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August 28, 2017

David S. Lorry of Versa Capital Management, LLC
Robert S. Brady, Esq. of Young Conaway Stargatt & Taylor, LLP[1]


Among the most powerful and best known tools the Bankruptcy Code provides a debtor is the ability to reject burdensome contracts or to assume (and potentially assign) valuable contracts.  From the perspective of non-debtor counterparties to such contracts, it may seem that the Bankruptcy Code stacks the deck against them.  The well-publicized spike in retail bankruptcy cases has highlighted the treatment of leases of non-residential real property (i.e., store leases).  This article summarizes the rights and protections afforded to non-debtor counterparties to contracts other than non-residential real property leases.  These contracts could include equipment leases, supply contracts, intellectual property licenses, employment agreements, financing arrangements, or contracts for services.

 

The Debtor’s Perspective on Executory Contracts

Section 365 of the Bankruptcy Code governs the treatment of executory contracts[2] and, generally, describes a debtor’s obligations to perform, establishes a timetable for disposition (assumption or rejection), sets forth the conditions for assumption and consequences of rejection, and also provides rights and remedies for the non-debtor.  In the context of a business debtor’s chapter 11, the debtor has three basic options to dispose of an executory contract.  If the debtor is reorganizing, it may assume the contract.  In the common scenario of a sale of the debtor’s assets, it can assume the contract and assign it to a third party, even if, in some instances, the non-debtor objects to that assignment.  Assumption effectively continues the contractual relationship with the debtor (or the assignee) as if, with limited exceptions, the bankruptcy case had not occurred.  Finally, a debtor may reject a contract, which is deemed a breach of the contract occurring right before the debtor filed for bankruptcy.  While rejection does not technically terminate a contract, it effectively ends the contractual relationship leaving the non-debtor counterparty with a claim for damages.

The Bankruptcy Code permits the debtor to decide how to treat an executory contract at any time prior to the confirmation of a chapter 11 plan[3], and that could take months, even years.  Where the debtor contemplates a sale of its assets, the practical effect is that the decision to assume, assign, or reject is driven by the milestones for the sale process.  Where the outcome is uncertain and there is a prospect for liquidation, this period of uncertainty could linger.  All the while, the non-debtor is at a significant disadvantage; it is obligated to continue to perform its duties under contract, but restricted in its ability to enforce the contract against the debtor.

 

Non-Debtor Rights Before the Decision Point

The debtor seems to be in the driver’s seat – it may continue to accept the benefits of a contract without having to perform, while the non-debtor is restricted in its ability to enforce the contract, and the debtor has a potentially lengthy window of time to decide what to do with the contract.

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What is the non-debtor counterparty to do?

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One of the first things an executory contract counterparty should do is assess the debtor’s plans to operate during the bankruptcy case and understand how it will exit the proceedings.  Questions to consider are:

  • Will the debtor seek to reorganize?
  • Does the debtor plan to sell some or all of its assets?
  • Will the debtor cease operations and liquidate?
  • How will the debtor finance its operations during the bankruptcy case?
  • Will there be debtor-in-possession financing or just use of cash collateral?
  • Does the debtor’s budget fully cover its contract obligations?

Answers to these questions will start to inform a non-debtor counterparty’s approach to asserting its rights and protecting itself.

In an effort to limit uncertainty, a counterparty may ask the court to compel the debtor to make a decision on how it will treat a contract or specify a date by which the debtor must assume or reject a contract.  Such relief, however, is granted rarely and, drawing from other benchmarks in the Bankruptcy Code, is unlikely to be considered within the first 60 days of the case.  Contrast this with the Bankruptcy Code protections afforded to non-debtor counterparties to unexpired leases for personal property.  Pursuant to section 365(d)(5) of the Bankruptcy Code, a debtor must timely fulfill obligations that arise under an unexpired lease for personal property starting at 60 days after the petition date and through the time that the debtor makes its ultimate decision on how to treat the contract.[4]  The counterparty need not make any showing as to the debtor’s benefit under the lease to be entitled to this relief; the burden is shifted onto the debtor, should it wish to not honor these payments, to prove that the equities of the case favor nonpayment.[5]

