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The Financially Distressed Subcontractor on a Government Contract: What a Prime Contractor Should Do to Protect the Project and Itself

Economic

By Jay Bender, Bradley

Some bankruptcy experts predict an increase in business failures for government contractors in the coming years. Increased demands and constraints on government spending will stress both prime contractors and subcontractors. As federal regulations generally place the burden of compliance on prime contractors, a financially distressed subcontractor is a concern not only for the sub, but also for the prime contractor.

A sub’s financial problems jeopardize the sub’s ability to perform its subcontract and, thus, pose serious threats to a prime contractor, including:

  • The prime’s inability to access promptly any equipment, parts, materials, inventories, or work in progress in the sub’s possession that is needed to complete the contract.
  • If the sub is in bankruptcy, the prime’s potential inability to terminate the subcontract, whether for default or for convenience, without first obtaining bankruptcy court approval.

Gaining Access to Equipment, Inventory and Other Property in Sub’s Possession

The Federal Acquisition Regulations (FAR) contain “title vesting” provisions, included in many government contracts, that provide for the making of advance payments, progress payments, performance-based payments, or the reimbursement of costs, to the prime or subcontractors. When a contract does include a title-vesting provision, the government will be deemed to hold full legal title to parts, materials, inventories, work in progress, tooling, test equipment, plans, drawings and other property that the prime or subcontractor has acquired or produced that are allocable or properly chargeable to the contract even though the contract is not yet fully performed.

Though title vesting provisions give the government ownership of property in a subcontractor’s possession, they do not guarantee that the government or the prime contractor will be able to get timely possession of that property from the under- or non-performing sub. Getting possession of that property can be complicated by a number of factors. Subs often refuse to turnover such property peacefully, hoping they will be able to stay on the job if they keep the property. A sub’s bank may have repossessed the property, or otherwise asserted that it has a lien on such property that takes priority over the government’s claims. If the sub is in bankruptcy, any efforts by the government or the prime contractor to take possession of property in the sub’s possession may be challenged as a violation of the automatic stay because the sub will argue it had at least a possessory interest in that property when it filed for bankruptcy. Any of these complications can delay obtaining possession of goods critical to the prime’s completion of the contract, exposing the prime to potentially significant losses.

For these reasons, prime contractors need to act quickly when one of their subs shows signs of financial distress. Primes should monitor their subs’ financial performance closely, especially the payment of their suppliers and sub-subs. Primes should include the full text of the applicable title-vesting regulation in subcontract forms, and not just cite to it, so that subs and the subs’ lenders have clear notice that the government will take title to the goods in the subs’ possession in accordance with those regulations. If the prime becomes concerned—based on solid indicators– that a sub will not be able to complete its subcontract obligations, the prime should consider alerting the government and work swiftly with the government to obtain a court order to get possession of the property and keep the job on track. Of course, such a drastic remedy may well tip the sub into insolvency and will certainly affect its ability to obtain any goods on credit thereafter. Should a sub file for bankruptcy, the prime should coordinate with the government to secure immediate relief from the automatic stay to get possession of the property.

Effect of a Sub’s Bankruptcy on the Prime’s Right to Terminate the Subcontract

Filing bankruptcy triggers an “automatic stay” of all collection actions against the sub and against any of the sub’s property. Action taken in violation of the stay is void and may result in sanctions against the party taking the action. A prime contractor is prohibited from terminating the right to proceed under a subcontract with a bankrupt sub unless the bankruptcy court “lifts” the automatic stay to allow such termination (whether the termination is for default or convenience).

Delaying the termination of the right to proceed under a subcontract can pose problems for the prime contractor, especially if the sub has ceased or slowed its performance of the contract (or clearly will not be able to complete the job) and the prime is eager to award the work to a takeover sub. The stakes are even greater when the underlying government contract pertains to national defense or other sensitive matters. Where time is of the essence to terminate a bankrupt sub’s right to proceed and bring in a replacement, the prime – in coordination with the government, if the government will cooperate – should file an emergency motion for relief from the automatic stay, asking the bankruptcy court for permission to terminate the sub’s right to proceed under the subcontract. A bankruptcy court may be reluctant to grant such relief early on in a bankruptcy case, especially if the prime seeks to terminate the right to proceed under the subcontract for default and does not have the right to terminate for convenience, or if termination of the right to proceed under the subcontract would be the proverbial final nail in the sub’s coffin. Again, however, if the subcontract implicates national security concerns, a bankruptcy court will be less likely to jeopardize national defense simply to give a bankrupt sub an extended opportunity to reorganize. If the bankruptcy court does not grant permission to terminate the right to proceed under the subcontract when requested and the bankrupt sub nevertheless fails to perform its obligations under the subcontract, the prime may need to bring in an additional sub to supplement the bankrupt sub’s work – though that decision should not be made without first obtaining advice from bankruptcy counsel.

Conclusion

A sub’s financial problems can push an otherwise profitable job into the red and destroy a government contractor’s reputation in the process. Prime contractors must monitor the financial affairs of subs and take prompt, deliberate action once a sub’s deteriorating condition becomes evident. While federal regulations often provide the government and its contractor with significant rights and remedies, a prime contractor must be ready to act decisively when necessary to protect its project and itself from being dragged under by a drowning sub. One step of course is to ask your lawyer to assist in evaluating an approach where the prime actually provides some monetary relief to the sub—perhaps based on change order that have been slow to process by the government. Another is to consider the effect of bankruptcy by the sub and proactive management of the developing situation. If you have any questions about how to manage a situation with a financially distressed sub on a government job, feel free to contact Jay Bender.

For more information, visit buildsmartbradley.com.

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