An Ounce of Prevention is Worth a Pound of Cure: How to Deal with Bankruptcy in Contracts

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1 An Ounce of Prevention is Worth a Pound of Cure: How to Deal with Bankruptcy in Contracts Joshua A. Lefkowitz, Ares Management, Legal Department Michael L. Bernstein, Arnold & Porter Kaye Scholer LLP Advanced Contracts Conference July 18, 2017 apks.com Arnold & Porter Kaye Scholer LLP All Rights Reserved.

2 What We Will Cover Why you want to avoid counterparty s bankruptcy Minimizing insolvency risk at the time of contract negotiation Mitigating risk when your counterparty suffers financial distress What you can and cannot do when your counterparty files bankruptcy 2

3 Why You Want to Avoid Counterparty s Bankruptcy Filing of petition triggers automatic stay: Bars most actions vs. debtor or debtor s property Contract counterparties generally cannot terminate without court approval Bankruptcy can take a year or more, and during that time: You probably won t get paid prepetition debt You will have to continue to perform any contractual obligations You will have uncertainty about your counterparty s future performance can complicate business decisions Your contact may be rejected and your rejection damage claim may be paid only pennies on the dollar You will spend money on lawyers 3

4 More Reasons to Avoid Counterparty s Bankruptcy Payments made within 90 days prepetition may be avoided as a preference (but not if contract is assumed) Debtor/Trustee may attack pre-bankruptcy transactions under fraudulent transfer laws Your contact may be assigned, on its own or as part of a sale of the business, despite an antiassignment provision 4

5 Minimizing Bankruptcy Risk at the Time of Contract Negotiation Include reporting provisions enabling you to monitor counterparty s financial position and watch for early warning signs of distress (requires internal monitoring function) There s no one-size-fits all: reporting and monitoring tailored to specific situation (nature of business, public vs. private, size of relationship) Include default triggers in contracts: Give yourself the ability to terminate the contract before bankruptcy (incorporate warning signs as defaults, and negotiate for termination on short notice) Consider short contract term, with renewal options 5

6 Minimizing Bankruptcy Risk at the Time of Contract Negotiation Cross default to other material obligations Use of master agreement that establishes the terms for transactions, but does not obligate you to any transactions Obtain financial security: Trade credit insurance Cash in advance or COD, or contractual right to transition to those arrangements upon specified events Letter of credit (provide for draw upon default without notice/demand) Deposit Guaranty (full-recourse of springing) Factoring Alternative of financial security requirement upon specified events (e.g., tripping covenants) 6

7 Minimizing Bankruptcy Risk at the Time of Contract Negotiation Consider contractual setoff right Consider attempting to define adequate assurance of future performance in contact Consider possible ways to limit assignability of contract in bankruptcy Bankruptcy Code contains special protections for IP licensees include contract provisions needed to fully utilize those protections Consider use of bankruptcy remote structures 7

8 Minimizing Bankruptcy Risk at the Time of Contract Negotiation Some provisions that will not work: Ipso facto clauses not enforceable Termination at will provisions are unlikely to be enforced if the contract is important for the debtor Waivers of the automatic stay and other Bankruptcy Code provisions are typically not enforceable 8

9 Mitigating Risk When Your Counterparty Suffers Financial Distress Initial Steps First step is early identification of counterparty s financial distress requires active monitoring Internal policy should require legal review in default/distress situations Initiate discussions quickly distress does not age well Consider restructuring or commencing litigation Make contingency plans (e.g., line up alternative counterparty) in case debtor liquidates or rejects contract 9

10 Mitigating Risk When Your Counterparty Suffers Financial Distress Some early warning signs of potential distress: Nonpayment or slow payment of invoices Actions by other creditors Downgrade in credit rating Delisting or warning from securities exchange Going concern qualification Issues raised in SEC filings Breach of financial covenants Major debt maturing Management upheaval Significant layoffs or plant closing Substantial litigation or entry of significant judgment Governmental investigations Industry distress Geopolitical issues Commodity values Rumors 10

11 Mitigating Risk When Your Counterparty Suffers Financial Distress Termination or modification of terms Terminate before bankruptcy per contract or negotiated termination Negotiate for security and/or altered terms as alternative to termination Move to COD or cash in advance if contract permits Consider cease shipping/providing services if no obligation to do so A Decision: maintain ordinary course payment schedule to minimize preference risk or modify terms to reduce credit risk 11

12 Mitigating Risk When Your Counterparty Suffers Financial Distress UCC remedies: Request adequate assurance upon insecurity (UCC 2-609) Stop shipment of goods in seller s possession (UCC 2-702(1)) Stop delivery of goods in carrier, warehouse or other third party s possession (UCC 2-705) Reclamation (UCC 2-702(2) and (3)) 12

13 Mitigating Risk When Your Counterparty Suffers Financial Distress Setoff and Recoupment Setoff allows entities that owe each other money to apply their mutual debts against each other: Requires mutuality same entities and both prepetition (or both postpetition) Exercising setoff gives you a secured claim to the extent of the mutual debt Requires relief from automatic stay if under taken in bankruptcy Recoupment claims must arise from same transaction: Can recoup prepetition debt against postpetition obligation Courts have held that recoupment does not require relief from the automatic stay If undertaken pre-bankruptcy, risk of set-off avoidance 13

