March 1, 2000

Chapter 11 Reorganization May Mean Chapter 7 Liquidation For Government Contractors

Holland & Knight Newsletter
Richard E. Lear | David S. Black

A decision by the Bankruptcy Court for the Eastern District of Virginia in the case of a government contractor has stirred up the debate as to whether a debtor-in-possession is able to continue to perform under an executory contract that is not assignable under applicable non-bankruptcy law. That court, with jurisdiction over the Virginia suburbs of Washington, D.C. – the primary place of business of many government contractors – has held that the debtor/contractor which has filed 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. The effect of such a decision is the likely liquidation of the contractor with little remaining for distribution to 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 re-procure the contracts at issue. With the bankruptcy case barely three months old, the 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 TechDyn 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." Adopting a strict interpretation of Section 365(c)(1) of the Bankruptcy Code, 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. Under the TechDyn court’s strict reading of the bankruptcy statute, it did not matter to the court whether the contractor/debtor-in-possession actually intended to assign the contract. If the debtor-in-possession hypothetically could assign the contract, that was enough to trigger the need for government approval. The TechDyn court’s adoption of the "hypothetical test" was consistent with the approach of the district court in the Eastern District of Virginia and of the majority of circuit courts which have addressed the issue.

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. Further, 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, 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. Arguably, courts adopting the "actual test" focus more on the policy underlying 41 U.S.C. § 15 than on the plain language of section 365(c)(1) of the Bankruptcy Code.

Congress has apparently recognized the concerns that have been raised by courts which have adopted the "hypothetical test." In the Bankruptcy Reform Act of 1999 (H.R. 833), section 305(a) provides that in a Chapter 11 case, a trustee in a case in which the debtor is a corporation, or a debtor-in-possession, may assume an executory contract even if applicable non-bankruptcy law prohibits the assignment of such contract. If this legislation is enacted into law, the concerns addressed by the TechDyn court will be resolved.

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