Executory Contracts under 365

Executory Contracts under 365

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Editor's Note: We addressed bankruptcy issues of concern to real estate landlords and tenants last month. That necessitated us to talk about §365, but only those parts that deal with real property leases of nonresidential real property. Section 365, however, covers a great deal more than that. This month, we discuss executory contracts and the way in which Bankruptcy Code §365 deals with them.

Bankruptcy Code §365(a) provides that "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." You would think these words are simple and straightforward. You would be wrong. This section is long. It is rifled with special-interest legislation. Case law is mixed in interpreting its various subsections. Even the term "executory contract" is more complicated than it appears at first blush.

The term "executory contract" is not defined in the Code. It may seem intuitive—but on a moment's reflection, we can see that it cannot mean what it means outside of bankruptcy. That is this: In state law, an "executory contract" is any contract unperformed on either side. Apply this to bankruptcy, and every creditor's claim becomes an executory contract. This would suggest that the trustee may pick and choose which claims to assume and which to reject. The whole idea of bankruptcy, however, is that we deal with claims pro rata. Picking and choosing is so far from pro rata that the drafters must have been thinking of something else. Faced with this perplexity, a lot of courts have fallen back on a definition that we associate with the late, great Prof. Vern Countryman—the so-called "Countryman definition," which holds that an "executory contract" is

[A] contract which the obligation of both the bankrupt and the other party to the contract is so far clearly unperformed that failure of either to complete performance would constitute a material breach excusing the performance of the other.
Countryman, "Executory Contracts in Bankruptcy: Part I.," 57 Minn.L.Rev. 439, 469 (1973).

Consider a deal in which the seller agrees to deliver a load of widgets every month for a year, the buyer to pay 10 days after delivery. Suppose the seller suspends delivery after three months, or suppose the buyer stops paying. Breach by either would seem to excuse the other from his obligation. This case, at least, seems to fit the Countryman definition. It seems reasonably clear what Countryman was up to. He wanted to distinguish "executory contract" on one side from "security interest" on the other. To see why this is important, consider the case of a transferor who transfers a widget to a transferee in exchange for a promise to pay $1 million. The buyer takes possession, but then files bankruptcy without paying. Suppose also that the widget, at the time of filing, is worth only $600,000. What are the rights of the parties? If the deal is a security agreement, the rights are tolerably clear. The transferor/seller has first dibs on the widget, and retains a deficiency claim for $400,000.

If the debtor is in chapter 11, then the trustee (or, more likely, debtor-in-possession (DIP), acting as a trustee) may do more: He may "rewrite the contract" and impose a new deal on the secured creditor, binding so long as it has a present value of $600,000. For example, suppose the debtor offers 10 payments of $81,500, discounted at six percent. The present value of this payment stream is $600,000. If six percent is the "right" rate, then the court can impose the plan on the secured creditor. However, the court can't do anything of the sort if the deal is an executory contract, even though the economics may be the same.

If the deal is an executory contract, the rights are equally clear and dramatically different. The DIP may assume or reject. But assume means "assume in tote"—assume the contract with all its attendant obligations, and no nonsense about scaling down or rewriting. Or he must "reject in tote," which means he must give back the property (for any shortfall there remains an unsecured claim). Which should the DIP do? The answer to that question ought to depend on the value of the deal. If the contract is burdensome to the estate, he ought to reject (Countryman taught us to think of it as an analog to abandoning worthless property). If it is a benefit to the estate, he ought to assume or even (as we shall see below) assign it to a third party.

