From Cradle to Grave: Using Bankruptcy Skills to Advise Clients on New Deals

The client's focus at the outset of a transaction is on making sure that the deal gets done and that its business points are addressed. Unfortunately, as a result, when disaster subsequently hits, its bankruptcy lawyers may be faced with litigating and enforcing contracts that may fail to address or define defaults, remedies, ownership, security interests, attorneys' fees, and bankruptcy, except for unenforceable ipso facto clauses. At that point, there may be little a bankruptcy lawyer can do to protect a client that is relying on a contract that leaves out key terms; is riddled with ambiguities that can be construed in its opponent's favor; or fails to incorporate any strategies for protecting the client from the risk of default, litigation and bankruptcy.

Unfortunately, bankruptcy lawyers are rarely, if ever, given the opportunity to get involved in structuring or drafting a new transaction because clients shortsightedly may relegate or typecast them as the “undertakers” of the legal profession, rather than those who should be called upon to review deals that are in their infancy. However, bankruptcy lawyers may be the best able to protect their clients from the outset because it is in bankruptcy courts and other litigation arenas that these transactions are tested and found to be lacking. As a result, after years of fighting over the interpretation and enforcement of transactions drafted by others, bankruptcy lawyers have developed a key expertise in analyzing how those transactions should be supplemented or enhanced from the outset to protect their clients from subsequent disasters.

Accordingly, around 20 years ago, I suggested to a long-term client that it bring me in when new deals are being negotiated and drafted, particularly, deals covering extended periods of time where the other party may suffer a change in fortune, and/or where a default, litigation, or bankruptcy might cause a delay in enforcement of the contract that would have a disastrous impact on the client's ability to meet key deadlines, causing it to suffer huge losses. After 2 decades of doing so, I have learned some key issues with respect to which bankruptcy lawyers can use their special skills to assist clients from the outset, both before and after disaster strikes, from “the cradle to the grave.” These are rules for reviewing transactions that bankruptcy attorneys are uniquely suited to apply, and are set forth below in no particular order of importance.

FIRST RULE: GIVE YOUR CLIENT A WAY OUT OF THE CONTRACT BEFORE IT GETS ENTANGLED IN A BANKRUPTCY CASE. Bankruptcy lawyers uniquely know from experience that once entangled in a bankruptcy case, a creditor cannot exercise its remedies or terminate a contract without obtaining relief from the automatic stay. This relief may be difficult to secure especially in the early stages of a Chapter 11 case. Using the occurrence of bankruptcy or insolvency as a default is too late. Such ipso facto clauses are unenforceable under Sections 363, 365 and 541 of the Bankruptcy Code, but nevertheless appear in almost every commercial contract as the major “protection” against bankruptcy. What the client needs is an “early warning system” to get out before the bankruptcy occurs.

Lenders typically use financial covenants as an early warning system, giving them the ability to call a default and pull out before insolvency or bankruptcy ensues. There is no reason why other creditors cannot use such covenants to protect themselves as well. Another mechanism may be using cross-defaults ' if the debtor's lenders call a default, leaving the debtor without financing, that is good time for other creditors to extricate themselves as well.

SECOND RULE: DON'T LET DEFAULT CURE PERIODS DELAY TERMINATION. Many contracts have default provisions that give the debtor a substantial cure period before the creditor can exercise its remedies. Bad idea. Pursuant to Section 108 of the Bankruptcy Code, if the debtor files for bankruptcy relief before the cure period expires, this period automatically is extended, making any automatic termination based on failure to cure ineffective. As a result, a long cure period gives the debtor an incentive to file for bankruptcy to prevent the creditor from exercising its remedies. In addition, the debtor can use the bankruptcy courts, often a friendly forum, to litigate whether such default or cure occurred.

Therefore, consider creating defaults that provide for automatic termination, with no cure period. This of course would only be practical where the default goes to the heart of the contract and certainly will not be easy to obtain from the debtor, who always will want the chance to cure. However, where time is of the essence, dragging out the time to cure and then possibly litigating over whether the cure was sufficient can lead to disaster.

