By Steven Diamond and Thomas Pettit

Law360 (May 18, 2020, 5:06 PM EDT )

Steven Diamond

Thomas Pettit

This is the second installment in a two-part article that examines the intersection of federal bankruptcy law with federal procurement law, which presents unique challenges, as well as opportunities, for federal contractors considering or undergoing bankruptcy.

Termination Provisions

The government generally has the right to terminate contracts for convenience or default.[1] The standard Federal Acquisition Regulation, or FAR, Termination-for-Convenience clause allows the government to terminate a contract if it is in its interest to do so.[2]

Commercial termination-for-convenience provisions may be broader and allow for termination for any reason whatsoever.

The government may terminate a contract for default if the contractor fails to perform the contract and to cure an identified breach.[3]

Significantly, bankruptcy or insolvency is not, in itself, a basis on which the government may can terminate a FAR-covered contract under the default clause.[4]

Government customers may be interested in terminating contracts after a contractor petitions for bankruptcy for a variety of reasons, including fear that the contractor may not have sufficient resources to perform or that resources used in performing the contract could be used to pay the contractor's creditors with more senior interests.

These termination provisions are not ipso facto provisions (i.e., provisions that automatically terminate contracts upon filing for bankruptcy), and the contractor/debtor cannot exercise its right to invalidate ipso facto provisions to circumvent termination for convenience and default provisions.

However, termination proceedings of prepetition contracts are subject to the automatic stay, meaning the government cannot initiate termination proceedings after the contractor files a bankruptcy petition absent court-ordered relief.[5]

Terminations of contracts executed after filing the petition are not subject to the stay.[6]

Importantly, however, contractors in hypothetical-test jurisdictions may find that courts are more inclined to grant a government request for relief from an automatic stay to pursue a termination based on the hypothetical test's principle that the Anti-Assignment Act prohibits the contractor/debtor from assuming the contract without the government's consent.[7]

As discussed above, the regulatory and police power exception to the automatic stay does not apply to government contract actions, including terminations. Courts have been reluctant to provide the government with special treatment and relief from an automatic stay, absent contract clauses that vest title to contractor-held property in the government.

Indeed, some courts have held that a provision allowing a party to terminate a contract for convenience is not in itself sufficient cause to grant relief from automatic stays, and a counter-party must still show cause to grant relief in accordance with Title 11, Section 362(d)(1) of the U.S. Code.[8]

Further, debtors in actual-test jurisdictions sometimes have been able to preclude a counterparty from enforcing a termination-for-convenience provision on the basis that the counterparty's real reason for termination was the debtor's bankruptcy filing, which runs afoul of Section 365(e)(1) of the Bankruptcy Code.[9]

For this reason, it is not unusual for a debtor in an actual-test jurisdiction to attempt to draw a counterparty out to explain why it is exercising a termination-for-convenience provision.

The debtor may do so on the chance that the counterparty will reveal that its real motivation for exercising the provision is the bankruptcy filing or the debtor's financial condition generally, in violation of Section 365(e)(1).

Requests for Equitable Adjustment

Many recent articles have addressed the broader challenges, impacts and opportunity posed by the COVID-19 pandemic. Contractors in various circumstances may be able to seek equitable adjustments if, for example, their contracting officers issue stop-work orders due to the COVID-19 pandemic.

However, contractors forced to declare bankruptcy may face hurdles in pursuing equitable adjustments and claims under the Contract Disputes Act. For example, in Doninger Metal Products Corp. v. U.S., the U.S. Court of Federal Claims held that the contractor, which was a debtor in bankruptcy, did not have standing to seek an equitable adjustment.[10]

This decision was based on the specific circumstances of that bankruptcy and the fact that the debtor's property had been placed in an estate and controlled by a trustee

The outcome may have been different if the contractor had been a debtor-in-possession, and thus continued to possess its property.[11]

Nevertheless, this case illustrates pitfalls contractors may face after petitioning for bankruptcy, and highlights the risk that contractors must plan carefully, and evaluate and balance all of their interests when deciding whether and when to file for bankruptcy, and whether and when to pursue equitable adjustment claims.

Conclusion

Companies holding even a single government contract face unique requirements and hurdles when seeking bankruptcy protection. These include notice requirements, loopholes that may jeopardize their right to an automatic stay, and restrictions on assumption, assignment, and termination of contracts and pursuit of equitable adjustment claims.

At the same time, contractors that think strategically may be able to use these features to their advantage. For example, a contractor facing financial hardship that anticipates that the government will terminate a contract that may be profitable or strategically important to the company, may be able to time its bankruptcy petition to avoid contract termination.

Similarly, contractors facing financial hardship as a result of COVID-19 may be able to pursue equitable adjustment claims, depending on the circumstances and the terms of their contracts. Requests for equitable adjustments, followed by submission of a certified claim and appeal of a contracting officer's final decision, if necessary, could allow contractors to recover funds sufficient to help offset existing debts and provide working capital to facilitate a restructuring.