In the early part of a chapter 11 case, the primary recourse of most non-debtor counter-parties to executory contracts is the right to be compensated for the reasonable value of services rendered during the pre-decision period.  The Supreme Court has ruled that regardless of whether a contract is assumed, assumed and assigned, or rejected, if the debtor continues to reap the benefits of an executory contract before making its decision to assume or reject, a non-debtor counterparty is entitled to the reasonable value of goods or services rendered during that time.[6]  An important distinction is to seek the right to receive payment or performance on a current basis, as opposed to accepting an administrative claim that may be paid at a later date.  Where there is a secured creditor with liens against all of the debtor’s assets, there may not be sufficient assets or proceeds to pay administrative claims at the end of the case or following a sale.[7]  That risk highlights the importance of assessing the debtor’s financing and budget for its case, as well as its exit plans.  Ultimately, a non-debtor counterparty should be prepared to file a motion with the court promptly if the debtor fails to make payment under the contract when due.  This will help highlight for the court early any concerns that the debtor has adequate liquidity to implement its chapter 11 strategy.

 

Non-Debtor Rights in the Assumption Scenario

A non-debtor counterparty’s next concern is ensuring proper notice when the debtor seeks to assume the contract.  When a debtor determines to assume (and potentially assign) a contract, whether in a sale or plan context, it must provide advance notice of its intentions, disclose the amount of any unpaid pre- and post-petitionamounts due under the contract to be “cured”, and provide adequate assurance that it (or its assignee) will be able to perform under the contract following assumption.  The debtor must seek the court’s permission to approve the assumption (and any assignment) and fix the cure amount.  A non-debtor should pay close attention to the relief sought and the timing to make sure it is afforded adequate time to protect its rights.

There are several issues with the timing and adequacy of this process that regularly arise in practice.  Frequently, the timing of the notice and its accompanying information is extremely tight; a counterparty might receive notice of assumption within mere days of a sale hearing or a confirmation hearing.  Moreover, information on adequate assurance is often extremely general and vague.  In the sale context, bidders may not wish to submit sensitive data to support adequate assurance, leaving counterparties without this valuable information and simply hoping that the winning bidder will be able to perform.  To combat these issues, a counterparty should carefully evaluate any filing by the debtor explaining when assumption notices and adequate assurance information must be provided.  Often, the debtor’s plan, solicitation procedures, or in the case of a sale, bidding procedures will include these deadlines.  Knowing when the information is due, the hearing date, and the deadline to object to notice, cure, or adequate assurance can help a counterparty manage the process and prepare arguments to challenge the assumption/assignment, proposed cure amount, or demanding greater clarity on adequate assurance.

Should a debtor decide to assume or assume and assign a counterparty’s contract, the debtor’s rights in this scenario are not unfettered.  A debtor may not assume an executory contract unless it (1) cures any pre- or post-petition default or provides adequate assurances that such default will be promptly cured; (2) compensates or provides adequate assurance that the debtor will promptly compensate the other party of any pecuniary loss to the party resulting from default; and (3) provides adequate assurance of future performance under such contract.[8]

With respect to cure, the debtor’s notice will typically focus primarily on pre-petition past due payment defaults under the contract, because the debtor will assume it is generally current on post-petition payments.  The non-debtor counterparty should diligently validate this amount and reconcile it with its records, including a review of any post-petition amounts due or coming due.  Indeed, a counterparty should be prepared to provide its own calculation of the cure amount.  A useful method is to have the figure broken down into (1) pre-petition amounts due, (2) post-petition amounts past due, and (3) a per diem rate that shows the run rate from the date of the notice through the effective date of assumption (which could be the effective date of a plan or closing of a sale).  If the counterparty does not agree with the debtor’s proposed cure amount, it should file an objection asserting the correct amount.  In the absence of a timely objection, the amount scheduled by the debtor may be binding upon the non-debtor counterparty.

