Timing and Knowledge are Crucial to Minimize Disruptions tied to a Financially Distressed Subcontractor
An increase in the likelihood of subcontractor insolvencies and bankruptcy petitions is but one of the economic impacts the COVID-19 pandemic has and will continue to have on the construction industry. Therefore, prime contractors and construction managers should have some understanding of the common warning signs that a subcontractor is experiencing financial distress and may be on the precipice of filing bankruptcy, as well as some understanding of how a defaulting subcontractor’s bankruptcy filing can delay and impede the ability of contractors and construction managers to complete the subcontractor’s scope of work.
A telltale sign that a subcontractor is experiencing financial distress is that suppliers and other downstream subcontractors will have made non-payment claims and filed mechanic’s liens (on private projects), and perhaps initiated lawsuits against the subcontractor to collect unpaid contract balances and/or to foreclose mechanic’s liens. Another is that there will typically be an increase in the frequency of change order claims by the subcontractor seeking additional compensation for work within their original scope, based on pricing which is unjustifiable or ignores subcontract provisions that govern pricing for change orders. Typically, the subcontractor’s applications for progress payments will be increasingly front-loaded to an extreme degree, especially with regard to payment for stored materials. Another common warning sign is that there will often be a high rate of departure of the subcontractor’s key management personnel and valued senior project staff who are best-positioned to foresee imminent financial problems for the company, and there is often a deterioration in the quality and timeliness of the subcontractor’s performance due to these departures and other project manpower reductions.
When a contractor or construction manager is faced with these warning signs, termination of the subcontractor is a serious but sometimes necessary measure if the subcontractor is in default of its performance obligations and the subcontractor’s present or imminent insolvency will likely render it unable to cure its defaults or complete its scope of work. In that case, a contractor’s or construction manager’s ability to timely and successfully deliver a project will in large part depend on its ability to swiftly implement alternative measures for achieving completion of the subcontractor’s scope. The abilities of contractors and construction managers to implement such completion measures, whether by termination, procurement of a replacement subcontractor, and/or a bond claim, can be significantly delayed and complicated if the subcontractor files a petition for bankruptcy. This is in large part because the filing of a bankruptcy petition by the “debtor” triggers the “automatic stay” provisions of Section 362(a) of the United States Bankruptcy Code.
The automatic stay, among other things, prohibits any act by any entity to “obtain possession” or “exercise control over” property of the bankruptcy estate, and any act to “collect, assess, or recover a claim” against the debtor which arose before the filing of the debtor’s bankruptcy petition. The “bankruptcy estate” is the group of the debtor’s assets that will be used to pay claims of its creditors, and generally includes all the debtor's legal and equitable interests in all forms of property as of the date of filing of the bankruptcy petition. A bankrupt subcontractor’s active uncompleted construction contracts are generally considered “executory” contracts which automatically become property of the bankruptcy estate for the purpose of the automatic stay when the subcontractor’s bankruptcy petition is filed. As a result, the automatic stay prohibits contractors and construction managers from: terminating uncompleted subcontracts with a bankrupt subcontractor; preventing the subcontractor’s performance or access to the project site; or intentionally refusing to make progress payments earned by the subcontractor, which are due pursuant to the terms of the governing subcontract. Conduct which violates the automatic stay is either void or voidable, and exposes the violator to potential court sanctions and monetary penalties.
In order to avoid violating the automatic stay, a contractor or construction manager that wants to, but has not, validly terminated a defaulting subcontractor before the subcontractor files for bankruptcy, must seek and obtain permission from the bankruptcy court through a motion for relief from the automatic stay to be allowed to terminate their uncompleted subcontract or otherwise end the bankrupt subcontractor’s further performance of the subcontract. In addition, where the bankrupt subcontractor is bonded and the contractor or construction manager would like to look to the bond, depending on the particular circumstances and type of bond, relief from the automatic stay may be necessary.
