Be wary of underfunded clients

As the resurgent economy demands more housing, private infrastructure, and other capital assets, a design firm faces the increased possibility that a client might encounter financial troubles. In addition to carefully vetting your client to determine their ability to successfully fund a project, you should understand your legal positions if a client experiences cash-flow problems.

A client in financial trouble may file for Chapter 11 protection in bankruptcy court so that it has a safe period to attempt to settle its debts and reorganize its operations. This is more likely when the client is a project developer that sets up a separate limited liability company for the project. While in Chapter 11, the client (now called a debtor) continues to operate its business while being monitored by the bankruptcy court. If you have an existing contract with that client, you have to continue to perform your services. In return, the debtor must perform its side of the contract. However, if the debtor does not continue to pay the professional service fees, you cannot simply terminate the contract; you must obtain the permission of the bankruptcy court before contract termination is possible. If you terminate the contract without permission of the court, you may be subject to a substantial fine. The reason is that the debtor’s interest in the contract is an asset that the court wants to protect along with all the other client assets to give the debtor an opportunity to re-organize and come out of bankruptcy. 

The situation above applies even if your contract with the client has a provision that would otherwise allow termination if the client files for bankruptcy protection or becomes insolvent — you still cannot do so without court permission. A valid termination provision alone will not be sufficient to allow you to get court permission to terminate the contract. There has to be a performance reason, such as the client’s failure to perform its side of the contract.

At the first indication that a client could be in financial trouble, you should explore your options, including termination of the contract for non-payment. If the client has failed to perform its duties under the contract before it files for bankruptcy, you can terminate the contract. Once the client files bankruptcy, the contract no longer exists and you do not have to deal with the debtor and the court’s control over the contractual relationship. However, that does not free you from the project because once bankruptcy is filed, the client is now a debtor and has the opportunity to cure the default and reinstate the contract. 

If the debtor wants to continue its contract with your firm during its Chapter 11 bankruptcy protection, it will file a motion to assume the contract. If it is in default, it must cure the default. When the court authorizes the debtor to assume the contract, the contract continues in existence after the bankruptcy and both sides are bound by it. If the debtor does not want to continue to perform its contract with you, the debtor has the option to reject the contract. If the debtor rejects the contract, the debtor is no longer required to perform it. Your company has a claim for damages for breach of the contract and will receive whatever creditors receive from the bankruptcy on that damage claim. In addition, the debtor may assign its interest in your contract to a new party. You must accept performance even if the contract prohibits assignment.

Bankruptcy law is complex, and once a client files for bankruptcy, the chances of finishing a project or collecting an outstanding fee at full value are rare. Eternal vigilance and timely billing and collection are necessary to avoid providing unpaid services and creating your own cash-flow problems. Moreover, as with any legal issue, it is always prudent to consult with a bankruptcy lawyer about your company’s rights and obligations when a client enters Chapter 11 bankruptcy and protection during reorganization.

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