In addition, any notice of termination or default should be effective when sent by the client, not when received by the debtor. The latter can lead to disputes over when receipt took place, a fact that may not be known to the client. Think about using e-mail or fax as a means of giving notice, with service being deemed to occur on the date of transmission by the client.

Make sure that notices received by the client from the debtor are copied to you and are sent to a specific address and person at the client, so it does not wander around a huge corporation until the right party is located.

THIRD RULE: OWN IT. Since the automatic stay can cause great delay and expense, the first line of defense is to try to structure a transaction so that the subject matter is not property of the estate to which the stay applies. This is not easy because the definition of property of the estate is much broader than under traditional state property law concepts. In addition, not setting forth clearly who owns the subject matter or proceeds of the contract can lead to the debtor trying to sell or use it free and clear of your client's interests. Finally, if all your client has is an executory contract, its interest can be rejected, leaving the client with nothing more than an unsecured claim payable, if at all, in “little bankruptcy dollars.”

One way to deal with ownership is to expressly define in the contract who owns the subject matter, products and proceeds. Although that may not be binding on a bankruptcy court, which “will not exalt form over substance,” it at least shows the parties' intent.

In addition, if you are dealing with intellectual property, make sure that all registrations and other formalities showing ownership in the client's name have been obtained. This will bolster the client's claim of ownership plus provide additional remedies, such as infringement, that can be used to seek an injunction.

If feasible, have the property irrevocably assigned or transferred by the debtor to the client, but make sure that these are not subject to avoidance as preferences or fraudulent conveyances. Be aware that “escrow accounts” may still be property of the estate and subject to the automatic stay.

FOURTH RULE: GET THIRD-PARTY CREDIT ENHANCEMENTS. Having a solvent third party to pursue not only may provide a source of recovery, but also can have an in terrorum effect ' the principal of a corporation may take extra pains to avoid a default if he/she/it is personally on the line due to a guarantee.

Accordingly, try to get a guarantee from an insider ' the parent, affiliates, or majority shareholder. As part of that guarantee, get an agreement that the parent will not cause assets of the debtor to be upstreamed or side-streamed to related entities. A secured guarantee is even better. Since the DePrizio case was overturned by legislation, in whole or in part, the risk of preference liability due to an insider guarantee significantly may have been reduced. In addition, make sure you get all of the waivers possible under state law to preclude exoneration of the guarantee. California, for example, has express statutory provisions relating to waivers by sureties.

A letter of credit from a financial institution also enhances the chances of payment or performance. However, if the lender providing the letter of credit becomes secured by the debtor's assets within 90 days prior to bankruptcy, there could be a risk of preference liability.

FIFTH RULE: GET A BROAD ATTORNEYS' FEE CLAUSE. Bankruptcy cases can be very expensive, even if only monitoring of the cause is involved, especially in “mega-cases” where hundreds of motions and pleadings can be filed each month. Nevertheless, a motion can have an adverse affect on the client even if it is not named specifically as a target, and the client's bankruptcy counsel should review the docket and upcoming motions even if only an indirect impact could result.

As such, standard form attorneys' fees clauses, such as those providing that only the “prevailing party” gets reimbursed, may be totally inadequate. Ask for a broad provision that covers any attorneys' fees and expenses incurred to protect or enforce the clients' rights, even if no litigation is commenced, including monitoring a bankruptcy filed by or against the debtor or any third party that may have any direct or indirect effect on the subject matter of the contract; objecting to a disclosure statement and/or plan of reorganization; or objecting to a motion brought by the debtor or any third party such as a reclamation procedures motion under Section 546, a sale motion, or motion for relief from the stay to foreclose on assets in which your client has an interest.

However, note that in some jurisdictions, such as California, if one party has an attorneys' fee clause, the other also can seek reimbursement of its fees even if that is not provided by the contract.

Next month's installment will provide the final 10 rules.

Part One of a Two-Part Series

Of the many hats worn by leasing attorneys, one is of the bankruptcy practitioner. It is a skill set that usually comes into play at the end of a transaction gone bad. This two-part series outlines the case for ending this practice and having bankruptcy counsel get involved in lease deals from the outset.

