Five Focus Points for Protecting Against Your Counterparty’s Bankruptcy: Dealing with Companies in Financial Distress, Straightline

Risk, inherent in business, is heightened when dealing with a company in financial distress. Understanding the weapons that will be available to a debtor if it files bankruptcy can often assist you in managing and minimizing those risks. There are five focus points when assessing exposure to the potential bankruptcy of a contract counterparty.

#1: HOW WOULD THE AUTOMATIC STAY AFFECT YOU?

The most frustrating aspect of dealing with a debtor in bankruptcy is the inability to take action due to the automatic stay and to enforce “ipso facto” clauses. The Bankruptcy Code lists several actions specifically prohibited by the automatic stay, including “any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the [bankruptcy] case.” Additionally, once a debtor has filed for bankruptcy, a contract counterparty cannot terminate or modify a contract with the debtor based on the debtor’s bankruptcy or insolvency. Such clauses are commonly referred to as “ipso facto” clauses. A bankruptcy court may provide a creditor relief from the automatic stay “for cause,” but the burden to show cause is high. Limiting exposure under a contract by requiring prepayment or securing the debtor’s obligations with a letter of credit is the best way to minimize risk.

#2: ARE YOU PARTY TO AN EXECUTORY CONTRACT OR LEASE?

During the bankruptcy proceeding, the non-debtor party must continue to perform under an executory contract or lease while the debtor decides whether to assume or reject. If the debtor chooses to reject, the rejection is treated as a breach of the agreement immediately prior to the bankruptcy filing—giving rise to a prepetition (usually unsecured) claim for rejection damages. However, if a counterparty has validly suspended performance on a contract prior to bankruptcy, the suspension remains in place in bankruptcy. Similarly, a validly terminated contract may not be resurrected in bankruptcy. For this reason, caution should be taken in drafting contracts to allow performance to be suspended awaiting adequate assurance of future performance.

Typically, a counterparty has the right to demand adequate assurance if it has reasonable grounds for uncertainty that its counterparty will perform. Rumors alone regarding the distressed company’s financial condition are seldom sufficient grounds for insecurity. However, downgrades in your counterparty’s credit rating or a specified percentage decline in its stock price, if set forth in the contract as grounds for insecurity, can be a basis for suspending performance or even terminating the contract.

#3: ARE YOU RELYING ON 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. In order to effect a setoff in bankruptcy, courts have held that the debts to be offset must be mutual (i.e., same parties in the same capacities) prepetition debts. Allowing a creditor to offset a debt owed to one corporation against funds owed to it by another corporation—even a wholly-owned subsidiary—constitutes an improper triangular setoff. A careful review of all affiliated party transactions for your counterparty on the one hand and your company on the other provides a clearer picture of what offsets may be available. Many a company has been lulled into a false sense of security only to discover upon the bankruptcy of A that no offset is avoidable because A owes B, but B owes A’s sub.

#4: WILL YOUR OPTION TO PURCHASE OR RIGHTS OF FIRST REFUSAL BE ENFORCEABLE?

The Bankruptcy Code and case law do not provide a clear answer whether rights of first refusal (“ROFR”) or options to purchase will be enforceable in a bankruptcy case. That risk should be understood up front. The non-debtor’s ability to enforce these rights in a bankruptcy often hinges upon the rationale applied by the court in which the bankruptcy is filed. Many courts view these contractual rights as being subject to rejection. A non-debtor can best position its option to buy real estate by recording its option in the real property records, and by formulating the contract in a way that makes the exercise of the option extremely simple, with as few steps or restrictions as possible for exercise, payment and delivery of documentation. With respect to options and ROFR on stock or other equity interests, the likelihood of success in enforcing those rights in bankruptcy is heightened by incorporating the right into the formation documents for the business entity to allow for the argument that the debtor can only sell what it owns and it owns the equity interest subject to the ROFR.

#5: WHAT TRANSFERS WILL BE AT RISK?

One of the bankruptcy estate’s most significant powers is its ability to avoid prepetition transfers made by the debtor which were actually or  constructively fraudulent or preferred one creditor over another. The most basic fraudulent conveyance concern is that a bankruptcy court, with hindsight, will make a determination that the debtor did not receive reasonably equivalent value in exchange for the transfer of its assets.  Transactions susceptible to fraudulent conveyance attack include affiliate guaranties and third party pledges of collateral, intercompany dividends, asset transfers between affiliates and contractual obligations to third parties undertaken for the benefit of affiliates. They can also include a sale to a third party for a price “too good to be true.” Obtaining valuation or solvency opinions from independent third parties, limiting guaranties to the amount of the benefit received by the guarantor and making sure purchase price funds flow to the true asset owner (as opposed to its parent or other affiliate) are a few ways to protect against risk.

The Bankruptcy Code also provides that a transfer of property to an entity that is a creditor of a debtor can be avoided if the transfer can be characterized as a payment within 90 days of bankruptcy (or one year if you are an insider) in satisfaction of such creditor’s antecedent debt which “preferred” it over other creditors. This covers not only cash payments but obtaining liens and letters of credit to secure an antecedent debt within the preference period. There are several defenses to a preference attack,  including: ordinary course of business transactions; contemporaneous exchange for new value; and enabling loans, but, as with any defenses, you will have the burden of proof. If you require prepayment there is no antecedent debt and if you are secured you are protected up to the value of the collateral or letter of credit, so don’t wait until it is too late! The ordinary course defense can be the easiest to establish if contract payments have been made according to schedule.

Focusing on these five factors and assessing the related risk when a contractual relationship is first established is optimum. At a minimum, these should be analyzed at the first signs of financial distress by a counterparty when you may still have time to “work down” your exposure.