As noted earlier, however, contractors that file bankruptcy petitions — particularly those that will not be debtors in possession — could find themselves unable to pursue equitable adjustment claims and contractual relief, if they file bankruptcy petitions prematurely.

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Steven S. Diamond is a partner and Thomas A. Pettit is an associate at Arnold & Porter.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] See, e.g., FAR 52.249-2, Termination for Convenience of the Government (Fixed-Price); FAR 52.249-6, Termination (Cost-Reimbursement). Many commercial contracts also contain ipso facto clauses, which are contract clauses that terminate contracts when a party files for bankruptcy. The Bankruptcy Code generally allows debtors to override ipso facto provisions. 11 U.S.C. §365(a). Termination for convenience and default provisions are not ipso facto clauses, and federal procurement contracts governed by the Federal Acquisition Regulation do not contain ipso facto provisions, although such provisions may be included in other government contracts, though non-procurement contracts that are not subject to the FAR (e.g., other transaction agreements, or OTAs) can contain these clauses. Government subcontracts awarded under government prime contracts may include an ipso facto provision separate from a flow-down of the FAR Termination for Convenience clause. 

[2] Id.

[3] See, e.g., FAR 52.249-6(a)(2).

[4] See, e.g., FAR 52.249-8; see also 11 U.S.C. § 525(a) (prohibit discrimination by government entities against debtors).

[5] See, e.g., In re Enron Corp. , 300 B.R. 201, 211-212 (Bankr. S.D.N.Y. 2003) (holding that a contract cannot be terminated without first seeking stay relief, regardless of the existence of a provision in the contract allowing for termination); In re Redpath Computer Servs. , 181 B.R. 975, 978 (Bankr. D. Ariz. 1995) (finding that "the Bankruptcy Code neither enlarges the contract rights of a debtor, nor prevents termination of a contract by its own terms," but "[a]n executory contract that is property of the estate can only be terminated after a grant of relief from the stay"); Communications Tech. Applications Inc. , ASBCA No. 41573, 92-3 BCA ¶ 25,211 (holding that termination for default way stayed by bankruptcy proceeding); Harris Prods. Inc. , ASBCA No. 30426, 87-2 BCA ¶ 19,807 (holding that terminations for default based on facts that arose prior to the debtor filing the petition are stayed); In re Corporacion de Servicios Medicos Hospitalarios de Fajardo , 805 F.2d 440 (1st Cir. 1986) (same). But see Valley Forge Plaza Assocs. v. Schwartz , 114 B.R. 60 (E.D. Pa. 1990) (holding that the Bankruptcy Code does not prevent termination of a contract by its own terms, and "the ability to terminate a contract on its terms survives bankruptcy").

[6] See In re New England Marine Servs. Inc. , 174 B.R. 391, 397 (Bankr. E.D.N.Y. 1994).

[7] See also United States v. TechDyn Sys. Corp. , (In re Tech Dyn Sys. Corp.), 235 B.R. 857 (Bankr. E.D. Va. 1999) (distinguishing between debtor and debtor-in-possession, and granting agency relief from automatic stay to terminate contract because, under the Anti-Assignment Act, contractor/debtor could not assume or assign government contract without agency's consent). 

[8] See In re The Elder-Beerman Stores Corp. , 195 B.R. 1012, 1018 (Bankr. S.D. Ohio 1996) ("The conditions under Section 362(d) govern relief from the stay, and when those conditions are not met, courts have not hesitated to leave the stay intact, even in the presence of 'at will' termination clauses."); Coaldale Energy LP v. Lehigh Coal & Navigation Co. (In re Lehigh Coal & Navigation Co. ), 2009 WL 1657096, at *3-4 (Bankr. M.D. Pa. June 12, 2009) (holding that the debtor's ability to terminate the agreement at will "may not be sufficient to constitute cause to grant relief," but finding that cause existed to grant stay relief on other grounds).

[9] See In re Nat'l Hydro-Vac Indus. Servs. , 262 B.R. 781, 786 (Bankr. E.D. Ark. 2001) (holding that a contract termination clause did not enable a bank to terminate on the basis of the debtor's Chapter 11 filing, and noting that "[i]n a commercial contractual relationship, terminable-at-will provisions must be exercised in good faith"); In re B. Siegel Co. , 51 B.R. 159, 163 (Bankr. E.D. Mich. 1985) (convenience termination clause does not confer an unrestricted right to cancel a contract, when the only reason for its invocation is the debtor's bankruptcy filing, because this would nullify the remedial policy of Section 365(e)(1)).

[10] 50 Fed. Cl. 110 (2001). The Armed Services Board of Contract Appeals reached a similar conclusion in connection with a contractor that has been "liquidated under Chapter 7." Traction Sys. Inc. , ASBCA No. 53081, 03-1 BCA ¶32169 (holding that contractor that had liquidated under Chapter 7 did not have standing to appeal a contracting officer's final decision under the Contract Disputes Act because, although the company continued to exist for some period of time after the liquidation pending dissolution in accordance with state law, "the corporation's existence outside the confines of the bankruptcy estate is wholly extinguished" (citations omitted)).

[11] See 11 U.S.C. §§363(c), 1107.

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