By Thomas T. Pennington, Guest Contributor

The device sometimes referred to by industry insiders as a “Bechtol Letter” is, at its core, a trap for the unwary. Properly composed, it does not look or sound dangerous. Nevertheless, the project owner receiving one must recognize it for what it is and govern its actions accordingly. Failure to do so could set the stage for assertion of surety defenses by the issuer of payment and performance bonds related to the project.

Background on Bechtol

The reference is to a relatively obscure but well-reasoned bankruptcy decision rendered in 1990 by the Bankruptcy Court for the Southern District of Ohio, In re: Hughes-Bechtol, Inc. 117 BR 890 (Bankr. S.D. Ohio 1990). In this opinion, the Hughes-Bechtol court held that the surety did not violate 11 U.S.C. § 362(a), the bankruptcy code’s “automatic stay,” (an injunction issued automatically upon the filing of a bankruptcy case prohibiting collection actions against the debtor, its property or the property of the estate) when it wrote to a project owner and demanded that sums otherwise properly payable to a bankrupt contractor be paid into escrow during the pendency of the bankruptcy proceedings. Instead, the letter at issue made a proper demand to protect funds that were outside of the debtor contractor’s bankruptcy estate and not within the grasp of the debtor and its creditors. Through this opinion, the court illuminated a boundary beyond which sureties could not pass when writing demand letters to non-debtor bond obligees. Lawyers immediately recognized a potential weapon and began to use it.

Avoiding Exhibit A

The text of the letter is invariably non-threatening, instructional (while disclaiming the giving of legal advice) and suggestive of the benefits of further conversations between the two non-debtor parties to a tri-partite agreement (the bond at issue). Other than the fact that it appears under the surety’s letterhead, it might be of no more consequence than any other collegial professional exchange. The letter is designed, however, to pass the scrutiny of a bankruptcy judge while remaining useful as “Exhibit A” in later litigation between the surety and the obligee. The wise and well-informed bond obligee will respond positively to the invitation to talk before it ever becomes necessary for the surety to attach the letter as an exhibit to a complaint for declaratory judgment.

Sureties understand that contractors reorganizing under the bankruptcy code have (at least theoretically) an interest in undisbursed contract balances and retainages remaining in the hands of project owners (obligees), subject to proper performance under the bonded contract. Sureties also understand that the bankruptcy reorganization process can be crushingly expensive and that the money for it has to come from somewhere. Further, sureties accept that the “automatic stay” prevents the declaration of default and contract termination by the owner/obligee. Typically, sureties conclude that, however bad their exposure might be on a debtor’s bankruptcy petition date, it only gets worse during the bankruptcy proceeding. The simplest and most effective loss mitigation tool for a surety is to push its obligee to take firm and decisive action.

Sureties do not routinely seek out direct contact with bond obligees because, among other things, it subjects the surety to potential liability for interfering with the contract rights of its bond principal. The receipt of a Bechtol Letter by a bond obligee may therefore fairly be interpreted as an indication that either: (a) pre-bankruptcy discussions with the principal/contractor/debtor went poorly; or (b) the principal’s bankruptcy took the surety by complete surprise. Either is extremely bad (fatal, really) news for the debtor’s prospects of successful reorganization. The appropriate conclusion might be that cooperation with the surety may be the best way to get a project completed.

Most importantly, the Bechtol Letter is a surety’s serious invitation to talk, coupled with an equally serious “or else.” A surety bond is not an insurance policy. Any augmentation of the surety’s liability that results from the acts or omissions of the bond obligee have the same value in the hands of the surety as they would have had in the hands of the bond principal, notwithstanding the bankruptcy of the principal. In addition to all of the bond principal’s legal rights (to which they succeed by virtue of having performed its obligations), sureties have rights of their own that are rooted in a history so long that it predates the written word. Accordingly, the wise and well-informed bond obligee should prefer to side-step the legal wrangling over surety arcana and proceed directly to a prompt project completion with the consent and willing cooperation of the surety.

Thomas T. Pennington has nearly three decades of experience in advising institutional and corporate clients with respect to finance and insolvency issues as well as substantial experience representing sureties and commercial lending institutions in bankruptcy proceedings nationwide. As leader of the Insolvency Group, Tom adds a dimension to WTHF’s ability to analyze and address complex financial issues and problems confronting its clients with ever-increasing frequency. The Insolvency Group is an important complement to WTHF’s other practice areas, enabling them to develop and execute strategies fluidly and efficiently for the firm’s clients. Tom has been instrumental in achieving successful results for clients in complex Chapter 11 cases that include, among others, Drexel/Burnham/Lambert; Stone & Webster, Inc.; Washington Group International; Encompass Services Corporation; Integrated Electrical Services; Kmart Corporation; Enron Corporation; Delta Airlines; Winn-Dixie Supermarkets and WCI Communities. He can be reached at [email protected].

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