By Steven Diamond and Thomas Pettit

Law360 (May 15, 2020, 5:41 PM EDT) --

Steven Diamond

Thomas Pettit

The novel coronavirus has wreaked havoc on the U.S. and global economies, increasing unemployment, jeopardizing businesses and reducing gross domestic product.

This pandemic has subjected nearly 3 billion people across the world to quarantines, lockdowns or stay-at-home orders, forcing many domestic businesses to close and disrupting international supply chains.

Employers and employees are under tremendous strain, not only due to those restrictions, but also to the need to focus on personal and family needs, as well as concern and fear about returning to work and contracting COVID-19.

While many businesses will be able to weather this storm, perhaps with federal assistance provided under the Families First Coronavirus Relief Act, the Coronavirus Aid, Relief, and Economic Security, or CARES, Act, or the interim COVID-19 relief bill enacted on April 24, many companies will need to find relief through restructuring or reorganizing under the protections of the Bankruptcy Code.

Chapter 11 of the Bankruptcy Code can be used to liquidate a company. It also allows companies to stabilize, reorganize, restructure and repay debts without liquidating and dissolving.

Federal contractors, however, face unique challenges when navigating the Bankruptcy Code and bankruptcy proceedings.

This two-part series examines the intersection of federal bankruptcy law with federal procurement law,[1] and the unique challenges and opportunities facing federal contractors considering or undergoing bankruptcy.

We focus on how standard provisions of the Federal Acquisition Regulation, or FAR, affects rights at issue in bankruptcy proceedings and how government contracts are affected by the automatic stay in bankruptcy proceedings; how the Anti-Assignment Act affects contractor/debtors' ability to assume and assign government contracts; how bankruptcy restricts the government's ability to terminate contracts; and how bankruptcy may limit a government contractor's ability to seek contractual relief through equitable adjustments). 

Notification Requirements

The FAR regulates contractors seeking relief through the Bankruptcy Code as soon as the contractor files a bankruptcy petition. Every contract subject to the FAR that exceeds the simplified acquisition threshold[2] must incorporate FAR 52.242-13, the bankruptcy clause.[3]

This clause is straightforward and does not regulate bankruptcy proceedings. Rather, it requires contractors that have entered bankruptcy, voluntarily or involuntarily, to notify "the contracting officer responsible for administering the contract" of the bankruptcy within five days after bankruptcy proceedings have been initiated.

The notification must be in writing and sent "by certified mail or electronic commerce method authorized by the contract."[4]

The contracting officer responsible for administering the contract depends on the procuring agency. In some agencies, it may be the procuring contracting officer, or PCO, while in other agencies it may be a separate administrative contracting officer, or ACO (e.g., a Defense Contract Management Agency ACO).

The contracting officer will likely seek assurances that the contractor will be able to meet its performance obligations under the contract.

Once a contractor notifies the government of bankruptcy proceedings, the government must "take prompt action to determine the potential impact of a contractor bankruptcy on the [g]overnment in order to protect the interests of the government."[5]

Prompt actions include notifying "legal counsel and other appropriate agency offices," identifying any potential claims the government may have against the contractor (e.g., contract disputes and terminations for default), and taking "actions necessary to protect the [g]overnment's financial interests and safeguard [g]overnment property."[6]

The interests of the government will vary depending on the circumstances. For example, the government's interests in the bankruptcy may be most acute when the contractor possesses government property, performs contracts that are rated orders under the Defense Production Act, or DPA, or is a sole-source supplier or service provider.

The government could also have unique interests when the contract is classified or involves access to classified information. The government's options for protecting its interests are broad under some circumstances, but limited under others.

Effect of the Bankruptcy Filing

Once a debtor declares bankruptcy, all of the debtor's prepetition property (tangible and intangible) is part of the estate overseen by the bankruptcy court,[7] either under the control of either a trustee appointed to administer the estate or, if no trustee is appointed (which is typical in a Chapter 11 proceeding), the debtor itself (referred to as a debtor in possession or DIP).[8]

As discussed below, this distinction can be particularly important in the government contracts context, where the debtor may have a right to relief through equitable adjustments or a changes clause.

