California Bar Journal
OFFICIAL PUBLICATION OF THE STATE BAR OF CALIFORNIA - JULY 1999
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MCLE SELF-STUDY

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Executory Contracts in Bankruptcy

What you don't know about bankruptcy can cost your client

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By W. RICHARD LEE
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Virtually every attorney with business clients will from time to time have to recognize and address a potential bankruptcy problem. The client may hold a secured or unsecured claim against the bankrupt and be entitled to file a proof of claim or seek protection for the collateral. More immediate issues arise for the client who has an ongoing business relationship with the debtor in bankruptcy under a pre-petition "executory contract."

Bankruptcy law is codified under Title 11 of the United States Code (the "Code"). Bankruptcy law preempts state law under the Supremacy Clause of the U.S. Constitution; however, many bankruptcy issues look to substantive state law to define the property and contract rights of the parties.

Competing interests

Once a bankruptcy is filed, the Trustee (a Chapter 11 debtor-in-possession acts in the same capacity as a trustee) (the "Trustee") may cure any default and preserve the remaining benefits of the debtor's unexpired executory contracts. Alternatively, the Trustee may unilaterally terminate an executory contract and minimize the financial impact of the default. An executory contract may be sold and assigned to a third party, even though the contract has a provision which otherwise prohibits assignment. The non-debtor party to such a contract (the "Client") may find itself in the often risky position of having to continue doing business with a bankruptcy estate or a third party that the Client might not otherwise choose to do business with.

The Client will want protection for any future business it does under the executory contract. Conversely, the debtor's rights under the contract, such as the remaining term of a favorable lease, may have significant value to the bankruptcy estate. The Trustee may wish to sell those rights for the benefit of the creditors. A license agreement or an insurance policy may be absolutely necessary to the debtor's ability to reorganize in chapters 11 or 13. Fortunately, the Code contains a special set of procedures and remedies to protect both the bankruptcy estate and the non-debtor parties to an executory contract.

W. Richard LeeWhat is an Executory Contract?

When does the Client have an "executory contract" with a debtor in bankruptcy? The Code does not define "executory contract," that function having been left to the courts to analyze on a case by case basis. The U.S. Supreme Court defined the term as a contract in which ""performance is due to some extent on both sides" N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513 (1984). In the Ninth Circuit, a contract is executory if the obligations of both parties "are so far unperformed that the failure of either party to complete performance would constitute a material breach excusing the performance of the other" In Re Frontier Properties, Inc., 979 F.2d 1358 (9th Cir. 1992). Real property and equipment leases are perhaps the most common forms of executory contract. The lessor has a duty to provide future possession of the property and the debtor/lessee has a duty to make the future payments. Other examples might include an insurance policy, an escrow for the sale of land, a license agreement or a joint venture. Conversely, some contracts that appear to be executory, such as an installment sales contract, may already be so fully performed by the non-debtor that they are no longer executory. These contracts are often treated as unsecured claims or "disguised" security agreements subject to the applicable lien perfection rules.

Property of bankruptcy estate

The filing of a bankruptcy petition creates an estate similar to a trust. The Trustee administers the estate with a fiduciary duty to the creditors. Under Code 541, the estate is vested with "all legal or equitable interests of the debtor in property as of the commencement of the case." The bankruptcy courts frequently look to state law to define those "property" rights. The analogy is much like the proverbial "bundle of sticks." Code 541 is broadly construed. The debtor's rights under an executory contract become property of the bankruptcy estate that the Trustee may use, lease or sell under Code 363.

Right of Redemption. Even after property such as leased equipment has been repossessed, the debtor's rights of redemption under state law will become property of the bankruptcy estate. Under Code 365(b)(1), the Trustee may cure the default, or provide "adequate assurance" of a "prompt" cure, and continue enjoying the benefits of the lease. If repossessed property can be used, sold or leased by the Trustee for the benefit of the estate, the Client may have a duty under Code 542(a) to surrender the property back to the Trustee. Conversely, if the executory contract has already expired by its own terms, or terminated under applicable state law before commencement of the bankruptcy, the Trustee may no longer have a right of possession or redemption. The filing of a bankruptcy petition does not reinstate a property right that terminated prior to filing the petition.

Ipso Facto Clauses. Contracts frequently include an "ipso facto" clause that purports to terminate or modify the contract based upon the debtor's financial condition or insolvency. With some exceptions, Code 365(c) and (e)(1) expressly invalidate ipso facto clauses and preempt similar state laws that may deprive the estate of the benefits of the unexpired contract.

Protection of the automatic stay

The debtor's rights under an executory contract are protected by the "automatic stay" which arises by operation of law under Code section 362(a) immediately upon commencement of the bankruptcy case. The filing of a bankruptcy petition operates as a stay, applicable to all entities, of certain proscribed actions which include, (a) the commencement or continuation of an action against the debtor to enforce a pre-petition claim, and (b) any act to obtain possession of, or to exercise control over property of the estate. The automatic stay prohibits the Client from terminating or interfering with the debtor's executory contract rights without permission of the bankruptcy court (relief from the automatic stay).

Relief From Stay. The grounds for relief from the automatic stay are set forth in Code 362(d). They include "cause" and lack of "adequate protection" for the Client's interest under the contract. The court will also look to see if the benefits of the executory contract have value to the estate or are necessary to the debtor's reorganization.

