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The position of non-performed contacts

1. Introduction

There may at the commencement of bankruptcy proceedings exist mutually burdening contracts that are wholly or partially non-performed.  In the following the parties to such contracts are referred to as the (solvent) co-contractor/ creditor and the bankruptcy debtor.  One example of a situation that might arise is where the debtor has purchased goods from the co-contractor but the goods have not yet been supplied or paid for.

Contracts of this nature frequently involve the purchase of goods or services or continuous contributions such as electricity, telephone subscriptions, the rental of premises etc.  Thus the contract requires one of the parties to pay money in return for a contribution by the other party in the form of something other than money (what is known as payment in kind).  In the event of bankruptcy the legal position of the co-contractor in the case of wholly or partially non-performed contracts will depend on whether he was to provide payments in kind or pay money.  Both situations are therefore described.

The purpose of this presentation is to inform co-contractors on how they should proceed in the event of the bankruptcy of the debtor.

1. Introduction
2. Some general rules
3. The right of the estate to assume the position of the debtor in contracts
4. Where the contribution of the co-contractor consists of something other than money (payment in kind)

5. Where the contribution of the co-contractor consists of money

2. Some general rules

Chapter 7 of the Creditors Recovery Act contains general provisions on the rights and obligations of the parties.  As a general rule these provisions apply to all types of contracts, e.g. contracts of sale, contracts of lease, manufacturing contracts etc.  Contracts of sale are also regulated by the provisions of Section 61 et seq of the Sale of Goods Act.

The estate assumes the debtor’s position and as a general rule both the estate and the co-contractor are bound by the agreements entered into by the bankruptcy debtor before the commencement of bankruptcy proceedings.  This means that if one of the parties fails to fulfil his side of the agreement, the other party may either affirm the agreement and secure a judgment for performance or terminate the agreement in the event of serious breach of contract.  In the event of bankruptcy the debtor will clearly not be able to fulfil his side of the agreement.  Nor will the co-contractor be obligated to stand by the agreement unless the estate assumes the position of the debtor.  The co-contractor may disclaim or cancel the agreement, see Section 62 of the Sale of Goods Act and Section 7-7 of the Creditors Recovery Act.

However, the general rule that the estate is bound by the agreements of the debtor must be modified since the main function of the estate is to meet the commitments of the debtor by means of the payment of dividends.  Insolvency on the part of the debtor entails that the debtor has insufficient funds to cover all commitments.  The debtor’s funds must therefore be divided proportionately between the creditors.  This includes creditors under non-performed contracts.

3. The right of the estate to assume the debtor’s position in contracts

As a general rule the bankruptcy estate may choose whether it wishes to assume the position of the debtor in non-performed contracts or not.  This right of choice is limited to the estate.  Nevertheless the co-contractor may ask whether the estate wishes to assume the position of the debtor in the contract and, if so, the estate is required to respond without undue delay, see Section 7-3 first para of the Creditors Recovery Act.  If the estate does wish to assume the debtor’s position, it must notify the co-contractor either expressly or through its actions (e.g. by accepting a delivery).  A special rule applies to agreements entered into by the debtor to rent business premises, see Section 4.

If the estate does assume the position of the debtor, it must cover the co-contractor’s claims as preferential claims.  As a general rule the estate becomes a party to the agreement in addition to the debtor, see Section 7-4 first para of the Creditors Recovery Act. If the estate does assume the position of the debtor it must as a general rule perform the agreement in full, for further details see article 4.2.2.  For this reason estates are normally reluctant to assume the position of the debtor in contracts.

Some agreements are of such an unusual nature that the estate cannot require the co-contractor to accept the estate as a party.  This type of agreement assumes the personal participation of the bankruptcy debtor.  A further example of an agreement of this type is a credit agreement (overdraft facility, suppliers’ credit).  In such cases the co-contractor may choose to invoke the insolvency of the debtor and cancel the agreement.  The co-contractor cannot object to the estate assuming the position of the debtor.

4. Where the contribution of the co-contractor consists of something other than money (payment in kind)

4.1 The contribution is delivered before the commencement of bankruptcy proceedings

The co-contractor may have fulfilled his side of the agreement before the commencement of bankruptcy proceedings.  A typical example of this would be a credit or instalment purchases where the co-contractor has supplied the goods and the purchaser is declared bankrupt before the purchase price is paid.  The co-contractor’s claim for the purchase price will be processed in accordance with the ordinary rules on dividend claims in bankruptcy, see the information published by the Norwegian Advisory Council on Bankruptcy on "The position of monetary claims in bankruptcies".  The co-contractor cannot in such cases cancel the agreement and claim the release of the item unless he has reserved a purchase-money security interest.

