United States: Dealing With Companies In Financial Distress (Part I)

Last Updated: February 3 2011
Article by Robin Russell

Risk is inherent in business and that risk is heightened when you are dealing with a company in financial distress. Financial distress often leads to bankruptcy where a whole new set of rules come into play. Understanding the weapons that will be available to a debtor if it files bankruptcy can often assist you in managing and minimizing those risks. The top ten risks you face in dealing with a company in financial distress and the steps you can take to minimize those risks are discussed below.

  • Risk #1 - The Automatic Stay or Prohibition on "Ipso Facto" Clauses Preventing You From Taking Action Against The Debtor or Drawing on a Letter of Credit
  • Risk #2 - The Debtor Rejecting Your Contract or Lease
  • Risk #3 - Not Understanding and Not Taking Steps to Minimize Your Exposure
  • Risk #4 - Losing Your Rights of Set-Off
  • Risk #5 - Losing an Option to Purchase
  • Risk #6 - Losing a Right of First Refusal
  • Risk #7 - Having a Prebankruptcy Transaction With the Debtor Attacked as a Fraudulent Transfer
  • Risk #8 - Having a Prebankruptcy Payment from the Debtor Attacked as a Preferential Transfer
  • Risk #9 - Other Creditors Seeking to Have Your Claim Against a Debtor Equitably Subordinated
  • Risk #10 - Other Creditors Seeking to Have Debt Owed to You By the Debtor Recharacterized as Equity

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RISK #1: THE AUTOMATIC STAY AND PROHIBITION ON "IPSO FACTO" CLAUSES

The most frustrating aspect of dealing with a debtor in bankruptcy is the inability to take action due to the automatic stay and the courts' unwillingness to enforce "ipso facto" clauses.

The Automatic Stay

Section 362 of the Code provides for a statutory injunction in favor of a debtor and its assets upon the commencement of a bankruptcy case that protects the debtor from actions of creditors seeking to recover on their pre-petition claims. This statutory injunction is referred to as the "automatic stay." The statute lists several actions specifically prohibited, including "any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the [bankruptcy] case." A bankruptcy court may provide a creditor relief from the automatic stay "for cause." This is a very broad standard and the court has a great deal of discretion in determining whether and to what extent to grant relief from the automatic stay. 11 U.S.C. § 362.

The "Ipso Facto" Clause

Section 365(e)(1) of the Code provides that clauses which provide for the termination of an executory contract of the debtor as a result of the "commencement of a case under this title" are of no effect. 11 U.S.C. § 365(e)(1)(B). In general, termination clauses in a contract triggered by the debtor's bankruptcy or insolvency. are invalid. 11 U.S.C. § 365(e)(1). (i.e. once a debtor has filed for bankruptcy, the contract counterparty can no longer terminate or modify the contract based on the debtor's bankruptcy or insolvency.) Such clauses are commonly referred to as "ipso facto" clauses. Courts have held that bankruptcy default provisions are per se invalid, as violative of the spirit and purpose of the Code. "No default may occur pursuant to an ipso facto clause and no reliance may be placed upon an alleged default where the only cause for default is the debtor's commencement of a bankruptcy case." Reloeb Co. v. LTV Corp. (In re Chateaugay Corp., WL 159969 (S.D.N.Y. 1993)

Letters of Credit

Securing the debtor's obligations with a letter of credit is 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" under Section 541(a)(1). Matter of Compton Corp., 831 F.2d 586, 589 (5th Cir. 1987). Proceeds distributed pursuant to the letter of credit are also not property of the bankruptcy estate. In re San Jacinto Glass Industries, Inc., 93 B.R. 934, 937 (Bankr. S.D. Tex. 1988). Thus, an issuer does not violate the automatic stay provision by a payment to a beneficiary under a letter of credit and the claim covered by the letter of credit is not limited as it might otherwise be under the Code. In re Stonebridge Technologies, Inc., 430 F.3d 260 (5th Cir. 2005). 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.

