A Non-Debtor’s Rights in Executory Contracts

A Non-Debtor Perspective on Executory Contracts

Non-debtor’s rights may not look robust and substantial. The Bankruptcy Code allows a debtor 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 spike in retail bankruptcy cases highlights the treatment of leases of nonresidential real property like store leases.

This article summarizes non-debtors’ rights and protections in the treatment of executory contracts other than non-residential, real property leases. These contracts could include:

• Equipment leases
• Supply contracts
• Intellectual property licenses
• Employment agreements
• Financing arrangements
• Contracts for services

The Debtor’s Perspective on Executory Contracts

Executory contracts are contracts with outstanding material obligations unfulfilled by both debtor and non-debtor. Failure to perform would constitute a breach and excuse the other party’s performance.

Section 365 of the Bankruptcy Code governs the treatment of executory contracts and, generally:

• Describes a debtor’s obligations to perform
• Establishes a timetable for disposition (assumption or rejection)
• Sets forth conditions for assumption and consequences of rejection 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:

1. If the debtor is reorganizing, it may assume the contract.
2. In the sale of the debtor’s assets, the debtor can assume the contract and assign it to a third-party even if the non-debtor objects to that assignment. Assumption effectively continues the contractual relationship with the debtor or assignee as if, with limited exceptions, the bankruptcy case had not occurred.
3. A debtor may reject a contract. That is deemed a breach of the contract occurring right before the debtor filed for bankruptcy. 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.¹ That could take months, even years. Where the debtor contemplates a sale of assets, the decision to assume, assign, or reject is driven by milestones for the sale process. This period of uncertainty could linger if the outcome is uncertain and there is a prospect of liquidation. 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. The debtor may continue to accept contract benefits without having to perform, while the non-debtor’s ability to enforce is restricted. Additionally, the debtor has a potentially lengthy window of time to decide what to do with the contract.

What is the Non-Debtor Counterparty to Do?

An executory contract counterparty should 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 will start to inform a non-debtor’s rights and ability to protect itself.

To limit uncertainty, a counterparty may ask the court to compel a debtor to make a decision. How will the debtor treat a contract? By what specific date must the debtor assume or reject a contract? Such relief, however, is rarely granted. Drawing from other benchmarks in the Bankruptcy Code, it is unlikely to be considered within the first 60 days of the case.

Contrast this with non-debtor rights in unexpired leases for personal property. Pursuant to section 365(d)(5), a debtor must fulfill obligations that arise under an unexpired lease for personal property. The clock begins at 60 days after the petition date and runs through the debtor deciding how to treat the contract.² The counterparty need not make any showing as to the debtor’s benefit to be entitled to this relief. The burden shifts to the debtor, should it wish to not honor these payments, proving that equities of the case favor nonpayment.³

In the early part of a Chapter 11, non-debtors’ rights include compensation for reasonable value of services rendered during the pre-decision period. The Supreme Court ruled that  contracts assumed, assumed and assigned, or rejected are treated equally. If the debtor continues to reap benefits of a contract before deciding to assume or reject, a non-debtor gets reasonable value of goods or services rendered during that time.⁴

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.⁵ 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 file a motion with the court if the debtor does not  make payment when due under the contract. This will highlight for the court concerns about whether 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. It must disclose the amount of any unpaid pre- and post-petition amounts due under the contract to be “cured.” It must 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 non-debtor rights.

Several timing and adequacy issues arise in practice. Frequently, a counterparty might receive notice of assumption within mere days of a sale hearing or confirmation hearing. 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. This means  counterparties lack valuable information and must hope the winning bidder will be able to perform.

A counterparty should carefully evaluate any filing by the debtor relating to deadlines for assumption notices and assurance information. Often, these deadlines appear in the debtor’s plan, solicitation procedures, or in the case of a sale, bidding procedures. A counterparty must know:

• When the information is due
• The hearing date
• The deadline to object to notice, cure, or adequate assurance

Such knowledge allows a counterparty to manage the process and prepare arguments to:

• Challenge the assumption/assignment
• Challenge the proposed cure amount
• Demand 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 resulting from default
3. Provides adequate assurance of future performance under such contract⁶

With respect to cure, the debtor’s notice will focus on pre-petition past due payment defaults. The debtor will generally assume it is current on post-petition payments. The non-debtor counterparty should validate and reconcile amounts, including reviewing post-petition amounts due or coming due.

A counterparty should provide its own calculation of the cure amount. Perhaps break the figure down into:

1. Pre-petition amounts due
2. Post-petition amounts past due
3. A per diem rate showing the run rate from the date of notice through the effective date of assumption. That could be the effective date of a plan or closing of a sale.

If the counterparty disagrees with the debtor’s 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.

