Rejecting Executory Contracts Is the Standard Changing

Rejecting Executory Contracts Is the Standard Changing

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In administering its bankruptcy estate, a debtor-in-possesion (DIP) has the ability to reject an executory contract. See 11 U.S.C. §365(a). A DIP may want to reject a particular executory contract for a variety of reasons, including the goal of negotiating a new, more lucrative contract upon the existing contract's rejection and termination.

While §365 sets forth certain requirements for the assumption of an executory contract, the rejection of an executory contract is generally left to the DIP's business judgment. Thus, more often than not, there is little a non-debtor party can do in response to a motion to reject other than file or amend its proof of claim.

Until recently, few courts attempted to alter that status quo. However, the Fifth Circuit has suggested the application of a new standard for rejecting an executory contract that implicates the public interest. See Mirant Corp. v. Potomac Electric Power Co., 378 F.3d 511 (5th Cir. 2004). Interestingly enough, the issue in Mirant was not the applicable standard for rejecting executory contracts, but whether a bankruptcy court has jurisdiction to approve a motion to reject an executory contract governed by Federal Energy Regulatory Commission (FERC)-approved rates. While this is a groundbreaking opinion on the jurisdictional issue alone, it may also result in additional considerations when rejecting an executory contract, as well as increased litigation as to when this new standard should apply.

The Time-honored Standard

As stated above, the Bankruptcy Code allows a DIP to freely reject an executory contract subject to few exceptions. See 11 U.S.C. §365(a). In fact, "the authority to reject an executory contract is vital to the basic purpose of a chapter 11 reorganization, because rejection can release the debtors' estate from burdensome obligations that can impede a successful reorganization." See In re National Gypsum Co., 208 F.3d 498, 504 (5th Cir. 2000). As such, courts have widely applied the business-judgment rule in determining whether to approve the proposed rejection of an executory contract. See Group of Institutional Investors v. Chicago, Milwaukee, St. Paul & Pac. R.R. Co., 318 U.S. 523, 550, 63 S.Ct. 727, 742, 87 L.Ed. 959 (1943).

The business-judgment rule provides that "[a]s long as assumption [or rejection] of a lease appears to enhance a debtor's estate, court approval of a DIP's decision to assume the lease should only be withheld if the debtor's judgment is clearly erroneous, too speculative or contrary to the provisions of the Bankruptcy Code." Richmond Leasing Co. v. CapitalBank N.A., 762 F.2d 1303, 1309 (5th Cir. 1985) (citing Allied Technology Inc. v. R.B. Brunemann & Sons, 25 B.R. 484, 495 (Bankr. S.D. Ohio 1982)). The business-judgment rule, therefore, focuses on the interests of the bankruptcy estate without any real consideration of the interests of the non-debtor party to the executory contract or other third-party interests. Since certain executory contracts may raise issues that affect public interest, the Supreme Court once created a "more rigorous standard." See NLRB v. Bildisco and Bildisco, 465 U.S. 513, 526-27, 104 S.Ct. 1188, 1196, 79 L.Ed.2d 482 (1984), superceded by statute.

In Bildisco, the Court held that due to the special nature of a collective-bargaining agreement, Congress must have intended for a higher standard than that of the business-judgment rule. Bildisco, 465 U.S. at 526. Thus, the Supreme Court mandated careful scrutiny of the equities in rejecting a labor contract—while also directing bankruptcy courts to examine whether the parties negotiated—to ensure that the national labor policies of avoiding labor strife and encouraging collective bargaining were adequately served. Id.

Though subsequent legislation superceded Bildisco, its holding demonstrates the Court's thoughts on reconciling Congress's intent to allow an effective reorganization under the Bankruptcy Code with conflicting federal law that seeks to protect the public interest. Based on the Court's willingness to create a new standard where the public interest is involved, and the otherwise limited consideration given thereto under the business-judgment rule, the Fifth Circuit recently revisited Bildisco's public interest scrutiny. See Mirant Corp. v. Potomac Electric Power Co., 378 F.3d 511 (5th Cir. 2004).1

The Mirant Opinion

During the course of its bankruptcy, Mirant sought to reject an ancillary schedule (the contract) to an asset-purchase agreement (APA). The contract was executed because of the contractual inability of the seller, Potomac Electric Power Co. (PEPCO), to assign certain power purchase agreements. The rates charged in the contract were approved by FERC. Though beneficial upon execution, the contract's FERC-approved rates were higher than market rates.

Mirant, therefore, sought authority from the bankruptcy court to reject the contract, but not the APA itself. Mirant's motion received strong opposition from both PEPCO and FERC alleging, inter alia, that Mirant could not reject the contract without rejecting the entire APA and that the bankruptcy court was not the proper forum for a challenge to a FERC order. Following a preliminary hearing, the bankruptcy court held that it had the power to authorize the rejection of the contract, but did not decide the merits of the motion to reject.

Prior to ruling on the merits of the motion to reject, the district court withdrew the reference, set a new hearing on the matter and held that FERC has "exclusive" authority to determine whether wholesale rates charged for electricity sold in interstate commerce are reasonable and that any challenge to approved rates must occur in a FERC proceeding. As a result, the district court found that Mirant's motion to reject was an improper attempt to avoid FERC-approved contractual rates.

