Bankruptcy Proofing Your Contracts: A Summary of Bankruptcy Protection Devices
The never-ending quest for suppliers of credit, goods and services is to create the contracts and procedures that will insulate them from the consequences of bankruptcy filings by the counterparties to their agreements. This article touches on many of the methods and concepts that can be used by general and outside counsel to minimize the negative effects of bankruptcy on your contracts.
The reality is that there is nothing that you can do to insulate yourself completely through contractual provisions. However, many actions and techniques can help alleviate some of the problems arising from the bankruptcy or insolvency of counterparties and competing claims of other creditors.
A key point here is that a majority of the techniques to insulate yourself from the effects of bankruptcy, insolvency and other financial distress of your counterpart come not from the contents of the agreement, but how the transaction and relationship is structured.
Essential Bankruptcy Concept
To understand what makes a contractual provision effective in bankruptcy and what does not, it is helpful to understand some basic facts about bankruptcy itself, specifically Chapter 11.
When thinking in terms of protecting yourself from “bankruptcy” – what you are really saying is how to protect yourself from other creditors of the Debtor, not the bankruptcy itself. The Bankruptcy Code and accompanying caselaw are designed to protect creditors from improper actions, including preferential or fraudulent transactions, committed by desperate management on the slide into insolvency and to re-level the playing field among many types of creditors. Among the features of this design is that, upon filing a Chapter 11 petition, the debtor becomes a fiduciary (a trustee in fact) to the creditor body as a whole.
For the foregoing reasons, the bankruptcy system reduces the power of weak management to agree in advance of a bankruptcy filing how it will act once it is a fiduciary in the bankruptcy itself. Management should not agree to limit its power to exercise its fiduciary obligations and, if it does, its actions will be reined in by the bankruptcy judge, usually after notice to creditors. It would not be unusual, therefore, to hear a debtor state that while he understands that he made a certain agreement prior to a bankruptcy filing, he neither is bound by the agreement nor could he, consistent with his fiduciary duties, adhere to that deal.
The countervailing policy is the encouragement of free negotiation of business relationships. This article discuss where creditor protections are permitted.
There are two categories of methods: the first, ones that attempt to eliminate the bankruptcy filing of a counterparty altogether and the second, ones that mitigate the negative effect of bankruptcy on your bargained-for contract. Each category is discussed below.
Methods to Prevent a Bankruptcy Filing Altogether:
The first category of methods attempt to discourage a bankruptcy filing altogether.
Method 1: Require Personal Guaranties – “Bad Boy” or otherwise
A common method is the requirement of a “bad boy guaranty” (a/k/a recourse carve out guaranty), which provides for personal liability against the counterparty and its principals upon the occurrence of certain enumerated bad acts committed by the counterparty or its principals such as waste, fraud, misappropriation, bankruptcy, violation of single purpose entity covenants, or incurring subordinate debt without your consent. If triggered by enumerated bad acts, bad boy guarantees require the counterparty and/or guarantor to be personally liable for damages to you, or alternatively, converts an otherwise non-recourse loan into a full recourse loan as against the borrower or guarantor. In either result, lenders will have the right to seek significant personal liability against the borrower and/or guarantors, so it is essential that borrowers and/or guarantors have complete control over the potential triggering acts. In my view, the primary function of these guaranties are not a source of repayment but a “motivator” – the stick in the carrot and stick approach. However, this motivation exists even if traditional rather than “bad boy” guaranties are used. Note: Although bad boy guaranties remain subject to a challenge in that they arguably motivate breaches of director fiduciary duties, they have not been challenged effectively in recent years.
Method 2: Use/Require Bankruptcy Remote Entities
The concept of “single purpose,” “special purpose,” and “bankruptcy remote” entities is a an entity, formed concurrently with or immediately prior to the subject transaction, that is unlikely to become insolvent as a result of its own activities and that is adequately insulated from the consequences of any related party’s insolvency. The entity will typically have features that (a) limit or eliminate the ability of the entity from incurring liabilities other than the debt to be included as part of the concerned transaction; (b) insulate the entity from liabilities of affiliates and third parties; (c) protect the entity from dissolution risk; or (d) limit a solvent entity from filing a bankruptcy petition (or taking any other insolvency action), such as requiring the vote of an independent director. Contracting with entities that cannot or will not likely file bankruptcy is a common technique.
