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Issues Facing Business Partners of Bankrupt Government Contractors

September 30, 2013

The economic impact of forced budget cuts from the sequester and other government funding crises—ranging from a government shutdown to the federal debt limit—and congressional gridlock place disproportionate pressure on smaller- or second tier-government contractors. Business partners of a financially infirm contractor must prepare for when a contract business partner, co-venturer, or teaming partner falls over the fiscal cliff and files for bankruptcy protection. In this article, we will provide an overview of the impact of bankruptcy on a government contractor and address certain actions that can be taken upon the bankruptcy filing of a business partner.

Operating in Chapter 11

Absent unusual circumstances, the management in control of the debtor prior to the bankruptcy remains in control of the business operations and the direction of the bankruptcy case following the filing of the bankruptcy petition. The debtor-in-possession retains many of the rights and powers that it possessed prior to the filing of the bankruptcy petition, thereby enabling the debtor-in-possession to operate its business in the ordinary course. The Bankruptcy Code does limit the rights of a debtor-in-possession to incur additional debt or sell its key assets, including contracts, absent court approval.

Assumption and Assignment of Contracts in Bankruptcy

Section 365 of the Bankruptcy Code authorizes a debtor-in-possession to assume, assign, or reject executory contracts, provided certain statutory requirements are met. While not defined in the Bankruptcy Code, the definition of an executory contract most often used by bankruptcy courts is one where “the obligation of both the debtor and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.” Assumption or rejection of executory contracts can be accomplished either by motion or through a confirmed plan of reorganization. The debtor must assume or reject contracts in their entirety, and cannot pick and choose to keep those portions it deems desirable. In addition, multiple contracts are occasionally so integrated that they can only be assumed or rejected together.

The assumption and assignment provisions of the Bankruptcy Code allow a debtor to cure pre-petition contract defaults and assume (retain) profitable contracts, or reject unprofitable contracts. Rejection is judicially sanctioned breach available to debtors and permits a debtor-in-possession to relieve the bankruptcy estate of the burdens of performing an agreement or curing defaults.

A debtor-in-possession may have up to the confirmation of a plan of reorganization to determine whether or not to assume or reject, while the non-debtor party must continue performance of executory contract during bankruptcy. Because confirmation of a plan (and the debtor's deadline to make a business decision on the executory contract while the non-debtor party is obligated to continue to perform) may take months or years, creditors should address the issues proactively and request an order from the bankruptcy court requiring a debtor to render its decision on a particular executory contract ahead of this fluid and attenuated deadline.

Government Contractors in Bankruptcy

Upon the bankruptcy filing of a party to a government contract, a number of provisions of government contracting law are implicated within the bankruptcy.

Initially, the party filing the bankruptcy must notify the contracting officer for each of its non-closed prime contracts that it has filed bankruptcy within five days of the filing. The notice must advise the government of the date bankruptcy petition filed, identify of court where the bankruptcy petition was filed, and list all of the government contract numbers and contracting offices for all government contracts for which final payment has not yet been made.

The Federal Acquisition Regulation (FAR) also places requirements on the governmental agencies and describes certain minimum procedures agencies shall follow upon notification of bankruptcy proceedings. Pursuant to this provision, the contracting officer shall: (a) furnish notice of the bankruptcy to legal counsel and other agency offices and affected buying activities; (b) determine the amount of government's potential claim against the bankrupt contractor; (c) take actions necessary to protect the government's financial interests and safeguard government property; and (d) furnish pertinent contract information to the legal counsel representing the government.

If the bankrupt contracting party intends to sell assets out of bankruptcy, unique issues can arise, including the need for consent from the government for the assumption and assignment of the contract from the bankrupt debtor to a third-party buyer, and the novation of the contract or contracts as part of that sale and assignment process. There is wide government discretion on whether to approve the novation of a contract, and any such approval must be determined to be “consistent with the government's interest.”

Sales and novation issues in bankruptcy can give rise to difficult issues when a bankrupt government contractor seeks to sell specific task orders under a General Services Administration Agency (GSA) schedule contract. More specifically, where a GSA schedule contract—an agreement between a bankrupt entity and the GSA—involves performance of task orders that have been awarded by the bankrupt entity by ordering agencies other than GSA, novation becomes a more challenging and complicated process. Although some of these issues may be addressed by limiting the assets to be purchased to only “active” GSA schedule task orders, this strategy may raise difficult to resolve issues where a bankrupt entity seeks to sell GSA schedule task orders under the same master GSA schedule contract to different entities.