Bankruptcy lawyers may not get involved in their clients' transactions until it is too late. They may be called in only upon the occurrence of a default, litigation, or the commencement of a bankruptcy case. At that point, they are faced with deals that have been “set in stone” ' drafted and structured by lawyers specializing in the front end, who may have looked at the transaction from an overly optimistic viewpoint, especially in the case of a long-term deal with another party that presently is in good financial health.

The client's focus at the outset of a transaction is on making sure that the deal gets done and that its business points are addressed. Unfortunately, as a result, when disaster subsequently hits, its bankruptcy lawyers may be faced with litigating and enforcing contracts that may fail to address or define defaults, remedies, ownership, security interests, attorneys' fees, and bankruptcy, except for unenforceable ipso facto clauses. At that point, there may be little a bankruptcy lawyer can do to protect a client that is relying on a contract that leaves out key terms; is riddled with ambiguities that can be construed in its opponent's favor; or fails to incorporate any strategies for protecting the client from the risk of default, litigation and bankruptcy.

Unfortunately, bankruptcy lawyers are rarely, if ever, given the opportunity to get involved in structuring or drafting a new transaction because clients shortsightedly may relegate or typecast them as the “undertakers” of the legal profession, rather than those who should be called upon to review deals that are in their infancy. However, bankruptcy lawyers may be the best able to protect their clients from the outset because it is in bankruptcy courts and other litigation arenas that these transactions are tested and found to be lacking. As a result, after years of fighting over the interpretation and enforcement of transactions drafted by others, bankruptcy lawyers have developed a key expertise in analyzing how those transactions should be supplemented or enhanced from the outset to protect their clients from subsequent disasters.

Accordingly, around 20 years ago, I suggested to a long-term client that it bring me in when new deals are being negotiated and drafted, particularly, deals covering extended periods of time where the other party may suffer a change in fortune, and/or where a default, litigation, or bankruptcy might cause a delay in enforcement of the contract that would have a disastrous impact on the client's ability to meet key deadlines, causing it to suffer huge losses. After 2 decades of doing so, I have learned some key issues with respect to which bankruptcy lawyers can use their special skills to assist clients from the outset, both before and after disaster strikes, from “the cradle to the grave.” These are rules for reviewing transactions that bankruptcy attorneys are uniquely suited to apply, and are set forth below in no particular order of importance.

FIRST RULE: GIVE YOUR CLIENT A WAY OUT OF THE CONTRACT BEFORE IT GETS ENTANGLED IN A BANKRUPTCY CASE. Bankruptcy lawyers uniquely know from experience that once entangled in a bankruptcy case, a creditor cannot exercise its remedies or terminate a contract without obtaining relief from the automatic stay. This relief may be difficult to secure especially in the early stages of a Chapter 11 case. Using the occurrence of bankruptcy or insolvency as a default is too late. Such ipso facto clauses are unenforceable under Sections 363, 365 and 541 of the Bankruptcy Code, but nevertheless appear in almost every commercial contract as the major “protection” against bankruptcy. What the client needs is an “early warning system” to get out before the bankruptcy occurs.

Lenders typically use financial covenants as an early warning system, giving them the ability to call a default and pull out before insolvency or bankruptcy ensues. There is no reason why other creditors cannot use such covenants to protect themselves as well. Another mechanism may be using cross-defaults ' if the debtor's lenders call a default, leaving the debtor without financing, that is good time for other creditors to extricate themselves as well.

SECOND RULE: DON'T LET DEFAULT CURE PERIODS DELAY TERMINATION. Many contracts have default provisions that give the debtor a substantial cure period before the creditor can exercise its remedies. Bad idea. Pursuant to Section 108 of the Bankruptcy Code, if the debtor files for bankruptcy relief before the cure period expires, this period automatically is extended, making any automatic termination based on failure to cure ineffective. As a result, a long cure period gives the debtor an incentive to file for bankruptcy to prevent the creditor from exercising its remedies. In addition, the debtor can use the bankruptcy courts, often a friendly forum, to litigate whether such default or cure occurred.

