible. Depending upon the exact type of relationship, i.e. a joint venture, subcontract or partnership, the SVP may be able to take steps, both before and after any bankruptcy filing, to protect its economic interests in an effort to maximize the value of the investment and preserve business relationships. Factors such as the level of financial distress, the relative size of the business and the extent of the other contracts or investments with the troubled company can affect the appropriate course of action.

Any due diligence performed at the inception of a business venture will become stale or otherwise unreliable over time. Thus, it is imperative to gather as much information as possible upon learning of a business partner's distress. Among the relevant information is whether your company has other contracts or relationships with the failing entity. Additional business relationships may provide leverage both before and after a bankruptcy filing and enhance the prospects for an optimal result from the otherwise bleak situation. Indeed, distressed businesses are often deluged with demands from various parties and usually only pay attention to their most demanding and important business partners. In addition, other business partners of the potential debtor may be willing to share information regarding the distressed company. Even knowing who these business partners are and the extent of their relationships with the debtor can be important in formulating an effective strategy.

After conducting this early investigation, the next step is to formulate a plan of action. If the failing enterprise is cooperative, one of the best possible steps may be to restructure the transaction to avoid a bankruptcy filing or so that a bankruptcy filing is less damaging. Workout agreements, also known as voluntary restructures, are useful tools in preserving business relationships and can often reduce or eliminate the need for bankruptcy. Indeed, the entire purpose of a voluntary restructure or workout is to avoid a bankruptcy filing. However, there are certain limits to what can be accomplished in a workout agreement, and certain transactions can be later set aside by the bankruptcy court. Prior to any course of action, it is important to identify your maximum exposure and any previously paid costs so that resources are not expended unnecessarily. Fully appreciating the maximum exposure and how the claim may be impacted by a bankruptcy filing provides the SVP with the overall framework of any workout agreement and should establish the boundaries for any course of action.

Armed with as much information as possible and a frank understanding of the nationwide injunction that issues automatically when a bankruptcy is filed, SVPs are able to navigate the hedgerow of a business reorganization under the Bankruptcy Code to limit exposure and enhance the prospects of preserving value. Dealing with bankrupt business partners and knowing when contracts have to be honored irrespective of a bankruptcy filing can prevent the SVP of being accused of a breach of contract and may be used to elevate certain contracts to critical and administrative status. Knowing your solvent business's exposure to not only the liquidated losses, but also for any potential new liability, provides essential insight on how to manage a financial disaster. Keeping abreast of the debtor's reorganization efforts and possible distressed assets sales also enables the SVP to gauge its conduct and may provide a means to capitalize on the bankruptcy of the former business partner.

The filing of a bankruptcy petition triggers what is referred to as the "automatic stay," which is a nationwide injunction that prohibits certain actions, including any actions by a creditor to collect on pre-petition amounts owed by the debtor. SVPs should also be aware of the restrictions imposed by the automatic stay and the consequences that can result from violation of the same. Violation of the automatic stay can result in sanctions, including punitive damages in the more egregious cases. Accordingly, routine attempts by a creditor to collect on a pre-petition debt must cease once the bankruptcy petition has been filed. In certain circumstances, however, a creditor may petition the court to have the stay lifted to permit such creditor to exercise its rights. The Bankruptcy Code provides for the lifting of the automatic stay for "cause" or in cases where the debtor has no interest in the property at issue and such property is not necessary for an effective reorganization.

In connection with the assessment of their rights and obligations surrounding the automatic stay, creditors should also consider their rights of setoff immediately upon learning of a bankruptcy filing by one of their business partners. Setoff involves a creditor's right, arising under nonbankruptcy law, to "setoff" debts owed between the debtor and creditor. The debts must be mutual, i.e., both due and owing pre-or post-petition. While the automatic stay initially prohibits a creditor from enforcing its right of setoff, creditors can petition the court for relief from the automatic stay in order to enforce their setoff rights. In the interim, the SVP may place an administrative freeze on the payment of any amounts due to the debtor that the creditor reasonably believes are subject to setoff as long as court approval of the setoff is sought promptly. Recognition and enforcement of setoff rights enable creditors to recover a greater percentage of their claims, and thus such rights should be vigorously pursued.