4.2 The contribution is not delivered before the commencement of bankruptcy proceedings

Situations may also arise where all or parts of the co-contractor’s contribution are not supplied before bankruptcy proceedings commence.  Issues relating to the legal position of the co-contractor are discussed below.  It is useful to discuss continuous agreements separately from typical contracts of sale, service contracts and construction contracts.

4.2.1 The rental of real property

The estate automatically assumes the debtor’s position in agreements to rent business premises where use of the premises started before the commencement of bankruptcy proceedings unless the estate gives notice no later than four weeks after the commencement of bankruptcy proceedings that it does not wish to assume the debtor’s position, see Section 7-10 first para of the Creditor Recovery Act. 

If the estate is deemed to have assumed the debtor’s position in the contract of lease, it will have the rights and obligations that follow from the agreement.  (Nevertheless the estate has a special right of termination, see Section 7-6 first para of the Creditors Recovery Act.)  This entails that the claim of the co-contractor (the lessor) for rent after the commencement of bankruptcy proceedings will be a preferential claim.  If the rent is overdue the lessor may claim performance or security for such performance, see Section 7-5 of the Creditors Recovery Act.

If the estate does not assume the debtor’s position in the contract of lease the lessor may claim only a dividend on outstanding rent, see the information published by the Norwegian Advisory Council on Bankruptcy on "The position of monetary claims in bankruptcies".  Furthermore the lessor may cancel the agreement and claim for losses sustained as a result of non-performance of the agreement in the form of a dividend claim, see Sections 7-7 and 7-8 of the Creditors Recovery Act.  Nevertheless, the estate must cover rent during the period between the commencement of bankruptcy proceedings and the point at which the declaration that the estate does not intend to assume the debtor’s position reaches the lessor or the premises are made available to the lessor, see Section 7-10 second para of the Creditors Recovery Act.  The estate must cover this part of the rent as a preferential claim.  Instead of cleaning the premises the estate may relinquish the title to movables on the leased premises (abandonment) without being bound by the contract of lease.

4.2.2 Purchases, construction contracts etc.

In practice, estates rarely find it worthwhile to assume the debtor’s position in contracts of sale etc. where the co-contractor has not performed any obligations prior to the commencement of bankruptcy proceedings.

Estates rarely opt to assume the debtor’s position in construction contracts.

If the estate chooses to assume the debtor’s position in a contract that has been performed in part by the co-contractor, the estate may as a general rule confine itself to assuming the debtor’s position with respect to the non-performed part of the contract, cf. Section 7-4 second para first point of the Creditors Recovery Act.  Thus in the case of a purchase comprising of several deliveries the co-contractor will have a dividend claim only with regard to deliveries effected before the commencement of bankruptcy proceedings.  (Deliveries after the commencement of bankruptcy proceedings, however, will be covered as preferential claims.)  This presupposes, however, that the co-contractor’s contribution cannot be said to be indivisible under the agreement, e.g. a suite of furniture for a particular room, cf. the second point.

Even if the estate has assumed the debtor’s position in a continuous agreement, it may terminate the agreement at any time on the usual notice, see Section 7-6 of the Creditors Recovery Act.  This is because it would be disadvantageous for the estate to have to assume the debtor’s position for the entire contractual term which may extend beyond the needs of the estate.  If the estate chooses to cancel the agreement, the co-contractor may sustain a financial loss for which compensation may be sought as a dividend claim, see Section 7-6 first para of the Creditors Recovery Act. 

4.2.3 The right of stoppage in transitu

Where the estate does not assume the debtor’s position in a contract that has not been performed by the co-contractor, Section 7-2 of the Creditors Recovery Act entitles the co-contractor to withhold his contribution, regardless of whether the contract required performance before bankruptcy proceedings commenced.  Contributions received by the estate after the commencement of bankruptcy proceedings must be returned or paid for in full, see Section 7-9 of the Creditors Recovery Act.  This right is known as stoppage in transitu and applies to all types of contributions (Section 61 et seq of the Sales of Goods Act provides express legal authority in the case of sales/purchases).

Stoppage in transitu serves its most important function before the bankruptcy of the debtor since it arises where the debtor, even before delivery, proves unable to pay on time.  In other words, the debtor need not be insolvent, it is sufficient for him to be temporarily unable to pay.  However, stoppage in transitu cannot be applied if the debtor is able to furnish security for performance, in the form of, for example, a bank guarantee.

The stoppage in transitu right is retained right up until the contribution is supplied to the debtor.  The precise time will depend on what the parties have agreed.  In the case of sales of goods where the parties have agreed that the debtor will collect the object from the co-contractor stoppage in transitu will normally be retained for as long as the item has not been collected.  If the item is to be transported to the debtor, the item will as a general rule not be deemed to have been delivered for the purpose of stoppage in transitu until it has been released to the debtor or his employees.  This applies even if the debtor has arranged carriage.