On appeal, the Fifth Circuit held that although the Federal Power Act (FPA) gives FERC the exclusive responsibility of approving rates charged in wholesale contracts for the interstate sale of electricity as being "just and reasonable," Mirant's attempt to reject the schedule was not a challenge to FERC-approved rates. Mirant, 378 F.3d at 519-20. Instead, the rejection of the contract was akin to a breach of contract, which a district court could consider without a separate FERC proceeding so long as the breach of contract was not related to a FERC-approved rate. Id. Thus, rejection only has an "indirect" impact on rates, as the FERC-approved rates would determine PEPCO's unsecured rejection damage claim. Id. at 520. In this regard, the Fifth Circuit specifically stated:

The FPA does not preempt a district court's jurisdiction to authorize the rejection of an executory contract subject to FERC regulation as part of a bankruptcy proceeding. A motion to reject an executory power contract is not a collateral attack upon that contract's filed rate because that rate is given full effect when determining the breach-of-contract damages resulting from the rejection. Further, there is nothing within the Bankruptcy Code itself that limits a public utility's ability to choose to reject an executory contract subject to FERC regulation as part of its reorganization process. Id. at 522.

The Fifth Circuit did not clarify, however, the relevance of a debtor's intentions in seeking to reject a power contract. Specifically, FERC asserted, and the district court held, that Mirant's reason for seeking to reject the contract was that its rates were higher than the current market rate. Mirant asserted, however, that it did not need the electricity provided under the contract to meet its supply requirements.

Based in part on Mirant's assertions, the Fifth Circuit held that a debtor's use of the filed rate as a criterion to select contracts for rejection under §365(a) does not convert that decision into a prohibited collateral attack on the filed rate when the electricity purchased under the rejected contract is not necessary to fulfill a debtor's supply obligations. Id. at 520. This leaves the unanswered question of whether the district court would have jurisdiction to authorize the rejection of the contract if Mirant's basis for rejection were the unprofitable rates charged therein. Nonetheless, the Fifth Circuit concluded that nothing in the Bankruptcy Code itself limited a DIP's ability to reject executory contracts that are subject to FERC regulation. Id. at 521-22.

Since neither court had ruled on the merits of rejection, the Fifth Circuit remanded the matter to the district court. Upon remand, the Fifth Circuit made certain "suggestions" to the district court. This dicta may create more controversy than the bankruptcy/FERC jurisdictional issue.

The Fifth Circuit's Suggestive Language: The New Standard?

In remanding the case to the district court for determination of whether grounds for rejection exist, the Fifth Circuit noted that the bankruptcy court had previously indicated that it might choose to apply a more "rigorous" standard than the usual business judgment standard in evaluating Mirant's rejection motion. See Mirant, 378 F.3d at 524. The Fifth Circuit noted that because FERC can only approve a rate change if it is in the public's interest, the district court "should" consider applying more stringent standards to Mirant's motion to reject than the typical business judgment test. Id. at 525.

Further, the Fifth Circuit "suggested" the adoption of a standard whereby Mirant bore the burden of showing that (a) the contract "burdens the estate," (b) the "equities" are in favor of rejecting the contract and (c) rejection would further Mirant's reorganization. Id. at 525. In doing so, the Fifth Circuit instructed the district court to "carefully scrutinize the impact upon the public interest" and to "ensure that rejection does not cause any disruption in the supply of electricity to other public utilities or to consumers," reminiscent of the Supreme Court's Bildisco opinion. Id. In fact, the Fifth Circuit relied on Bildisco as authority for "suggesting" a different standard. Id. at 524-25.

While couched as "suggestions," the Fifth Circuit made clear its expectation that the district court apply a more stringent standard to the rejection of executory contracts like the contract at hand. Although the Fifth Circuit did not specifically state what this higher standard entails, "public interest" is the stated factor to consider. Since public interest is a broad and potentially all-encompassing term, application of this new standard could alter a DIP's ability to reject an executory contract in more than just energy-related bankruptcies.


Mirant is an important decision for two reasons. First, it addresses what some argue is a lack of bankruptcy court jurisdiction. In the only circuit court opinion addressing the authority of a bankruptcy court over FERC-approved contracts, the Fifth Circuit has swung a blow for bankruptcy.

Second, and what could conceivably result in much litigation, is the "suggestion" that a stricter standard should apply to the executory contract rejection analysis when the contract in issue affects the public interest. The potential for additional litigation is the notion of "public interest" and the varying contracts that affect public interest outside the power generation industry.

Interestingly enough, the Fifth Circuit declined to create an exception for contracts regulated by FERC because of the express language in §365, while creating an exception for analyzing the propriety of the actual rejection of the executory contract based on superceded case law. Yet just as Congress sought to supercede Bildisco by enacting 11 U.S.C. §1113, it could have created a subsection in §365 that addresses such matters. It did not.

On a practical note, one might argue that public interests, though not plead, are already taken into account under the business judgment standard. After all, if the public interest is affected, it naturally follows that the rejection damage claim against the bankruptcy estate could increase, thereby decreasing the return to other unsecured creditors—making rejection not in the best interest of the bankruptcy estate.


1 While this Fifth Circuit opinion appears to be the First Circuit Court of Appeal's decision directly addressing this issue, a similar situation arose recently in the NRG Energy Inc. bankruptcy. In NRG, the bankruptcy court determined that the business-judgment standard had been satisfied, yet refused to vacate an existing FERC order requiring NRG to continue providing energy under the contract. In re NRG Energy Inc., 2003 WL 21507685, *2 (S.D.N.Y. 2003). NRG then filed a motion with the U.S. District Court for the Southern District of New York requesting authority to cease performance under the contract and for injunctive relief. That court, much like the district court in Mirant, held that it did not have subject-matter jurisdiction to make a decision on these issues. See Id. at 4. This issue was settled prior to a ruling by the Second Circuit. Return to article

Journal Date: 
Friday, October 1, 2004