Overview
Most businesses with an ongoing business relationship with a debtor in bankruptcy will face issues involving prepetition "executory contracts" with the debtor. Under the Bankruptcy Code, debtors and bankruptcy trustees are authorized to assume or reject executory contracts (and unexpired leases) in bankruptcy. This reflects the underlying bankruptcy policy that debtors should have the ability to abandon burdensome contracts and retain beneficial contracts. This QuickCounsel will provide a brief overview of executor contracts in bankruptcy and the issues they present.
What is an Executory Contract?
Most courts define an executory contract as an agreement where "the obligations of both the bankruptcy and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other." N.L.R.B. v. Bildisco & Bildisco, 456 US 513 (1984); Countryman, Executory License Agreements in Bankruptcy, 57 Minn. L. Rev. 439, 460 (1973). Courts of Appeal in the Third, Fourth, Seventh, Eighth and Ninth Circuits use this "material breach" test. Some courts in the First, Sixth and Eleventh Circuits have used a more fluid "functional test." A long-term supply agreement, a franchise agreement, or most intellectual property licenses would usually be considered to be an executory contract. A promissory note, a completed sale or assignment, an expired agreement, an agreement effectively and completely terminated prior to the bankruptcy filing, or a single purchase order would typically not be an executory contract. Exclusive and perpetual licenses are sometimes argued to be more like a completed assignment for the rights and/or territory covered than an executory contract. However, any ongoing obligations on both sides, if material, will still be examined as part of the analysis of whether it is an executory contract or not.
How are Executory Contracts Treated Upon a Bankruptcy Filing?
Property interests of the entity or person filing bankruptcy becomes property of the bankruptcy estate upon a bankruptcy filing. An executory contract is property of the bankruptcy estate. Property of the bankruptcy estate is generally protected by the automatic stay. The automatic stay is a broad injunction which arises upon the filing of a bankruptcy petition that protects the property of the bankruptcy estate from the exercise of remedies by a creditor (e.g., proceeding to judgment or seizing assets) or a contract counterparty (e.g., termination or changing terms), absent obtaining relief from the automatic stay from the Bankruptcy Court. Section 365 of the Bankruptcy Code provides that clauses terminating an executory contract upon a bankruptcy filing or insolvency (so-called "ipso facto" clauses) are generally unenforceable.
Bankruptcy Cases Filed After Termination Notice Given but Before Cure or Termination Period has Expired
Executory contracts that are terminated prior to the filing of the bankruptcy petition do not become property of the estate. Moody v. Amoco Oil Co., 734 F.2d 1200 (7th Cir. 1984). But the termination "must be complete and not subject to reversal, either under the terms of the contract or under state law." Id., at 1212. Thus, in situations where the nondebtor party to the contract has given its termination notice for the contract, and the debtor subsequently files for bankruptcy protection but before the cure or termination period has expired, courts may treat the underlying contract as an executory contract. In re Masterworks, Inc., 100 B.R. 149 (Bankr.D.Conn. 1989); In re C.W. Mining Co., 422 B.R. 746 (10th Cir. BAP 2010). Whether the default under the contract can be cured after the expiration of the cure period depends on the nature of the default, the phrasing of the notice of the default, and sometimes the court hearing the matter.
Limbo Period During Bankruptcy Case and Timing of Decision
The nondebtor counterparty to an executory contract is obligated to perform its obligations under the contract pending assumption, assignment, or rejection of that contract by the debtor (discussed below). In re Leslie Fay Companies, Inc., 166 B.R. 802 (Bankr.S.D.N.Y. 1994). If both parties owe each other money or credits, the nondebtor counterparty may have set-off, recoupment, and/or administrative freeze rights. A counterparty can file a motion to seek to compel an assumption or rejection of the contract but such relief is extremely difficult to obtain. 11 U.S.C. § 365(d)(2); In re Physicians Health Corp., 262 B.R. 290 (Bankr.D.Del. 2001). Moreover, the counterparty's desire for certainty or for payment of unpaid prepetition amounts as a "cure cost" is generally not compelling to a bankruptcy court, which is typically more focused on the bankruptcy estate's attempt to reorganize or sell its assets.
In a Chapter 7 liquidation, executory contracts are generally rejected 60 days into the bankruptcy case absent special relief from the bankruptcy court. In a Chapter 11 case, there is no set time period to make the decision to reject or assume a general executory contract. Instead, absent an earlier rejection of an executory contract, which is burdensome and disfavorable to the bankruptcy estate, decisions on whether to assume or reject typically do not occur until a Chapter 11 plan is confirmed or until the division, assets or entity, which the contract relates to, is sold or liquidated generally.
