What Happens to Ongoing Projects or Contracts During Bankruptcy?

 When a business files for bankruptcy, one of the many critical considerations is what happens to its ongoing projects and contracts. For businesses in industries where long-term contracts and projects are common—such as construction, software development, or manufacturing—understanding how bankruptcy affects these agreements is vital for the company, its creditors, and any external parties involved.

Bankruptcy is a legal procedure that allows a business to reorganize or liquidate its assets to repay creditors. However, the impact of bankruptcy on existing contracts and projects varies depending on several factors, including the type of bankruptcy filed (Chapter 7 or Chapter 11), the nature of the contract, and the business’s ability to continue operations.

This blog will discuss what happens to ongoing projects or contracts during bankruptcy, examining the legalities, the roles of the bankruptcy trustee and court, and how different stakeholders are affected.

1. The Impact of Bankruptcy on Contracts

When a business files for bankruptcy, it is faced with numerous questions about how to handle its contractual obligations. Here’s a breakdown of what may happen to contracts during the bankruptcy process:

A. Rejection or Assumption of Contracts in Chapter 11 Bankruptcy

Under Chapter 11 bankruptcy, which is a reorganization process, the business is allowed to continue operations while it develops a plan to restructure its debts and obligations. The business’s management may retain control of day-to-day operations, though a bankruptcy trustee could be appointed if the court deems it necessary.

In this scenario, contracts are typically handled in one of two ways:

• Assumption of Contracts: The business may choose to assume certain contracts that are beneficial to its reorganization. Assumption means that the business will continue to honor the terms of the contract, including making payments and meeting other obligations. This is often the case with contracts that are vital to the company’s ongoing operations or that have terms favorable to the business.

• Rejection of Contracts: On the other hand, the business can choose to reject contracts that are not advantageous to its reorganization. Rejection of a contract releases the business from its obligations under the agreement and allows the company to walk away from unprofitable or burdensome contracts. Rejection is typically used for leases, supplier contracts, or service agreements that the business cannot afford to continue.

  When a contract is rejected, the other party to the contract (the non-debtor party) may have a claim for damages. However, these claims are typically treated as unsecured claims in the bankruptcy proceeding, meaning they will only be paid after secured and priority creditors.

B. Assumption and Rejection Procedures

Under the Bankruptcy Code, businesses in Chapter 11 bankruptcy have a period (usually 120 days) to assume or reject contracts. If the business does not take any action within this period, the contracts may automatically be deemed rejected. However, the court has the authority to extend this period if needed.

If the business opts to assume a contract, it must also cure any outstanding defaults, meaning it must bring any overdue payments or obligations up to date. The assumption of a contract can be beneficial to both the business and the counterparty, as it allows the business to continue receiving goods or services while honoring the agreement.

For example, a business may continue a long-term supply contract with a vendor that is critical to its operations, or it may keep a customer agreement in place if the contract guarantees revenue for the company.

C. Executory Contracts and Leases

Executory contracts are those in which both parties still have significant ongoing obligations. Common examples of executory contracts include leases, licensing agreements, service contracts, and supplier agreements. In bankruptcy, the debtor (the business filing for bankruptcy) has the right to either assume or reject these executory contracts.

• Leases: If the business has leased equipment or property, the bankruptcy process can impact whether the business continues with the lease or seeks to terminate it. In Chapter 11 bankruptcy, the debtor typically has 120 days to decide whether to assume or reject the lease. If the lease is assumed, the debtor must continue paying rent and meeting other obligations. If the lease is rejected, the debtor is released from its obligations, but the landlord may file a claim for damages in the bankruptcy.

• Licenses and Franchise Agreements: In some cases, businesses may hold licenses or be party to franchise agreements. These contracts can be assumed or rejected in Chapter 11 bankruptcy, though some contracts—such as those for intellectual property—might have clauses that complicate this process.

D. Chapter 7 Bankruptcy and Ongoing Contracts

In Chapter 7 bankruptcy, the goal is liquidation, and the business ceases its operations. As a result, ongoing projects and contracts are generally terminated as the business winds down its affairs. However, there are still some important points to consider:

• Contracts Are Likely Terminated: In a Chapter 7 liquidation, the business typically does not continue with ongoing projects or contracts. The bankruptcy trustee will evaluate whether any contracts can be beneficial to the liquidation process (for example, by selling the contract or assigning it to another party), but generally, contracts are terminated. The business will not honor these contracts, and the counterparty may have a claim for damages in the bankruptcy proceeding.

• Sale of Contracts: In some cases, a bankruptcy trustee may sell or assign certain contracts to third parties. For example, if a company is involved in a long-term project, a buyer may be found who can take over the contract. The trustee might negotiate with the counterparty and seek court approval for such a sale.

• Breach of Contract Claims: If the business terminates contracts during Chapter 7 bankruptcy, the counterparty may file a breach of contract claim in the bankruptcy proceeding. However, these claims are typically treated as unsecured claims, meaning the counterparty may only receive a portion of what they are owed after other creditors have been paid.

2. Impact on Project Stakeholders

The impact of a business’s bankruptcy on ongoing projects can be profound for stakeholders, including employees, customers, suppliers, and contractors. Here are some of the ways bankruptcy can affect these groups:

A. Employees and Contractors

Employees and contractors working on ongoing projects may be impacted by the business’s bankruptcy, particularly if the company decides to terminate contracts or halt operations. Employees may be laid off, and contractors may be left without payment for work completed. However, employees may have priority claims in a bankruptcy proceeding for unpaid wages, benefits, and severance, though they will still need to file claims in the bankruptcy case.

B. Suppliers and Vendors

Suppliers and vendors that are part of ongoing contracts may face challenges if the business rejects contracts or delays payments. These suppliers could be left with outstanding invoices or unpaid obligations. If a contract is assumed, the supplier may continue to provide goods or services, but they must be prepared to deal with potential delays in payments as part of the bankruptcy process.

C. Customers and Clients

Customers and clients who are parties to contracts with the bankrupt business could see delays in receiving goods, services, or project completions. If the business decides to reject or terminate contracts, the customer might be left without recourse, unless the bankruptcy trustee can assign the contract to another business. In some cases, customers may seek to recover damages through a breach of contract claim, though their ability to recover may be limited by the bankruptcy proceedings.

3. Conclusion

The impact of bankruptcy on ongoing projects and contracts depends largely on the type of bankruptcy filed, the nature of the contract, and the business’s ability to continue operations. In Chapter 11 bankruptcy, the business may assume or reject contracts, allowing for the continuation of critical projects or the termination of unprofitable ones. In Chapter 7 bankruptcy, ongoing projects and contracts are generally terminated, and the business will liquidate its assets. Stakeholders such as employees, customers, suppliers, and contractors can be significantly affected by these decisions, and they may need to file claims in the bankruptcy proceedings to recover any owed funds.

Understanding how bankruptcy affects contracts and ongoing projects is crucial for all parties involved in the process, as it helps mitigate risks and ensures that they can take appropriate legal and financial steps.