Adverse Impact of the Federal Bankruptcy Law on the Government's Rights in Relationship to the Contractor in Default

• Author: by Major Scott E. Ransick
• Pages: 02

1. INTRODUCTION

When "two inclusive, exclusive, sweeping schemes"' such as bankruptcy and federal procurement overlap, procedural and substantive discord OCEUT~ unless careful legislative coordination has taken place in the drafting of each. Even a curwry analysis of the legislative histories of the Bankruptcy Code' and the federal 6tatutes underpinning the procurement system reveals only haphazard coordination between the two. A comparison of the major provisions of the two systems clearly indicates that conflict must occur when a eontiactor doing business with the government files a petition in bankruptcy. Conflicting provisions and ambiguities, real or imagined, are guaranteed to provoke needless litigation involving the government, the contractor [hereinafter also referred to 88 the debtor], the trustee, and other creditors of the debtor. Under the present bankruptcy system, there are few preventative measu~ea the government c m take to prevent the disruption Lt suffers 88 a creditor in a bankruptcy proceeding. The date of the bankruptcy petition filing is a watershed that drastically changes the relationship between the government and the contractor. An illustration of this change concerns the government's absolute right to "terminate" a contract. If the government terminates anunsatisfactory contract with thedebtor onedaypnorto the petition filing, there is no ongoing contractual relationship for the bankruptcy trustee or court to exercise power over. Once discharged from con-tinuing performance under the previous contract, the government is

'Judge Advocate General's Corps Currently assigned to Contrmct Appals Dwmon US Army Lesal Serviees Asmcv Reviouslv assimed as Chief. Administrative Law

Arkansas at Faysttevdle, 1983, B A Rice Univeralty, 1376 Thie am& 1based "ion

a thema submitted m palrial satisfaelion of the requirements of the 38th Judge Advocate omcer Graduate covrsp

'In rr Gary AirrreR Cow 698 F 2d 776 (6Lh Cir >,

cert hnwd, 464 U S 620 11983) ?he Bankruptcy Refom Act of 1378, Pub L No 35-538,

92 Stat 2543 (1376)(cdfied as amended m scartersd sections of 11 and 28 US C 1

free to contract for that need elsewhere Incontrast, once the petitionis filed, the bankruptcy system, not the government, controls the exis-tence or termination of rights under the contract

Even ifthe government termmates the contract pnor to the petition, any ongomg contract litigation against property or funds of the debt-or's estate 1s automatically stayed by the pending bankruptcy action. Despite governmental vigilance and prompt action at the first sign of impending bankruptcy, the contractor can always file the bankruptcy petition and obtain protection from further contractual claims for money and property

However, the government should still act whenever possible to preserve Its contractual rights. When dealing with a contractor on the bnnk of bankruptcy, the contracting officer should aggressively assert the government's rights until prevented by the bankruptcy court For example, the contracting officer could obtain physical possession of property the government has title to under the progress payments clause. Once accomplished, the bankruptcy court8 will usuaily allow the government to keep the property and defend instead against a monetary clam far the value of the property. In this limited way, the government may be able to facilitate re-procurement of the required product, despite the continuing bankruptcy litigation to recover funds from the bankrupt contractor.

An understanding of the policy supporting these two complex. self-contained legal systems iB a prerequmite to any attempt to identify which problems are salvable and which are not. Some statutory or regulatory relief for the government appears possible in the relatively narrow areas of progress payment property title and jurisdiction over claims liquidation Realistically, from the government'a perspective, there are no satisfactory solutions to its loss of control over the contract and the funding obligated to it With no sweeping statutory or regulatory change probable, the government must continue to identify the moat feaslble litigation strategies in order to more fully protect its interests

First, in order to acquaint the reader unfamiliar with the arcane field of bankruptcy, part I1 provides a brief survey of 8ome of the relevant history, statutes. and regulations Critical provisions covered include the nature of the debtor's estate and the powera of the trustee to preserve the estate.

Part 111 identifies and analyzes the conflicts between bankruptcy and government contract law. Issues covered include bankruptcy limitations on the government'a power to terminate a contract and

19891 BANKRUPTCY AND GOVERNMENT CONTRACTS

pursue other contractual remedies against the debtor; methods whereby the government may obtain relief trom bankruptcy's automatic stay pravimons; bankruptcy jurisdiction over liquidation of can. tract claims; and ownership, possession and title to property under the contract and bankruptcy law.

Finally, conelusmns are presented in part IV.