Executory Contracts

One of the most common business relationships one might have with a bankrupt party is by contract or subcontract. Upon a bankruptcy filing, certain rules come into play with respect to the debtor's contracts and leases. Parties to leases or executory contracts with the debtor may be able to force the non-debtor party to adhere to such contracts. As a general rule, the non-debtor party is required under the Bankruptcy Code to continue performance under the contract notwithstanding the debtor's pre-petition failure to make payment on that contract. A debtor has 120 days from the petition date to decide whether to assume (retain post petition) or reject (breach or disavow) its leases of real property. The bankruptcy court may extend this deadline only once for a period of 90 days, unless the commercial landlord agrees to further extensions. The debtor typically has until confirmation of a reorganization plan to assume or reject other contracts or residential leases, and this is where the problem arises for the SVP who has a pre-petition contract (other than a commercial lease) with the debtor. Because confirmation of a plan (and the debtor's deadline to make a business decision on the executory contract that the SVP is obligated to continue to perform under) may take months or years, creditors should request that the bankruptcy court order the debtor to render its decision on a particular executory contract ahead of this amorphous and attenuated deadline. The debtor must assume or reject contracts in their entirety, and cannot pick and choose to keep those portions it deems desirable. In addition, multiple contracts are occasionally so integrated that they can only be assumed or rejected together.

In order to assume a contract, the debtor must cure all pre-bankruptcy defaults under the contract. Thus, in addition to the certainty provided by the debtor's advance decision, assumption of an executory contract by a debtor enables a creditor to fully recover the amounts owed by the debtor prior to the bankruptcy filing. Once a contract is assumed, the debtor is required to perform under such contract as if the bankruptcy never happened. Any subsequent breach following assumption would allow the non-debtor, non-breaching party to sue for breach and recover all amounts due as a result of the breach.

While the general rules related to contract assumption or rejection are typically the same, a few exceptions do exist. For example, contracts with the United States government are impacted by the Anti-Assignment Act and may not be assigned over the objections of the government. Courts interpret the effect of this act differently, and some have even prohibited the assumption (as opposed to the assumption and assignment) of such contracts over the objection of the government. Accordingly, it is important to communicate with the relevant contracting officer regarding issues related to the assumption of contracts in bankruptcy in order to ascertain the government's position.

Critical Vendors

Creditors who believe that they may be integral to the successful reorganization of a debtor may wish to consider seeking "critical vendor" status. Critical vendors are those vendors determined by the bankruptcy court to be necessary to the debtor's successful reorganization, without whom the reorganization effort will fail. Typically, these creditors provide goods and services that cannot be obtained elsewhere without substantial additional costs. Thus, if another party provides a similar good or service at a reasonable price, the vendor is not "critical" by definition and critical vendor status will be difficult to obtain. Upon the debtor's request, the bankruptcy court may authorize the debtor to pay all or a portion of a critical vendor's pre-petition claim in exchange for that creditor's agreement to continue to do business with the debtor. SVPs who believe they may be critical vendors of the debtor need to proceed cautiously so that they do not transform their appreciation that their goods or services are critical to the debtor into a refusal not to honor the pre-petition contract without payment of the amounts owed pre-bankruptcy. Critical vendor status requires an order by the bankruptcy court, and it would not be proper for an SVP who is a party to a pre-petition contract to condition its performance post petition on critical vendor status. Critical vendor status elevates a creditor's unsecured pre-petition claim, typically of very low priority, to that of an administrative claim that must be paid ahead of general unsecured claims.

