Five Simple Rules for In-House Counsel to Avoid the Most Hidden Insolvency Risks in Commercial Transactions

16 Min Read By: Chelsea Kiara Davis, Sheryl Toby, Matt Ochs

IN BRIEF

  • The insolvency and bankruptcy of a business partner is an inherent—and often hidden—risk in nearly every transaction.
  • Practitioners can address the uncertainty associated with these concepts by following five simple rules.
  • Each of these rules allows in-house counsel to educate their business teams, set appropriate expectations with stakeholders, and improve documentation, as well as lessen the impact of an insolvency event or bankruptcy case.

In-house counsel is responsible for advising internal clients on a wide variety of risks associated with day-to-day business operations, including the insolvency and bankruptcy of a business partner. These risks are inherent—and often hidden—in nearly every transaction. It is important that in-house counsel is familiar with certain fundamental bankruptcy concepts to effectively counsel their business teams and, if at all possible, mitigate those risks. Among the most common insolvency and bankruptcy concepts are the scope of the automatic stay, the treatment of executory contracts (assumption and rejection), “free and clear” asset sales, fraudulent conveyances, and preferences. Counsel can address the uncertainty associated with these concepts by following the five simple rules set forth below, each of which allows in-house counsel to educate their business teams, set appropriate expectations with stakeholders, and improve documentation, and all of which lessen the impact of an insolvency event or bankruptcy case.

Five Bankruptcy Risk Factors to Consider with Each Transaction

1. Automatic Stay

Know the impact of the automatic stay on property rights. When a party (a debtor) files for bankruptcy, the filing automatically triggers an extremely broad stay provision. Under 11 U.S.C. § 362, an automatic stay immediately enjoins the commencement (or continuation) on any process or action against the debtor or its assets. Analyzing the consequences of the contract being stayed at each phase of performance will help you assess the risks associated with the agreement. For example, (a) if your contract requires notice, you may be stayed from giving the notice; (b) if the counterparty has property of yours in its possession or has knowledge (e.g., provides operational support) critical to your operations, you may be unable to quickly gain access to the property or force compliance with the agreement or turnover of the critical information; (c) you will be unable to sue to enforce your rights; and (d) you may be unable to stop performance. Analyzing the consequences of the contract being stayed at each phase of performance will also allow you to consider whether there are means for mitigating the risk. Counsel should consider mitigating the company’s risks by establishing mechanisms that are enforceable in the event of a bankruptcy and are outside of the scope of the automatic stay, including certain automatic triggering events that do not require pre-notice, escrow agreements, letters of credit, and rights against guarantors.

2. Treatment of Contracts in Bankruptcy

In bankruptcy, with very limited exception, a debtor has the right to reject, or assume and assign, a contract. The decision to reject or assume a contract often does not occur until plan confirmation, creating uncertainty for the contract counterparty.

Rejection. Know how to protect ongoing business operations if a contract is rejected. Outline each phase or provision of the contract and consider what happens if the contract counterparty files bankruptcy and rejects the contract under 11 U.S.C. § 365. For example, although suppliers often consider the risk factors associated with a customer filing bankruptcy and failing to pay, customers that rely on the supplier for critical materials or information often do not give equal weight to the possibility that the critical supplier could reject the contract. This can be particularly disruptive when the customer relies heavily on the specialized knowledge of the supplier or holds confidential or proprietary information critical to the customer’s operations. If the contract is rejected, the customer may be forced to seek alternative services, providers, and other resources to operate its business without the ability to enforce transition service provisions and purchase options. A grant of security, escrow agreements, and letters of credit can mitigate the risks associated with rejected contracts.

Assumption and Assignment Rights. Know how an assigned contract may impact business interests and proprietary information. Under 11 U.S.C. § 365, a debtor also has the right to seek to assume a contract for its own continued performance, or assume and assign a contract to a third party. Although the debtor may assume or reaffirm its obligation under the contract, the debtor/assignee must cure any outstanding payment defaults as well as provide adequate assurance of the assignee’s ability to continue performing under the contract. Counsel should consider a debtor’s right to assign the contract to a competitor or a third party and whether a termination provision will be effective to protect those proprietary interests. This is an inherent risk and one difficult to protect against at the outset of a relationship, but may be worth a warning to the business team as a risk factor. In some circumstances and jurisdictions, a debtor cannot assume or assign a license without the licensor’s consent. Well-crafted termination and assignment provisions in license agreements may allow the licensor to obtain greater protections than an ordinary vendor. Fortunately, there are processes and notices that must be given, which will afford the nondebtor counterparty an opportunity to evaluate the effect of the proposed assumption and consider whether there are protections available before the contract is assumed.