The DIP has to act within the realm of "business judgment" in deciding whether to assume or reject, but the courts aren't eager to second-guess him. Even within "business judgment," though, the DIP cannot assume on a whim. He must "cure and assure." That is, he must follow the dictate of Bankruptcy Code §365(b):

(1) If there has been a default in an executory contract or unexpired lease of the debtor, the trustee may not assume such contract or lease unless, at the time of assumption of such contract or lease, the trustee—
(A) cures, or provides adequate assurance that the trustee will promptly cure, such default;
(B) compensates, or provides adequate assurance that the trustee will promptly compensate, a party other than the debtor to such contract or lease, for any actual pecuniary loss to such party resulting from such default; and
(C) provides adequate assurance of future performance under such contract or lease.
The devil is in the details: A fair amount of bankruptcy litigation, and a great deal of knuckle-crunching negotiation, occurs in the realm of "cure and assure."

How soon must the DIP decide whether to assume or reject? Code §365(d) says that in chapter 11, "the trustee may assume or reject an executory [contract]...at any time before the confirmation of a plan." But it also says, "the court, on the request of any party to such contract...may orde r the trustee to determine within a specified period of time whether to assume or reject such contract or lease." (Don't confuse this rule with the time limits on real estate leases, which are trickier.)

The practical effect of this rule is to put the ball in the non-debtor's court. If he is tired of waiting for a decision, it is he who must ask the court to make a determination—and the court may choose not to make a determination if it thinks the issue is best left to the plan.

It is one thing to assume the executory contract, but quite another to assign it to a third party. Remarkably, the Code provides both. See Bankruptcy Code §365(f). To assign, the DIP must first assume (recall "cure and assure"). Then he must provide "adequate assurance of future performance by the assignee." Once again, there is plenty of contention over the nature of "adequate assurance."

Not every contract is eligible for assumption and assignment. Bankruptcy Code §365(c), for example, prohibits assignment where "applicable law" excuses a party "from accepting performance from or rendering performance to an entity other than the debtor." Think personal service contracts. If Metallica were to go into bankruptcy, you wouldn't want Ozzfest to have to accept a performance from Barbra Streisand.

The Code seems also to say that if the contract cannot be assigned, it cannot be assumed. In chapter 7, perhaps this makes sense: you wouldn't want the trustee striding onstage. But suppose Metallica files for relief under chapter 11 and remains as DIP. You might not think that the Code should prohibit its assumption of its own deal, but it may: In an important case, the Code used just such reasoning to prevent the assumption of an intellectual property agreement. In re Catapult Entertainment, 165 F.3d 747 (9th Cir. 1999).

One notable fact of executory contract law is that courts seem to assume that if something is an executory contract when the debtor is the transferee, then it must be also when the debtor is the transferor. It isn't obvious that this must be so. But in a much-noticed case, the Fourth Circuit held that a technology licensing agreement was an executory contract when the debtor was the licensor. Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc., 756 F.2d 1043 (4th Cir. 1985), cert denied, 475 U.S. 1057 (1986).

The decision touched off a rumpus in the Intellectual Property (IP) bar. Consider the case of a non-debtor licensee who had poured a big investment into developing a factory to deploy the IP. It risked losing the value of its investment with nothing but (at best) an unsecured claim against the estate. Responding to the concerns of the industry, Congress adopted present §365(n), designed to secure the rights of the nondebtor licensee, notwithstanding the rejection by the licensor. Congress could, of course, have simply redefined "executory contract" to specify that it did not cover IP rights where the debtor was the transferor—but it did not.

If the DIP assumes an executory contract, the counterparty has all the rights he had before bankruptcy, and a bit more: The counterparty has a first-priority administrative claim against the estate, or a post-discharge claim against the reorganized debtor.

Note that assumption or rejection must be done "subject to the court's approval." The purpose of this was to make sure that the DIP didn't assume "by accident" (or perhaps better, "by ambush"). It hasn't quite worked that way: There remains the question of contracts that are neither assumed nor rejected before the confirmation of the plan. Do we assume that they are implicitly rejected? Or implicitly assumed? There is no compelling answer to this question. Prudent counsel sidesteps it by language in the Code, as, for example "all executory contracts not explicitly assumed are deemed rejected."

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Monday, November 1, 2004