Can Surety Bonds Be Cancelled or Non-Renewed after the Principal's Bankruptcy Case Has Been Filed?

Robert J. Berens

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A. Introduction

An issue to be considered after a surety's principal files for bankruptcy protection is whether a surety can cancel its bonds pursuant to the Bankruptcy Code. This chapter will address a surety's rights, options and responsibilities with respect to the cancellation or non-renewal of its bonds and the impact of a principal's bankruptcy filing upon these rights, options and responsibilities. The scope of this chapter is limited to the extent it is written from the unique perspective of the surety. Contract and commercial surety bonds are considered separately below.

B. Contract Surety Bonds

Two of the main considerations when analyzing whether a surety may cancel a bond post-petition is whether the bond is an executory contract and, if so, whether it will be construed as a "financial accommodation" under the Bankruptcy Code. Although a debtor can assume certain executory contracts, it cannot assume an executory contract that constitutes a financial accommodation. Bankruptcy Code Section 365(c)(2) provides that a debtor's estate cannot assume an executory contract if "such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor …” As discussed further below, although courts have come to different conclusions as to whether a bond is an executory contract, there should be no question that a bond is a form of "financial accommodation." Thus, if a contract surety bond is determined to be an executory contract, the debtor should not be allowed to assume the bond. And, if the bond cannot be assumed by the debtor, the stage is set for the surety to seek relief from the automatic stay to cancel the bond.

It is important to note that cancellation of a contract surety bond is prospective with respect to post-petition performance of the contract by the principal and post-petition payment obligations. Cancellation of a bond does not eliminate the surety's obligation to the obligee and third party payment claimants for pre-petition obligations. In essence, the surety's position is that it will not agree to bond the post-petition performance of the contracts by the principal.

C. Is a Contract Surety Bond an Executory Contract?

The Bankruptcy Code does not contain a definition of the ten "executory contract." It has been defined in the legislative history and in numerous opinions as a contract "on which performance remains due to some extent on both sides." Some courts have adopted a "functional" approach in determining whether a contract is executory; namely, whether the estate will benefit from the assumption or rejection of the contract. Applying either approach, a surety bond could be considered an executory contract. The debtor-principal is obligated to fulfill its duties to the respective bond obligees pursuant to the terms of its contract with that obligee. The surety would be obligated to step into the debtor's shoes and perform the debtor's contractual obligations in the event the debtor fails to do so itself. If the debtor fails to perform its contractual obligations and the surety is obligated to substitute performance, the surety would have a claim for exoneration and indemnification against the debtor's estate under both common law and the indemnity agreement executed by the debtor. Hence, it appears that there is performance remaining due on both sides, thus qualifying the bond as an executory contract under the traditional definition.

Under the "functional" approach, the surety's bond could also be considered executory. Since the debtor's contracts with the respective bond obligee require the debtor to maintain performance and payment bonds, the debtor's ability to maintain the bonded contracts would be imperiled without the bonds. Obviously, the debtor's estate would benefit if the bonds remained in force post-petition, allowing the debtor to complete the bonded projects and realize the profits it expects from the bonded contracts. Thus, under either test, the surety's bonds should be considered "executory."

In determining whether a performance bond is an executory contract, the surety should also consider whether the bond incorporates by reference the underlying construction contract. Such incorporation by reference makes the construction contract part of the bond. Assuming the construction contract has not been terminated, the principal has not completed all of the construction work contemplated by the contract, and the obligee has not paid the principal the entire contract amount, the construction contract should be considered an executory contract. It thus follows that if the performance bond incorporates the construction contract by reference, the performance bond should also be considered an executory contract.

In In re Maxon Engineering Services, Inc. the court ignored the duties that ran between the surety and its principal and held that contract surety bonds were not executory contracts, and denied the surety's motion for stay relief to permit cancellation of its bonds. In that case, the surety issued performance and payment bonds for 29 projects naming the Puerto Rico Electric Power Authority as obligee. The court, applying the "Countryman" approach, held that those bonds were not executory contracts because they did not constitute a continuing transaction and there was no substantial performance left on both sides. In rendering its decision, the court relied upon the fact that all premiums for the bonds were paid by the project owners and the fact that the construction projects were commenced before the principal's bankruptcy filing. The court further held that since the bonds were not executory contracts, "it follows that they do not constitute 'financial accommodations' either.” It should be noted, however, that the troubling holdings in the Maxon case may have been results oriented. More specifically, it could be argued that the court was swayed by the fact that the obligee was the Puerto Rico Electric Power Authority, the public entity responsible for providing electrical power to the entire island.