Waiver of Consequential Damages

Finally, consideration should be given when drafting a contract to a provision waiving consequential damages so that if the debtor later claims a letter of credit was wrongfully drawn on or a contract wrongfully terminated the counter parties damages will be limited.

RISK #2: CONTRACT AND LEASE REJECTION

Section 365 of the Bankruptcy Code permits a debtor to either assume or reject executory contracts and unexpired leases. 11 U.S.C. § 365. Although the definition of an executory contract is not widely agreed on, 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." H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 347, reprinted in 1978 U.S. CODE CONG. & ADMIN. NEWS 5787, 6303; S.Rep. No. 95-989, 95th Cong., 2d Sess. 58, reprinted in 1978 U.S. CODE CONG. & ADMIN. NEWS 5844. Section 365 of the Bankruptcy Code gives the debtor special rights with respect to executory contracts although these rights are not unlimited.

Rights of Debtor

During the bankruptcy proceeding, the non-debtor party must continue to perform while the debtor decides whether to assume or reject the contract. If the debtor chooses to reject the contract, the rejection is treated as a breach of the agreement immediately prior to the bankruptcy filing – giving rise to a claim for rejection damages as of that time. 11 U.S.C. § 365(g). The rejection claim is, in most instances, an unsecured claim – although the counterparty will usually have an administrative priority claim for goods or services provided post-petition. The debtor may generally assume and assign the contract to a third party, not withstanding a clause in the contract prohibiting or restricting assignment. 11 U.S.C. § 365(f). With respect to timing, the debtor has no hard deadline for assuming or rejecting a contract (other than prior to confirmation of a plan which can take several years). The Non-Debtor counterparties could file a motion requesting that the bankruptcy court set a deadline for assumption or rejection.

Certain limits do apply. If there has been a default under the contract, to assume the contract the debtor or trustee must (i) cure existing defaults, (ii) compensate the other party for any actual pecuniary loss resulting from the default, and (iii) provide adequate assurance of future performance. 11 U.S.C. § 365(b) (emphasis added). A debtor must assume or a reject an executory contract in its entirety. (see discussion below under Integration). The debtor may not assign a contract if applicable law excuses the non-debtor from accepting performance from, or rendering performance to, a party other than the debtor (e.g. certain contracts for personal services). 11 U.S.C. § 365(c). In certain jurisdictions, the debtor may not even assume the contract in such circumstances.

Cherry Picking Favorable Contracts

The ability of a debtor to assume favorable contracts while rejecting unfavorable ones is the central purpose of Section 365 of the Bankruptcy Code. Nevertheless, in certain instances a debtor's ability to "cherry pick" contracts to assume with a given counterparty is limited.

  • Integration. One method of preventing a debtor from assuming a favorable contract while rejecting an unfavorable one is to argue that the two contracts are part of one unified agreement. As mentioned above, a fundamental requirement of the Bankruptcy Code is that an executory contract must be assumed or rejected as a whole. See, e.g., Pacific Express, Inc. v. Teknekron Infoswitch Corp. (In re Pacific Express, Inc.), 780 F.2d 1482, 1488 (9th Cir. 1986). A debtor cannot "cherry pick" portions of a contract to assume and reject unfavorable portions. Thus, if two contracts form in reality one indivisible agreement, the debtor will have to either assume both or reject both.

In applying this rule, bankruptcy courts recognize state law principles that related individual contracts may in some cases be viewed as creating one unified agreement. See Byrd v. Gardinier, Inc. (In re Gardinier, Inc.), 831 F.2d 974, 975-76 (11th Cir. 1987); In re Integrated Health Services, Inc., No. 00-389, 2000 WL 33712484, at * 3 (Bankr. D. Del. July 7, 2000); but see In re Plitt Amusement Co. of Washington, Inc., 233 B.R. at 846 & n. 10 (claiming that although state law is a guide, courts must also look to federal bankruptcy law).