Therefore, consider creating defaults that provide for automatic termination, with no cure period. This of course would only be practical where the default goes to the heart of the contract and certainly will not be easy to obtain from the debtor, who always will want the chance to cure. However, where time is of the essence, dragging out the time to cure and then possibly litigating over whether the cure was sufficient can lead to disaster.

In addition, any notice of termination or default should be effective when sent by the client, not when received by the debtor. The latter can lead to disputes over when receipt took place, a fact that may not be known to the client. Think about using e-mail or fax as a means of giving notice, with service being deemed to occur on the date of transmission by the client.

Make sure that notices received by the client from the debtor are copied to you and are sent to a specific address and person at the client, so it does not wander around a huge corporation until the right party is located.

THIRD RULE: OWN IT. Since the automatic stay can cause great delay and expense, the first line of defense is to try to structure a transaction so that the subject matter is not property of the estate to which the stay applies. This is not easy because the definition of property of the estate is much broader than under traditional state property law concepts. In addition, not setting forth clearly who owns the subject matter or proceeds of the contract can lead to the debtor trying to sell or use it free and clear of your client's interests. Finally, if all your client has is an executory contract, its interest can be rejected, leaving the client with nothing more than an unsecured claim payable, if at all, in “little bankruptcy dollars.”

One way to deal with ownership is to expressly define in the contract who owns the subject matter, products and proceeds. Although that may not be binding on a bankruptcy court, which “will not exalt form over substance,” it at least shows the parties' intent.

In addition, if you are dealing with intellectual property, make sure that all registrations and other formalities showing ownership in the client's name have been obtained. This will bolster the client's claim of ownership plus provide additional remedies, such as infringement, that can be used to seek an injunction.

If feasible, have the property irrevocably assigned or transferred by the debtor to the client, but make sure that these are not subject to avoidance as preferences or fraudulent conveyances. Be aware that “escrow accounts” may still be property of the estate and subject to the automatic stay.

FOURTH RULE: GET THIRD-PARTY CREDIT ENHANCEMENTS. Having a solvent third party to pursue not only may provide a source of recovery, but also can have an in terrorum effect ' the principal of a corporation may take extra pains to avoid a default if he/she/it is personally on the line due to a guarantee.

Accordingly, try to get a guarantee from an insider ' the parent, affiliates, or majority shareholder. As part of that guarantee, get an agreement that the parent will not cause assets of the debtor to be upstreamed or side-streamed to related entities. A secured guarantee is even better. Since the DePrizio case was overturned by legislation, in whole or in part, the risk of preference liability due to an insider guarantee significantly may have been reduced. In addition, make sure you get all of the waivers possible under state law to preclude exoneration of the guarantee. California, for example, has express statutory provisions relating to waivers by sureties.

A letter of credit from a financial institution also enhances the chances of payment or performance. However, if the lender providing the letter of credit becomes secured by the debtor's assets within 90 days prior to bankruptcy, there could be a risk of preference liability.

FIFTH RULE: GET A BROAD ATTORNEYS' FEE CLAUSE. Bankruptcy cases can be very expensive, even if only monitoring of the cause is involved, especially in “mega-cases” where hundreds of motions and pleadings can be filed each month. Nevertheless, a motion can have an adverse affect on the client even if it is not named specifically as a target, and the client's bankruptcy counsel should review the docket and upcoming motions even if only an indirect impact could result.

As such, standard form attorneys' fees clauses, such as those providing that only the “prevailing party” gets reimbursed, may be totally inadequate. Ask for a broad provision that covers any attorneys' fees and expenses incurred to protect or enforce the clients' rights, even if no litigation is commenced, including monitoring a bankruptcy filed by or against the debtor or any third party that may have any direct or indirect effect on the subject matter of the contract; objecting to a disclosure statement and/or plan of reorganization; or objecting to a motion brought by the debtor or any third party such as a reclamation procedures motion under Section 546, a sale motion, or motion for relief from the stay to foreclose on assets in which your client has an interest.

However, note that in some jurisdictions, such as California, if one party has an attorneys' fee clause, the other also can seek reimbursement of its fees even if that is not provided by the contract.

Next month's installment will provide the final 10 rules.