3. Sales “Free and Clear”

Know how to protect your interests if the debtor intends to sell your property. 11 U.S.C. § 363 allows the debtor to sell its assets (which can include all assets as a going concern) “free and clear” of existing liens, claims, and encumbrances (commonly referred to as “363 sales” in chapter 11 cases). An order approving a 363 sale typically contains numerous “bells and whistles” that will further protect and benefit the purchaser while at the same time potentially jeopardizing the interests of the nondebtor, including loss of a real property interest (tenant lease rights) and lost or delayed recovery of personal property interests critical to business operations (molds, plans, and specifications). For this reason, 363 sales can be both a benefit and a curse. Buyers interested in purchasing assets can often better insulate themselves from some risks inherent in purchasing from a distressed seller. For entities doing business with a debtor whose assets are sold in bankruptcy, it is critical to obtain advice on how the sale may impact your interests and determine whether proactive measures must be taken. Some courts have held, for example, that real property could be sold “free and clear” of leasehold interests. As a result, tenants who thought they could rely on a notice provision associated with assumption or assignment of leases in a bankruptcy suddenly find themselves out in the cold. In addition, if the debtor holds your proprietary information, you may find that the debtor is selling that information to a competitor. Suppliers to the debtor often agree to enter into new contracts with the purchaser and afterward learn that they are now subject to claims by the selling debtor. Had the supplier been proactive, it might have arranged to protect against those claims in the sale process. Counsel should consider whether a properly perfected security interest would improve the business’s controls over its interests. Counsel should also be aware that, under most circumstances, it will be unable to prevent the sale of property, but that other means of protecting interests, like termination rights, might be effective even after a sale is consummated.

4. Fraudulent Conveyances

Know the indices of fraudulent conveyances/transfers when assessing a prebankruptcy asset purchase. A transfer for less than reasonably equivalent value made while the transferor was insolvent or caused it to become insolvent may be subject to later claims for recovery of losses associated with that transaction under 11 U.S.C. § 548. In-house counsel should be cautious when a deal sounds too good to be true and weigh the risks against the business goals. Specifically, counsel should be aware that in the event the counterparty to a transaction later files bankruptcy, prior transactions with that entity might be closely scrutinized. Be mindful that creditors’ committees and trustees may obtain broad authority from a bankruptcy court to examine transactions involving a debtor and determine whether actions prejudicial to creditors (whether by wrongdoing or otherwise) have occurred. For example, what if your company pays or provides value to the “wrong party”? In that instance, your company purchases assets from company “A,” but the owner of company A asks you to transfer the purchase price to the related company “B.” This transaction will almost certainly be scrutinized by a committee or trustee. As a result, one should always consider whether the “right party”—the entity that provided the value—is paid. Another indicia of concern is if the deal sounds too good to be true, it may be. Assume, for instance, a company is in financial trouble and begins selling noncritical assets and is desperate for cash, and your company is keen to buy the undervalued asset (a “great deal”). In-house counsel will be wary of interfering with the deal, but if one or more of the indices of a fraudulent transfer are present, discuss the potential risks with the deal team and allow them to make an informed business decision. Also consider options for reducing risk, such as obtaining a fairness opinion from a third-party expert to evaluate the value of the asset and the price to be paid. The business team should also be advised to conduct diligence carefully with respect to indemnified claims to ensure that any indemnity is funded to an escrow with a financially stable third party pursuant to a negotiated escrow agreement. Another option is considering whether it is feasible and beneficial to purchase through a 363 sale, discussed above.