Recently, a Connecticut bankruptcy court also rejected a surety's motion for stay relief to cancel its performance and payment bonds. See In re All Phase Electrical Contracting, Inc. Similar to the Maxon case, the court applied the "Countryman" approach and determined that the bonds were not executory contracts. In so holding, the court completely misapprehended the tri-partite nature of a contract surety bond and the respective obligations of the principal and surety under such bonds. The All Phase court's analysis of whether the bonds were executory depended on "the issue of a party's performance under a contract should be viewed by what are, not what may be, a party's duties.” The court held that the relevant date to determine whether a contract was executory was the petition date or, at the latest, the date the motion for stay relief is heard. Possible future contingencies or future obligations would not make a contract executory. The court thought that the respective duties of the principal and surety were the debtor's duty to pay the bond premiums and the surety's duty was to issue the bonds. Since those duties were fully performed on the petition date, the court held that the bonds were not executory contracts. The court was not persuaded by the surety's arguments based on future defaults in performance or in payment of premiums if the amount of the contract increased, or in turning over contract funds. The court described the surety's obligations to the obligee as merely "speculative," because there was no default as of the petition date. The court similarly dismissed the principal’s contractual obligations to the obligee and indemnity obligations to the surety as mere “contingencies” because the bonded project had been suspended by the obligee, for reasons unrelated to the principal’s performance. Under the court’s suspect analysis, a contract surety bond would only become executory in the event of default no later than the date the stay relief motion was heard.

Both the Maxon and All Phase courts ignored the fact that the principal is the primary obligor under the bond and the surety is the secondary obligor. Indeed, the promise of performance by the principal of the bonded obligations is the primary obligation of the principal. The premium charged by the surety is not the principal consideration upon which the surety relies and it is not an actuarially determined premium for an expected loss. Rather, the surety contemplates no loss, as the principal remains the primary obligor whose obligations remain outstanding until completion of the bonded project. If the obligations were not outstanding, then the surety would have no further obligations under its bond.

The Maxon court failed to consider the remaining obligations of the principal under the bonded construction contract, while the All Phase court side-stepped this argument due to the construction project being suspended when the bankruptcy petition was filed. The All Phase court, however, does not explain how the principal (the primary obligor under the performance bond) can be said to have no obligations to the obligee under its construction contract, while its surety can be held liable for any post-petition breach of that contract by the principal. In sum, these two cases are poorly reasoned decisions and were probably results oriented.

D. Is a Bond a Financial Accommodation?

If a bond is deemed to be an executory contract, then the bond cannot be assumed by the debtor because it would be considered a "financial accommodation" pursuant to Bankruptcy Code Section 365(c)(2). The courts have defined "financial accommodations" as "the extension of money or credit to accommodate another …” The underlying rationale for the prohibition against the assumption of contracts that are financial accommodations is discussed in In re TS Indus., Inc., as follows:

The financial circumstances of the debtor are of course fundamental considerations in any credit contract … Presumably these circumstances were assessed in entering the contract. The risk of bankruptcy was accounted for, but that risk had not yet matured before the loan was made. Bankruptcy dramatically alters the assumption under which the contract was arranged. Independent of any contract terms, Section 365 adopts the optimal remedy from the creditor's standpoint. The creditor is then allowed to reassess the desirability and terms for offering credit in light of its changed circumstances. Simply put, the Bankruptcy Code cannot compel a party who extended credit to a debtor pre-petition to extend that credit post-petition.

Surety credit should be considered no differently than other forms of credit in this regard. A surety provides bonding credit to its principal just as a bank provides loans to its borrower. A surety's decision to issue surety credit in the form of a bond is driven by the underwriting of the financial condition of the principal (as well as its character and capacity) in the same way that a bank analyzes the financial condition of its borrower and potential collateral in deciding whether to issue a loan.

As explained by the court in In re Wegner Farms:

the issuance of a bond is intimately connected to Debtor's financial integrity as evidenced by the requirement that Debtor furnish financial statements to Merchants and Merchants' alarm over Debtor's recent losses. Given these characteristics, the Court concludes the bond is a financial accommodation within the meaning of section 365(c) and (e). As such it cannot be assumed by Debtor and can be terminated by Merchants because of Debtor's bankruptcy.

Once a surety establishes that its bond constitutes an executory contract that is a financial accommodation under Code Section 365(c)(2), its bond cannot be assumed by the principal's bankruptcy estate. Therefore, the bond should not be available to continue to guarantee the principal's obligations to the obligee without the surety's consent. Where the surety does not consent to the assumption of the bond, it cannot be compelled to renew or extend its bond post-petition.