Assess Potential Exposure to Liability

In addition to immediately assessing the rights of a non-debtor upon the filing of a bankruptcy petition by one of its customers, an SVP must also be aware of its own exposure to potential liability. While most properly drafted agreements will prohibit the distressed company's creditors from looking to the SVP for payment, certain guarantees or indemnity provisions may apply. In addition, once a bankruptcy is filed, the debtor or bankruptcy trustee is vested with additional "strong arm" powers that provide additional remedies that may result in liability against certain seemingly innocent third parties.

Among these potential liabilities is an action brought by the debtor or bankruptcy trustee to recover payments made by the debtor to a creditor prior to the filing of the bankruptcy petition. These are known as preferences. Early assessment of any potential preference exposure can have a substantial impact on the SVP's overall strategy. Notwithstanding the validity of any debts paid by the distressed company, a party may be required to return any payments received within the 90 days prior to the filing of the bankruptcy petition. Thus, if you have received payment upon any unsecured debt within 90 days prior to bankruptcy, you are a potential preference target. In addition, the debtor may seek to set aside any lien granted on property made prior to the bankruptcy case for which "reasonably equivalent" value was not received by the debtor.

The Bankruptcy Code permits such actions as a means of remedying past preferential treatment of certain creditors for the benefit of all -- even where the debtor did not expressly intend to prefer the creditor. Under the recently enacted bankruptcy reform legislation, however, defending preference cases should become easier. Early analysis of potential preference liability and available defenses enable a creditor to gather and preserve the documentation necessary to properly defend any preference claim. To the extent any claim is threatened or any lawsuit filed, it may also enable the creditor to engage in settlement negotiations designed to resolve the preference claim without protracted litigation.

Get Involved in the Bankruptcy Case

The Bankruptcy Code affords creditors various opportunities to become involved in the bankruptcy proceedings. Knowledge is power. In cases where a creditor has a significant stake in the proceedings, the creditor may wish to consider seeking appointment to the unsecured creditors' committee. In most commercial Chapter 11 cases, the Office of the United States Trustee appoints a committee comprised of the largest unsecured creditors who represent the interests of their class of creditors and who will work toward achieving an optimal distribution for unsecured creditors. A committee of unsecured creditors typically participates in plan formation, evaluates proposed actions advanced by the debtor, employs its own attorneys and financial advisors (at the expense of the debtor), and often has standing to pursue litigation on behalf of the debtor. Through participation on the creditors' committee, parties are often provided access to information not available to the general public regarding the debtor's future. While confidentiality requirements may prohibit certain use of this information, parties interested in serving on the committee might consider informing the U.S. Trustee's Office early in the case that they would be willing to serve in this capacity.

Asset Sales

The bankruptcy process often allows for the orderly sale of a debtor's assets as opposed to a reorganization. Where the debtor is unable to craft a successful turnaround and emerge as a healthy, competitive venture, it may seek to sell its assets outside the ordinary course of business. If you are a party to a joint venture or have contracts with the debtor, assets sales in bankruptcy may provide an opportunity to salvage the enterprise and minimize the risk of being trapped with an unknown partner replacing the bankrupt partner. Any sale of assets outside of the ordinary course of the debtor's business must be approved by the bankruptcy court, and the Bankruptcy Code provides that a debtor may seek court approval to authorize the sale of its assets free and clear of all liens and encumbrances. These bankruptcy sales often take the form of a public auction and can present a unique opportunity for a creditor to obtain valuable assets at a favorable price. Often, the debtor presents the court with a "stalking horse" bid to encourage other purchasers. Typically, the bankruptcy court approves bidding procedures, including qualifying bids, a break-up fee for the "stalking horse" bidder, and an auction date.

Conclusion

While learning that a customer has filed for bankruptcy may leave a creditor feeling as though its hands are tied, SVPs should be aware of the numerous steps that they can take to preserve their claims and assert their rights in the bankruptcy proceeding. Non-debtor business partners can become involved in the bankruptcy in a variety of ways that may affect the outcome of the case. From the filing of timely proofs of claim to seeking relief under the automatic stay, non-debtor business partners have many options to enable them to proactively assert their rights and play a role in shaping the bankruptcy proceedings.