A Legal View: What is the impact of filing for bankruptcy?

A company official asked the following question: Because of cash flow issues, our company is considering filing for bankruptcy protection in order to reorganize our business.

A company official asked the following question: Because of cash flow issues, our company is considering filing for bankruptcy protection in order to reorganize our business. What is the potential impact of such an action on our existing government contracts and our ability to compete for future contracts?

Under Chapter 11 of the Bankruptcy Act, a company that has become insolvent may seek temporary protection from its creditors to reorganize itself as a going concern. Alternatively, under Chapter 7, the company voluntarily may seek to liquidate its assets and cease operations altogether. Under certain circumstances, a company's creditors can force the company into involuntary bankruptcy. The potential impact of these actions on a company's ability to contract with the federal government can vary depending on the circumstances.

In general, when a company initiates Chapter 11 proceedings to reorganize its business, it is required to give immediate notice to its creditors. Creditors must file proof of their claims against the debtor with the bankruptcy court or else those claims are waived. Under the automatic stay provisions of the Bankruptcy Act, creditors are prohibited from taking any actions that may jeopardize the debtor's ability to reorganize unless the bankruptcy court gives the creditors permission to do so.

After the initial filing, the debtor then must prepare a plan of reorganization. As part of the plan, the debtor must identify executory (specific, unperformed) contracts that it would like to assume and complete. The debtor also must describe the process by which it plans to satisfy the claims of its creditors. The act establishes detailed procedures by which the creditors may approve the plan or register their objections. Moreover, the bankruptcy court is given plenary jurisdiction to resolve all claims against the debtor. Once the plan has been approved by the court, the debtor is obliged to conform to it unless it is modified.

Only an executory contract may be assumed by a debtor. For example, in American Ship Building Co. [164 Bankr.M.D.Fla. 358 (Feb. 22, 1994)], the court found that the debtor could assume a contract with the Navy to build one ship because the contract was still executory when the bankruptcy action was initiated, but it could not assume another contract because it already had been terminated when the petition was filed. In that case, the debtor argued that it should be allowed to assume both contracts because the termination of the first one was improper. However, the court disagreed on the grounds that lawsuits involving contracts with the United States can be pursued only in accordance with the Contract Disputes Act of 1978. This is an exception to the general plenary power of the bankruptcy court to decide claims against debtors.

In its ruling, the court in the American Ship Building case followed a large body of precedents. For example, in Gary Aircraft Corp. v. United States [698 F.2d 775 (5th Cir. 1983)], the Court of Appeals for the Fifth Circuit found that a debtor's contractual disputes with an agency were properly set before the agency's board of contract appeals under the Contract Disputes Act. Accordingly, the bankruptcy court lacked jurisdiction to decide the disputes. Most other courts that have reviewed the issue have reached similar conclusions.

However, in Quality Tooling Inc. v. United States [47 F.3d 1569 (Fed. Cir. 1995)], the Court of Appeals for the Federal Circuit reached a different conclusion. According to that court, the jurisdiction of the Court of Federal Claims and the boards of contract appeals under the Contract Disputes Act overlap with the jurisdiction of the bankruptcy courts. According to the Federal Circuit, it is proper for the bankruptcy court to initially decide which forum will resolve a particular contract dispute. Obviously, there is a considerable difference of opinion on this issue. Which view will prevail in a particular case is likely to depend on the forum in which the issue is raised.

Under the Bankruptcy Reform Act of 1978, the automatic stay provisions were made applicable to governmental entities at all levels. At a minimum, this means that an agency cannot unilaterally decide to terminate a contract once a contractor files for bankruptcy protection. Moreover, in Exquisito Services Inc. [823 F.2d 151 (5th Cir. 1987)], the Court of Appeals for the Fifth Circuit affirmed an order by a bankruptcy court to direct the Air Force to exercise an option in a contract with a debtor. According to the court, the evidence showed that the bankruptcy proceeding was the only reason the Air Force did not want to exercise the option, and discrimination based solely on a bankruptcy filing is improper.

In competitions for new contracts, the General Accounting Office consistently has stated that the mere fact that an offeror is undergoing bankruptcy proceedings does not make it ineligible for an award. See, for example, Hugo's Cleaning Service Inc. [B-228396.4, July 27, 1988, 88-2 CPD ¦ 89], in which the fact that an offeror is undergoing bankruptcy proceedings does not necessarily mean that the company is not a responsible offeror; and C. Martin Co. [B-228552, Jan. 20, 1988, 88-1 CPD ¦ 56], in which the agency was not required to downgrade an offeror's technical evaluation scores based on the company's bankruptcy filing.

However, when a company seeks to dissolve its business under Chapter 7 of the Bankruptcy Act, its only legitimate purpose is to close down its affairs. See, for example, Sheppard's Interior Construction Co. [ASBCA No. 45902, 97-1 BCA ¦ 28,744], in which, by closing its Chapter 7 case, the appellant lost standing to prosecute its appeal. A company undergoing liquidation ordinarily may not pursue new business.

Peckinpaugh is a member of the government contracts section of the law firm of Winston&Strawn, Washington, D.C. This column addresses legal topics that arise in government acquisition and management of ADP resources. Readers are encouraged to submit topics by e-mail to carl@carl.com. This column discusses legal topics of general interest only and is not intended to provide legal advice. Should you have a specific question or legal problem, consult an attorney.

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