The ABCs of ABCs, Business Bankruptcy, & Corporate Restructuring/Insolvency
In Installment 16, we discuss how Bankruptcy Code § 365 permits a debtor to assume, assume and assign, or reject its executory contracts and unexpired leases. Before reading this installment, we suggest you start there for appropriate context. In this installment, we discuss in greater detail how these concepts work in practice and some applicable case law governing executory contracts and unexpired leases in bankruptcy.
Before diving in, it’s important to recall that § 365 is lengthy and contains specific provisions applicable under specific circumstances depending on the type of agreement at issue and the type of bankruptcy proceeding. When addressing any contract or lease in bankruptcy, it is, therefore, key to understand (1) the nature of the agreement; and (2) the context of the bankruptcy case itself before looking to the provisions of § 365. This Installment is also limited in scope and does not discuss specific issues for commercial landlords and licensors or commercial tenants and licensees.
The time by which a trustee or debtor must assume or reject an executory contract or unexpired lease is not always constant. The type of bankruptcy filing and the type of agreement at issue both influence the time by which an agreement must be assumed or rejected.
Chapter 7 Cases
In a chapter 7 case, Bankruptcy Code § 365(d)(1) generally requires that the trustee assume or reject an agreement within 60 days of the petition date. If the trustee fails to do so, the agreement is deemed rejected.
Chapter 11 Cases
By contrast, in a chapter 11 case, § 365(d)(2) allows for most agreements to be assumed or rejected at any time prior to confirmation of a plan. Unlike chapter 7 cases, the Bankruptcy Code does not deem an agreement to be rejected if the debtor fails to assume or reject within this timeframe (or under the terms of its plan), but courts have held that such agreements ‘ride through’ a debtor’s bankruptcy case when the debtor reorganizes and remain enforceable against the reorganized debtor. See, e.g., In re JZ L.L.C., 371 B.R. 412 (B.A.P. 9th Cir. 2007).
Non-Residential Real Estate Leases
In certain circumstances, different rules apply regardless of the type of case filed. If the agreement at issue is an unexpired non-residential lease for real estate under which the debtor is a tenant, for example, § 365(d)(4) provides that the lease is deemed rejected if it has not been assumed by the earlier of 210 days after the petition date and the date of the entry of a confirmation order.
Trying to Make Things Move Faster
A creditor who is unwilling to wait and see whether a debtor will assume or rejects its agreement in a chapter 11 case can try to force the issue using § 365(d)(2).
Section 365(d)(2) allows for the bankruptcy court to set a deadline for the debtor to assume or reject the relevant agreement on the request of the counterparty to the executory contract or unexpired lease. A creditor seeks such relief by filing a motion to compel assumption or rejection of the agreement.
In considering such motions, courts weigh a number of factors to determine a reasonable time in which the debtor must assume or reject the agreement. These include:
(1) the damage the non-debtor will suffer beyond the compensation available to it under the Bankruptcy Code;
(2) the importance of the contract to the debtor’s business and reorganization;
(3) whether the debtor has had enough time to assess its financial situation and the potential value of its assets in formulating a plan;
(4) whether the debtor’s plan exclusivity period has terminated;
(5) the complexity of the case;
(6) the number of agreements the debtor has to evaluate; and
(7) the need to determine whether the lease is truly a lease, among others.
See In re Enron Corp., 279 B.R. 695, 702 (Bankr. S.D.N.Y. 2002).
Tips for Chapter 11 Debtors Dealing with Contracts & Leases Postpetition
During the period following the petition date and prior to the assumption or rejection of an executory contract or unexpired lease, the debtor’s obligations to perform under the contract or lease depend again on the nature of the agreement at issue. Most chapter 11 debtors should generally continue honoring their postpetition contractual and lease obligations for at least those agreements they need for their continued operations unless a compelling reason exists not to.
