Three Contract Tips to Safeguard Your Business from Another’s Default

The beginning of a new partnership between companies is often a time of excitement. Like any new relationship, expectations for the future are promising and it is easy to see the best in your partner.

Months (or years) later, when your business partner’s prospects have cooled and the company struggles to pay their creditors, your own business might be at risk.

Avoid getting swept up in the moment and insulate your company from a partner’s bankruptcy by not overlooking the following provisions each time you draft a contract.

Recovering Your Attorney’s Fees Upon Breach of the Contract

When someone who owes money under a contract fails to pay as obligated – i.e., breaches the contract – it is an unfortunate fact of life that it will cost money to hire an attorney to pursue collection of what is owed. You would think that the defaulting party should also have to pay your attorney’s fees – right? They are the defaulting party here!

Well, not necessarily. If your contract does not have a specific provision related to who must pay attorney’s fees and when, the default rule is that each party is responsible for paying its own attorney’s fees.

The easy “fix” is to in fact include a specific provision in the contract regarding payment of attorney’s fees. Such provision becomes part of the overall bargain between the parties. Courts will generally enforce specific attorney’s fees provisions. Commonly, the contract will state that upon a default, the attorney’s fees of the prevailing party must be paid by the defaulting party. If there is a breach of the contract and you must hire an attorney to sue the defaulting party, your attorney will seek a judgment against the defaulting party for all amounts due and owing under the contract (principal; interest), but on top of that, all the attorney’s fees incurred to rightfully collect what is owed. This is really the only way to make you “whole."

If the defaulting party files bankruptcy, the good news is that the Bankruptcy Court will also, generally, enforce attorney’s fees provisions in contracts. So, if you had incurred attorney’s fees in trying to collect a debt before a bankruptcy was filed, and your contract has an attorney’s fee provision, you can file a Proof of Claim (a document that proves you have a right to payment) in the bankruptcy case not only for the principal and interest due as of the date the bankruptcy was filed, but also for the total amount of attorney’s fees you incurred before the bankruptcy case was filed.

But some bankruptcy cases are a lot more involved for creditors than just the filing of a Proof of Claim.  Can you receive “post-petition” (after the filing of the bankruptcy case) attorney’s fees if your attorney must actively pursue your rights in the defaulting party’s bankruptcy case? In certain prescribed situations the answer is “yes” – provided, of course, that your contract has an attorney’s fees provision.

Perfecting Your Security Interest

If your contracts involve payment terms, you likely know that a provision securing the payment obligation with collateral improves your chances of being repaid. The prospect of losing valuable property encourages borrowers to make payments on time. If a borrower defaults, you can foreclose on pledged assets to cover or offset your losses. In a bankruptcy, secured creditors generally receive at least the value of the collateral, or the collateral itself.

To get the most out of a secured obligation, you must “perfect” it. Perfection puts the world on notice of your interest in the collateral. If you fail to perfect your secured interest, later creditors can obtain superior rights to the property. In bankruptcy, unperfected security interests can be avoided such that your claim is treated as a general unsecured debt.

The manner of perfection depends on the type of asset pledged. For example, a mortgage should be filed with the appropriate authority where the real property is located. A UCC-1 financing statement is sufficient to perfect a security interest in many types of personal property. Certain other assets, like intellectual property or motor vehicles, are governed by different filing requirements. Often, possession or control of an asset will trump a financing statement.

Because perfection is so important, prudent secured parties will include a contract provision granting express authorization to perfect the security interest. Similarly, secured parties should consider language obligating the borrower to cooperate in efforts to cure perfection defects.

Bankruptcy as an Event of Default

It is also common to include a provision in your contract which provides that bankruptcy is an event of default, and the nonbreaching party has the right to terminate the contract. Courts often refer to such clauses as "ipso facto," i.e. a clause in an agreement stipulating to consequences. While such a provision sounds ominous enough to deter the breaching party from filing bankruptcy, it may not actually be enforceable in every instance.

Normally, when a business files for bankruptcy, it seeks to reorganize its business or financial affairs by shedding debt, but also optimizing the profitable portions of its business. With certain exceptions, the Bankruptcy Code allows the debtors to "pick and choose" which executory contracts they wish to keep (in the bankruptcy case, “assume”) or reject. Executory contracts are essentially contracts for which performance is not yet complete on both sides of the transaction, such as equipment leases or other long-term contracts. Debtors can reject many executory contracts that they believe are not economically profitable, thus facilitating its reorganization.

But many executory contracts are valuable to the debtor and its reorganization, so the debtor would prefer to keep (assume) the contract. If an ipso facto clause says a non-breaching party can terminate the contract upon a bankruptcy filing, that would defeat the debtor’s right to assume it.

It is no surprise then, that the Bankruptcy Code states that any provision in an executory contract that permits one party to terminate the contract in the event of the other’s insolvency or in the event that the other files a bankruptcy petition is unenforceable.

As mentioned, however, there are certain exceptions to a bankruptcy debtor’s right to assume an executory contract. For example, personal services contracts may not be assumed if applicable law excuses performance, or without consent. Also, contracts to extend further credit to a debtor, and contracts of nonresidential real property that had been terminated before the bankruptcy filing cannot be assumed.