Navigating a Crisis: Bankruptcy and Other Governmental Interference with Contracts

The most basic rule of contract law is that the plain and unambiguous language of a contract controls, but every rule has its exceptions. In times of crisis, government authorities sometimes step in to modify or supersede even the clearest terms of private contracts.

Bankruptcy

The bankruptcy of a counterparty to any contract (whether an insurance policy, lease, construction agreement, project finance agreement, investment or other agreement) can result in the modification or even termination of certain contractual rights. At minimum, immediately upon a bankruptcy filing, an automatic stay generally prevents you from terminating your contract or enforcing obligations past due. If you think your counterparty is financially stressed, you should immediately consider the following steps:

• Review the contract. Consider provisions relating to non-performance and defaults so you have a full understanding of your contract rights, including how a bankruptcy filing might affect them.

• Be proactive, and consider a non-bankruptcy solution. Communicate with your counterparty and other stakeholders early, including to explore creative, mutually beneficial solutions. To achieve certainty and mitigate costs, a negotiated solution usually is preferable to a formal bankruptcy case. Understand your counterparty’s needs and financial circumstances, as well as the impact on any lenders, other creditors, and guarantors.

• Consider what, if any, action to take before a bankruptcy filing triggers the automatic stay. Pre-bankruptcy actions could range from sending a default notice or requesting adequate assurance of future performance (if permitted by contract or by the UCC), to terminating the contract. Make sure any contemplated action will not run afoul of any government moratorium such as on commencing actions or eviction.

• Be careful about what you agree to and how you implement it. Make sure your “informal” email or other communications do not bind you unintentionally. If you find an agreed pre-bankruptcy solution, observe corporate formalities when implementing it to avoid challenges or potential unintended liability down the road.

As we have seen over and over in past financial crises, numerous businesses (landlords, lenders, insurance companies, energy and construction companies, funds, just to name a few) need considerable assistance and counseling in order to maximize the value of their contract rights during pre-bankruptcy and bankruptcy-related disputes and negotiations. As the impact of COVID-19 shakes out, we are likely to see numerous companies stressed and seeking out-of-court debt restructurings or filing for bankruptcy.

Ad Hoc Government Actions

In times of crisis, especially in highly regulated sectors—e.g., insurance, finance, housing, public health—governments can try to alter contract performance to alleviate the crisis.

Following disasters like the Northridge Earthquake (1994), the September 11 attacks (2001), and Hurricane Harvey (2017), politicians and regulators put severe pressure on the insurance industry to pay claims their policies did not cover. Similarly, states also have imposed moratoria on enforcing rent and mortgage obligations in times of financial crisis.

In the midst of the COVID-19 pandemic, governments are actively seeking to alter both insurance and housing contract rights. Several states have proposed legislation prohibiting insurers from denying business interruption claims, regardless of their policy terms. Several states have issued or are exploring eviction and foreclosure moratoria, or even rent or mortgage forgiveness, not just deferral.

These government measures will face constitutional challenges. First, the US Constitution’s Contracts Clause provides, “No State shall … pass … any Law impairing the Obligation of Contracts.” In Sveen v. Melin, the US Supreme Court recently stated the legal standard: Has the state law “operated as a substantial impairment of a contractual relationship”? If so, was the impairment an “appropriate” and “reasonable” means to “advance a significant and legitimate public purpose.”

The Fifth Amendment’s Takings Clause may also be relevant. The Clause states that no one shall be “deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.” What is “just compensation” will likely be open for dispute.

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Navigating a Crisis: Special Valuation Issues

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