Under Texas law, a contract is indivisible when by its terms, nature, and purpose it contemplates and intends that each and all parts and the consideration shall be common to each other and interdependent. whether Summers v. WellTech, Inc., 935 S.W.2d 228, 232 (Tex.App.-Houston [1 Dist.],1996). Factors courts consider include whether the agreements were supported by independent consideration and whether they were executed with distinct and identifiable purposes independent of each other. Id.

  • Cross-Default Provisions. Likewise, cross-default provisions throughout various agreements do not make them "integrated." Because cross-default provisions restrict a debtor's right to assume favorable contracts while rejecting unfavorable ones, they are not generally enforced in bankruptcy. See Lifemark Hospitals, Inc. v. Liljeberg Enterprises, Inc. (In re Liljeberg Enterprises, Inc.), 304 F.3d 410, 445 (5th Cir. 2002) (holding that cross-default provisions, while not per se unenforceable, are inherently suspect and only enforceable under certain limited conditions); The Shaw Group, Inc. v. Bechtel Jacobs Co., LLC (In re IT Group, Inc.), 350 B.R. 166, 177 (Bankr. D. Del. 2006) ("[A]ssumption under § 365 is subject to a 'well-established' cross-default rule: '[C]ross-default provisions do not integrate executory contracts or unexpired leases that otherwise are separate or severable'") (quoting United Air Lines, Inc. v. U.S. Bank Trust Nat'l Ass'n (In re UAL Corp.), 346 B.R. 456, 467 (Bankr.N.D.Ill. 2006)); In re Braniff, Inc., 118 B.R. 819, 845 (Bankr. M.D. Fla. 1989) ("Cross default provisions are unenforceable in bankruptcy where the provisions restrict the debtor's ability to assume an executory contract.").

    The Fifth Circuit has recognized that cross-default provisions are "inherently suspect" and has held that "where the non-debtor party would have been willing, absent the existence of the cross-defaulted agreement, to enter into a contract that the debtor wished to assume, the cross-defaulted provision should not be enforced." In re Liljeberg Enterprises, Inc., 304 F.3d at 445.

    If the agreements do not have cross-default provisions, amending them to include such provisions is unlikely to help. A court is likely to find in such circumstances that the agreements would have been entered into separately because they were in fact originally entered into separately without cross-default provisions. Thus, for future planning, it is important that cross-default provisions be included in the agreements at their inception to improve the chances that they would be enforced in bankruptcy.

Adequate Assurance of Future Performance

As previously noted, prior to the Debtor assuming a contract with favorable terms, the Debtor must provide adequate assurance of its ability to perform in the future. In determining whether there is adequate assurance of future performance, courts must look to "factual conditions, including consideration of whether the debtor's financial data indicated its ability to generate an income stream sufficient to meet its obligations, the general economic outlook in the debtor's industry, and the presence of a guarantee." Liljeberg, 304 F.3d at 438-439. The Bankruptcy Code borrows the phrase "adequate assurance" from Section 2-609(1) of the Uniform Commercial Code. See In re Texas Health Enterprises, Inc., 246 B.R. 832, 835 (Bankr.E.D. Tex. 2000).

Forward Contracts

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.

The invalidation of bankruptcy termination clauses under the Bankruptcy Code does not apply as to a forward contract in the hands of a forward contract merchant. Further, the automatic stay does not prevent the forward contract merchant from terminating the forward contract pursuant to the bankruptcy termination clause. Further, damages for forward contracts are measured as of the earlier of (i) date of the rejection or (ii) date of liquidation, termination, or acceleration. 11 U.S.C. § 562(a). This is in contrast to most executory contracts, where damages are determined as of the petition date.

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)1 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 re Olympic Natural Gas Co., 294 F.3d 737, 741-42 (5th Cir. 2002).

A "forward contract merchant" is defined in the Bankruptcy Code to include "an entity the business of which consists in whole or in part of entering into forward contracts as or with merchants in a commodity . . . 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." 11 U.S.C. § 101(26). Congress's addition of the phrase "in whole or in part" had the effect that "essentially any person that is in need of protection with respect to a forward contract in a business setting should be covered, except in the unusual instance of a forward contract between two nonmerchants who do not enter into forward contracts with merchants." 5 Collier on Bankruptcy § 556.03[2] at 556-6 (15th ed. rev. 2001) (quoted in In re Borden Chemicals and Plastics Operating Ltd. Partnership, 336 B.R. 214, 225 (Bankr. D. Del. 2006)).

