Financially Troubled Contractors and Their Creditors - Beware
 
September 1, 1999
 
David Scott "Dave" Black- Northern Virginia
Richard E. Lear- Washington

A recent decision by the Bankruptcy Court for the Eastern District of Virginia has potentially momentous consequences for bankrupt government contractors and their creditors. That court, with jurisdiction over the Virginia suburbs of Washington, D.C., the primary place of business for many government contractors, has held that the debtor/contractor filing for reorganization under Chapter 11 of the Bankruptcy Code is not automatically entitled to continue performing its federal contracts. Instead, the government can obtain permission from the bankruptcy court to immediately terminate such contracts. This decision may result in a Chapter 11 contractor being forced into liquidation proceedings, with little remaining for its creditors.

Filing a Chapter 11 petition protects a debtor from certain adverse legal action, including termination of ongoing contracts, unless and until the Bankruptcy Court allows such a termination. In United States v. TechDyn Systems Corp., 235 B.R. 857 (Bankr. E.D.Va. 1999), the contractor had several contracts to maintain and repair telecommunication networks for the U.S. Army. In April 1999, the contractor filed a bankruptcy petition under Chapter 11 and continued to operate its business as the "debtor-in-possession." Shortly thereafter, the Army filed a motion seeking relief from the automatic stay so that it could terminate for default and reprocure the contracts at issue. The Virginia-based bankruptcy court granted the Army's motion, reasoning that the contractor could not legally continue to perform its government contracts without the government's consent.

The bankruptcy court's decision flows from the interplay between the Bankruptcy Code and the Anti-Assignment Act. Section 365(c)(1) of the Bankruptcy Code prohibits a debtor-in-possession from assuming any executory contract (i.e., a contract that is not yet fully performed by at least one of the parties) without the approval of the other party to the contract, if the other party is permitted by law to reject "performance from . . . an entity other than the debtor or the debtor-in- possession." In the case of executory government contracts, the Anti-Assignment Act, 41 U.S.C. § 15, prohibits a contractor from transferring the contract "to any other party." The bankruptcy court therefore held that, because the Army could reject assignment of the contract under the Anti-Assignment Act, the contractor/debtor-in-possession was prohibited by the Bankruptcy Code from assuming its executory government contracts without the Army's consent. It did not matter whether the contractor/debtor-in-possession actually intended to assign the contract. If it hypothetically could assign the contract, that was enough to trigger the need for government approval.

The TechDyn court appeared to agree with the contractor's argument that the fundamental purposes of the bankruptcy code may be ill-served by its decision. Indeed, the court acknowledged that refusing to recognize the debtor-in-possession as the actual contractor would present problems for debtors whenever the debtor's business includes large unassignable contracts. And, as a practical matter, the benefits and protections of Chapter 11 would be foreclosed in such case. The court, however, would not take on a "judicial rewrite" of the Bankruptcy Code to fix "poor bankruptcy policy."

Other than the Eastern District of Virginia, jurisdictions applying this so-called "hypothetical test" include the Third Circuit (covering Pennsylvania, New Jersey and Delaware), the Ninth Circuit (covering Alaska, Arizona, California, Hawaii, Idaho, Nevada, Montana, Oregon and Washington), the Eleventh Circuit (covering Florida, Georgia and Alabama), the Middle District of North Carolina, and the Southern District of Ohio.

Bankruptcy courts in other jurisdictions have applied the so-called "actual test." These courts view the contractor and the newly minted debtor-in-possession as one in the same and not subject to the constraints of the Anti-Assignment Act (that is, the debtor-in-possession is actually the contractor and therefore no assignment has occurred). Jurisdictions applying the "actual test" include the First Circuit (covering Maine, New Hampshire, Massachusetts and Rhode Island), the Middle District of Louisiana, the District of Nebraska, the Western District of Texas, and the Western District of New York.

Preservation of its contract inventory is an essential component of a government contractor's reorganization plan. Consequently, a contractor considering Chapter 11 will want to carefully weigh its options with regard to where to file a bankruptcy petition. A corporate debtor's business may provide alternative jurisdictions from which to chose when filing for bankruptcy protection. Generally, a corporation may file for bankruptcy in the judicial district in which (1) it is incorporated, (2) it has its principal place of business, or (3) its principal assets in the United States are located. 28 U.S.C. § 1408. A debtor may also file in any judicial district in which an affiliated business has already commenced a bankruptcy proceeding. In light of the government's predictable reluctance to deal with a contractor coping with the problems associated with bankruptcy, filing in the wrong jurisdiction could mean the quick termination of crucial government contracts and the ultimate liquidation of the company.