The courts that have addressed the issue have held that surety bonds and similar agreements are precisely the type of financial accommodation that cannot be assumed by a debtor pursuant to Bankruptcy Code Section 365(c)(2).

Another important Bankruptcy Code provision relating to "financial accommodations" is Code Section 365(e), which provides in pertinent part:

(e) (I) Notwithstanding a provision in an executory contract. . , an executory contract of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

(2) Paragraph (1) of this subsection does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, If-

* * * *

(B) such contract is a contract to make a loan, or extend other debt financing or financial accommodations. To or for the benefit of the debtor, or to issue a security of the debtor.  

Bankruptcy Code Section 365(e)(2)(B) permits termination of an executory contract that constitutes a financial accommodation. However, as discussed below, the automatic stay most likely prevents the surety from unilaterally terminating the bond without first obtaining relief from the automatic stay by the bankruptcy court.

E. Effect of Ipso Facto Clauses

As discussed above, the court in Maxon concluded that the bond at issue was not an executory contract and, hence, not a financial accommodation. Equally troubling, the court also held that the surety could not terminate the bonds under Bankruptcy Code Section 365(e)(2) because the bonds did not provide for termination based on insolvency or the bankruptcy filing by the principal; that is, the bond did not have an ipso facto clause. An ipso facto clause is a clause in a contract or lease that provides that if an entity files for bankruptcy or is insolvent that the contract or lease can be terminated, and may also provide for other consequences such as acceleration of payment. Generally, ipso facto clauses are not enforceable in bankruptcy.  Bankruptcy Code Section 365(e)(I) provides that notwithstanding an ipso facto clause in an executory contract, an executory contract cannot be terminated or modified solely because of a bankruptcy filing. However, Bankruptcy Code Section 365(e)(2), which permits termination of an executory contract that constitutes a financial accommodation, does not only apply to executory contracts with ipso facto clauses but applies to all executory contracts. As such, the Maxon court's reading of this Bankruptcy Code section is impermissibly narrow. The court's rationale is also contrary to the legislative history. Specifically, a 2005 House Committee note states that "Section 365(e)(2)(B) expands the section to permit termination of an executory contract or unexpired lease of the debtor if such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or for the issuance of a security of the debtor …” This note conspicuously has absent any reference to executory contracts with ipso facto clauses. In short, should the issue of ipso facto clauses arise, a surety should argue that, despite the court's questionable holding in Maxon, the presence of an ipso facto clause should have no effect on whether a surety may terminate a bond pursuant to Bankruptcy Code Section 365(e)(2).

F. Effect of the Automatic Stay

As discussed above, the automatic stay prohibits many actions from being taken against the debtor and the bankruptcy estate after the bankruptcy case has begun. In fact, actions taken in violation of the automatic stay are deemed void. As such, the automatic stay must be taken into account when a surety is considering cancellation of a bond post-petition.

In In re Edwards Mobile Home Sales, Inc, the surety sent a notice of cancellation of the bond post-petition without first obtaining relief from the automatic stay. The debtor filed a motion in the bankruptcy court asserting that the surety violated the automatic stay by sending the post-petition cancellation notice. The surety argued that the bond was a financial accommodation that could not be assumed by the debtor pursuant to Bankruptcy Code Section 365(c)(2). Although the court agreed with the surety, the court held that the automatic stay prevented the surety from unilaterally cancelling its bond without first seeking relief from the automatic stay, and stated:

Section 365(e)(2), ... allows the termination based on the bankruptcy filing if the executory contract is a 'financial accommodation.' Having found the surety bond to be a 'financial accommodation,' Ohio Casualty may be permitted to terminate its surety bond in accordance with the provision allowing termination based on Debtor's bankruptcy filing.

The court in In re Wegner Farms Co. reached the same conclusion. In that case, the court held that a grain dealer license bond was a financial accommodation that could be terminated by the surety. However, the court held that the surety was not permitted to unilaterally terminate the bond because doing so violated the automatic stay, holding as follows:

[T]he issuance of a bond is intimately connected to Debtor's financial integrity as evidenced by the requirement that Debtor furnish financial statements to Merchants and Merchants' alarm over Debtor's recent losses. Given these characteristics, the Court concludes the bond is a financial accommodation within the meaning of section 365(c) and (e). As such it cannot be assumed by Debtor and can be terminated by Merchants because of Debtor's bankruptcy...

Having accepted Merchants 365(e) argument, the Court must nonetheless reject its contention that right of termination necessarily propels cancellation of the bonding agreement outside the orbit of the automatic stay...

