Bankruptcy court filings
How to treat the surety within the framework of the Bankruptcy Code appears at times a mystery. Construction contracts are executor contracts that at times can be assumed by the contractor/debtor. A surety bond, however, is in the nature of a financial accommodation, and under the Code, agreements cannot be assumed. The surety possesses rights by virtue of its status that sets it apart from other creditors, a distinction which is of great importance, and is often misunderstood by both other creditors and some of the bankruptcy decisions. To the extent it pays pre-petition claimants, it is an unsecured creditor.
The contract surety relies on the efficient and timely payment of the contract proceeds for the performance of the work and application of the contract proceeds to the construction project. The oblige purchases the bond to assure completion in accordance with the terms of its contract with the principal. When the principal/debtor files for relief under the Code, the surety?s interest in the contract proceeds and the rights of the obligee under the bond must be protected. Applying the principles of the Code to protect these rights, the debtor should only assume a contract where it can assure timely and proper completion of the project at a cost less than the amount of the remaining contract funds available for the work.
The Code affects the surety's rights. Section 541 broadly defines property of the estate and, for a debtor to assume executor bonded contracts, it follows that progress payments must in some respect be the debtor?s. Striking the balance between the protection of the surety?s interest in contract proceeds and the debtor?s right to use property of the estate is another area of uncertainty. While the surety?s interest might be entitled to adequate protection, the procedural means and the test for ascertaining whether the surety?s interest in contract proceeds in adequately protected have not been the subject of any clearly developed authority. Presumably, by providing adequate protection for the surety?s interest in contract proceeds, the surety will be protected from loss arising out of the debtor?s use of the proceeds during the pendency of the proceedings.
During the pendency of the debtor?s proceeding, the automatic stay prohibits the surety from taking certain action without approval of the court. The surety might want to cancel a bond, effect a takeover of a contract, apply contract balances to completion costs or the payment of claimants. Before taking these actions, the surety may need to lift the automatic stay. The debtor or the surety might assert that the automatic stay operates as a stay of actions by third parties to recover on the bond. Procedurally, the bankruptcy of the principal will impose constraints on the surety in addressing claims and fulfilling bonded obligations.
AUTOMATIC STAY:
Section 362(a) of the Bankruptcy Code imposes an automatic stay on actions by creditors against the debtor upon the filing of the petition. The stay prohibits the filing and service of suits or claims, the enforcement of judgments, or the perfection of liens against the property of the debtor. The stay prohibits the surety from unilaterally taking certain action. The cancellation of bonds or the takeover of contracts by the surety might require that the surety first request the bankruptcy court lift the automatic stay. In some cases, either the surety or the debtor might attempt to stay actions by creditors against the surety. The debtor or surety might assert that the protection of the automatic stay extends to the surety, or that the court in exercising its equitable powers granted by the Code can stay a proceeding against a surety.
ASSUMPTION AND REJECTION OF EXECUTORY CONTRACTS:
One of the significant tools available to a trustee or debtor in possession is the ability to assume or to reject executor contracts. An executor contract is described in the legislative history as a contract on which performance remains due to some extent on both sides. It is intended that a debtor may keep favorable contracts and avoid performance of unwanted contracts. A contractor/debtor who continues to work on bonded contracts may not be a blessing to the surety. If the debtor is failing to meet deadlines, lacks quality control or disproportionately uses contract proceeds for general administrative and overhead expenses, the surety?s ultimate losses on the project may actually increase as a result of the contractor/debtor?s presence on the project.
DEBTOR?S EFFORTS TO ASSUME A BONDED CONTRACT:
In a Chapter 7 case, the debtor must assume executor contracts within 60 days of the date of the filing of the petition. However, in a Chapter 11 case, contracts can be assumed by the debtor at any time prior to the confirmation of the plan. It may be years before the debtor-in-possession confirms a plan. The debtor does not impliedly assume an executor contract simply by continuing to perform or by collecting proceeds under the contract. The debtor must expressly assume an executor contract, by filing a motion, and giving notice to other parties. To prevail on its motion, the debtor must first show that the contract is executor in nature, i.e., that it has not been completely terminated prior to the date of the bankruptcy filing. If there has been any default, the debtor must promptly cure the defaults, compensate the other party for any pecuniary losses caused by the default, and provide adequate assurances of future performance under the executor contract. Where there has been no default by the debtor, the debtor may assume an executor contract without satisfying the above tests, so long as the assumption appears to be in the best interests of the estate.
Similarly, the surety must be prepared to demonstrate to the court the unreasonableness of the debtor?s decision. This requires more than a showing that the surety will be disadvantaged by the assumption. The court must be convinced that the debtor and the overall interests of creditors will be harmed by the economic results of the debtor?s continued performance of the bonded contract work. A Chapter 11 debtor is under no obligation to assume or reject a contract at any time before the confirmation of a plan of reorganization. Section 365 (d) (2) of the Code provides that, upon request of a party to the contract, the court may set a deadline for the debtor to assume or reject an executor contract. Courts are very reluctant to force debtors to make early assumption or rejection decisions, recognizing that the debtor prefers to know if its plan will be confirmed before it commits to the legal effects of assumption of a contract. Nonetheless, such a motion may be asserted successfully. In the context of executor contracts, a court has noted that where there is no convincing evidence that debtor had sufficient financing or labor force to complete contract, where post petition breach of contract would expose estate to possibly devastating damage claim, and where early take-over of project by bonding company would minimize, if not completely eliminate, any claim against estate, rejection may be the best course for the debtor.
Motion practice relating to executor contracts tends to be slow and deliberate. As a practical matter, the surety?s urgent need for relief on bonded projects will more likely take the form of stay relief litigation designed to permit termination of the contract and takeover by the surety, or cash collateral litigation seeking wrest control of bonded contract funds from the debtor.
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