Assuming Executory Contracts & Unexpired Leases in Bankruptcy
As we discuss in Installment 16, when a debtor seeks court approval to assume an executory contract or unexpired lease, courts apply a deferential ‘business judgment’ standard, typically granting motions where the debtor shows a valid business justification for assuming the agreement. And when the debtor assumes an agreement, it must assume the agreement in its entirety. It cannot cherry pick the best parts of an agreement and reject others.
Additionally, when a debtor or trustee assumes a contract or lease in bankruptcy, it must ‘cure’ any outstanding defaults under the agreement at the time of assumption. Generally speaking, this means that the debtor must pay any amounts outstanding under the agreement when it assumes the agreement and perform any nonmonetary obligations that were unperformed on the petition date.
Bankruptcy Code § 365(b) sets forth three specific conditions that must be satisfied before an agreement can be assumed by a debtor or trustee. The debtor/trustee must:
(1) cure or provide ‘adequate assurance’ of a prompt cure of the default unless the default arose from failures to perform nonmonetary obligations under an unexpired real estate lease;
(2) compensate the counterparty to the agreement or provide adequate assurance of prompt compensation for any actual pecuniary loss caused by any default under the agreement; and
(3) provide adequate assurance of future performance of the contract or lease.
The concept of adequate assurance of future performance is important in the context of assumption as well as assumption and assignment. In the context of assumption, this may be a fact-intensive inquiry if a party objects to the assumption of a contract, and the debtor/trustee will have to show that it is capable of satisfying its outstanding and upcoming financial obligations under the agreement.
The Bankruptcy Code’s requirement that a debtor assume an agreement in whole and cure its defaults gives non-debtor counterparties to contracts and leases a good deal of leverage in dealing with the debtor in a chapter 11 case, particularly if the agreement is important to the debtor’s continued operations. But this does not mean that debtors have no negotiating leverage when seeking to deal with counterparties to their contracts and leases. The threat (where credible) of rejecting a contract or lease and seeking to enter into a new agreement with a third party can give the debtor leverage in such negotiations, and the parties may agree to the assumption of an agreement on modified terms when doing so makes good sense for all parties involved.
Assigning Executory Contracts & Unexpired Leases in Bankruptcy
Beyond assumption, debtors and trustees have the ability to assign executory contracts and unexpired leases under § 365(f), but only after (a) they have been assumed and cured according to the requirements of § 365(b), and (b) the debtor/trustee demonstrates that the proposed assignee (the party who will step into the debtor’s shoes under the agreement) provides adequate assurance of future performance of the debtor’s obligations under the agreement.
The ability to assign contracts in bankruptcy can be lucrative for a debtor’s bankruptcy estate. In the case of a going concern sale of the debtor’s business under § 363, a buyer is likely to want the ability to take assignment of the debtor’s key contracts or leases to ensure a smooth turnover of operations post-sale. Even in the context of a piecemeal liquidation of a debtor’s business in chapter 7, executory contracts and unexpired leases can have significant value to parties seeking assignment.
Treatment of Anti-Assignment Provisions in Contracts & Leases
Importantly, § 365(f) permits the assignment of a contract or lease even if the agreement contains provisions prohibiting or conditioning its assignment; or provisions that are so restrictive as to be tantamount to a prohibition against assignment.
Exception to the General Rule Allowing for Assumption or Assignment of Contracts
Section 365(c) creates two significant exceptions to the ability of a debtor or trustee to assume or assign a contract or lease without the consent of the counterparty to the agreement:
Section 365(c)(2) and (c)(3) is straightforward:
Section 365(c)(1) prevents assumption or assignment (again, without consent of the counterparty) of a contract or lease if nonbankruptcy law “excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or debtor-in-possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties…”
Many attorneys think of this as the ‘personal services’ exception. In law school, a common way to demonstrate the concept of § 365(c)(1) is as follows: you entered into a contract with Bruce Springsteen to sing at your party, and Bruce files bankruptcy before the party, you should not be required to let someone else sing in his place. This is a good way to think about the concept, but it can lead to one forgetting that § 365(c)(1) is not limited to service contracts. E.g., Matter of West Electronics, Inc., 852 F.2d 79 (3d Cir. 1988). Case law is extremely fact dependent. Read A Non-Debtor’s Rights in Executory Contracts for more information.