Section 365(e) and (c) are intended to be limited and closely circumscribed exception to the general rule permitting a debtor to assume executory contracts and prohibiting nondebtor parties from terminating such contracts upon the filing of bankruptcy. Therefore, bringing these kinds of contracts within the ambit of the automatic stay ensures that the legal question of whether a particular contract may be terminated will be decided in the proper forum, after full briefing by the parties, rather than by a nondebtor party acting unilaterally and perhaps erroneously…

Preserving the status quo pending a request for relief from the automatic stay by a contracting party and a ruling by the court that relief should be granted is not only dictated by the Code but also serves important policy concerns.

Having concluded that Merchants must seek relief from the stay as a necessary predicate to terminating the bonding agreement, the Court concludes the bonding agreement should remain in effect.

In a case unrelated to surety bonds, the Ninth Circuit likewise held relief was required to terminate a financial accommodation contract. In Computer Communications, the court held that a unilateral of a joint marketing and development agreement due to bankruptcy filing violated the automatic stay. However, the Circuit issued a contrary decision in Watts v. Pennsylvania Housing Finance Co. In that case, the court held that the post-petition termination of the executory contract, a public mortgage assistance loan, was authorized pursuant to Bankruptcy code Section 365(e(2)(B) and did not violate the automatic stay, reasoning as follows:

The question remains whether the automatic stay applies even though the Code expressly permits the post-filing termination of an executory contract to make a loan. We conclude it does not. Section 365(e)(2)(B), unequivocally and without qualification, provides for termination of a contract to make a loan after the commencement of a bankruptcy is, at the same time, stayed under section 362 would be at worst anomalous, and at best an imposition of a pro forma requirement that the creditor must ask for what the Code plainly grants him. In short, we are unwilling to grant "a protection or benefit pursuant to 11 U.S.C. Section 362 when the [contrary] intent of Congress appears clear at 11 U.S.C. Section 365." [Citations. omitted].

However, the court did caution in footnote that "the nondebtor party acting unilaterally may want to make a motion for relief from the automatic stay in a doubtful case in order to avoid liability for ex parte action which is later determined to be unlawful …” While neither the Computer Communications nor Watts cases deal with surety bonds, they do suggest that a prudent surety should file a stay relief motion prior to cancelling any surety bonds post-petition.

G. Conclusion on Contract Surety Bonds

The most critical issue when considering post-petition cancellation of a surety bond is whether the surety bond is an executory contract. If so, there should be no question that the bond is a financial accommodation under Bankruptcy Code Section 365(c)(2). If the surety can demonstrate that the bond is an executory contract, then the bond cannot be assumed by the debtor's estate and the surety may seek relief from the automatic stay to cancel the bond. Surety counsel should bring this important issue to the attention of counsel for the debtor and the obligee immediately, and settlement negotiations should be attempted in earnest. If settlement negotiations are unsuccessful, then the surety should consider filing a motion for relief from the automatic stay seeking authorization to cancel the applicable bonds. However, formal effort to cancel the bonds should be a last resort option to be taken only after negotiations have failed or would be futile.

H. Commercial Bonds

Commercial bonds may require a slightly different analysis.

Commercial bonds, unlike contract surety bonds, are not tied to a contract. As such, unlike the contract bonds discussed above, commercial bonds will not incorporate any construction contract by reference. Therefore, the argument that incorporation of the underlying construction contract results in the bond being an executory contract is not available.

The surety should closely examine the commercial bond to determine what duties the principal/debtor has under the bond. Some bonds contain explicit duties for the principal to perform thereunder. The surety can also argue that the commercial bond is an executory contract based on the principal having the common law duty to exonerate the surety. This argument is not as strong as the incorporation of the construction contract argument because the express terms of the bond do not contain the exoneration duty.

Commercial bonds contain the obligation that the principal pay the premiums for the bond on a periodic basis. Thus, commercial bonds can be described as a contract under which the principal owes a continuing duty to pay its yearly premium and, in exchange, the surety may then consent to the maintenance of its bond in force and to perform any obligations owing under the bond. If the principal fails to pay its annual premiums (i.e., breaches the bond contract), then the surety may be able to cancel the bond. Moreover, and more importantly, the underlying obligation of the principal to the obligee remains subject to continued performance by the principal, and its obligation to the surety to continue with performance of such obligation and to exonerate and indemnify it with respect to such obligation remains to be performance as long as there exists any remaining obligation under the bond. Because the duties run between both the surety and the principal, the bond should be considered an executory contract under the definition adopted by most courts.