The Bankruptcy Code permits the non-debtor counterparty to a master netting agreement to terminate, liquidate, or accelerate or to offset or net termination values, payments amounts, or other obligations arising under or in connection with one or more (1) securities contracts, (2) commodity contracts, (3) forward contracts, (4) repurchase agreements, (5) swap agreements, or (6) master netting agreements. 11 U.S.C. § 561. However, to do so, the party must have the ability to terminate, liquidate, or accelerate each individual contract covered by the netting agreement under section 555 (securities contracts), 556 (forward contract), 559 (repurchase agreement), or 560 (swap agreement) of the Bankruptcy Code. 11 U.S.C. § 561(b). Hence, if, for example, the master netting agreement covers three contracts that qualify as forward contracts but also one that does not and does not fit any of the other categories covered by sections 555, 556, 559, or 560, then the counterparty will be unable to net this agreement under the master agreement without relief from the automatic stay.

Managing Risk

There are several avenues to minimizing risk.

  • Contract Must be Executory. 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.
  • Security. The counterparty could obtain a security interest in property of the debtor or a letter of credit issued on behalf of the debtor to ensure that it can actually recover on any damages claim arising from such rejection of its contract. Note that obtaining a security interest to secure a pre-existing unsecured debt or contract obligation may be attacked as a preference if the debtor files bankruptcy within 90 days thereafter.
  • Assumption. In some situations you may prefer rejection of your contract over assumption and possibly assignment to a third party. A debtor may assume executory contracts over the objection of a counterparty if adequate assurance of future performance by the assignee of the contract or lease is provided. Contractual provisions prohibiting assignment are not enforced. A debtor must also generally cure any existing defaults in executory contracts or unexpired leases as a condition to assumption. A debtor does not have to cure non-monetary defaults arising under its leases if it is impossible to remedy such default at the time of assumption. 11 U.S.C. § 365(b)(1)(A). Instead, with respect to "failure to operate" defaults under commercial real property leases, the Code now allows a debtor to remedy the default by performance (i.e. coming into compliance with such a provision). The debtor must compensate the lessor for the actual economic loss the lessor has sustained as a result of the prior breach. Personal services contracts are typically not assumable.
  • Cure. When the debtor files a motion to assume your contract, act promptly if defaults exist. Documenting all monetary and nonmonetary defaults as they occur and the damage to you as counterparty will assist you in preparing an objection. Your goal is a court order recognizing the existing defaults and either denying the motion to assume based on the defaults or specifically ordering their cure. Seeking discovery of financial information from the party to whom the contract will be assigned is also key. If the third party cannot establish its ability to perform under the assumed contract, it is grounds for denying the motion to assume and assign. Verifying the parties' ability to perform (i.e. pay) under an assumed contract will also minimize the risk of post assumption default.

RISK #3: MINIMIZING EXPOSURE

If a counterparty has validly suspended performance prior to bankruptcy the suspension remains in place in bankruptcy. For this reason, caution should be taken in drafting contracts to provide for adequate assurance of future performance

  • Adequate Assurance. As to contracts for the sale of goods, which fall within the scope of Article 2 of the Uniform Commercial Code, a counterparty has the right under the Uniform Commercial Code to demand adequate assurance of performance if it has reasonable grounds for uncertainty that its counterparty will perform. See Tex. Bus. & Comm. Code Ann. § 2-609, which provides:

RIGHT TO ADEQUATE ASSURANCE OF PERFORMANCE

(a) A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return.

(b) Between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.

(c) Acceptance of any improper delivery or payment does not prejudice the aggrieved party's right to demand adequate assurance of future performance.