The Bankruptcy Code automatically enjoins creditors from unilaterally taking action against the estate or DIP immediately upon the filing of the bankruptcy petition.[9]

For example, creditors cannot take possession of the debtor's property, or try to control the estate or perfect liens.[10] This automatic stay continues until certain events trigger its termination, such as resolution of the bankruptcy case[11] or a court decision granting a creditor relief from the stay.[12]

In government contracting, protections afforded by the automatic stay can be limited in two key ways. First, the government often has title in tangible and intangible property held by contractors, and several courts have provided the government relief from automatic stays to allow the government to recover its property in a debtor's possession.

This can occur where, for example, the debtor holds and uses government-furnished property[13] in performance of government contracts, where contract clauses vest title to property (e.g., patents)in the government,[14] or where contractors receive progress or advance payments.[15]

For instance, in In re: American Pouch Foods Inc., the U.S. Court of Appeals for the Seventh Circuit allowed the government to recover property where it "held absolute title (and right to possession) to certain goods in the possession of the [d]ebtor."[16]

The court based its conclusion on a contract clause that vested title in the government "to all parts, materials, inventories, work in process and various other categories."[17]

In In re: Reynolds Manufacturing Co., the Seventh Circuit similarly held that courts should interpret government contract vesting clauses literally, and concluded that title to all supplies that the debtor acquired in performance of a government subcontract vested in the government.[18]

Second, government actions may be exempt from automatic stays if those actions involve enforcement of the government's police and regulatory power.[19]

Some courts, such as the U.S. Court of Appeals for the Fourth Circuit, have interpreted this exception narrowly,[20] and limited it to instances in which the government is enforcing laws and regulations relating to public health and safety.[21]

Other circuits, such as the U.S. Court of Appeals for the Ninth Circuit, appear to interpret this exception more broadly.[22] Notably, however, courts have recognized that this exception does not apply to governments seeking to enforce rights arising solely by contract.[23]

The police and regulatory power exception from automatic stays has a somewhat unique application in the government contracting context because contractors are subject to compliance requirements not imposed on nongovernment contractors.

For example, government services contracts are, with certain exceptions, subject to the Service Contract Labor Standards statute (formerly known as the McNamara-O'Hara Service Contract Act),[24] which requires contractors to comply with, among other things, wage standards.

At least one court has held that the government can bring actions against debtors to enforce these requirements notwithstanding the automatic stay.[25] Automatic stays also do not prevent the U.S. government from enforcing the civil False Claims Act.[26]

Another unique application of this exception could arise under the DPA, though this does not appear to have been tested.[27] The DPA has risen to new prominence during the COVID-19 pandemic.

The DPA authorizes the Defense Priorities and Allocations System, or DPAS, which is implemented through U.S. Department of Commerce regulations.[28]

President Donald Trump invoked the DPA through a March 18 executive order.[29] This executive order provided the U.S. Department of Health and Human Services to prioritize contracts and orders for "health and medical resources needed to respond to the spread of COVID-19 within the United States."[30]

On April 28, the president signed an executive order designating meat processing facilities as critical infrastructure and invoking the DPA to order meat processing facilities to remain open amid the COVID-19 pandemic.

The DPAS allows certain delegate agencies to place so-called rated orders and allocation orders that require companies holding rated contracts, and in some cases industry more broadly, to prioritize U.S. government orders and allocate resources as necessary to support national defense and emergency preparedness.[31]

It is conceivable, if not likely, that the U.S. government could require a debtor to satisfy federal needs pursuant to the DPAS notwithstanding any pending bankruptcy proceeding.[32]

The Anti-Assignment Act and Traditional Bankruptcy Concepts of Assumption and Assignment

The Anti-Assignment Act applies to all contracts with the U.S. government valued at $1,000 or more. It generally prohibits contractors from assigning contracts to third parties without the government's consent.[33]

If a contractor violates the Anti-Assignment Act, it annuls the contract, though the government retains the right to bring a breach of contract claim against the contractor.[34] The purpose of this statute is to ensure that the government receives the benefit of the bargain when it contracts for supplies and services, and knows and approves of the parties with which it is contracting.[35]

Section 365(f) of the Bankruptcy Code sets forth the general rule that a debtor may assume and/or assume and assign an executory contract[36] or unexpired lease, notwithstanding a contractual provision to the contrary that prohibits, restricts, or conditions such assignment.