Methods to Reduce Negative Effects of Bankruptcy
The second category of methods seek to reduce the negative repercussions on your bargained-for transaction.
Method 3: Perfect your Liens and Security Interests and establish procedures for follow up!
Probably the single most import bankruptcy insulation vehicle is to actually properly and continually perfect your liens and security interests in the applicable collateral, especially cash. The basics include: (a) if real estate, filing applicable real estate deed of trust documentation with the applicable county record; (b) if personal property, filing financing statements (UCC1) in the applicable secretary of state (sometimes prothonotary) and applicable county, and (c) if cash/accounts, by taking control of the Debtor’s power to dispose of the cash through a deposit account control agreement (DACA) or other control/lockbox agreement.
To often, liens are lost by (a) improper perfection through bad collateral descriptions (missing the forest for the trees in long collateral lists), failed acknowledgements, overlooked UCCs, attachments omitted, etc. – typically a result of improper supervision of the perfection process; (b) improper postclosing diligence (failing to renew UCCs), agreements and actions made by lender representatives allowing use of cash or inadvertently releasing control of bank accounts or the contents thereof; (c) general failure of related parties from properly documenting affiliated intercompany transactions.
Method 4: Require Prepayment/Deposits
Requiring deposits or prepayment by the distressed entity allows for the likelihood of setoff. Setoff “allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding ‘the absurdity of making A pay B when B owes A.’ ” Bankruptcy Code section 553 “preserves for the creditor’s benefit any setoff right that it may have under applicable nonbankruptcy law,” and “imposes additional restrictions on a creditor seeking setoff” that must be met to impose a setoff against a debtor in bankruptcy. In order to effect a setoff in bankruptcy, courts have held that the debts to be offset must be mutual, prepetition debts. Because of the mutuality requirement in section 553(a), courts have held that triangular setoffs are impermissible in bankruptcy.
Method 5: Secure Performance from Solvent Third Party entities
Securing the debtor’s obligations with a third party letter of credit is often the best way to minimize risk. Drawing on a letter of credit is not subject to the automatic stay that is imposed in bankruptcy because the letter of credit is not “property of the bankruptcy estate” nor proceeds thereof. However, if a condition precedent to drawing on the letter of credit is presentment of an invoice or demand to the debtor and such notice has not been given prior to bankruptcy a problem may exist. Care must be taken to avoid requirements that a collection-type notice be sent to the debtor prior to the draw. Drawing on a letter of credit does not violate the automatic stay but a condition precedent to draw such as demand on the debtor may.
Method 6: Require a Bankruptcy Filing First and Obtaining Blessing from a Bankruptcy Court (363 Sales and other approved transactions) | Prepackaged Bankruptcies
When you are negotiating with another entity, on the surface, it appears that you are only negotiating with the management of that entity; however, if the entity is under any type of financial distress, you are also implicitly negotiating with the other creditors of that entity. If you do not have the consent of all of the other creditors of that distressed entity, your transaction, if unfair to them, may be subject to challenge in a subsequent bankruptcy. Therefore, when negotiating with distressed entities, you must either come to the conclusion that your transaction is fair to all of its creditors or seek their approval.
One tactic of parties is to actually require the bankruptcy of the distressed entity prior to entering into the relationship. This is most commonly seen as acquisition of the distressed entities assets through a Bankruptcy Code Section 363 sale/purchase or debtor in possession financing. In a nutshell, obtaining a Bankruptcy Court order authorizing the transaction binds all of the other creditors of the distressed entity to your transaction.