Assumption
A debtor may assume an executory contract by:
- Obtaining an order from the bankruptcy court permitting assumption of such contract after notice and an opportunity for the nondebtor counterparty to be heard in the bankruptcy court, or Confirming a plan of reorganization, which provides for assumption of such contract upon the effective date of the confirmed plan.
The debtor must assume the executory contract in its entirety. Upon assumption, the bankruptcy estate becomes bound by the contract, and all amounts thereafter owed by the debtor under the contract will constitute administrative expense claims, which are generally entitled to be paid in full. If an executory contract is in default at the time the debtor seeks to assume the contract, assumption will not be permitted unless all monetary defaults are promptly cured, and adequate assurance of future performance of the debtor's obligations under the contract is provided. Section 365(c) of the Bankruptcy Code prohibits the assumption of an executory contract by the debtor without the consent of the nondebtor counterparty for contracts with respect to which applicable law excuses the nondebtor party from accepting performance from, or rendering performance to, a third party, such as certain personal services contracts, certain non-assignable governmental contracts and certain intellectual property licenses.
Assignment
Upon assumption, the debtor may assign an executory contract to a third party provided there is adequate assurance of future performance by the assignee of the executory contract. It is the bankruptcy court that ultimately determines whether the proposed assignee meets the standards, not the nondebtor counterparty. Contractual limitations on the assignment of an executory contract are generally not enforceable in bankruptcy, with some exceptions. One such exception arises in contracts that are not assignable to third parties under applicable law and the party does not consent to such assumption or assignment. Otherwise, debtors sometimes are able to assign under market or otherwise favorable executory contracts at a profit.
Rejection
Rejection of an executory contract is essentially the debtor's declaration that it will not perform its remaining obligations under a contract under which performance remains due from each party. Upon rejection, the debtor no longer can be compelled to perform the debtor's unperformed remaining obligations under the contract, leaving the counterparty with the sole remedy of a breach of contract damage claim against the bankruptcy estate, which ordinarily will constitute a general unsecured claim as of the petition date, which often is paid only cents on the dollar. Rejection of the executory contract by the debtor does not reverse or undo any transactions completed before the point of rejection. In addition, an executory contract cannot be rejected in parts and assumed in parts. In situations where the executory contract is found to form a part of a series of related agreements (which may be difficult to prove), all the agreements will be deemed to constitute a single integrated transaction, requiring that all of such agreements either be assumed or rejected as a group. In re Atlantic Computer Systems, Inc., 173 B.R. 844 (S.D.N.Y. 1994); In re Grede Foundries, Inc., 440 B.R. 497 (Bankr.W.D.Wis. 2010). Bankruptcy courts review the debtor's decision to reject an executory contract under the business judgment standard and generally do not consider the fact that rejection is damaging to the nondebtor counterparty to the contract.
Rights Against Persons or Entities Who are not Part of Bankruptcy Filing
The automatic stay and other bankruptcy protections are generally specific to the entity in bankruptcy. If your agreement has a broad insolvency clause, which includes bankruptcy filings and/or insolvency by affiliates as an event of default or termination of the agreement, and the particular counterparty to the agreement does not immediately file for bankruptcy, it may be possible to terminate the license based on the parent's or affiliate's insolvency or bankruptcy filing.
Conclusion
Section 365 of the Bankruptcy Code sets out the bankruptcy trustee's duties and powers with regard to executory contracts. It is a lengthy section with many details, subtleties and gaps. The Bankruptcy Code attempts to empower the trustee to take advantage of the rights and assets of the estate while affording some protection to the countervailing interests of the counterparty. Given the complexity of the section and the numerous possible outcomes of executory contracts in bankruptcy, effective advocacy can make a large difference in achieving optimal results. This QuickCounsel provides in-house counsel with a brief overview of the issues and considerations involved in executor contracts in bankruptcy.
Additional Resources
- Executory Contracts in Bankruptcy: Navigating the Legal Ambiguities (McKenna Long & Aldridge 2012) The Assumption Or Rejection of Executory Contracts in Bankruptcy - Are Commodity Contracts Within A Safe Harbor? (Iowa State University Center for Agricultural Law and Taxation 2009) Executory Contracts -- What Are They And Why Do They Matter In Bankruptcy? (Cooley LLP 2006) Executory Contracts And Unexpired Leases (Bernstein-Burkley PC)