"Assumption" is a technical term under the Bankruptcy Code. It does not refer to a debtor's mere continuation of performance under an agreement subsequent to a bankruptcy filing.

Rather, assumption is the mechanism by which a debtor, upon notice to creditors, seeks authorization from the bankruptcy court to reaffirm its obligations under an agreement. It requires the debtor to cure monetary and other defaults and prove that it has the wherewithal to continue to honor its contractual obligations on a going-forward basis.[37]

The formal assumption of an agreement by a debtor during its bankruptcy proceeding is essentially equivalent to the debtor entering into a new agreement subsequent to the bankruptcy filing.[38] Once a debtor assumes a contract, it can generally assign that contract, typically through a sale, to a third party.[39]

Notwithstanding this broad power, a counterparty may enforce a prohibition or restriction on assignment where an applicable nonbankruptcy law (statute or case law) would excuse the counterparty from accepting performance from, or rendering performance to, an entity other than the debtor or debtor-in-possession, and the counterparty does not consent to such assumption or assignment.[40]

Enter the Anti-Assignment Act.[41]

Most courts have interpreted the Anti-Assignment Act as an applicable law for purposes of the Bankruptcy Code that prohibits or restricts a contractor/debtor from its generally broad discretion to assign government contracts.[42] Importantly, the Anti-Assignment Act is not an absolute proscription on assignments.[43]

For example, transfers or assignments occurring by operation of law are exempt from the Anti-Assignment Act's application, including transfers occurring incidental to corporate mergers, consolidations or reorganizations, assignments by judicial order, transfers by will and intestacy, transfers to trustees during bankruptcy proceedings, and assignments for the benefit of creditors.[44]

The Anti-Assignment Act also includes an exception for assignment of the right to payment under a government contract to a financing institution.[45] And, the government may consent to assignment, either under what courts have termed the waiver exception[46] or as implemented in the FAR in the case of acquisitions structured as asset purchases, which require a formal novation.[47]

In sum, although the Anti-Assignment Act may not create an outright prohibition on assignment given its various exceptions, it clearly imposes some restrictions on a contractor's ability to freely assign a government contract notwithstanding the typical assignment powers afforded under the Bankruptcy Code.

Importantly, and perhaps counter-intuitively, the Anti-Assignment Act has potential legal ramifications beyond just limiting assignments. In the context of bankruptcy proceedings, the Act may result in a de facto termination of the government contract.

The outcome may depend on the judicial circuit in which the bankruptcy case is filed and whether the circuit follows the so-called hypothetical test or actual test.

As explained below, in those circuits that follow the hypothetical test, a government contractor may be precluded from assuming and retaining its government contracts by virtue of the Anti-Assignment Act.

The Hypothetical Test

The U.S. circuit courts are split in how they address the impact of anti-assignment provisions in contracts, including under the Anti-Assignment Act. Most of the circuits that have interpreted Section 365(c) of the Bankruptcy Code, including the U.S. Court of Appeals for the Third Circuit, the Fourth, Eighth, and Ninth Circuits, and the U.S. Court of Appeals for the Eleventh Circuit, have construed that provision as imposing what is known as the hypothetical test.

These courts have held that if an applicable nonbankruptcy law would prohibit or restrict assignment, the debtor can neither assume nor assign the agreement.[48]

Courts applying the hypothetical test have, depending on the circumstances, prevented debtors from assuming government contracts. For example, the U.S. Court of Appeals for the Eighth Circuit held in In re: West Electronics Inc. that the debtor could not assume the contract because the Anti-Assignment Act prohibited it from assigning the contract to a third party without the government's consent.[49]

Contractors in hypothetical-test jurisdictions generally should obtain the government's consent to assume a government contract as they enter bankruptcy proceedings.