The automatic stay is not without limits. For example, it does not prevent the Client from inquiring as to the debtor's intention and ability to continue performance of the contract. Under Federal Rule of Bankruptcy Procedure 2004, the Client may examine the debtor and compel production of documents relevant the debtor's ability to perform the contract. Neither does the automatic stay prevent the Client from demanding protection for its post-petition performance, such as cash on delivery of goods. The Code does not require any party to extend new trade credit to a Trustee.

What happens to the contract?

Under Code 365(a), the Trustee may elect to affirm and accept (assume) or terminate and surrender (reject) an executory contract or unexpired lease. Assumption requires court approval. Most courts will apply the "business judgment test" to determine if assumption is appropriate. Rejection is automatic if the contract is not assumed within a proscribed time. The entire contract must be assumed or rejected. The Trustee may not assume part of the contract and reject or modify the rest. The contract may not be assumed unless the Trustee first cures the defaults or provides "adequate assurance" that any defaults will be cured. (Code 365(b)). With some exceptions, the Trustee may assume and assign an executory contract notwithstanding an anti-assignment clause in the contract unless applicable non-bankruptcy law excuses the non-debtor party from accepting or giving performance to a third party, such as a personal service contract, without the party's consent (Code 365(c)). A contract to make a future loan or extend future financial accommodations to the debtor cannot be enforced by the Trustee (Code 365(e)(2)(B)).

Time Limits. Code 365(d) proscribes certain time limits for assumption or rejection of executory contracts. For example, in chapter 7, a lease of residential real property or personal property is automatically rejected unless the Trustee assumes the lease within 60 days after the bankruptcy is filed. In chapters 11, 12, or 13 the same leases and other executory contracts must be assumed or rejected before confirmation of a plan unless the court fixes an earlier or later date. An unexpired lease of non-residential real property is automatically rejected in 60 days under all chapters unless the Trustee assumes the lease. The court may extend the time limits for good cause on application made before the time expires. The Trustee is obligated to timely pay rent under a non-residential real property lease until the lease is assumed or rejected. (Code 365(d)(3)). The property must be surrendered immediately upon rejection of the lease. (Code 365(d)(4)). Non-performance of an executory contract may be grounds for the Client to seek an order compelling assumption or rejection or granting relief from stay to terminate the contract.

Rejection damages. Rejection of an executory contract is treated as a pre-petition breach of the contract under Code 365(g). In that event, the damages recoverable under state law for breach of the contract will be treated as an unsecured claim. If a lease of real property is rejected, the lessor's claim is limited under Code 502(b)(6) to the amount of any pre-petition default plus rent for the greater period of one year or 15 percent of the unexpired term of the lease.

An administrative claim

Under Code 503(b), the court can award the Client an "administrative expense" claim. Administrative expenses of the bankruptcy estate include the "actual, necessary costs and expenses" of preserving and administering the estate. Administrative expenses may include professional fees (attorneys, accountants, etc.), taxes and other liabilities that accrue during the bankruptcy. The debtor's performance under an executory contract is generally an administrative obligation. If the debtor assumes the executory contract, the entire contract, including all unperformed pre-petition and post-petition obligations, becomes an administrative liability of the estate. Assumption of the executory contract can therefore have significant benefits for the Client vis-a-vis the secured and unsecured creditors.

Payment priority. Administrative expenses are technically entitled to priority payment ahead of the unsecured creditors under Code 726(a). However, an administrative claim is seldom preferable to actual performance of the contract. There is no time limit for payment of administrative expenses unless the court fixes the time for payment or the debtor confirms a Chapter 11 plan, in which event the administrative expenses must be paid upon confirmation. Over the course of a bankruptcy case, administrative expenses can become significant and may exceed the estate's financial resources. An administrative claim can be a hollow remedy if the debtor cannot reorganize, if the estate turns out to be administratively insolvent or if the estate cannot close and pay its administrative claims for a long period of time.

Protect Your Client!

If the Client's executory contract falls under the protection of a bankruptcy proceeding, the Client should act quickly to ascertain the debtor's intention and ability with regard to future performance. Unless the Trustee can adequately assure the estate's performance, the Client remains at risk for the cost of its performance. For example, if a business debtor is in arrears to its workers' compensation insurance carrier, the insurance carrier may not terminate the policy prior to expiration of the contractual term without relief from the automatic stay. The carrier remains at risk for benefits to the debtor's employees until stay relief is granted and the carrier gives the required termination notice. The carrier should move quickly for an order compelling the Trustee to assume or reject the contract and demand adequate assurance of future performance. Alternatively, the carrier may move for relief from the automatic stay to pursue its termination remedies. It is incumbent on the Client to act quickly to evaluate its rights and remedies with regard to executory contracts, to determine the Trustee's intention and ability to perform and to take appropriate action to minimize the risk of loss.

W. Richard Lee is a shareholder of Kimble MacMichael & Upton of Fresno, specializing in bankruptcy and commercial law. He is a past president of the Central California Bankruptcy Association and a member of the Personal and Small Business Advisory Commission for the State Bar's Board of Legal Specialization.