When a business partner goes bankrupt

No one likes to think that the people they buy from or sell to might not be around tomorrow. But the situation can be even worse if the person or firm files for bankruptcy because then the rights of others who do business with the debtor are controlled by federal bankruptcy law, which often produces results that you would not expect and that you don't like. And I cannot think of an industry that is more severely impacted by court-imposed delays than construction.

As of the moment of filing, everything stops. The law imposes what is known as the “automatic stay,” which freezes everything in the position it was as of the time of filing. The automatic stay is taken very seriously — any action taken that violates it is punishable by stiff fines, which bankruptcy courts are not at all hesitant to impose.

From the moment you hear about the bankruptcy, you must obey the bankruptcy laws. Many people think that until they get an official notice from the bankruptcy court they can continue to take steps to protect their interests. If you are aware that someone has filed, however, you are considered bound even without official notice and will be subject to those penalties mentioned above if you don't get court permission before acting.

The debtor may no longer have any say in what happens. A “trustee” is appointed to collect the assets and pay the bills of the debtor, which may even be the debtor itself (called a “debtor in possession” or “DIP”). Everything a trustee or DIP does still has to have approval of the bankruptcy court. You cannot take the word of the debtor that anything is or is not possible without also getting court approval.

“Executory” contracts can't be canceled. An executory contract is one that has not yet been fully performed. The bankruptcy law says that the debtor's right to perform that contract is an asset of the bankruptcy estate that can't be taken away without the court's permission. The result of this rule is often extremely harsh on contractors. Of course, in order to hold onto the contract, the DIP or trustee will have to be able to prove that the debtor is capable of curing past defaults and performing as called for in the contract (which is generally unlikely, or the firm wouldn't be in bankruptcy), but the process can take a long time. Before a bankruptcy is filed, however, you are free to terminate contracts (provided that you otherwise have the right to do so), so it is very important to verify whether someone has actually filed.

If you can't prove that it's yours, it's still theirs. The courts make a distinction between payments on account and actual purchase of goods. If you have bought specific items that can be identified by serial number or markings, you can (with court permission) take possession of them. If you have just made payments but don't yet “own” specific goods, you are just another creditor. For this reason, it really helps to have a bill of sale showing that the title to equipment has transferred to you, and as a means of identifying that equipment.

Money received as a preference has to be returned. Desperate people tend to do desperate things, and it is very common for people on the brink of financial disaster to pay off some debts and not others — to repay family members or loans that they have personally guaranteed, for example. To assure that all creditors are treated fairly, the bankruptcy code also says that all payments on past debts made within 90 days of filling bankruptcy are improper preferences, which have to be returned to the bankruptcy estate. For this reason, it is important to keep accounts current.

Bankruptcy courts can move quickly. While bankruptcy proceedings often drag on for many years, it is possible to get emergency hearings and expedited relief.

An experienced bankruptcy lawyer who understands construction can often get a hearing to “lift” the automatic stay and allow a contract to be rejected by the court (allowing you to terminate it and move forward) within a few days of filing. It is absolutely worth it to find the right lawyer to represent you in such a situation.

Most bankruptcies do not have happy endings. Even those that are initially filed as Chapter 11 reorganizations nearly always end up being converted to Chapter 7 liquidations because the debtor can't get new financing. Any payment may be delayed for years, and could ultimately only get you pennies. The most important thing to remember about bankruptcy is that it is a different world, so you need to get expert advice as soon as possible to minimize the impact on your company.

Susan McGreevy is a partner at Stinson, Morrison, Hecker LLP, Kansas City, Mo., 816/842-4800, e-mail to [email protected].

Read more articles by Susan Linden McGreevy