In some cases, however, Chapter 11 debtors in hypothetical-test jurisdictions have attempted to avoid the prohibition on unilateral assumption of an agreement subject to applicable nonbankruptcy law that would restrict assignment, such as the Anti-Assignment Act.

These debtors did so essentially by ignoring the issue and allowing the agreements to ride through the bankruptcy proceedings without ever making a determination regarding assumption or rejection.

Under the ride-through doctrine, an agreement may pass through a bankruptcy proceeding without being either assumed or rejected. Essentially, the counterparty's claim — or, in the government contracts context, the government's claim — would survive the bankruptcy proceeding.

Although some courts in hypothetical-test jurisdictions have permitted ride-through, the ultimate efficacy of this approach is uncertain.

At least one court has noted that although an agreement not formally assumed under Section 365(a) of the Bankruptcy Code may ride through the bankruptcy proceedings, the debtor will not be entitled to the benefits of the exceptions to cure contained in section 365(b)(2), which excuses a debtor from curing certain types of defaults in connection with assumption.[50]

As a result, a counterparty to an agreement that has ridden through bankruptcy may be able to terminate the agreement as soon as the debtor emerges from bankruptcy.

Contractors in hypothetical-test jurisdictions cannot, however, count on being able to ride through a bankruptcy proceeding.

In TechDyn Systems Corp., which was decided by the U.S. Court of Appeals for the Fourth Circuit, a hypothetical-test jurisdiction, the bankruptcy court granted the government relief from the automatic stay to terminate the debtor's contracts based on "the debtor's legal inability to assume the contracts over the government's objection."[51]

In the court's view, this was "more than sufficient 'cause' for relief from [the] stay to terminate the contract."[52]

Applying the the logic of this decision, debtor contractors seeking to use the ride through tactic rather than obtaining the government's consent to novate the contract may find that the court and the government make the decision for the contractor.

The Actual Test

Not all courts that have interpreted Section 365(c) agree that it prohibits the assumption of an agreement in cases in which the agreement could not be assigned to a third party on a nonconsensual basis, because of an applicable nonbankruptcy law prohibiting or restricting assignment.

These courts, including the U.S. Court of Appeals for the First Circuit and the U.S. Court of Appeals for the Fifth Circuit, and a majority of lower courts, have adopted what has come to be known as the actual test.

These courts have concluded that the exception to the general rule allowing assignment of agreements notwithstanding anti-assignment provisions is triggered only when the debtor actually seeks to assign the agreement and is not implicated by an assumption of the agreement by the debtor.

Reasoning that an assumption in and of itself does not involve a transfer to a third party, courts in actual-test jurisdictions conclude that the trustee may assume an agreement, as long as the trustee does not actually seek to assign that agreement to a third party (i.e., a party other than the debtor or debtor-in-possession) over the objection of the counterparty, and in contravention of an applicable nonbankruptcy law prohibiting assignment.[53]

In these jurisdictions, contractor/debtors typically can assume contracts without running afoul of the Anti-Assignment Act.

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Steven S. Diamond is a partner and Thomas A. Pettit is an associate at Arnold & Porter.

The authors wish to thank and acknowledge the comments provided by Arnold & Porter partners Benjamin Mintz and Rosa J. Evergreen on bankruptcy law issues.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] This article builds on an article published in Westlaw Journal Government Contract, Vol. 28, Issue 2, May 27, 2014, "The Impact of Prime Contractor Bankruptcy On U.S. Government Contracts," co-authored by Steven S. Diamond.

[2] The simplified acquisition threshold is currently $250,000. See FAR 2.101, Definitions.

[3] FAR 42.903.