Confronting the Anti-Assignment Act in Bankruptcy Court

As a general rule, executory contracts are assignable notwithstanding contractual anti-assignment provisions. The Bankruptcy Code does, however, prohibit a debtor from assuming and assigning an executory contract or unexpired lease if “applicable law” excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the debtor-in-possession. This provision of the Bankruptcy Code implicates the Anti-Assignment Act, which prohibits the assignment of government contracts to a third party absent the government's consent. The majority of courts interpret the effect of the Anti-Assignment Act to prohibit both the assumption and assignment (as opposed to only the assignment) of such contracts over the objection of the government. The government maintains wide discretion on whether to approve the novation and approval must be determined to be in the best interests of the government.

Failing to obtain the government's consent to the assumption and/or assignment of a debtor's government contract through novation may not only adversely affect a debtor's reorganization where government contracts are a significant asset, but may also hinder performance under the contract if the government does not consent to assignment to a third party and the debtor is unable to fully perform its duties under the contract. In particular, where a debtor is a prime contractor, subcontractors should pay particularly close attention to the debtor's performance under the contract and whether the debtor seeks to assume and/or assign or reject a contract so as to reduce the risk of being unpaid for post-petition services performed under a subcontract. Subcontractors should seize on the opportunity to request an order from the bankruptcy court requiring a debtor to assume or reject an executory subcontract if the debtor seeks to assume or reject a prime contract that governs the subcontract.

The novation submission and approval process can take a significant amount of time. As a result, there is a critical need to develop strategies in advance that properly apportion the risk and liability associated with the scope of the contracts to be transferred but that also do not adversely affect the government. For example, debtors and strategic buyers should consider whether to “carve out” certain contracts or orders from the novation process because the buyer may not be able to purchase all existing prime contracts because of independence issues and organizational conflicts of interest. A carve out will reduce such risks and may also hasten the approval process because there are fewer contracts to review. Debtor and buyers should also take care to ensure that any carve out is explicit and unambiguous in the novation agreement. As with novation outside of bankruptcy, purchasers should be prepared to assume all of the transferor's obligations under the contracts.

Prospective purchasers of assets out of a bankruptcy estate should also take additional care to tailor the novation agreement to account for bankruptcy issues. For example, outside of bankruptcy, the transferor typically guarantees performance of the contract by the transferee. However, in bankruptcy, this may not be possible because a guarantee would require a debtor to incur a potentially significant contingent liability that may be viewed unfavorably by the bankruptcy court. Prospective purchasers should also take care to thoroughly analyze the contracts to determine whether the nature of the contracts are either executory or non-executory, because only executory contracts may be assumed and assigned in bankruptcy. Finally, prospective purchasers should consider the appropriate effective date of the novation, which could be one of several dates—including the date of the sale, the date the bankruptcy court approves the novation, or the date of novation approval by the government.

Conclusion

Fiscally healthy government contractors will inevitably interact with less financially strong business partners, including those that may file for bankruptcy protection. Understanding the impact of financial distress and bankruptcy upon the financially healthy business contractor is key to preparing for and mitigating the impact of the financial failure of a business partner. In particular, understanding the impact of bankruptcy on government contracts is particularly important where a team member on a government contract or series of government contracts has filed for bankruptcy protection. Given the political turbulence surrounding the budget discussions, the debt ceiling, and the sequester, a thorough review of these issues with counsel experienced in both bankruptcy and government contracting law is critical to navigating these issues.

Wiley Rein's Government Contracts Practice is comprised of nearly 40 experienced attorneys and consultants who provide the full range of government contracts legal counseling and litigation services to clients of all sizes. The firm's clients span virtually all industries, including defense and aerospace, intelligence, information technology, professional services, telecommunications, health care, architectural & engineering, and construction services. The firm represents contractors of all sizes, from the largest Pentagon partners to small, disadvantaged businesses and Historically Underutilized Business Zone contractors.