This court approval may also take the form of a prepackaged bankruptcy to reduce the time and risk of a bankruptcy involved. Accordingly, “prepackaged” Chapter 11 plans (“Pre-Packs”) — which may include a Section 363 Sale — are becoming relatively prevalent. Indeed, where a company has a sound business model, but is overburdened by debt, a Pre-Pack may be particularly appealing.
Method 7: Draft and Negotiate Stipulations and Affidavits of Fact
Although less glamorous than the structure-based methods, simple contract recitals and affidavits can be useful. Although outright agreements as to the postpetition conduct of the Debtor are generally not enforceable, stipulations of fact may actually have varying levels of success. Here, the strategy is to look at the relevant bankruptcy code provisions that establish the elements of what you want to occur and getting the debtor to agree (or even better, sign affidavits) to facts that would support such elements to justify the bankruptcy court to enforce the specific contractual rights in question (e.g., lift stay relief).
Method 8: Limit conveyance of title
Although the debtor in possession/trustee has significant strong-arm powers (11 U.S.C. § 544(a)) to avoid unperfected liens; these powers are less so when it comes to determinations of actual title. For example, if goods are sold to a debtor on credit with a security interest held by the seller, the lien may be avoidable if unperfected and, even if perfected, the debt can be restructured under the plan or the goods sold free and clear of the lien under section 363.
In contrast, if title to the goods does not pass until payment is made, then the debtor has little power to affect the payment provisions of the agreement short of recharacterizing the transaction as a disguised financing transaction. However, maintaining title to goods delivered to, and in the possession of the Debtor is difficult, likely requiring consignment-style financing statement filings and procedures.
The point, however, is that maintaining title outside of the debtor limits the estate’s power to modify the agreement.
Method 9: Recharacterize transaction as Executory Contract/Unexpired Lease Rather than Credit or Financing.
Financing transactions and credit are the types of arrangements that the trustee/DIP’s strong arm and restructuring powers are keyed to modify in bankruptcy. However, the debtor has almost no power to modify or change the terms of executory contracts absent an outright acceptance or rejection of the agreement under Section 365.
Although the definition of an executory contract is not widely agreed upon, many point to the legislative history to section 365 of the Bankruptcy Code as offering guidance as to the definition of an executory contract. This legislative history states that “executory contracts generally include contracts on which performance remains due to some extent on both sides.” It goes on to say that “a note is not usually an executory contract if the only performance that remains is payment. Performance on one side of the contract would have been completed and the contract is no longer necessary.”
Method 10: Terminate Agreement prior to Bankruptcy
A debtor’s power to assume or reject executory contracts is limited to those contracts that are actually executory. If a particular contract has been fully performed or terminated prior to the debtor’s bankruptcy filing, the debtor has no right to “resurrect” it (unless such termination constitutes a fraudulent conveyance). Accordingly, the risk to a counterparty of an unfavorable contract being assumed or a favorable contract being rejected can be eliminated if the contract can be terminated or fully performed prior to any bankruptcy.
Method 11: Ipso Facto Clauses Generally Pointless
Practically every contract has a provision that makes the bankruptcy or insolvency of one contracting party a trigger for the other party to terminate the contract. These are standard fare and rarely negotiated unless they also include a provision for the reversion back of ownership of property, often intellectual property, upon bankruptcy or insolvency. Unfortunately, these provisions are almost completely nullified by Section 541(c) (denying ipso facto clauses that result in the loss of property or a contract right) and Section 365(e)(1) (denying ipso facto clause that terminate contracts). Generally they only continue to be included in contracts because of (a) force of habit; (b) useful if insolvency without bankruptcy; and (c) the very limited exception found in Section 365(e)(2) and (c)(1) for contracts not assignable under “applicable law“ (typically IP contracts). There is also an exception under section 365(e)(1) for swap agreements (see below).