[4] Contractors should always timely notify the cognizant contracting officer for each contract of pending bankruptcy petitions. A contractor that fails to provide the required notice could be liable to the government for injuries caused by the contractor's failure to provide the required notice. Although contractors should ensure that they comply with the FAR notice requirements, contractors may have various defenses, when they fail to provide the required notice. For example, in In re: Dos Santos , 589 B.R. 413 (Bankr. D. Col. 2018), the bankruptcy court held that constructive and actual notice were insufficient to satisfy notice requirements but held that the equitable defense of laches prevented the government from raising claims after the debtor's case was closed. The court found that the government had actual notice of the debtor's bankruptcy and could have raised its claims, while the bankruptcy case was pending. If the government had not received actual notice and then sat on its claims, the government's claims could have survived the bankruptcy action. Contractors are well advised not to assume this risk.

[5] FAR 42.901.

[6] FAR 42.902(a).

[7] 11 U.S.C. §541. Contractors must be careful when notifying the government of actual or potential bankruptcy because contracts terminated prior to filing a bankruptcy petition are not subject to the automatic stay. Id., recognizing that the estate includes property interests that exist as of the commencement of the case.

[8] Id. § 1107.

[9] Id. §362(a).

[10] Id.

[11] Id. §362(c)(2).

[12] Id. §362(d).

[13] "Government-furnished property" is tangible "property in the possession of, or directly acquired by, the [g]overnment and subsequently furnished to the [c]ontractor for performance of a contract." FAR 52.245.

[14] See, e.g., FAR 52.227-11, Patent Rights — Ownership by the Contractor.

[15] FAR 52.232-16(d), Progress Payments; FAR 52.232-12, Advance Payments (providing for liens and vesting of titles).

[16] 769 F.2d 1190, 1191 (7th Cir. 1985) (affirming district court decision that, due to certain contract clauses, "the [U.S.] held absolute titled (and right to possession) to certain goods in the possession of the [d]ebtor").

[17] Id. at 1192.

[18] In re: Reynolds Mfg. Co. , 68 B.R. 219 (W.D. Pa. 1986).

[19] 11 U.S.C. §362(b)(4)

[20] See, e.g., In re: Royal , 137 Fed. App'x 537, 541 (4th Cir. 2005) ("The statutory context therefore indicates that we should read Section 362(b)(4) narrowly because the bankruptcy court can quickly and easily correct issues resulting from a problematic stay, but has no power to correct issues caused by a problematic exception to a stay.").

[21] Id., (holding that government's use of eminent domain was not exempt from the stay because eminent domain was not used to enforce "pre-existing public health or safety regulations").

[22] See, e.g., In re: Chapman , 264 B.R. 565, 569 (9th Cir. 2001) (explaining that the exemption applies where "the government acted primarily to protect its pecuniary interest in the debtor's property or the public safety and welfare" or where "the government's actions are motivated to effectuate public policy or private rights").

[23] See, e.g., United States v. Nicolet Inc. , 857 F.2d 202, 207-09 (3rd. Cir. 1988); In re: Corporacion de Servicios Medicos Hospitalarios de Fajardo , 805 F.2d 440, 445-47 (1st Cir. 1986).

[24] 41 U.S.C. §§6701-6707; 29 C.F.R. Part 4; FAR Subpart 22.10.

[25] See Eddleman v. United States Dep't of Labor , 923 F.2d 782, 783 (10th Cir. 1991).

[26] See In re: Commonwealth Cos. Inc .¸913 F.2d 518, 520 (8th Cir. 1990).

[27] 50 U.S.C. App. §§ 2061-2070.

[28] 15 C.F.R. Part 700.

[29] https://www.whitehouse.gov/presidential-actions/executive-order-prioritizing-allocating-health-medical-resources-respond-spread-covid-19/.

[30] Id. §2(a).

[31] FAR 11.602.

[32] Implications of DPAS rated orders should be of particular interest to companies purchasing debtors or their assets. They could be purchasing assets for certain intended purposes only to find that the government forces them to use those assets to satisfy government orders.

[33] Id. §6305(a).

[34] Id.

[35] See United Int'l Investigative Servs. v. United States , 26 Cl. Ct. 892, 899 (1992).

[36] The Bankruptcy Code does not define "executory contract." However, the Supreme Court recently clarified that an executory contract is "a contract that neither party has finished performing." Mission Prod. Holdings Inc. v. Tempnology, LLC , 139 S. Ct. 1652, 1657 (2019).