Non-Monetary Defaults

A non-monetary default may be more difficult to resolve and cure. Often, historical acts (or failures to act) cannot be reversed as of that prior date. Non-monetary defaults frequently involve time limits by which a party fails to meet certain contractual obligations. Non-monetary defaults include failure to properly maintain equipment and failure to follow franchise agreement operating guidelines.

Do these types of defaults bar the debtor’s ability to assume? That is often a question of the materiality of the breach. Several courts have determined that a non-monetary cure only prevents a debtor from assuming a contract if the default is material or caused the non-debtor counterparty substantial economic detriment.⁷ “Material” depends on facts and circumstances of contract and default, but largely depends on economic ramifications.⁸ There is no bright line rule on what non-monetary defaults prevent a debtor from assuming a contract. Counterparties seeking to avoid assumption should present specific facts on economic loss based on the debtor’s breach.

The debtor (or its assignee) must also provide assurance that it can perform under the contract, post-assumption. The Bankruptcy Code does not specify what constitutes adequate assurance of future performance. A fact-intensive determination evaluates the debtor’s (or its assignee’s) ability to perform. It considers, among other factors, its financial condition and operating performance (during the bankruptcy and projected after the assumption). The determination looks at the existence of any credit enhancements and the industry outlook.

The standards tend to be based on commercial reality and reasonableness. In the first instance, the non-debtor counterparty should look for sufficient information to make a determination. That may require going to the Bankruptcy Judge, if the debtor or its assignee refuses to provide necessary details. After receiving sufficient notices, the non-debtor rights provide for  reviewing the adequate assurance information. It’s important that the non-debtor does not take unnecessary risk of future defaults and losses.

Non-Assumable Contracts

The non-debtor’s inquiry does not end there. Not all executory contracts are assumable. 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, the Bankruptcy Code says a contract cannot be assumed.⁹ What “applicable law” is relevant depends on 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 assigning a contract to a third-party, it might mean a debtor cannot assume 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.¹⁰ Likewise, certain contracts are widely considered to be unassignable.¹¹ Generally, if non-bankruptcy law says “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.

Common examples of non-assumable contracts include:

• Contracts for personal services
• Trademarks
• Non-exclusive intellectual property licensing agreements
• Partnership agreements
• Franchise agreements.

Whether the specific contract can be assigned will likely boil down to a state law analysis. Non-debtors with these types of contracts should reach out to counsel if they are concerned about a potential assumption.

Rejection: Non-Debtor Rights

If a debtor rejects an executory contract, the rejection is treated like a breach of contract that occurred immediately before filing the bankruptcy petition. Counterparties to rejected contracts hold an unsecured claim for damages resulting from the breach.¹²

Damages are calculated from the petition date, not from the date of rejection. Actual calculation, however, includes types of damages (consequential, lost profits, accelerated payments) and how damages are determined. The calculation is based on the terms of the rejected contract and how state law determines damages. Notably, rejection does not usually mean termination. Because of this, certain provisions of the contract not affected by breach still bind the parties. For example, despite rejection, a non-compete clause binding the debtor may still be in effect.

The Bankruptcy Code provides two kinds of special treatment for executory contracts. One is real property purchase agreements where the non-debtor is the purchaser. The other involves intellectual property licenses where the debtor is the licensor.¹³

Non-debtors who have purchased real property or timeshares under contracts rejected by a debtor have two options. They may treat the contract as terminated and submit an unsecured claim for damages. Or they continue to make all payments under the contract. Then the debtor must turn over the title to the non-debtor. With the latter, non-debtor rights permit offsetting non-performance damages against payments.

A non-debtor licensee of intellectual property — patents, copyrights, trade secrets, but not trademarks — can also treat the contract as terminated. The non-debtor may submit an unsecured claim for damages. Or a non-debtor may retain its rights for the duration of the contract and any renewal term. In the latter, the non-debtor can continue to make use of the intellectual property. It may retain any exclusivity rights or other rights from supplemental agreements to the license contract.

Practical Considerations Regarding Treatment of 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 to ask for more information and 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 you 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.

---

[Editors’ Note: The authors wish to thank Kenneth A. Listwak, Esq. of Young Conaway Stargatt & Taylor, LLP for his invaluable assistance with this article. 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 customer PowerPoint about the topic):

• Help, My Business is In Trouble!
• And What to Expect and Do When Your Customer Becomes Insolvent

This is an updated version of an article originally published on August 28, 2017. It was recently edited by Maryan Pelland]

©2022. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. 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.
2. 11 U.S.C. § 365(d)
3. Id. See generally 3-365 Collier on Bankruptcy P 365.07
4. See generally NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984).
5. 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.
6. 11 U.S.C. § 365(b)
7. 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).
8. 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.]).
9. 11 U.S.C. § 365(c)(1)
10. 11 U.S.C. § 365(c)
11. See 3-365 Collier on Bankruptcy P 365.07
12. See 11 U.S.C. § 365(g).
13. 11 U.S.C. § 365(i) and (n).