Method 11A: Exception: Ipso Facto Clauses in Intellectual Property contracts Useful
There is an exception to the lack of usefulness of ipso facto clauses for ipso facto clauses including licenses of intellectual property. As mentioned above, Section 365(c)(1) of the Bankruptcy Code puts a limit on a debtor’s ability to assign executory contracts, and perhaps even to assume them, when “applicable law” gives the non-debtor party to the contract the right to refuse to deal with someone else. Collectively, a number of courts have interpreted the phrase “applicable law” to mean patent, copyright, and trademark law, holding that these federal intellectual property laws excuse a non-debtor party to an IP license from accepting performance from or rendering performance to an entity other than the debtor in bankruptcy. As a result, these courts have held that an IP licensor who does not consent can successfully block a debtor from assigning a patent, copyright, or trademark license to a third party during a bankruptcy case. This rule applies with greatest force to non-exclusive IP licenses but may also apply to certain exclusive licenses too.
Method 12: Take advantage of Swap Agreement treatment
The expanded definitions in the bankruptcy reforms of 2005 – especially the definition of “swap agreement” – are now so broad that nearly every derivative contract is subject to the Bankruptcy Code’s protection. Instead of protecting particular counterparties to particular transactions, the Code now protects any counterparty to any derivative contract. Entire markets have been insulated from the costs of a bankruptcy filing by a financial contract counterparty. Equally important, the amendments limit judicial discretion to assess the economic substance of financial transactions, even those that resemble ordinary loans or that retire a debtor’s outstanding debt or equity. The reforms of 2005 direct judges to apply a formalistic inquiry based on industry custom: a financial transaction is a “swap,” “repurchase transaction,” or other protected transaction if it is treated as such in the relevant financial market. The transaction’s loan-like features or its effect on outstanding obligations of the debtor are irrelevant, unless they affect the transaction’s characterization in financial markets. Absent fraud, form often trumps substance in distinguishing between combinations of ordinary financial contracts and loans, dividends, or debt repurchases.
Method 13: Take Advantage of Forward Contract treatment
A Debtor’s ability to assume or reject contracts may also be limited by the characterization of the contracts. Contracts may qualify as “forward contracts” which are entitled to special protections under the Bankruptcy Code. To the extent that a contract is a “forward contract,” the provisions of Section 365 of the Code are largely inapplicable. Section 556 of the Bankruptcy Code preserves the right of a “commodity broker, financial participant, or forward contract merchant to cause the liquidation, termination, or acceleration of a commodity contract . . . or forward contract” on account of the debtor’s insolvency or bankruptcy. 11 U.S.C. § 556.
To determine whether the right to terminate exists, the key questions are (i) is the contract a forward contract and (ii) is the non-debtor party a forward contract merchant? If the answer to both is “yes,” then the non-debtor may terminate the contract notwithstanding the automatic stay.
A “forward contract” is defined in the Bankruptcy Code to include, among other things “a contract (other than a commodity contract, as defined in section 761 for the purchase, sale, or transfer of a commodity, as defined in section 761(8) of this title, or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof, with a maturity date more than two days after the date the contract is entered into . . . .” 11 U.S.C. § 101(25). The fact that the contract contemplates actual delivery does not prevent it from being a forward contract.
In fact, some courts have addressed concerns previously expressed in other cases that “ordinary supply contracts” should not have the benefit of the safe harbors and held that these concerns are immaterial to the plain statutory language.
Once you understand the central concept that working with other entities with unknown financial situation requires drafting contracts to avoid or minimize the ability of its other creditors (as represented by the bankruptcy process) to interfere with your desired goals, the door is opened to adding provisions that support your desired effect. This article merely touches upon many of the concepts involved to note that you are not without options. Feel free to contact us if you have any questions about applicability in your sector. A simple “bankruptcy review” may eliminate significant risk and future unexpected cost if the counterparties to your agreements are (or could become) financially distressed.
Richard Grant concentrates his practice on Chapter 11 bankruptcy, business restructuring and recoveries, official unsecured creditor committee representations, secured lender representation, 363 asset sales/purchases, mergers and acquisitions and other processes benefited by the United States Bankruptcy Code.