(d) After receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract. (emphasis added)

It is unclear under Texas law whether a right to adequate assurance of performance exists under contracts, that (i) are silent as to a right to adequate assurance of performance and (ii) are not subject to Article 2 of the Uniform Commercial Code. However, we note that Section 251 of the Restatement (Second) of Contracts recognizes such a right:

Where reasonable grounds arise to believe that the obligor will commit a breach by non-performance that would of itself give the obligee a claim for damages for total breach under § 243, the obligee may demand adequate assurance of due performance and may, if reasonable, suspend any performance for which he has not already received the agreed exchange until he receives such assurance.

Texas caselaw does not exist adopting the Restatement's position or otherwise considering whether an implied common law right to adequate assurance of performance exists under a contract not subject to Article 2 of the Uniform Commercial Code.

  • Reasonable Grounds for Insecurity. Assuming the existence of a right to adequate assurance of performance, whether under the express terms of the contract, arising under the Uniform Commercial Code, or under common law, are the rumors regarding the Distressed Company's financial condition and the inferences that drawn from conduct such as offering substantial discounts for cash payments sufficient grounds for insecurity as to permit a Counterparty to seek adequate assurances of performance?
    • Commercial Standard. Under contracts subject to the Uniform Commercial Code, "the reasonableness of grounds for insecurity . . . shall be determined according to commercial standards." Tex. Bus. & Comm. Code § 2-609(b). See also Universal Resources Corp. v. Panhandle Eastern Pipe Line Co., 813 F.2d 77, 78 (5th Cir. 1987). Whether "reasonable grounds" for insecurity exist will be determined "in the light of all the circumstances of the particular case." Comment (c) to Restatement (Second) of Contracts § 251. The grounds for insecurity must be based upon facts that arose after the time the contract was made and as to which the insecure party did not assume the risk when it made the contract. Id; See also Universal Resources Corp. v. Panhandle Eastern Pipe Line Co., 813 F.2d 77, 78 (5th Cir. 1987). Whether a party has reasonable grounds for insecurity is a question of fact. AMF, Inc. v. McDonald's Corp., 536 F.2d 1167, 1170 (7th Cir. 1976); BAII Banking Corp. v. UPG, Inc., 985 F.2d 685, 702 (2d Cir. 1993). See also Phibro Energy, Inc. v. Empresa De Polimeros De Sines Sarl, 720 F. Supp. 312, 322 (S.D.N.Y. 1981).

A ground for insecurity need not arise from nor be directly related to the contract under which performance is deemed insecure. Clem Perrin Marine Towing, Inc. v. Panama Canal Co., 730 F.2d 186, 188 (5th Cir. 1984), Comment (c) to Restatement (Second) of Contracts § 251. Thus, an obligor's failure to perform under contracts with third parties, or under unrelated contracts with the party seeking assurance of performance, could constitute a ground for insecurity, even though the obligor has not yet defaulted under the agreement as to which assurance of performance is sought. Cresuot-Loire Intern'l, Inc. v. Coppus Engineering Corp., 585 F. Supp. 45, 49 (S.D.N.Y. 1983) (a buyer of precision parts has reasonable grounds for insecurity if similar goods sold by seller to others have proved defective); Smyers v. Quartz Works Corp., 880 F. Supp. 1425, 1434 (D. Kan. 1995) (failure to pay for goods previously shipped under separate contract was a reasonable ground for insecurity as to performance of obligation to pay for future shipments under another contract with same seller); Comment (c) to Restatement (Second) of Contracts § 251.

