The Intersection of Government Contracts and Bankruptcy Law in the Era of COVID-19

The novel coronavirus (COVID-19) has wreaked havoc on the US and global economies, increasing unemployment, jeopardizing businesses, and reducing gross domestic product. This pandemic has subjected nearly three 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 due not only 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 (CARES) Act, and/or the interim COVID-19 relief bill enacted on April 24, 2020, many companies will need to find relief through restructuring or reorganizing under the protections of the Bankruptcy Code, which appears in title 11 of the United States Code (the Bankruptcy Code). While Chapter 11 of the Bankruptcy Code can be used to liquidate a company, Chapter 11 of the Bankruptcy Code also allows companies to stabilize, reorganize, restructure, and repay debts without liquidating and dissolving. However, federal contractors face unique challenges when navigating the Bankruptcy Code and bankruptcy proceedings.

This is the first in a series of articles examining the intersection of federal bankruptcy law with federal procurement law. The first and second articles (the second will be published tomorrow) consider unique challenges and opportunities facing federal contractors considering or undergoing bankruptcy. They focus on how standard provisions of the Federal Acquisition Regulation (FAR) affect rights at issue in bankruptcy proceedings, 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 (e.g., equitable adjustments). These articles will be followed by an article addressing the unique issues presented when acquiring a federal government contractor or government contracts from a contractor that is seeking protection under the Bankruptcy Code.

I. 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 threshold¹ must incorporate FAR 52.242-13, Bankruptcy.² 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 no later than five days after the bankruptcy proceedings have been initiated. The notification must be in writing and sent “by certified mail or electronic commerce method authorized by the contract.”³

The contracting officer responsible for administering the contract depends on the procuring agency. In some agencies, it may be the procuring contracting officer (PCO) while in other agencies it may be a separate administrative contracting officer (ACO) (e.g., a Defense Contract Management Agency (DCMA) 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 Government in order to protect the interests of the Government.”⁴ These 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 Government’s financial interests and safeguard Government property.”⁵ 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 (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. As discussed below, however, the Government’s options for protecting its interests are broad under some circumstances, but limited under others.

II. Effect of the Bankruptcy Filing

Once a debtor declares bankruptcy, all of the debtor’s pre-petition property (tangible and intangible) is part of the estate overseen by the bankruptcy court,⁶ which is either under the control of 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” (DIP)) may retain possession of the property.⁷ 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.⁸ For example, creditors cannot take possession of the debtor’s property or try to control the estate or perfect liens.⁹ This “automatic stay” continues until certain events trigger its termination, such as resolution of the bankruptcy case¹⁰ or a court decision granting a creditor relief from the stay.¹¹

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 (GFP)¹² in performance of government contracts or where contract clauses vest title to property (e.g., patents¹³) in the Government, or where contractors receive progress or advance payments.¹⁴

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 to which it “held absolute title (and right to possession) to certain goods in the possession of the Debtor.”¹⁵ 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.”¹⁶ In re Reynolds Mfg. 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.¹⁷

Second, government actions may be exempt from automatic stays, if those actions involve enforcement of the Government’s “police and regulatory power.”¹⁸ Some courts, such as the U.S. Court of Appeals for the 4th Circuit, have interpreted this exception narrowly¹⁹ and limited it to instances in which the Government is enforcing laws and regulations relating to public health and safety.²⁰ Other circuits, such as the 9th Circuit, appear to interpret this exception more broadly.²¹ Notably, however, courts have recognized that this exception does not apply to governments seeking to enforce rights arising solely by contract.²²

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 non-government contractors. For example, government services contracts are, with certain exceptions, subject to the Service Contract Labor Standards (formerly known as the McNamara-O’Hara Service Contract Act),²³ which require 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.²⁴ Automatic stays also do not prevent the U.S. Government from enforcing the civil False Claims Act.²⁵

