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Contract Provisions for Troubled Times: Myths and Realities of Bankruptcy (Technology Law Letter #4)

Contract Provisions for Troubled Times: Part 4  Myths and Realities of Bankruptcy

Bankruptcy is a clear and present danger to many business contracts, especially in our difficult economy.  Of course, companies can go bankrupt at any time and with little warning.  Good negotiators always will plan around this risk, even when times are good.  With the credit crunch and cash flow crises in many industries, the risk of bankruptcy now is seen as a burning issue, and not an insignificant “theoretical” risk.

The U.S. Bankruptcy Code and bankruptcy system are very complex.  So complex, in fact, that bankruptcy cases even have their own separate court system.  I am not a bankruptcy lawyer, and this brief article touches only on a few high points.  However, being aware of even these high points can save you a lot of grief and expense!

Often, when a company’s debts exceed its assets (in legal terms, when it is “insolvent”), it may file for bankruptcy.  Companies generally can file under two chapters of the Bankruptcy Code.  First, they may file under Chapter 7, which is solely for liquidation and in which an independent trustee will be appointed.  Alternatively, they may file under Chapter 11 and the company’s management will stay in control.  Chapter 11 can be used to conduct an orderly liquidation or to reorganize by eliminating or restructuring claims against the company.  Those claims can include claims for loans extended by lenders, for salaries earned by employees, for taxes, and for amounts due from sales of goods, rendering of services, leasing of equipment or real property to the company or for the company’s other contractual relationships.  If the company is liquidated, its assets are transferred to others and it disappears.  If it is restructured, some claims may be reduced and others paid over time, equity may be restructured and it gets a “fresh start” to continue business.

There are many common myths about what can happen if the other party to your contract goes bankrupt.  (If you or your company go bankrupt, you will face a host of issues, but I don’t cover them here.)  Here they are:

Myth: “I’m set.  They paid me two months before they filed for bankruptcy.” Reality:  You probably aren’t set.  The bankruptcy laws are written to prevent companies from paying off one creditor in preference to other creditors.  You may have to return this kind of early payment, known as a “preferential transfer,” if the payment was made on account of a debt outstanding at the time, was made less than 90 days (three months) before the bankruptcy was filed (or less than one year if made to certain “insiders” of the company) and if the company was insolvent at the time of payment to you.

Myth: “I’ll collect what they owe me — probably at pennies on the dollar — but everything else will stay the same as before.” Reality:  Collecting at pennies on the dollar (or even nothing on the dollar) is probably correct, unless your debt is entitled to priority under the Bankruptcy Code (e.g., certain types of unpaid wages) or your contract provides you with a “security interest” or mortgage on the bankrupt company’s property (which is common only in equipment leases and real estate transactions).  But everything may not stay the same as before.  Bankruptcy permits the trustee to “assume” (agree to perform) or “reject” (terminate) the “executory” (unperformed) contracts of the bankrupt company so that the bankrupt company may free itself from burdensome contracts and perform only those that are profitable.  In other words, the trustee may terminate your contract.  Even if termination is acceptable to you, the trustee can take other actions, discussed below. Any damages due to this termination will be paid as with general unsecured creditors, usually at pennies on the dollar.

Myth:  “If they go bankrupt, I’ll just get out of the contract.  The contract says I can.” Reality:  This myth is widespread.  Many contracts have a clause that says the contract can be terminated or modified if the other party files for bankruptcy.  Here’s the catch: under the U.S. Bankruptcy Code, this clause (known as an “ipso facto” clause) is generally not enforceable, i.e., the court won’t let you terminate.  This is why, if bankruptcy could be an issue, you should make your contract term as short as possible (so that the contract can expire on its own, which the court generally will observe) and limit any automatic renewals.  Also, it is helpful for your contract to specify events that can result in contract termination (also called “defaults”).  For the company to agree to perform the agreement (i.e., to “assume” it as stated above), the bankruptcy trustee must cure defaults and pay damages for any breach (to reinstate the contract) or get you to waive them, and provide adequate assurances of future performance.  If uncurable defaults exist in the contract, you may convince the bankruptcy court to force the company to let you get out of the contract.

Myth: “They can’t transfer my contract to someone else.  The contract says so.” Reality:  The bankruptcy court can override this contract clause as well in most cases.  The Bankruptcy Code assumes that the bankrupt company may need to transfer assets (including contracts) in order to bring in as much money as possible for the company’s creditors.  The court may prohibit certain “personal service” contracts from being transferred, where the performance is truly unique to the parties, but that is cold comfort in most commercial contracts between businesses.  However, if you granted the other party a license to intellectual property, in many cases you will be able to block the transfer of the license.

Myth: “They licensed some intellectual property to me.  If they cancel that license contract, then my company, my distributors and my customers will be harmed.” Reality:  Finally, some good news.  If you received a license from a bankrupt company, you may be able to prevent it from terminating the license to you.  The Bankruptcy Code has a specific section (365(n)) that permits you to keep the license as it existed at the time of the bankruptcy filing, to enforce exclusivity and, if your contract has proper legal provisions, to access supplementary rights (such as computer source code in escrow).  However, there is no free lunch.  To keep the license, you must continue to pay any royalties provided for in your contract and you cannot obtain ongoing positive performance from the bankrupt company, such as ongoing software updates or maintenance.   Also, Section 365(n) has gaps.  It covers trade secrets and U.S. patents and copyrights.  Oddly, it does not cover trademarks, most other intellectual property or most foreign intellectual property, or any future improvements and modifications (e.g. future software upgrades).  If your business depends on ongoing performance from the company, and not merely a “bare” license of intellectual property, then Section 365(n) may not provide enough protection.  You may want to consult bankruptcy counsel at the planning stages, especially to avoid potential loopholes in Section 365(n).  Also, in some transactions where the value involved merits it, it is better to take ownership or joint ownership of the intellectual property instead of a license.

Many bankruptcy concepts are not intuitive. Under- standing the realities, and not falling victim to the myths, is a key to staying ahead of the game.

I would like to thank bankruptcy attorney Mark E. Porter of Fenwick & West LLP for his comments in the preparation of this article.