  • Insolvency. Whether an obligor's insolvency is reasonable grounds for insecurity depends on the nature of the obligor's duties. Comment (c) to Restatement (Second) of Contracts § 251. See also BAII Banking Corp. v. UPG, Inc., 985 F.2d 685, 702-03 (2d Cir. 1993) (rumors of Seller's financial distress and imminent bankruptcy were not reasonable grounds for insecurity in seller's performance under petroleum sales contract where insolvency did not affect Seller's ability to deliver product and Buyer was merely trying to avoid its own performance due to declining petroleum prices). However, where a buyer is receiving goods on credit, insolvency is a reasonable ground for insecurity. See Comment (c) to Restatement (Second) of Contracts § 251 ("If for example, [the nature of the obligor's duties] is merely to perform personal services, the fact of insolvency alone may not give reasonable grounds to believe that the obligor will commit a breach, but if it is to pay for goods on credit it will.")
  • Objective Standard. Whether reasonable grounds for insecurity exists is measured by an objective standard, not a subjective one. See Universal Resources Corp. v. Panhandle Eastern Pipe Line Co., 813 F.2d 77, 78 (5th Cir. 1987) (Buyer of natural gas was not entitled to suspend performance because of fear of lack of makeup gas where (i) there was no change or event occurring after execution of the agreement; (ii) insecurity was purely subjective and was not based on any objective, identifiable conduct of seller, and (iii) conclusion of insecurity was based on Buyer's unsupported assumptions about the natural gas market). See also Pittsburgh-Des Moines Steel Co. v. Brookhaven Manor Water Co., 532 F.2d 572, 581 (7th Cir. 1976) (a more factual basis than subjective questioning is needed to demonstrate reasonable grounds for insecurity).
  • Deterioration of Market Conditions. In addition to a buyer's insolvency, deterioration of market conditions may be a reasonable ground for insecurity. Top of Iowa Co-op v. Sime Farms, Inc., 608 N.W.2d 454, 467 (Iowa 2000) (Market conditions were facts that would support a jury finding that a buyer had reasonable grounds for insecurity). In addition, the fact that an obligor has been downgraded by a credit rating agency may support a demand for adequate assurance of performance, but a finding of such a right is not automatic and the issue must be determined in light of whether insecurity based on the downgrade was reasonable. Enron Power Marketing, Inc. v. Nevada Power Co., 55 UCC Rep. Serv. 2d 31 (SDNY 2004), supplemented, 2004 WL 3015256 (SDNY 2004).
  • Demand for Adequate Assurance. If the Non-Debtor concludes that it is insecure and desires adequate assurance of performance from the Distressed Company, that demand must be made in writing under those contracts that are subject to the Uniform Commercial Code. Tex. Bus. & Comm. Code Ann. § 2-609(a). As to those contracts that are not subject to the Uniform Commercial Code but nevertheless expressly provide for adequate assurance of performance, demand for such assurance would be subject to the notice provisions of the respective contracts.

    The form of such assurance will be as specified in the terms of the relevant contract. If the relevant contract is silent, then the assurance of performance shall be determined "in accordance with commercial standards." Tex. Bus. & Comm. Code Ann. § 2-609(b). "What constitutes 'adequate assurance' is to be determined by factual conditions; the seller must exercise good faith and observe commercial standards; his satisfaction must be based upon reason and must not be arbitrary or capricious." Richmond Leasing Co. v. Capital Bank, N.A., 762 F.2d 1303, 1310 (5th Cir. 1985) (In a bankruptcy context, factors considered by the court in determining the adequacy of offered assurances included the obligor's ability to generate sufficient income to meet its obligations, the "general economic outlook" in the obligor's industry, and the presence of a guaranty).
  • Suspending Performance. May the Non-Debtor suspend its performance simultaneously with its demand for assurance? The Uniform Commercial Code provides that performance may be immediately suspended if it is "commercially reasonable" to suspend performance. Tex. Bus. & Comm. Code Ann. §2-609(a) ("until he receives such assurance [he] may if commercially reasonable suspend any performance for which he has not already received the agreed return") (note the drafter's formulation that performance may be suspended until assurance is received, rather than providing that performance may be suspended if assurance is not received). If the applicable contract provides a period in which the counterparty must provide adequate assurance or performance may be suspended, the Non Debtor cannot immediately suspend performance.