5. Preferences

Know how to make informed decisions about preference risks and mitigate the impact on the business. A preference is a payment or other transfer of value of the debtor that may be subject to avoidance (clawed back) under 11 U.S.C. § 547. For noninsiders to the debtor, a payment made by an insolvent entity 90 days before the bankruptcy case is filed (or 120 for “insiders”) on an “antecedent debt” is subject to claw-back provisions as part of the bankruptcy process. In-house counsel often ask whether they should accept such payments or transfers even if they are likely to be avoidable as a preference; the short answer is “yes.” It is almost always advisable to take the money and use it as leverage in the event a committee or trustee seeks to recover the transfer. Although there are defenses to preference claims, asserting defenses can be costly, both in the value of time spent by in-house counsel and the business teams, and in attorney’s fees. Consider strategies to avoid preference exposure altogether. For example, payments received in advance of providing goods or services are not subject to preference recovery because they are not payments on an antecedent debt. Conversely, a prebankruptcy settlement may seem innocuous, but the payments are, by their nature, almost always susceptible to attack. Structure the settlement agreement so that unless and until the last payment is made and 91 days has passed, no claims or consideration are released. As with other bankruptcy risks, establishing protections in advance of bankruptcy filing, such as letters of credit, security interests, or guarantees, can mitigate against the potential pecuniary loss associated with preferences.

By familiarizing yourself with these five fundamental bankruptcy concepts, you can counsel your business teams and mitigate those risks, if not eliminate them. A practical guide for spotting and analyzing these issues follows.

PRACTICAL GUIDE FOR ISSUE SPOTTING AND PRACTICE POINTERS

1. Automatic Stay and Rejection rights: Consider each “phase” of the contract and consider what happens if the contract counterparty files bankruptcy and the automatic stay takes effect and/or the contract is rejected.

(a) Examples of automatic stay considerations and warnings:

(i) All actions against debtor or its assets including the right by the nondebtor party to send notices to terminate the contract will be stayed.

(ii) Creditor will not be able to recover property in the debtor’s possession without relief from the court.

(iii) If written notices are required in order for parties to implement rights or interests, the stay will likely prevent the notice from being sent.

(b) Example of impact of rejection warnings:

(i) Transition service provisions may not be protected.

(c) Will the party be in possession of property rights or knowledge critical to your ongoing operations?

(i) Can you mitigate risks through an escrow?

(ii) Note: in context of licenses, escrow of source codes help, but often you need much more information in order to make use of the source code. Passwords/subsupplier/other operational info.

(d) Purchase options may be terminated.

(e) Debtor’s assets can be sold free and clear of all interests.

2. Assignment rights: Consider Debtors right to assign the contract to a competitor.

3. Fraudulent conveyances:

(a) Does the deal sound too good to be true? Why is that?

(i) Fairness opinions. Although not dispositive, a fairness opinion is considered by many courts to be strong evidence of value that can be considered.

(ii) Due diligence regarding seller solvency?

(iii) Strong arms-length proofs?

(b) Is the entity entering into the transaction (e.g., a sale transaction) the recipient of the value for the transaction? For example, is the purchase price directed to be made to an entity other than seller?

(c) Indemnified claims: Advise potential purchasers to conduct diligence carefully with respect to indemnified claims to insure that any indemnity is funded to an escrow with a reputable, financially stable third party, pursuant to a negotiated escrow agreement.

(d) General warning: If counterparty to transaction files, there is always a risk that the purchase will be investigated. Bankruptcy Rule 2004 permits extensive discovery of third parties, which can quickly become time-consuming and costly.

(i) Discovery can include depositions, written discovery, and production of documents.

(ii) Rule 2004 was intended to provide opportunities for “discovering assets, examining transactions, and determining whether wrongdoing has occurred.” Washington Mutual, 408 B.R. 45, 49 (Bankr. D. Del. 2009) (citing In re Enron Corp., 281 B.R. 836, 840 (Bankr. S.D.N.Y. 2002)).

(e) Mitigation of risk through bankruptcy sales. Should a purchase of seller’s assets through a bankruptcy sale be considered?

(i) Purchasers acquire assets free and clear of existing liens, claims, and encumbrances.

(ii) A sale in bankruptcy is subject to higher and better offers and the approval of a bankruptcy court nullifying fraudulent conveyance risk to a good-faith, arm’s-length purchaser.

(iii) Sale orders typically contain numerous “bells and whistles” that further protect and benefit purchasers.

(f) Note: Clients often ask whether they should take the money even though it may be subject to preference exposure. Most often the answer will be to take the money. Better to have been paid and have to give back then never to have been paid at all.