The result of the exercise of stoppage in transitu is that the co-contractor may cancel the agreement and claim compensation in the form of a dividend claim, for losses suffered as a result of non-performance of the agreement, see Sections 7-7 and 7-8 of the Creditors Recovery Act.

5. Where the contribution of the co-contractor consists of money

5.1 Where the co-contractor paid before the commencement of bankruptcy proceedings

In the case of advance payments, for example for the sale of goods, the question arises whether the estate is required to release the item sold by the debtor or whether the co-contractor can require performance of the agreement by means of the release by the estate of the contribution in question.  The legal position of the co-contractor will vary depending on the nature of the agreement with the debtor.  The discussion below covers ordinary contracts of sale, manufacturing contracts and building contracts. 

If the estate does have a right of seizure the co-contractor may cancel the contract and claim a dividend on the amount paid in advance, see Section 6.4 of the Creditors Recovery Act.  In addition the co-contractor may claim compensation (in the form of a dividend claim) for losses sustained as a result of non-performance of the agreement. 

The following discusses situations in which the co-contractor may claim performance by the debtor by virtue of the payment already effected.

It is not sufficient to document that a valid agreement was concluded with the debtor:  In addition, the co-contractor must establish legal protection for his claim.  If the co-contractor has secured such legal protection for his claim he is said to have the right to separate assets out of the bankruptcy estate.

The rules on legal protection vary depending on the type of asset in question.

Sale of goods:

In the case of movables the co-contractor must as a general rule have received the objects before the commencement of bankruptcy proceedings.  Only then will he be afforded protection.  Thus as a general rule items that have not been delivered may be seized by the estate.

In exceptional circumstances the co-contractor may demand the release of an item if it was in his interest for the item to remain in the care of the debtor.  This might be the case where, for example, it was inconvenient for a creditor to take delivery of a vehicle that he had purchased before garage space had been arranged.  As the law stands at present, the conditions under which the co-contractor may demand release of the goods are somewhat unclear, but there is probably a minimum requirement that the object must have been ready for delivery, and it must also be possible to individualize the object.

In the case of the sale of ships the co-contractor’s acquisition must be registered in the Register of Shipping no later than on the day before the commencement of bankruptcy proceedings, see Section 25 of the Maritime Act.

The sale of real property:

If the debtor has sold a piece of real property in return for advance payment, the co-contractor will acquire the right to the property only if he registered the purchase no later than on the day before the commencement of bankruptcy proceedings, see Section 23 of the Registration Act.  In other words, it is not sufficient for the creditor to have received the contract of sale or the deed before the commencement of bankruptcy proceedings.

Manufacturing sales and building contracts:

In the case of major assignments where the debtor has contracted to produce a specific item, e.g. a ship or a building, the co-contractor/orderer will as a general rule have paid all or parts of the contract price in advance.  All payments effected before delivery of the completed product are counted as advance payment.

If the debtor/manufacturer is declared bankrupt before delivery of the item (and the estate chooses not to assume the debtor’s position in the contract and complete the work), the issue will revolve around the co-contractor’s right to the incomplete building in relation to that of the estate.

If it is possible to register or record the agreement, the co-contractor/orderer becomes the owner of the building as it is completed, see for example Section 31 of the Maritime Act concerning shipbuilding.  In other cases there is uncertainty as to whether the co-contractor will derive legal protection for the completed part without delivery.  Legal theory argues that the co-contractor has a right to the release of the completed part in the case of major production contracts where it is not possible for the co-contractor to claim release in return for payment of the purchase price.  Where the debtor is to erect the building etc, it is in any event clear that the co-contractor/principal may claim release of materials that have been transported to the construction site and that are to be incorporated in the building, see the Norwegian Law Reports for 1990, page 59.

5.2 Where the co-contractor did not pay before the commencement of bankruptcy proceedings

If the co-contractor did not pay for a contribution received from the debtor he will be required to fulfil his part of the agreement in respect of the estate. 

If neither of the parties perform their sides of the agreement (and the estate does not assume the position of the debtor in the agreement), the co-contractor’s obligation to pay will cease to apply.  Under Section 7-2 of the Creditors Recovery Act the co-contractor may exercise stoppage in transitu in the case of payments of moneys up until the point at which the money is released to the debtor.  If the co-contractor has given a bank the assignment of transferring payment, the money will probably not be deemed to have been released until paid out to the debtor.  This probably applies even if the debtor has received payment advice before this time.  In the case of transfers by means of bank, letter or telegiro it is unlikely that the amount can be deemed to have been released until it is credited to the debtor’s account.


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