The Owner’s Dos and Don’ts When a General Contractor Files for Chapter 11 Bankruptcy

This blog post addresses: (1) steps to be taken, (2) issues to be aware of, and (3) recovery prospects when a general contractor files for bankruptcy protection under Chapter 11 of the Bankruptcy Code, from the owner’s perspective.

1. The Automatic Stay Prohibits Taking Immediate Adverse Action Against the General Contractor

When a general contractor files for bankruptcy protection, the automatic stay immediately takes effect, and no prior notice of the stay is required to be given to the owner or any other parties. See 11 U.S.C. § 362(a). Section 362(a) provides a broad list of activities that are immediately stayed by the filing of a bankruptcy case. Section 362(a) generally prohibits taking most adverse actions against the debtor without first requesting that the bankruptcy court grant relief from the automatic stay. For example, the owner cannot immediately terminate its contract with the general contractor once it files bankruptcy and the automatic stay is in effect.

To properly terminate the general contract, the owner must obtain relief from the automatic stay. This entails the filing of a written motion, providing notice in the bankruptcy proceeding, and showing “cause” for termination in a hearing. If cause is shown, then the bankruptcy court may modify the automatic stay to allow termination of the general contractor (or other adverse action). In addition, the owner cannot attempt to collect a debt or enforce any remedies to collect a debt against the general contractor outside of the bankruptcy process.

2. The General Contractor Can Choose to Assume or Reject Performance of its Contract with the Owner

Under 11 U.S.C. § 365, a construction contract is likely an “executory contract”—which (though undefined in the Bankruptcy Code) is generally considered a contract under which an obligation of both the debtor in bankruptcy and the contract counter-party are so far unperformed that the failure of either side to complete performance would constitute a material breach excusing performance of the other party. Notably, the debtor will have the opportunity to either “assume” the executory contract or “reject” it. See 11 U.S.C. § 365(a).

If the debtor general contractor rejects the contract, then it is relieved of its obligations under the contract, and the owner must find a replacement contractor. Rejection amounts to a pre-petition breach of the contract which will afford the owner with a pre-petition claim, likely unsecured, in the bankruptcy. Also, to the extent there exist guarantees of the contract, or bond claims, the owner may be able to proceed with collection actions relative to those items against non-debtor parties. Note that rejection of the contract pursuant to 11 U.S.C. § 365 does not equate to termination of the contract; however, termination may be an available remedy of the owner post-rejection due to the breach. Depending on the specific terms of the contract, owners should consider the merits and damages available in a termination versus non-termination scenario prior to effectuating termination post-rejection.

If the debtor general contractor chooses to assume the contract, then it must cure all outstanding defaults and provide adequate assurances to the owner that it can perform the construction contract moving forward. Adequate assurance and cure issues are commonly litigated in bankruptcy courts. There are statutory deadlines for when the debtor must elect to either assume or reject the executory contract, but an owner may be able to expedite consideration of these issues depending on the circumstances. Often a debtor will propose a cure amount that is binding upon entry of the order approving assumption of the contract. It is critical to review the proposed cure amount and file an objection detailing the true cure amount and any non-monetary defaults prior to any objection deadline.

3. Finishing Out the Construction Project

The owner must decide whether it will be better to allow the debtor general contractor to finish out the project or if it would be better to retain a replacement contractor. Where bonding is involved, the bonding company also may want to carry out performance of the contract. These are issues that often arise early in construction-related bankruptcy proceedings.

Should the owner decide a replacement contractor is the preferred option, then the owner should be proactive and request relief from the automatic stay to terminate the contract or seek an expedited deadline to require the debtor to make an election to either assume or reject performance under the contract.

If allowing the debtor general contractor to complete construction, then the owner should work with the contractor to assume the contract and finish out construction. Construction contracts are often modified and assumed during the assumption process.

4. Other Considerations

Bonds and Liens: The owner should be cognizant of whether there are any payment or performance bond claims, or lien claims that may still be filed against the owner’s property. Where a general contractor files bankruptcy, unpaid subcontractor lien claims are sure to follow. Although these are likely attributable to contractor default, the owner still must address these claims against the owner’s property. Owner liability is dependent upon whether there is a payment bond, the amount of reserved funds withheld, and if there is any fund trapping liability. With respect to any amounts paid directly to subcontractors, it is particularly important for an owner to preserve its right to seek recovery of any amounts paid to clear or avoid subcontractor liens by filing a proof of claim or asserting any cure amounts in the bankruptcy case.

Defects and Other Contract Claims: An owner’s claims against the debtor general contractor arising from construction defects or any other contractual breach may be asserted against the contractor in the bankruptcy case. Unless these claims are secured or covered by a bond, they will likely be treated as unsecured claims.

Conclusion

The takeaway is that once the owner learns its general contractor has filed for bankruptcy, the owner should refrain from taking any adverse action against the debtor general contractor without consulting an attorney regarding the various bankruptcy and construction issues. Violating Section 362 may result in sanctions, even without notice of the stay, which could potentially result in an award in favor of the debtor general contractor with actual damages, costs, attorney’s fees, and, in appropriate circumstances, punitive damages. See 11 U.S.C. § 362(k).

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