Extending the Stay to Third Parties: Sometimes a Bankruptcy Court Will Intercede

Durr Mechanical Constr., Inc. v. I.K. Constr. Inc. (In re Durr Mechanical Constr., Inc.), 604 B.R. 131 (S.D.N.Y. 2019) –

A general contractor debtor filed an adversary proceeding against a subcontractor seeking various relief. It then filed a motion seeking to extend the automatic stay to protect nondebtor insurers that had issued a surety bond relating to the debtor’s contract with the subcontractor.

The debtor was seeking monetary and injunctive relief and objecting to the proof of claim filed by the subcontractor. In the meantime, certain non-debtors had issued a surety bond that covered the debtor’s purported breach of the parties’ subcontract. The subcontractor had commenced and was continuing to pursue a state court action against the issuers seeking to recover on the payment bond.

The debtor was the general contractor on a project involving construction of three incinerators. It retained the subcontractor to perform all structural steelwork for the project, agreeing to pay $4.4 million. The debtor had the right to terminate for delay or failure to perform if the subcontractor failed to cure a default after three days’ notice.

If the contract was terminated under this provision, the subcontractor was not entitled to any further payments until performance of the contract was completed. At that time if the unpaid balance due the subcontractor exceeded the cost of completion, it would be paid the excess. On the other hand, if the expense of completion exceeded the unpaid balance, then the subcontractor owed the difference to the debtor.

The debtor contended that the subcontractor’s financial condition had deteriorated. It had insufficient funds to make payroll with the result that its workers walked off the project. So, the debtor gave a three day notice claiming that the walk off had caused a delay.

When the subcontractor failed to cure, the debtor set a letter terminating the contract. The unpaid balance due under the subcontract was ~$500,000, while the completion costs totaled ~$1.3 million. However, the subcontractor contended that the debtor wrongfully terminated the subcontract and disputed the debtor’s claims.

In connection with the issuance of a payment bond relating to the project, the debtor and others executed on Agreement of Indemnity with the insurers that provided:

The Contractor [i.e. the debtor] and Indemnitors shall exonerate, indemnify, and keep indemnified [the non-debtor insurers] from and against any and all liability for losses and/or expenses of whatsoever kind or nature (including, but not limited to, interests, court costs and counsel fees) and from and against any and all such losses and/or expenses which the surety may sustain and incur: (1) by reason of having executed or procured the execution of the Bonds, (2) by reason of the failure of the Contractor or Indemnitors to perform or comply with the covenants and conditions of this Agreement or (3) in enforcing any of the covenants and conditions of this Agreement.

The debtor’s indemnity obligations were secured by substantially all of its assets. A UCC financing statement was filed to perfect the security interests at some point prior to bankruptcy.

After the debtor’s termination of the subcontract, the subcontractor filed a bond claim asserting amounts were owed for retainage and change orders. The amount claimed was initially ~$900,000, but subsequently increased to ~$1.9 million. The subcontractor eventually sued the debtor, the insurers and others in state court seeking damages in the amount asserted in the bond claim. The debtor counterclaimed against the subcontractor for breach, asserting damages for ~$1.3 million.

After the debtor filed bankruptcy, the state court issued an order providing that any party making a claim against the debtor had to file a formal application with the bankruptcy court for permission to continue the state court litigation against the debtor. The order also laid out a procedure to be followed if a party obtained relief from the stay.

Failure to follow the designated procedure constituted a waiver of all rights to proceed against the debtor in the state court action. No party sought relief from the automatic stay and the debtor was administratively dismissed. However, the subcontractor’s cause of action against an insurer remained and a trial was scheduled.

With the trial date approaching, the debtor filed a motion in bankruptcy court seeking to extend the automatic stay to the insurers or to preliminarily enjoin continuation of the state court litigation. The debtor’s primary argument was that continuation of the litigation would have on immediate, adverse economic impact on the bankruptcy estate. The debtor had an absolute obligation to indemnify the insurer for its litigation expenses if the litigation continued, the debtor’s obligation would increase the secured claim under the indemnity and thus diminish recovery available to other creditors.

The subcontractor’s primary objection was that enjoining the state court litigation would inequitably require the subcontractor to reassert its breach of contract claims less than a month before trial after litigating them for nearly two and a half years. It also generally asserted that the debtor failed to show any immediate adverse economic consequence of continued litigation.

The court began by noting that generally the automatic stay does not apply to non-debtors. However, the Second Circuit had ruled that the stay could be extended where a claim against the non-debtors would have an immediate, adverse economic impact on the bankruptcy estate. The Second Circuit provided three examples: (1) claim to establish an obligation guaranteed by the debtor, (2) claim against the debtor’s insurers, and (3) actions where “there is such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant.”

The debtor argued that it continued to be the real party defendant since it had an absolute obligation to indemnify the insurer. This argument was supported by the case law. Further, the bankruptcy court noted that the indemnification obligation was secured by the debtor’s assets. Thus, continuation of the litigation would have an immediate, adverse economic impact on the estate and its unsecured creditors.

The court further noted that the adverse impact was exacerbated by the subcontractor’s own actions and inactions. It did not seek relief from the automatic stay to continue the litigation against the debtor. In addition, by filing a proof of claim it submitted to the equitable jurisdiction of the bankruptcy court. The court also made a side, that the insurers were amenable to resolving all disputes in the bankruptcy court.

Accordingly, the bankruptcy court granted the debtor’s motion.

As a matter of logic, the debtor had a strong argument. Permitting the subcontractor to recover on the payment bond would allow it to do indirectly what it could not do directly – namely recover against the debtor without regard to the bankruptcy. However, be aware that some courts may be more willing to take action involving third parties than others.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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