What Happens to Business Contracts During Bankruptcy?

 When a business files for bankruptcy, it triggers a series of legal and financial processes designed to either liquidate its assets (in the case of Chapter 7 bankruptcy) or reorganize and restructure its debts (in the case of Chapter 11 bankruptcy). One of the critical questions for business owners and their creditors is how existing business contracts are treated during bankruptcy proceedings.

Business contracts are legally binding agreements, and they can involve numerous aspects of a business’s operations, including vendor agreements, leases, employee contracts, customer service agreements, loans, and more. As the bankruptcy process unfolds, it’s crucial to understand how these contracts are affected.

This article will delve into the impact of bankruptcy on business contracts, including what happens to them, whether they can be rejected or assumed, and the rights of creditors and contract parties during and after the bankruptcy process.

What Is a Business Contract in the Context of Bankruptcy?

A business contract in the context of bankruptcy refers to any legally binding agreement the business has entered into, whether with employees, customers, vendors, creditors, or other business partners. These contracts are essential to the operation of a business and can include:

• Leases for office or retail space
• Supplier or vendor agreements for the provision of goods or services
• Customer contracts, including service agreements or subscription models
• Employee contracts, which govern the terms of employment and compensation
• Loan agreements, where the business is obligated to repay borrowed money
• Intellectual property agreements, such as licenses or patents

In bankruptcy, these contracts are subject to the oversight of the bankruptcy court, and their treatment depends on the type of bankruptcy filed and the specifics of each contract.

Chapter 7 Bankruptcy: Liquidation and Contract Termination

Under Chapter 7 bankruptcy, a business typically ceases its operations, and its assets are liquidated to pay off its debts. In this type of bankruptcy, the treatment of business contracts is as follows:

1. Rejection of Contracts

In Chapter 7 bankruptcy, the business will most likely terminate most of its operations. As a result, many of its contracts will be rejected. Rejection of a contract means that the business is no longer obligated to fulfill its terms. For example, the business may stop paying for a lease or end supplier agreements, as it no longer requires these services or assets due to the closure of operations.

• Lease Contracts: Commercial leases are often rejected in Chapter 7 bankruptcy if the business no longer intends to operate out of the leased premises. However, the business may still be liable for unpaid rent up to the date the contract is rejected.

• Employee Contracts: Employee contracts may also be terminated, but employees are entitled to severance or unpaid wages as part of the bankruptcy proceeding, depending on the circumstances.

• Vendor and Supplier Contracts: Contracts with vendors or suppliers may be rejected if the business no longer needs their goods or services. The supplier can file a claim for any outstanding payments, but they cannot enforce the contract after rejection.

2. Liquidation of Assets

Once contracts are rejected, the business’s assets are liquidated to pay creditors. This may include selling off any property, equipment, or inventory, and the proceeds are distributed to creditors according to the priority rules in bankruptcy law.

3. Potential Liabilities from Rejected Contracts

Although rejected contracts relieve the business from performing them in the future, there may still be liabilities from contracts that were in place before the bankruptcy filing. This could include:

• Damages for Rejected Contracts: The business may owe damages for breaching contracts that were not assumed or assigned, especially if the contract stipulated penalties for early termination.

• Unpaid Obligations: Even if a contract is rejected, the business may still be responsible for obligations incurred up to the point of rejection, such as unpaid rent, services rendered, or goods delivered.

Chapter 11 Bankruptcy: Reorganization and Contract Assumption or Rejection

In Chapter 11 bankruptcy, the business generally seeks to reorganize and continue its operations. The goal of Chapter 11 is not liquidation but the restructuring of debts and contracts to enable the business to regain financial stability. In this type of bankruptcy, the treatment of contracts is more complex, and the business has more flexibility in deciding what happens to existing agreements.

1. Assumption of Contracts

In Chapter 11 bankruptcy, the business may choose to assume certain contracts that are essential to its reorganization. Assumption of a contract means the business agrees to continue performing its obligations under that contract. To assume a contract, the business must typically demonstrate to the bankruptcy court that it is capable of fulfilling the terms of the agreement going forward.

For example:

• Vendor Agreements: If a business depends on a supplier for essential materials, it may assume the contract to continue receiving goods or services necessary for its operations.

• Leases: If the business intends to continue operating from its current location, it may assume its commercial lease. The business will then be responsible for paying the rent and complying with lease terms.

2. Rejection of Contracts

Just like in Chapter 7, a business under Chapter 11 may reject certain contracts, especially those that are not essential for the reorganization. Rejection of contracts in Chapter 11 allows the business to free itself from the burdens of agreements that are no longer in its best interest.

• Non-Essential Leases and Contracts: If the business is restructuring, it might reject non-essential leases, vendor contracts, or customer agreements that are not vital to the success of the reorganization.

• Employee Contracts: In some cases, the business may reject certain employee contracts, though employees may still have rights to unpaid wages, severance, and other compensation.

The rejection of contracts in Chapter 11 can result in a rejection claim from the other party to the contract. This means that the party whose contract was rejected can file a claim for damages in the bankruptcy court.

3. Reaffirmation of Debts and Contracts

In some cases, a business may be able to reaffirm certain contracts or debts under Chapter 11. Reaffirmation occurs when the business continues to honor the terms of a contract or debt, even though it may not be legally required to do so as part of the bankruptcy proceedings.

Reaffirming a contract may be beneficial if it allows the business to maintain a key relationship with a vendor or customer, ensuring continued operations during the reorganization process.

The Impact on Contract Parties

For businesses entering bankruptcy, the consequences for contract parties (such as vendors, customers, and employees) can vary based on the type of bankruptcy and the specific contract involved.

• Vendors and Suppliers: If the business assumes the contract, the vendor or supplier can continue providing goods or services, and the business will continue to pay as agreed. If the business rejects the contract, the vendor may have to file a claim in bankruptcy court to recover damages for any outstanding payments.

• Customers: Customers with contracts for services or products may find that their agreements are either honored or terminated based on the bankruptcy proceedings. If the business is reorganizing under Chapter 11, customers may see continued services. If the business is liquidating under Chapter 7, the customer may have to seek refunds or damages.

• Employees: Employees’ contracts are subject to the same rules—some may be assumed, while others may be rejected. Employees who lose their jobs may be entitled to severance or unpaid wages as part of the bankruptcy distribution.

Conclusion

The fate of business contracts during bankruptcy depends largely on the type of bankruptcy filed—Chapter 7 or Chapter 11. In Chapter 7, most contracts are rejected as the business ceases operations and liquidates its assets. In Chapter 11, the business has the option to either assume or reject contracts as part of its reorganization efforts, providing more flexibility in maintaining essential business relationships.

Regardless of the type of bankruptcy, creditors and contract parties are subject to specific legal protections, and they may be entitled to file claims in bankruptcy court for damages resulting from the rejection of contracts. For businesses considering bankruptcy, understanding how contracts will be treated is critical in managing the transition through the bankruptcy process and protecting the interests of all parties involved.

Business owners should consult with legal and financial advisors to navigate the complexities of bankruptcy law and ensure that they are making informed decisions about their contracts and obligations.