A non-monetary default may be more difficult to resolve and cure.  Often, historical acts (or failures to act) cannot be undone or done as of that prior date.  Non-monetary defaults frequently involve time limits by which a party fails to meet certain contractual obligations.  Examples of such non-monetary defaults include: failure to properly maintain equipment and failures to abide by operating guidelines in franchise agreements.  Whether these types of defaults bar the debtor’s ability to assume is often a question of the materiality of the breach.  Indeed, several courts have determined that a non-monetary cure will prevent a debtor from assuming a contract only if the default is material or caused the non-debtor counterparty substantial economic detriment.[9]  What qualifies as “material” will depend on the facts and circumstances of the contract and the default, but largely depends on the economic ramifications of the default.[10]  Unfortunately, for this reason, there is no bright line rule on what kinds of non-monetary defaults will prevent a debtor from assuming a contract, and counterparties seeking to avoid assumption should be prepared to present specific facts on economic loss based on the debtor’s breach.

The debtor (or its assignee) must also provide adequate assurance that it can perform under the contract post-assumption.  The Bankruptcy Code does not specify what constitutes adequate assurance of future performance.  It is a fact-intensive determination that evaluates the debtor’s (or its assignee’s) ability to perform considering, among other factors, its financial condition, operating performance (during the bankruptcy case and projected after the assumption), existence of any credit enhancements and industry outlook.  The standards tend to be based on commercial reality and reasonableness.  In the first instance, the non-debtor counterparty should make sure that sufficient information has been provided to make a determination, which may require going to the Bankruptcy Judge if the debtor or its assignee refuses to provide necessary details.  After it receives sufficient notices, the non-debtor must be vigilant in reviewing the adequate assurance information to ensure that it is not taking unnecessary risk of future defaults and losses.

The non-debtor’s inquiry does not end there.  Not all executory contracts are assumable.  The Bankruptcy Code provides that a contract cannot be assumed if applicable law excuses the non-debtor party from accepting performance from a third party and the non-debtor party does not consent to the assumption.[11]  What “applicable law” is relevant is dependent on the state law governing the contract.  Moreover, the scope of the applicability of state law is highly controversial, involving a circuit split.  In certain jurisdictions, if state law prohibits assignment of a contract to a third party, a debtor may be prohibited from assuming that contract at all.  In other jurisdictions, state law on non-assignment has no bearing on assumption.  Notwithstanding this divide, there are some constants.  For example, standard non-assignment clauses are generally ineffective in bankruptcy.[12]  Likewise, certain contracts are widely considered to be unassignable.[13]  As a general rule if non-bankruptcy law makes it apparent that “the identity of the contracting party is crucial to the contract or public safety is at issue” then the contract in question cannot be assigned.[14]  Common examples of non-assumable contracts include: contracts for personal services, trademarks, non-exclusive intellectual property licensing agreements, partnership agreements, and franchise agreements.  Although whether the specific contract can be assigned will likely boil down to a state law analysis, non-debtors with these types of contracts should likely reach out to counsel if they are concerned about potential assumption.

 

Non-Debtor Rights in the Rejection Scenario

In the event of the debtor’s decision to reject an executory contract, the rejection is treated like a breach of contract that occurred immediately before the filing of the bankruptcy petition; counterparties to rejected contracts hold an unsecured claim for the damages resulting from the breach.[15]  Damages are calculated from the petition date, not from the date of rejection.  The actual calculation, however, including what types of damages (consequential, lost profits, accelerated payments, etc.) and how those damages are determined, is based on the specific terms of the rejected contract and how damages are determined under the state law governing that contract.  Notably, “rejection” does not mean “termination” (with certain exceptions, to be addressed).  Because of this, certain provisions of the contract not affected by breach still bind the parties; for example, a non-compete clause binding the debtor may still be in effect, despite rejection.

The Bankruptcy Code provides for special treatment for two kinds of contracts: real property purchase agreements where the non-debtor is the purchaser, and intellectual property licenses where the debtor is the licensor.[16]  Non-debtors who have purchased real property or timeshare interests under contracts rejected by a debtor have two options: (1) treat the contract as terminated and submit an unsecured claim for damages or (2) continue to make payments under the contract, until all payments have been made, at which time the debtor must turn over title to the non-debtor.  In the latter scenario, the non-debtor can setoff against payments any damages caused by non-performance of any contractual obligations by the debtor.  Similarly, a non-debtor licensee of intellectual property (encompassing patents, copyrights, trade secrets, but not trademarks), can either: (1) treat the contract as terminated and submit an unsecured claim for damages or (2) retain its rights for the duration of the contract (and any renewal term).  In the latter scenario, the non-debtor can continue to make use of the intellectual property, retain any exclusivity rights, or other rights arising from supplemental agreements to the license contract.