The Interpretation Debate
Matter of West Electronics, Inc. is a widely cited case because it is the earliest Circuit-level case decided under the Code to address the fundamental question of whether the test stated in § 365(c)(1) is a ‘hypothetical’ or ‘actual test.’ Here’s how to understand the issue:
Rejecting Executory Contracts & Unexpired Leases in Bankruptcy
A debtor or trustee’s final option when addressing executory contracts and unexpired leases is the ability to reject these agreements under § 365(a). This power is particularly useful in a variety of scenarios in bankruptcy. A chapter 11 debtor seeking to reorganize or a chapter 7 trustee winding down a debtor’s business may wish to jettison unprofitable or burdensome agreements that it would otherwise be bound to outside of bankruptcy. A chapter 11 debtor seeking to sell its assets as a going concern may have buyers unwilling to take assignment of certain agreements.
Rejection Damages Claims
The reason this authority is salient inside of bankruptcy, however, is because of the effect rejection has on the claims of counterparties to those agreements. Upon rejection, a contract counterparty holds a “rejection damage claim,” which is generally treated as a mere unsecured claim against the debtor’s bankruptcy estate, entitled to low priority under the Bankruptcy Code. This is because rejection is typically considered a breach of the agreement, deemed effective immediately before the petition date under Bankruptcy Code § 365(g).1
The Bankruptcy Code also contains specific provisions governing treatment of rejection damage claims based on the type of agreement at issue. For example, Bankruptcy Code § 502(b)(6) sets forth a cap on the amount of damages a landlord can claim against a debtor under the terms of its lease. And § 365(n) contains specific provisions governing rejection of intellectual property license agreements under which the debtor is licensor. The concepts and legal framework governing the assumption, assignment, and rejection of executory contracts and unexpired leases in bankruptcy can be complicated. Lawyers representing debtors or the counterparties to contracts and leases must be diligent in analyzing both the terms of the agreement at issue and the potential benefits conferred or restrictions imposed on them under the Bankruptcy Code.
[Editors’ Note: This article, while written to be read and understood on a standalone basis, is part of a series. To read Installment 1, which includes a table of contents and links to every article in the series, click here.
The Bankruptcy Code also contains specific provisions governing treatment of rejection damage claims based on the type of agreement at issue. For example, Bankruptcy Code § 502(b)(6) sets forth a cap on the amount of damages a landlord can claim against a debtor under the terms of its lease. And § 365(n) contains specific provisions governing rejection of intellectual property license agreements under which the debtor is licensor.
The concepts and legal framework governing the assumption, assignment, and rejection of executory contracts and unexpired leases in bankruptcy can be complicated. Lawyers representing debtors or the counterparties to contracts and leases must be diligent in analyzing both the terms of the agreement at issue and the potential benefits conferred or restrictions imposed on them under the Bankruptcy Code.
The authors are corporate restructuring and insolvency attorneys with Much Shelist, P.C. and Levenfeld Pearlstein, LLP. Read more about them in their bios below.
Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy.]
To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive custom PowerPoint about the topic):
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer” by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
Rob is a principal at Much Shelist and has more than three decades of experience counseling financial institutions and debtors in all areas of creditors’ rights, bankruptcy, and financing matters. He brings a wealth of experience to clients in need of representation in bankruptcy proceedings, commercial foreclosures, bankruptcy litigation, out-of-court workouts, and the acquisition and…
Jack is a corporate and restructuring partner in the Chicago office of Sugar Felsenthal Grais & Helsinger LLP. Jack’s practice covers a range of healthy and distressed business engagements. He is widely recognized for his excellent work as a restructuring attorney including recognition by various organizations for his strategic thinking and tactical expertise, including SuperLawyers…
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