On a question where the circuits are split, Bankruptcy Judge Mina Nami Khorrami of Columbus, Ohio, took sides with the minority in adopting the “actual test” for Section 365(c)(1) in deciding that “the plain language of the statute” does not prohibit a debtor “from assuming an executory contract if it does not intend on assigning it.”

In addition to explaining why her reading “comports with the plain language of the statute,” Judge Nami Khorrami said that her interpretation “also is consistent with the overall objectives of chapter 11 relief and the purposes of the Bankruptcy Code.”

So far, the Sixth Circuit has not taken a position in the split. If the case reaches the Court of Appeals and Judge Nami Khorrami is affirmed, the existing circuit split will deepen, and the Supreme Court might grant certiorari to decide an issue that the justices ducked in 2009.

The Hotel Franchise Agreement

The debtor owned and operated a hotel under franchise with a major hotel brand. Before bankruptcy, the franchisor notified the debtor that the physical condition of the hotel was not up to snuff and that the debtor was in violation of the franchise agreement.

The debtor agreed to improve the property and spent $1.5 million. However, the debtor failed to meet deadlines.

With the debtor in chapter 11, the franchisor filed a motion to modify the automatic stay, contending that the Lanham Act combined with Section 365(c)(1) would preclude the debtor from assuming the contract, even if the debtor made no attempt to assign the franchise agreement.

The franchisor advocated the “hypothetical test” promulgated by the majority of circuits, which read Section 365(c)(1) to mean there can be no assumption if the franchisor does not consent. The debtor argued for the “actual test,” focusing on whether the debtor would assign the franchise agreement without consent.

The outcome turned on the interpretation of Section 365(c), which provides:

The trustee may not assume or assign any executory contract . . . if — (1) (A) applicable law excuses a party, other than the debtor, to such contract . . . or lease from accepting performance from . . . an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and (B) such party does not consent to such assumption or assignment.

As Judge Nami Khorrami said in her July 10 opinion, the parties agreed that the Lanham Act “prohibits the nonconsensual assignment of the Franchise Agreement.”

The Hypothetical Test

Judge Nami Khorrami laid out the thinking of the Third, Fourth, Ninth and Eleventh Circuits, which follow the hypothetical test. When law like the Lanham Act prevents assignment without consent, they interpret the statute to mean that “both assumption and assignment are prohibited even if the debtor does not intend on assigning the contract,” the judge said.

The four circuits focus on the word “or” to mean that assumption or assignment is barred without consent and that “the actual intent of the debtor is irrelevant to the court’s analysis,” Judge Nami Khorrami said.

The Actual Test

For courts following the actual test, Judge Nami Khorrami cited the First and Fifth Circuits, along with “the great majority of bankruptcy courts,” which ask “whether the nondebtor party to the executory contract is actually being forced to accept performance from a party other than the debtor.” In the case before her, the debtor only intended to assume the franchise agreement and not to assign it.

In the opinion of Judge Nami Khorrami, the most persuasive argument in favor of the actual test came not from the circuits but from a bankruptcy court in New York in In re Footstar Inc., 323 B.R. 566, 569 (Bankr. S.D.N.Y. 2005), where the late Bankruptcy Judge Adlai Hardin, Jr., faulted the majority of circuits for limiting their focus on the introductory language while disregarding the conditional language that followed.

As Judge Nami Khorrami read Footstar, Judge Hardin meant that the “prohibition regarding assumption or assignment applies only ‘if applicable law excuses a [counterparty] from accepting performance from or rendering performance to an entity other than the debtor or debtor in possession . . . .’ 11 U.S.C. § 365(c)(1)(A) (emphasis added).”

Since 2005, Judge Nami Khorrami said, “most of the courts that have reviewed this issue have agreed with [Footstar’s] approach.” She noted that the Collier treatise characterized the hypothetical approach as “troubling.”

Notably, Judge Nami Khorrami quoted the statement of Justices Anthony Kennedy and Stephen Breyer in connection with the Supreme Court’s denial of certiorari when presented with the identical issue in N.C.P. Mktg. Grp., Inc. v. BG Star Prods., 556 U.S. 1145, 1146-1147 (2009). She said that the justices “noted the potential inequities created by applying the ‘hypothetical test’ and the challenges presented with applying the ‘actual test.’”

Judge Nami Khorrami Chooses Sides

Not basing her decision on which approach is better policy, Judge Nami Khorrami decided that the actual test “is the most faithful interpretation of the language in § 365(c)(1)” and “also preserves the evident purpose of § 365(c)(1), which is to protect a counterparty from being forced to do business with someone other than the debtor.”

The hypothetical test, Judge Nami Khorrami said, “overemphasize[s] the introductory language of 11 U.S.C. § 365(c)(1) . . . and overlook[s] the conditional language that follows.” Based on the “plain language” of the statute, she held that “a debtor is not prohibited from assuming an executory contract if it does not intend on assigning it.”

Judge Nami Khorrami said that her interpretation “not only comports with the plain language of the statute, but it also is consistent with the overall objectives of chapter 11 relief and the purposes of the Bankruptcy Code.” In particular, she was disinclined to adopt a reading of the statute that, as she put it, would give the franchisor “a veto power over the debtor’s ability to reorganize.”

Judge Nami Khorrami denied the franchisor’s motion to modify the automatic stay based on the notion that the franchisor’s opposition barred assumption.