(g) Payments under a settlement agreement likely constitute prima facie preference payments, and a debtor or trustee in bankruptcy is likely to seek to avoid payment.

(h) Are there ways to mitigate risk? Think:

(i) Payments in advance

(ii) Guarantees

(1) Bankruptcy typically does not preclude a party from seeking to enforce its rights against a nondebtor third party, such as a parent entity, an affiliate, or individual owners.

(2) Guarantees are only as valuable as the guarantor giving them. Often entire enterprises (related entities) seek protection simultaneously in a jointly administered proceeding.

(3) There is a risk that an avoidance action could be brought to recover payment by insolvent guarantors (preference or fraudulent conveyance discussed below).

(4) Upstream guaranty payments are typically more susceptible to challenge than downstream.

(iii) Letter of credit (LC):

(1) Note: given that an LC is issued by a third-party bank, the automatic stay is not implicated, and the creditor may go directly to the LC issuer to be made whole.

(2) An LC is only as good as its language for the draw down.

(3) Carefully watch LC expiration provisions and try to set up notification system.

(4) Supply agreement should either expire prior to LC, or contain default provisions conditioning continued performance requiring LC’s maintenance (but if the contract is not terminated, the prepetition stay will likely prevent termination).

(iv) Security interests: Note: A security interest granted in the 90 days prior to bankruptcy on an antecedent debt will be subject to avoidance actions but generally better to take than not to take.

(v) Shorten credit terms (may minimize overall exposure depending on timing, but can destroy ordinary course defense).

(vi) Is it a commodity sale agreement and can it be formed as a forward contract? Seek front-end documentation bankruptcy consulting advice if you may fall into this business category for sales.

(vii) Retention of title until xyz occurs.

(1) Consider whether a purchase lease back/escrow of critical manufacturing items such as IP and manufacturing “know how” will help.

(2) Needs to be properly documented and monitored.

(3) Automatic stay will still prevent removal of property from debtor’s possession and thus creditor must seek relief from the stay.

(i) Assumption of contracts: Given that a debtor must cure monetary defaults in order to assume the contract, the debtor would have had to pay the supplier “in full.” Therefore, the prepetition payments to the creditor should not be considered a preference.

(i) Often the debtor or the purchaser of debtors assets seek to enter into new amended contracts upon the sale of debtor’s assets or emergence of debtor from bankruptcy. Often this is because the goal is to avoid paying the supplier in full. Warn clients at outset of bankruptcy case not to agree to new contract. Often sales team trying to sell to “new company” is unaware of desire of in-house counsel to have contract assume. Instead of entering into a new contract, suppliers should attempt to require assumption and amendment of the contract and waiver of cure amounts (negotiate the cure if the issue is the cure payment) rather than entering into a new contract.

(j) Earmarking: Payment made by a third party that is specifically designated as a payment of the debtor’s antecedent debt.

(i) The transaction should not negatively affect the debtor’s balance sheet, for example, by replacing an unsecured obligation with a secured obligation.

(ii) Involves a number of complex bankruptcy issues. Bankruptcy counsel should be consulted if client intends to receive an “earmarked” payment from a third party.

(k) Settlement agreement practice pointers and preferences:

(i) Preserve the claims being released for at least the 90-day preference period:

(ii) Springing release. Delay the reduction and effectiveness of any release of claims (and the dismissal of any pending litigation) until 91 days after the last payment is made and no insolvency proceedings filed.

(iii) Preservation of the claim: Provide for the preservation and reinstitution of the full amount of the client’s claim in the event any claw back is sought.

(iv) Escrow: Can be helpful in some circumstances (e.g., parties agree to mutual releases and X agrees to transfer an asset in exchange for Y payment).

ABOUT THE AUTHORS

Chelsea Kiara Davis

Chelsea Kiara Davis is a third-year student at Barry University, School of Law. She earned a B.S. in Political Science with a minor in Legal Studies  from the University of Central Florida, Orlando.…

Bloomfield Hills, MI

Sheryl Toby

Sheryl Toby (Member at Dykema) has substantial experience in two unrelated fields. First she regularly advises manufacturing entities (such as automotive clients)…

Denver, CO

Matt Ochs

Matt Ochs provides business-focused advice on real estate financing transactions, loan workouts, and complex bankruptcy matters.

Real…

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