Another unique application of this exception could arise under the DPA, though this does not appear to have been tested.²⁶ The DPA has risen to new prominence during the current COVID-19 pandemic. The DPA authorizes the Defense Priorities and Allocations System (DPAS), which is implemented through Department of Commerce Regulations.²⁷ President Trump invoked the DPA through a March 18, 2020 Executive Order.²⁸ This Executive Order provided the 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.”²⁹ On April 28, 2020, 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. DPAS allows certain “delegate agencies” to place “rated orders” and “allocation orders” to 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 the national defense and emergency preparedness.³⁰ It is conceivable, if not likely, that the U.S. Government could require a debtor to satisfy federal needs pursuant to DPAS notwithstanding any pending bankruptcy proceeding.³¹

III. 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, generally prohibits contractors from assigning contracts to third parties without the Government’s consent.³² 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.³³ The purposes of this statute are 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.³⁴

Section 365(f) of the Bankruptcy Code sets forth the general rule that a debtor may “assume” and/or “assume and assign” an executory contract³⁵ 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.³⁶ 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.³⁷ Once a debtor assumes a contract, it can generally assign that contract, typically through a sale, to a third party.³⁸

Notwithstanding this broad power, a counterparty may enforce a prohibition or restriction on assignment where an applicable non-bankruptcy 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.³⁹ Enter the Anti-Assignment Act.⁴⁰

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. ⁴¹ Importantly, the Anti-Assignment Act is not an absolute proscription on assignments.⁴² 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.⁴³ The Anti-Assignment Act also includes an exception for assignment of the right to payment under a government contract to a financing institution.⁴⁴ And, the Government may consent to assignment, either under what courts have termed the waiver exception⁴⁵ or as implemented in the Federal Acquisition Regulation in the case of acquisitions structured as asset purchases, which require a formal novation.⁴⁶ 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 “hypothetical” test or the “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.

A. The "Hypothetical" Test

The U.S. Circuit Courts of Appeals are split in how they address the impact of anti-assignment provisions, including the Anti-Assignment Act, in contracts. Most of the circuits that have interpreted Section 365(c) of the Bankruptcy Code, including the 3rd, 4th, 8th, 9th and 11th Circuits, have construed that provision as imposing what is known as the “hypothetical test.” These courts have held that if an applicable non-bankruptcy law would prohibit or restrict assignment, then the debtor can neither assume nor assign the agreement.⁴⁷ Courts applying the hypothetical test have, depending on the circumstances, prevented debtors from assuming government contracts. For example, the 8th Circuit held in In re West Electronics, Inc. held 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.⁴⁸

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 non-bankruptcy 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, would be 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.⁴⁹As 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 jurisdictions cannot, however, count on being able to ride through a bankruptcy proceeding. In TechDyn Systems Corp., which was decided by 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.”⁵⁰ In the court’s view, this was “more than sufficient ‘cause’ for relief from [the] stay to terminate the contract.”⁵¹ 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.

B. 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 non-consensual basis, because of an applicable non-bankruptcy law prohibiting or restricting assignment. These courts, including the 1st and 5th circuits 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 non-bankruptcy law prohibiting assignment.⁵² In these jurisdictions, contractor/debtors typically can assume contracts without running afoul of the Anti-Assignment Act.

IV. Termination Provisions

The Government generally has the right to terminate contracts for convenience or default.⁵³ The standard FAR Termination-for-Convenience clause allows the Government to terminate a contract if it is in its interest to do so.⁵⁴ Commercial termination-for-convenience provisions may be broader and allow for termination for any reason whatsoever. The Government may terminate a contract for default if the contractor fails to perform the contract and to cure an identified breach.⁵⁵ Significantly, bankruptcy or insolvency is not, in itself, a basis on which the Government may can terminate a FAR-covered contract under the Default clause.⁵⁶