The leading case that addressed whether an automatically renewing commercial bond is an executory contract under Bankruptcy Code Section 365 is In re Wegner Farms Co. In that case, an Iowa bankruptcy court held that a commercial bond was a "financial accommodation " under Bankruptcy Code Section prohibited the debtor from assuming the bond, and permitted the surety to cancel the bond, the court must have determined that the commercial bond was an executory contract. Unfortunately, however, the opinion does not contain that explicit finding.

Commercial bonds, depending upon the specific terms of the bond, may either automatically renew until formally cancelled or may need to be formally renewed on a periodic basis. If the bond does not automatically renew, then pursuant to its own terms the bond may cease to remain in effect upon a date certain. There is nothing in the Bankruptcy Code that obligates a surety to renew its bonds post-petition for a debtor/principal. As such, the surety refusing to renew the bonds should not be a violation of the automatic stay. If a commercial bond does not automatically renew, the surety should consider giving notice to all interested parties that the surety will not be renewing the commercial bonds post-petition and file some form of formal notice with the bankruptcy court of such non-renewal. If any party believes the nonrenewal is a violation of the automatic stay then this issue can be brought before the bankruptcy court. Care should be taken, however, to strictly follow the applicable procedures required by the bond and/or applicable state and federal law.

For bonds that do automatically renew, the surety should negotiate with the debtor and obligees for a stipulated cancellation plan on the ground that the bonds are executory contracts that cannot be assumed as financial accommodations. If negotiations are unsuccessful, then the surety should consider seeking relief from the automatic stay to cancel the bonds pursuant to Wegner Farms and similar case law.

I. Notices to Obligees and Other Conditions of Cancellation

If the bankruptcy court grants the surety relief from the automatic stay to cancel its bonds post-petition, the surety should consider the type, terms and conditions of a particular bond to determine the surety's precise rights and obligations with respect to cancellation of the applicable bond. After stay relief is granted, the surety should consult applicable state law to determine whether a bond is cancellable and, if so, the procedure for such cancellation. The surety should take care to comply with any notice requirements prescribed by the bond, the contract, and governing statutes and regulations.

The cancellation of bonds covering limited time periods or containing express cancellation provisions (which is typically the case for license and permit bonds, workers' compensation bonds, and custom bonds) can be accomplished quickly if the bankrupt principal is prepared to provide the obligee with replacement bonds or other security covering post-petition performance. In those cases, where the surety determines to cancel the bonds, it should act as quickly as possible to limit its exposure for pre-cancellation damages.

In the case of typical payment and performance bonds, cancellation does not relieve the surety of liability for the completion of the bonded contract and performance of the principal's obligations. As such, a cancellation of contract surety bonds invariably triggers a claim from the obligee and should therefore be limited to those cases where the surety can mitigate its damages by "accelerating" the termination of its principal. The most effective use of the surety's right to cancel its performance bonds is often the mere threat of cancellation. Once a principal understands that it cannot function without surety credit and that its prospects for effective reorganization will be dead on arrival in the bankruptcy court, it becomes easier to convince the principal, the bankruptcy court and other creditors of the need to protect the surety's rights, through a cash collateral order under Code Section 363, a financing order under Code Section 364, or otherwise. If the court and other creditors understand that the surety can cancel the bonds needed by the principal for its continued post-petition operations, the surety should have leverage to obtain the court's approval for any arrangements it reaches with the principal as concerns obtaining collateral and other protection to secure the principal's obligations to the surety.

J. Conclusion for Commercial Bonds

Before a principal files for bankruptcy and in the absence of any contractual or legislative requirements to the contrary, a surety is free to cancel or non-renew its bonds so as to avoid future liability. However, doing so will not shield the surety from any pre-termination liability. Promptly after a principal's bankruptcy filing, the surety should analyze the outstanding contract and commercial bonds for that principal to determine whether they are executory contracts. The determination that the bonds are executory contracts is critical. If they are, then the surety has a strong basis to seek the bankruptcy court's permission to cancel the bonds because those bonds are not assumable executory contracts. If commercial bonds do not automatically renew, then the surety should consider giving notice to all interested parties that the surety will not be renewing those bonds. Settlement negotiations with the debtor's/principal's and the obligee's counsel should be attempted to see whether some amicable resolution (such as a stipulated cancellation plan, obtaining collateral or obtaining some other form of adequate protection with respect to the principal's post-petition performance) can be worked out. If settlement negotiations prove unsuccessful, then the surety should consider seeking relief from the automatic stay to cancel the applicable bonds. u