14 Mitigating Risk When Your Counterparty Suffers Financial Distress Should you file an involuntary bankruptcy? Advantages: Court supervision Appointment of a trustee Control over a dishonest debtor Limits ability to dissipate assets Ability to obtain information/discovery Trustee or other estate representative may recover preferences and fraudulent transfers Disadvantages: You will have to share value with other creditors under the bankruptcy priority scheme Expense: your own legal fees and bankruptcy administrative expenses Possible award of attorneys fees and costs if petition is dismissed, and punitive damages for bad faith filing 14

15 Mitigating Risk When Your Counterparty Suffers Financial Distress Requirements For Involuntary Petition: Three creditors must join, if debtor has 12 or more creditors One creditor can file if debtor has fewer than 12 creditors Debts must not be contingent as to liability or subject to a bona fide dispute as to liability or amount Petitioning creditors must hold unsecured (or deficiency) claims totaling at least $15,755* * This amount is indexed and must therefore increase over time 15

16 What You Can And Cannot Do If Your Counterparty Files Bankruptcy You cannot: Unilaterally terminate contract with the debtor Commence or continue litigation against the debtor Exercise creditors rights remedies against the debtor or its assets (e.g., foreclosure) Setoff mutual obligations (but may be able to recoup) Demand payment of amounts owed prepetition 16

17 What You Can And Cannot Do If Your Counterparty Files Bankruptcy You can: Draw a letter of credit if the conditions precedent to a draw have occurred (but notice/demand may violate stay) Decline to extend a contract that has terminated prepetition or to enter into a new contract Decline to ship goods if there is no contractual obligation to do so Move bankruptcy court to establish a deadline for contract assumption or rejection Seek adequate protection File a proof of claim for prepetition debts and an administrative expense claim for postpetition debts Sell your claim to a claims trader 17

18 What You Can And Cannot Do If Your Counterparty Files Bankruptcy You should: Review first day motions quickly; consequential things may happen very quickly Consider whether to serve on creditors committee Determine claims bar date Review debtor s schedules and SOFA Consider attending 341 meeting Consider possibility of critical vendor treatment Monitor bankruptcy case docket and watch for key filings (e.g., sale motion, plan, motion to convert, assumption/rejection motion) 18

19 What You Can And Cannot Do If Your Counterparty Files Bankruptcy What is an executory contract: general rule is mutual obligations remain unperformed Treatment of executory contracts: Rejection: gives rise to rejection damage claim Assumption: requires cure and adequate assurance Assignment: generally permitted, with limited exceptions Must assume/reject/assign entire contract Integrating multiple parts avoids cherry-picking Make clear in contract parties intent that all agreements and transactions constitute a single, integrated contract 19

20 What You Can And Cannot Do If Your Counterparty Files Bankruptcy Deadlines for Contract Assumption/Rejection In Chapter 11: Generally until plan confirmation, but court may set earlier deadline In Chapter 7: 60 days after order for relief; unless extended Special Rule for Leases: Debtor or Trustee has 120 days (extendable up to 90 additional days) to assume or reject a lease of non-residential real property under which debtor is lessee 20

21 Questions & Discussion 21

22 Speaker Biographies Joshua Lefkowitz (Principal, Associate General Counsel, Ares Management, Legal Department ) is a Principal and Associate General Counsel (Credit) in the Ares Management, Legal Department. Prior to joining Ares in 2017, Mr. Lefkowitz was a Vice President and Associate General Counsel at American Capital, Ltd., where he focused on debt and equity investments, workouts and restructurings and compliance and regulatory matters. Previously, Mr. Lefkowitz was an Associate at Mayer Brown and Stroock & Stroock & Lavan LLP, where he focused on general corporate and finance matters and complex bankruptcies and restructurings. Mr. Lefkowitz holds a B.A. from the University of Rochester in History and a J.D. from Georgetown University. Michael L. Bernstein (Partner, Arnold & Porter Kaye Scholer LLP) is chair of Arnold & Porter Kaye Scholer LLP's Bankruptcy and Restructuring Practice. For more than 25 years, he has represented creditors, debtors, investors, and other stakeholders in restructuring negotiations, distressed M&A transactions, bankruptcy and other insolvency proceedings, and in related litigation throughout the United States. He also advises clients concerning corporate governance and fiduciary duty issues arising in the insolvency context. Chambers USA has described him as having "an encyclopedic knowledge of the Bankruptcy Code, an unbelievably tireless energy level, and a practical results-oriented approach to bankruptcy issues," noting that clients describe him as a "fierce and zealous advocate and skilled negotiator," and a "creative and loyal advocate whose knowledge of the Bankruptcy Code makes him incredible at getting the best results for his clients." Mr. Bernstein is a Fellow of the American College of Bankruptcy and a Director of the American Bankruptcy Institute. He is the author of Bankruptcy in Practice, now in its Fifth Edition, and other books and articles, and is a frequent lecturer. On several occasions, Mr. Bernstein has been invited to testify before the United States Congress, as an independent expert, on proposed bankruptcy reform legislation. He has also been interviewed by major newspapers and on television and radio. 22

23 Contact Information Michael L. Bernstein Joshua Lefkowitz