[37] See id. §365.

[38] Adamowicz v. Pergament (In re: Lamparter Org. Inc.) , 207 B.R. 48, 52 (E.D.N.Y. 1997) ("[T]he power given the debtor in possession or trustee to assume or reject executory contracts is intended to enable him to make a new decision as to the wisdom of the contract in light of the changed circumstances of bankruptcy or conversion, as if he were entering into a new contract.") (quotation omitted).

[39] Debtors frequently defer decisions regarding the assumption of contracts and leases, until they are compelled to decide, ordinarily at the end of the bankruptcy proceeding, upon plan confirmation. Adventure Res. Inc. v. Holland , 137 F.3d 786, 798-799 (4th Cir. 1998) (breach of an assumed executory contract results in an administrative priority claim). However, the deadline to assume a nonresidential real property lease cannot be extended more than 210 days after the petition date, without the landlord's consent.

[40] 11 U.S.C. §365(c)(1)(A).

[41] 41 U.S.C. §6305.

[42] But see Bonneville Power Admin. v. Mirant Corp. (In re: Mirant Corp.) , 440 F.3d 238, 253 (5th Cir. 2006), in which the court adopted the "actual test," (see discussion infra) but noted in dicta that the federal Anti-Assignment Act might not be considered an "applicable law" prohibiting assignment until an actual assignment was proposed that did not fall within the statutory exceptions to the Anti-Assignment Act's general prohibition on the assignment of federal contracts (e.g., the exception for assignment to a financing institution). The Fifth Circuit, however did not consider whether the Anti-Assignment Act might constitute an applicable law restricting assignment. Although the Anti-Assignment Act might not constitute an applicable law prohibiting assignment, given the exceptions to the general prohibition found within the statute and in the case law, the better interpretation of the Anti-Assignment Act is that it is an applicable law restricting assignment.

[43] Liberty Ammunition Inc. v. United States , 101 Fed. Cl. 581, 587 (2011) ("[C]ourts have recognized a number of exceptions to the Anti-Assignment Act under which a government contract can be validly assigned to another party.").

[44] See Webster v. United States , 90 Fed. Cl. 107, 116 (2009); Holland v. U.S. , 62 Fed. Cl. 395, 400 (2004); Johnson Controls World Servs. v. United States , 44 Fed. Cl. 334, 343 (1999).

[45] 41 U.S.C. § 6305(b)(1).

[46] See Liberty Ammunition, 101 Fed. Cl. at 588.

[47] See 48 C.F.R. §42.1204(a) (the government "may, when in its interest, recognize a third party as the successor-in-interest to a government contract when the third party's interest in the contract arises out of the transfer of — (1) All of the contractor's assets; or (2) The entire portion of the assets involved in performing the contract"). The FAR further provides that, in the case of an asset purchase, there may be change-of-ownership issues that the parties should address in a formal novation agreement. Id. at §42.1204(b).

[48] See RCI Tech. Corp. v. Sunterra Corp. (In re: Sunterra Corp.) , 361 F.3d 257 (4th Cir. 2004); Perlman v. Catapult Entm't (In re: Catapult Entm't) , 165 F.3d 747 (9th Cir. 1999); City of Jamestown v. James Cable Partners (In re: James Cable Partners) , 27 F.3d 534, 537 (11th Cir. 1994); In re: West Elecs. , 852 F.2d 79, 83-84 (3d Cir. 1988).

[49] 852 F.2d 79, 83 (8th Cir. 1988).

[50] See In re: Hernandez , 287 B.R. 795, 800 (Bankr. D. Ariz. 2002) (allowing the contract to ride through the bankruptcy, but noting that a contract that is not assumed is not entitled to certain benefits afforded by Section 365; these benefits include insulation from ipso facto provisions or the right to cure defaults).

[51] 235 B.R. 857, 860 (Bankr. E.D. Va. 1999).

[52] Id.

[53] See Institut Pasteur v. Cambridge Biotech Corp. , 104 F.3d 489, 493 (1st Cir. 1997).

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