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Although public works projects are projected to remain a major source of construction activity for the foreseeable future, municipal bankruptcy filings are on the rise—a trend that is likely to continue.

The issues facing parties under contract with a municipality when it files for bankruptcy protection are playing out nationally in places like Detroit and Stockton, Calif. Construction attorneys need to know the risks of a public owner filing for bankruptcy protection before project completion, and what to do if that occurs before the project is closed out, thereby jeopardizing the owner’s ability to pay.

A public owner or municipality may file for protection under Chapter 9 of the Bankruptcy Code if it is insolvent, wants to implement a plan to adjust its debts and satisfies other eligibility requirements. On the petition date, and before eligibility is determined, the automatic stay provisions of the code kick in, and all contract claim proceedings and legal actions against the municipality are stayed.

The stay creates complications for all creditors, including both contracting parties as well as claimants seeking disputed amounts owed. Ordinary course of business creditors may continue to be paid post-petition, although prudence may lead them to file claims to protect their rights pending payment. Claimants seeking disputed amounts must file their claims with the bankruptcy court in a timely fashion.

Among the earliest and often most contentious issue in a municipal bankruptcy is whether the municipality will assume or reject its executory contracts (and the terms under which it will do so). While this has most often played out in recent Chapter 9 bankruptcies among a municipality and its pension plans and labor unions, the same issues apply to construction contracts. Indeed, a contractor will want to know where it stands with its now bankrupt client.

At a minimum, the contractor should promptly seek assurances from a Chapter 9 debtor that it will be kept current if the company continues performing work, or seek an expedited determination from the bankruptcy court requiring the debtor to assume or reject its construction contract. If the debtor rejects an executory contract, it is deemed a breach as of the petition date. In other words, the contractor’s claim almost certainly will be treated as a general unsecured claim.

One way to avoid the undesirable status of a general unsecured creditor is to determine whether the public works project that is the subject of the claim is (or was) being funded using “special” or “restricted” funds, versus using only the municipality’s general funds. Unlike private projects, public works projects often are funded by bonds or grants. As seen in a bankruptcy case in the City of Vallejo, Calif., the complexity of municipal accounting “includes a mix of laws authorizing the creation of funds; laws restricting the use of funds; facts as to the correct amount of funds available in particular funds; laws de-authorizing the funds” and other considerations.

Recognizing the unique nature of municipal accounting, the Bankruptcy Code provides protection for special or restricted funds. If funding for an underlying project can be tied to an identifiable “restricted” source of funding, it may be possible for a claimant to get relief from the stay to prosecute a project-related claim outside the bankruptcy proceedings.

For example, a municipal owner issued a series of bonds to fund a major water project. These were “restricted” funds, meaning they could only be used to pay for projects and costs within the bond’s defined scope. The municipality could not use these funds to satisfy its general obligations. Disputes developed between a contractor and the municipality during construction of a pump station, resulting in the contractor claiming significant cost overruns and the municipality withholding the contractor’s retention. Meanwhile, the municipality’s financial condition deteriorated rapidly, leading it to file for bankruptcy protection.

Because of the gridlock caused by the bankruptcy filing, the contractor sought legal help. Counsel traced the funding sources for the payment of the project costs to restricted bond funds and persuaded the bankruptcy court to grant relief from the automatic stay. As a result, the contractor was allowed to file and prosecute its action in state court, unimpeded by the bankruptcy.

For construction firms performing public work, the lesson to be learned is that it pays to know the owner’s source of project funding. Doing so will enable a contractor to assess whether it is protected against the risk of a municipal bankruptcy filing, as well as how to avoid being relegated to general, unsecured creditor status should such a filing occur.

Read more at “Public Works Project and Municipal Bankruptcies.”

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