RISK #4: OFFSET RIGHTS

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.' " Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18, 116 S.Ct. 286, 133 L.Ed.2d 258 (1995) (quoting Studley v. Boylston Nat. Bank, 229 U.S. 523,528, 33 S.Ct. 806, 57 L.Ed. 1313, (1913)). 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. Packaging Indus Group Inc. v. Dennison Mfg. Co. Inc. (In re Sentinel Prod. Corp. Inc.), 192 B.R. 41, 45 (N.D.N.Y. 1996). Setoff is appropriate in bankruptcy when a creditor both enjoys an independent right of setoff under applicable non-bankruptcy law, and meets the further Code-imposed requirements and limitations set forth in section 553. See, e.g., In re Tarbuck, 318 B.R. 78, 81 (Bankr.W.D.Pa. 2004) (holding that courts must look to state law to determine whether a right to setoff exists, but that "the granting or denial of a right to setoff depends upon the terms of section 553, and not upon the terms of state statutes or laws."); see also In re Garden Ridge Corp., 338 B.R. 627, 632 (Bnkr.D.Del.2006).

Mutuality Required

In order to effect a setoff in bankruptcy, courts have held that the debts to be offset must be mutual, prepetition debts. See, e.g., Scherling v. Hellman Elec. Corp. (In re Westchester Structures, Inc.), 181 B.R. 730, 738-39 (Bankr.S.D.N.Y.1995) Debts are considered "mutual" only when "they are due to and from the same persons in the same capacity." Westinghouse Credit corp. v. D'Urso, 278 F.3d 138, 149 (2d Cir.2002) (citing Westchester, 181 B.R. at 740). Mutuality requires that "each party must own his claim in his own right severally, with the right to collect in his own name against the debtor in his own right and severally." Garden Ridge, 338 B.R. at 633-34 (quoting Braniff Airways, Inc. v. Exxon Co., U.S.A., 814 F.2d 1030, 1036 (5th Cir.1987)).

Triangular Set-Off Not Allowed

Because of the mutuality requirement in section 553(a), courts have held that triangular setoffs are impermissible in bankruptcy. See e.g., Matter of United Sciences of America, Inc., 893 F.2d 720, 723 (5th Cir.1990) ("The mutuality requirement is designated to protect against 'triangular' set off; for example, where the creditor attempts to set off its debt to the debtor with the latter's debt to a third party."); In re Elcona Homes Corp. (Green Tree Acceptance, Inc.), 863 F.2d 483, 486 (7th Cir.1988) (holding that the Code speaks of a "mutual debt" and "therefore precludes 'triangular' set offs"). Absent a piercing of the corporate veil, "a subsidiary's debt may not be set off against the credit of a parent or other subsidiary, or vice versa, because no mutuality exists under the circumstances." Sentinel Products Corp., 192 B.R. at 46 (citing MNC Commercial Corp. v. Joseph T. Ryerson & Son, Inc. 882 F.2d 615, 618 n. 2 (2d Cir.1989)). Allowing a creditor to offset a debt is owes to one corporation against funds owed to it by another corporation – even a wholly-owned subsidiary – constitutes an improper triangular setoff under the Code. A counterparty should be able to look to its right of setoff to protect its damages claim in a situation where the counterparty has other contracts or obligations it owes to the relevant debtor entity. The counterparty can ameliorate this risk by asserting its setoff rights in any bankruptcy proceeding. Some Courts have held that a non debtor may not offset the damages claim arising from rejected contracts against an obligation that the counterparty would have to the debtor under other contracts that the debtor has chosen to assume. In re Semcrude, 399 B.R. 388 (Bnkr.Del.20090).

RISK #5: OPTIONS TO PURCHASE

Neither the Bankruptcy Code nor case law provide a clear answer whether option contracts will be enforceable in a bankruptcy case. A non-debtor's ability to enforce its right to exercise its option in a bankruptcy will hinge upon whether or not the option has been exercised at the time bankruptcy is filed, on what obligations remain for each side at that time, and on the rational applied by the court in which the bankruptcy is filed. As previously noted under Section 365 of the Bankruptcy Code, a debtor may assume or reject executory contracts. Because no definition is given for an "executory contract" within the Bankruptcy Code or otherwise in legislation, federal courts differ on whether an option is an executory contract within the meaning of Section 365. Many courts using differing standards have held that an option contract is an executory contract such that the debtor can reject it in bankruptcy. Many other courts have held that option contracts are not executory contracts.

