As the nation’s most experienced insurer of design professional firms, the Victor and CNA program has the largest base of claims to inform firms of their greatest professional liability exposures and methods to keep those exposures from generating claims. For firms, clients are the source of most claims, and they often influence third-party claims as well.
Be Wary of Underfunded Clients
As the resurgent economy demands more housing, private infrastructure, and other capital assets, design firms face the increased possibility that their clients might encounter financial troubles. Client selection and the careful scrutiny of client-proposed projects is often the most effective risk mitigation process for design firms. Projects can “fall apart” while they are still in the design process during times of high inflation, which is a disruptive process for putting capital assets in place. Projects are also in jeopardy whenever the costs of construction materials and labor continue to rise.
Firms that have not performed appropriate due diligence in evaluating the client and project may find that they are neither paid for their services nor immune from cost-recovery efforts. In addition to carefully vetting a client to determine their ability to carry through on project, a firm also should understand its legal positions if the client runs into cash-flow problems.
Know the Firm’s Rights When a Client Files for Bankruptcy
A client in financial trouble may file for Chapter 11 protection in bankruptcy court so that it has a safe period to attempt to settle its debts and reorganize its operations. This is more likely when the client is a project developer that sets up a separate limited liability company for the project. While in Chapter 11, the client (now called a debtor) continues to operate its business while being monitored by the bankruptcy court.
A design firm with an existing contract with that client/debtor has to continue to perform its services. In return, the debtor must perform its side of the contract. However, if the debtor does not continue to pay the professional service fees, the firm cannot terminate the contract; the firm must obtain the bankruptcy court’s permission before contract termination is possible. If the firm terminates the contract without the court’s permission, it may be subject to a substantial fine. The reason is that the debtor’s interest in the contract is an asset that the court wants to protect, along with all of the other debtor’s assets, to give the debtor an opportunity to reorganize and come out of bankruptcy.
Even if the contract with the client has a provision that would otherwise allow termination if the client files for bankruptcy protection or becomes insolvent, the firm still cannot do so without the court’s permission. A valid termination provision alone will not be sufficient to allow the firm to get permission to terminate the contract. There has to be a performance-based reason, such as the client’s failure to perform its side of the contract.
Know the Firm’s Termination Rights to Avoid Being a Creditor
At the first indication that a client could be in financial trouble, a firm should explore its legal options, including termination of the contract for non-payment. If the client has failed to perform its duties under the contract before it files for bankruptcy, the firm can terminate the contract. Once the client files for bankruptcy, the contract no longer exists and the firm does not have to deal with the debtor and the court’s control over the contractual relationship. However, that does not free the firm from the project because once the client files for bankruptcy, the client is now a debtor and has the opportunity to cure the default and reinstate the contract.
If the debtor wants to continue its contract with the design firm during its Chapter 11 bankruptcy protection, it will file a motion to assume the contract. If the debtor is in default, it must cure the default. When the court authorizes the debtor to assume the contract, the contract continues in existence after the bankruptcy, binding both sides to the contract. If the debtor does not want to continue to perform its contract with the firm, the debtor has the option to reject the contract. If the debtor rejects the contract, the debtor is no longer required to perform it. The firm will have a claim for damages for breach of contract and will receive whatever creditors receive from the bankruptcy court’s decision. In addition, the debtor may assign its interest in the contract to a new party. The original firm must accept performance even if the contract prohibits assignment.
Always Rely on Legal Advice
Bankruptcy law is complex. Once a client files for bankruptcy, the chances of finishing a project or collecting an outstanding fee at full value are rare. Eternal vigilance and timely billing and collection are necessary to avoid providing unpaid services and cash flow problems. Moreover, as with any legal issue, it is always prudent to consult with a bankruptcy lawyer about the firm’s rights and obligations when a client enters Chapter 11 bankruptcy and protection during reorganization.
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