 

Practical Considerations Regarding Executory Contracts

Summarizing the above discussion, there are some practical things a non-debtor counterparty can do to preserve its rights in a bankruptcy case:

  • Be ready to promptly enforce your right to payment if the debtor is benefiting from your contract but not paying.
  • Contact a bankruptcy lawyer if in doubt of whether the debtor has the right to assume (or assign) the contract.  This is a nuanced and complex area of law, and the results do not always comport with common sense.
  • Make sure the proposed schedule to determine cure claims and provision of adequate assurance provides sufficient time ask for more information and to make decisions.
  • When determining cure costs, consider both pre-petition and post-petition defaults through the anticipated date of the assumption (e.g. sale closing or plan effective date).
  • If you do not wish to have your contract assumed and seek to prove an incurable non-monetary default, be prepared to present evidence of substantial economic harm caused by the default; this is the strongest evidence that the breach was material, thereby preventing assumption.
  • Though adequate assurance is difficult to define, the non-debtor counterparty should be getting the benefit of the bargain based on commercial standards.  If there is substantial doubt about a debtor’s or reorganized debtor’s ability to perform on a contract (apart from merely being in bankruptcy), raise an argument against assumption.
  • Rejection is not termination – terms of the contract not affected by breach are still in play.  Consider whether relief from the automatic stay is necessary to effect a termination after rejection is approved.
  • If you have purchased real property or a timeshare from a debtor or are a licensee under a licensing agreement with a debtor, you have options to continue your contract despite rejection.
  • Be aware that certain clauses in your contract will generally not be effective in bankruptcy.  Relying on clauses that deem insolvency or bankruptcy a breach and non-assignment clauses are not winning arguments.

 


 

[1]      The authors wish to thank Kenneth A. Listwak, Esq. of Young Conaway Stargatt & Taylor, LLP for his invaluable assistance with this article.

[2]      These provisions raise the question of “what is an executory contract?”  The most widely held view is that an executory contract is defined as one where there are outstanding material obligations that remain unfulfilled by both the debtor and non-debtor parties where the failure to perform would constitute a breach and excuse the other party’s performance.

[3]      This time period is distinct from the deadlines imposed on a debtor for the assumption of non-residential real property leases.  The Bankruptcy Code allows a debtor an outside date of 120 days, which may be extended an additional 90 days, to assume a lease for non-residential real property.

[4]      11 U.S.C. § 365(d)

[5]      Id.  See generally 3-365 Collier on Bankruptcy P 365.07

[6]      See generally NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984).

[7]      While most bankruptcy judges will require a DIP or cash collateral budget that establishes a debtor’s ability to “pay the freight” of a chapter 11 case, there are no guarantees that an estate will remain administratively solvent.

[8]      11 U.S.C. § 365(b)

[9]      See In re Joshua Solcum Ltd., 922 F.2d 1081 (3d Cir. 1990); In re Chapin Revenue Cycle Mgmt., LLC, 343 B.R. 728 (M.D. Fla. 2006); In re Walden Ridge Dev., LLC, 292 B.R. 58 (Bankr. D.N.J. 2003); In re New Breed Realty Enters., 278 B.R. 314 (Bankr. E.D.N.Y. 2002).

[10]     In re Chapin, 343 B.R. at 732 (ruling that a debtor’s failure to send the source code of a certain software to potential candidates to maintain and service the software did not constitute a material breach because it did not lead to significant economic loss on the part of the non-debtor counterparty; “this Court is satisfied that the Debtor did in fact default …but that the default was not material and did not cause a significant economic detriment to [the non-debtor.]).

[11]     11 U.S.C. § 365(c)(1)

[12]     11 U.S.C. § 365(c)

[13]     See 3-365 Collier on Bankruptcy P 365.07

[14]     Id.

[15]     See 11 U.S.C. § 365(g).

[16]     11 U.S.C. § 365(i) and (n).