Timing

Regardless of the standard the bankruptcy court uses to determine whether the option contract in the case at bar is or is not executory, all courts will examine the status of the option contract on the date the bankruptcy petition is filed. See Bankr. Code 11 U.S.C.A. § 365; In re Columbia Gas Sys., Inc., 50 F.3d 233, 240 (3rd Cir. 1995). At the time the debtor files for bankruptcy, the Non-Debtor's option to purchase could be: (i) paid for, but not yet exercised; (ii) exercised but without title having transferred (i.e. the deal not closed); (iii) exercised and closed; or (iv) expired. These situations are treated differently when determining whether the option is treated as an executory contract under federal bankruptcy law.

Clearly, if at the time bankruptcy is filed the time period available under the contract for exercise of the option has expired, performance could no longer remain due on either side, and the option would not be considered by the bankruptcy court to be executory. Similarly, if the Non-debtor has exercised the option to purchase and the deal has completely closed, no performance would be due on either side and the contract would not be executory. See In re Helms Constr. & Dev. Co., 139 F.3d 702, 705 (9th Cir. 1998); In re A.J. Lane & Co., 107 B.R. 435, 437 (Bankr. D. Mass. 1989); In re Giesing, 96 B.R. 229, 232 (Bankr. W.D. Mo. 1989). The real issue is the treatment in bankruptcy court of situations in which at the time of filing the option has been paid for, but not yet exercised, or alternatively, where the option has been exercised, but the deal has not yet closed.

  • A Paid for but Unexercised Option. Some courts have held that option contracts under which the optionee fully paid its price for the option to buy the property before the debtor filed for bankruptcy are not executory because no performance is due from the optionor unless the option is exercised. In re Penn Traffic Co., 524 F.3d 373, 379 (2nd Cir. 2008). However, as the bankruptcy court explained in In re Nat'l Fin. Realty Trust, other courts have treated these same types of unexercised option contracts as executory, including the Fifth Circuit. In In re Jackson Brewing Co., 567 F.2d 618 (5th Cir. 1978) where the optionee attempted to exercise its option to purchase real property after the debtor-optionor had filed bankruptcy but before the option expired under the contract, the Fifth Circuit determined the contract to be executory because: at the time of the filing the optionee, in order to exercise the option under the contract, had to (i) notify the debtor corporation of its intentions to purchase the property; (ii) pay the purchase price; and (iii) take title by a certain date).

When an option has been paid for but was not exercised at the time of trial, courts have been inconsistent in their treatment of the contract. Although the more modern and perhaps the majority of cases seem to treat these options as not executory, there is a risk, depending on where bankruptcy is filed, that the court could treat the option as executory.

  • An Exercised Option where Some Performance Remains Due at the Time Bankruptcy is Filed. In those situations where an option has been exercised at the time of the bankruptcy filing, most bankruptcy courts have not simply looked to the unique characteristics of an option contract but have instead conducted fact intensive inquiries as to whether performance remained due on either side of the contract. See In re Dunes Casino Hotel, 63 B.R. 939 (U.S.D.C. New Jersey 1986) (real estate purchase option agreement was executory contract at the time of bankruptcy filing, 14 days after date scheduled for closing and after prospective vendor had tendered deeds and title documents, but had not delivered them, where vendor had notified debtor prospective purchaser that it was still in default, thus triggering 15-day provisions for cure of default by purchaser, and purchaser still owed purchase price); see also In re Carlisle Homes, 103 B.R. 524 (Bankr. D.N.J. 1988) (option agreement for purchase of land was executory where only 16 of the 61 acres subject to the option agreement had been purchased by debtors and delivered by sellers and thus substantial performance remained on both sides under the agreement).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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This article is part of a series: Click Dealing With Companies In Financial Distress (Part 2) for the next article.
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