Government customers may be interested in terminating contracts after a contractor petitions for bankruptcy for a variety of reasons, including fear that the contractor may not have sufficient resources to perform or that resources used in performing the contract could be used to pay the contractor’s creditors with more senior interests. These termination provisions are not ipso facto provisions (i.e., provisions that automatically terminate contracts upon filing for bankruptcy), and the contractor/debtor cannot exercise its right to invalidate ipso facto provisions to circumvent termination for convenience and default provisions. However, termination proceedings of pre-petition contracts are subject to the automatic stay, meaning the Government cannot initiate termination proceedings after the contractor files a bankruptcy petition absent court-ordered relief.⁵⁷ Terminations of contracts executed after filing the petition are not subject to the stay.⁵⁸ Importantly, however, contractors in hypothetical test jurisdictions may find that courts are more inclined to grant a government request for relief from an automatic stay to pursue a termination based on the hypothetical test’s principle that the Anti-Assignment Act prohibits the debtor contractor from assuming the contract without the Government’s consent.⁵⁹

As discussed above, the regulatory and police power exception to the automatic stay does not apply to government contract actions, including terminations. Courts have been reluctant to provide the Government with special treatment and relief from an automatic stay, absent contract clauses that vest title to contractor-held property in the Government. Indeed, some courts have held that a provision allowing a party to terminate a contract for convenience is not in itself sufficient cause to grant relief from automatic stays, and a counter-party must still show “cause” to grant relief in accordance with 11 U.S.C. § 362(d)(1).⁶⁰

Further, debtors in actual test jurisdictions sometimes have been able to preclude a counterparty from enforcing a termination-for-convenience provision on the basis that the counterparty’s real reason for termination was the debtor’s bankruptcy filing, which runs afoul of Section 365(e)(1) of the Bankruptcy Code.⁶¹ For this reason, it is not unusual for a debtor in an actual test jurisdiction to attempt to draw a counterparty out to explain why it is exercising a termination-for-convenience provision. The debtor may do so on the chance that the counterparty will reveal that its real motivation for exercising the provision is the bankruptcy filing or the debtor’s financial condition generally, in violation of Section 365(e)(1).

V. Requests for Equitable Adjustment

Many recent articles have addressed the broader challenges, impacts and opportunity posed by the COVID-19 pandemic. Contractors in various circumstances may be able to seek equitable adjustments if, for example, their contracting officers issue stop-work orders due to the COVID-19 pandemic. However, contractors forced to declare bankruptcy may face hurdles in pursuing equitable adjustments and claims under the Contract Disputes Act. For example, in Doninger Metal Products, Corp. v. United States, the U.S. Court of Federal Claims held that the contractor, which was a debtor in bankruptcy, did not have standing to seek an equitable adjustment.⁶² This decision was based on the specific circumstances of that bankruptcy and the fact that the debtor’s property had been placed in an estate and controlled by a trustee. The outcome may have been different if the contractor had been a DIP and thus continued to possess its property.⁶³ Nevertheless, this case illustrates pitfalls contractors may face after petitioning for bankruptcy and highlights the risk that contractors must plan carefully and evaluate and balance all of their interests when deciding whether and when to file for bankruptcy, and whether and when to pursue equitable adjustment claims.

VI. Conclusion

Companies holding even a single government contract face unique requirements and hurdles when seeking bankruptcy protection. These include notice requirements, loopholes that may jeopardize their right to an automatic stay, and restrictions on assumption, assignment, and termination of contracts and pursuit of equitable adjustment claims. At the same time, contractors that think strategically may be able to use these features to their advantage. For example, a contractor facing financial hardship that anticipates that the Government will terminate a contract that may be profitable or strategically important to the company may be able to time its bankruptcy petition to avoid contract termination.

Similarly, contractors facing financial hardship as a result of COVID-19 may be able to pursue equitable adjustment claims, depending on the circumstances and the terms of their contracts. Requests for equitable adjustments, followed by submission of a certified claim and appeal of a contracting officer’s final decision, if necessary, could allow contractors to recover funds sufficient to help offset existing debts and provide working capital to facilitate a restructuring. As noted above, however, contractors that file bankruptcy petitions—particularly those that will not be debtors in possession—could find themselves unable to pursue equitable adjustment claims and contractual relief, if they file bankruptcy petitions prematurely.