If a contractor or construction manager is unsuccessful in obtaining permission from the bankruptcy court to terminate the debtor’s uncompleted subcontract(s) (or even if the contractor or construction manager is willing to allow the bankrupt subcontractor to complete its scope of work), the bankruptcy estate will have the opportunity to decide which uncompleted construction contracts and other contractual obligations will be “assumed” or “rejected.” Generally, a subcontractor who is the “debtor-in-possession” (Chapter 11 bankruptcy reorganization), or the bankruptcy trustee (in Chapter 7 bankruptcy liquidation), decides whether to assume or reject any of the subcontractor’s uncompleted construction contracts as part of the bankruptcy estate based on the potential financial benefits to the estate of doing so.
In Chapter 11 bankruptcy proceedings, the debtor-in-possession (or in some cases, the trustee) may have many months, perhaps years, before it will be required to decide if the estate will accept or reject an uncompleted subcontract. If it accepts a subcontract, the subcontractor will continue its performance, however, with the requirement that it (or the trustee) cure any defaults existing before filing its bankruptcy petition or provide adequate assurance that pre-petition defaults will be promptly cured. If the debtor-in-possession (or trustee) rejects an uncompleted subcontract, the bankruptcy estate and subcontractor are free of the obligation to further perform and complete the subcontract, and although the rejection is deemed a breach of contract, any damages resulting from the rejection will be considered general unsecured claims against the estate as if the breach occurred before the filing of the bankruptcy petition. Rather than wait for the subcontractor or trustee to make its decision to accept or reject subcontracts within the time customarily permitted by bankruptcy courts, a contractor or construction manager can ask the bankruptcy court to force that decision to be made sooner. Even under that scenario, bankruptcy courts are likely to give the subcontractor (or trustee) a fair amount of time before having to formally decide whether to accept or reject a particular subcontract, because the decision generally can have a substantial financial impact on the bankruptcy estate as a whole.
In a Chapter 7 bankruptcy, any uncompleted subcontract not accepted by the trustee within 60 days of the filing of the bankruptcy petition is deemed automatically rejected by the estate, unless that time period is extended by the court. The trustee will often seek an extension of the 60 period so that it can pursue sale of the subcontracts as part of a sale of the estate’s assets. Contractors and construction managers should be vigilant of these attempts, and anticipate opposing any such motion to extend.
In the foregoing post-petition scenarios, delays to the progress of the debtor-subcontractor’s scope of work, and resulting financial losses and additional costs to projects in-progress, are highly likely, if not certain. However, if a contractor or construction manager validly terminates an uncompleted subcontract before the subcontractor files a bankruptcy petition, the termination will prevent the subcontract from becoming property of the bankruptcy estate. Accordingly, the contractor or construction manager will be able to pursue available options for procuring performance and completion of the defaulting subcontractor’s scope from a replacement subcontractor, or the terminated subcontractor’s surety, without the complications and delay which would otherwise likely result from the Bankruptcy Code’s automatic stay.
In conclusion, to ensure their projects are impacted to the least extent possible by a subcontractor bankruptcy, contractors and construction managers would be wise to proactively use subcontract terms and conditions which may help minimize the potential impact of a subcontractor’s bankruptcy, as well as proactively develop strategies to be employed when a subcontractor’s bankruptcy filing appears imminent. Contractors and construction managers must be alert to any mid-project warning signs of subcontractor insolvency, and when presented with those warning signs act quickly to implement their available and best options for ensuring completion of the insolvent subcontractor’s scope of work, before those options are limited by the subcontractor’s bankruptcy filing. Furthermore, when a contractor or construction manager is not, prepetition, able to adequately address the issues surrounding a distressed subcontractor, contractors and construction managers should be prepared to act quickly within the bounds of the laws in the bankruptcy proceedings and fully understand the various rights and obligations of the contractor, the construction manager, the debtor, and the debtor’s surety, among other impacted parties.