11. SURVEY OF THE BANKRUPTCY CODE A. BANKRUPTCY POLICY

"Bankruptcy serve8 a role in corporate life eerily similar to that of the doctrine of reincarnation In some eastern rel~gions."~

Just as reincarnation promises a new life, bankruptcy is designed to legally resurrect the financially deceased. Historically, one of the main purposes of the bankruptcy code has been to relieve B debtor "from the weight of oppressive indebtedness and permit him to start afresh from the obligations and responsibilitiea consequent upon business miafortunes."4 Congress has spoken of bankruptcy law as a fun-damental protection that "gives the debtor a breathing spell from his creditors . . . to attempt a repayment plan, or reorganization plan or simply to be relieved of the financial pressures that drove him into bankrupt~y."~

As a compliment to the policies favoring rehabilitation of the debtor, Congress promotes bankruptcy to protect individual creditors through establishment of "an orderly liquidation procedure under which all creditors are treated equally."6 Numerous economic arguments for bankruptcy relief are also baaed on protecting ereditors and the economy a8 a whole.' This rationale a180 supports pratecting the government when it acta as a contractual creditor in praeurement.

A major body of bankruptcy law has developed from these policy roots. In searching for the genesis of bankruptcy, the Starting point must be the United States Constitution.

"Gary Airrrnit. 893 F 2d at 779 'Williams v US.

Fidellfy & Guaranty Co , 236 US 649. 664.665 11916) See d m 'FIR. Rep No 96-696,

95th Cong , 1st Seis. 340 (15771 [hemmaRer H.R Rep No 'Id at 340, repnnld ~n 1978 US Code Cong R Admin News at 6297'Bawd ?a Jackson, Cornomle ReorgonuaLions and the Treatment of Dwrrse Oun-

Local Laan Y Hunt. 292 US 234, 244 (1934) 95.5551, nprmled an 1973 US Code Con8 d Admm News 5963, 6296-97

emhip Inlmbli, 61 U Chi L Rev 97 11984)

2. BANKRUPTCY'S CONSTITUTIONAL, STATUTORY, AND REGULATORY STRUCTURE

   Under the United States Constitution, Congress has long had the power to enact bankruptcy law.' Although Congress could hwe exer-cised this constitutional grant of authority to create a sweeping, ex-clusive body of law to cover all aspects of bankruptcy. the present system has not excluded all application of state law.' The Bankruptcy Code 18 designed to use pre-existing state law as a starting point from which the bankruptcy court proceeds in exercising Its federally based statutory and equitable powers." An excellent example of this interaction is the Code's definition of creditors and claims in sections 101(91 and 101(4)." A creditor LS an entity (to include the with a right to payment or some equitable relief against the debtor. Because no all-encompassing system of federal common law exists,13 state law determines whether a claim, and thus a creditor, exists.

   While the Bankruptcy Code has certam basic rules of clam ~rionty,'~these priorities apply only to unsecured claims. As a gener. al rule, &ate law dictates that secured interests are satisfied before any distribution to unsecured claimints." Applying these state IBWB to the government procurement area causes disagreement over the meaning of progress payment title vesting provisions found in part 32 of the Federal Acquisition Regulation A discussion of the difficulties encountered in determining which law is applicable. i e federal or Btate, LS contained in part 111

   loid"11 0 SC 9 101141. 191 (19821"Id k 10hl41"€ne R R Y Thompkins 304 C S 64 I18381 "11 US

   C I 507 11982)

   "D Cowuans. Bankruptcy Law and Practice 6 12 32 i3rd ad 1986>

   "Srr First Katmnal Bank ofGenav3 Y Umwd States, 13 C1 Cf 385 387 n 3 (19871, In re Amencan Pouch Foods. Inc , 769 F 2d 1190 (7th C n 1885) csn denbid, 4:6 U S1082 '18861

   19891 BANKRUPTCY AND GOVERNMENT CONTRACTS

3. CRITICAL BANKRUPTCY PROVISIONS

   1. Chapter 7 Lquidation and Chapter 11 Reorganization

   Title 11 is divided into eight major chapters, with three general administrative chapterP and five operative chapters.'d Most provisions of the three general chapters apply to the operative chapters.'' BY far the largest number of cases dealing with a government contractor come under the provisions of two of the operative chapters, chapter 7 or chapter llzo Further discussion of bankruptcy will be limited to case8 filed under one of these two chapters unless otherwise stated.

   Chapter 7 deals with the complete liquidation of the debtor's estate." In contrast, chapter 11 provides for resolving clalms while allowing the debtor to reorganize for eventual re-emergenee from bankruptcy as a surviving business The twin options of liquidation and reorganization are generally available to both busi-ness entities and individual debtors. While chapter 11 was created primarily to deal with corporations, partnerships, and other business entities, it is available to...