A business in financial trouble may file Chapter 11 in bankruptcy court to get a breathing spell and try to settle its debts. While in Chapter 11, the business (now called a debtor) continues to operate its business under the eye of the bankruptcy court.
If your company has a contract with that business, you may be surprised to learn that bankruptcy law requires you to continue to perform your contract. In return, the debtor must perform its side of the contract. If the debtor doesn’t and you want to terminate the contract, you must obtain the permission of the bankruptcy court before you terminate it.
If you terminate the contract without permission of the court, you may be subject to a substantial fine for doing so. The reason is that the debtor’s interest in the contract is an asset that the court wants to protect along with all the other assets to give the debtor an opportunity to re-organize and come out of bankruptcy.
Even if your contract has a provision that you can terminate it if the other party files bankruptcy or becomes insolvent, you still may not do so without court permission. But that provision alone will not be sufficient to allow you to get court permission to terminate the contract. You would need another ground such as the debtor’s failure to perform its side of the contract.
There is an exception. If your contract is to make a loan to the debtor, the court cannot compel you to make the loan after bankruptcy is filed.
Suppose the debtor has failed to perform its duties under the contract before bankruptcy. If you terminate the contract before bankruptcy, when the debtor files bankruptcy the contract no longer exists, and you do not have to deal with the debtor.
However, if you have not terminated the contract before bankruptcy, you must obtain court permission to terminate it after bankruptcy is filed. Once bankruptcy is filed, the debtor has the opportunity to cure the default and reinstate the contract.
If the debtor wants to continue to perform its contract with your company after bankruptcy, it will file a motion to assume the contract. If it is in default, it must cure the default. When the court authorizes the debtor to assume the contract, the contract continues in existence after the bankruptcy, and both sides are bound by it.
If the debtor does not want to continue to perform its contract with your company, the debtor has the option to reject the contract. If the debtor rejects the contract, the debtor is no longer required to perform it. Your company has a claim in the amount of its damages for breach of the contract and will receive whatever creditors receive from the bankruptcy on that damage claim. The court will set a deadline for your company to file such a claim.
Tenants under real estate leases and licensees of intellectual property have special protections upon rejection of their leases or licenses by landlords or licensors who file bankruptcy.
The debtor may assign its interest in your contract to a new party. You must accept performance even if the contract prohibits assignment. However, if you relied on the debtor’s unique ability to perform in making the contract, you do not have to accept an assignment to someone else. For example, a baseball club that has a contract with a player who files bankruptcy does not have to accept an assignment of the contract to a substitute player to perform that contract.
This area of bankruptcy law is complex. It is always prudent to consult with a bankruptcy lawyer about your company’s rights and obligations when a business you have a contract with files Chapter 11.
By Jules Cohen
Jules Cohen is a partner and a former chair of Akerman LLP’s Bankruptcy and Reorganization Practice Group. He is Board Certified in Business Bankruptcy Law by the American Board of Bankruptcy Certification and is a Fellow of the American College of Bankruptcy. He has extensive experience in representing all parties in Chapter 11 bankruptcy cases and has served as a Chapter 11 trustee.