Rejecting Executory Contracts Is the Standard Changing

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Oct 2004

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In administering its
bankruptcy estate, a debtor-in-possesion (DIP) has the ability to reject an
executory contract. See 11 U.S.C. §365(a). A DIP may want to reject a
particular executory contract for a variety of reasons, including the goal
of negotiating a new, more lucrative contract upon the existing
contract's rejection and termination.

While §365 sets forth certain requirements for
the assumption of an executory contract, the rejection of an executory
contract is generally left to the DIP's business judgment. Thus, more often than
not, there is little a non-debtor party can do in response to a motion to
reject other than file or amend its proof of claim.

Until recently, few courts attempted to alter that
status quo. However, the Fifth Circuit has suggested the application of a
new standard for rejecting an executory contract that implicates the public
interest. See Mirant Corp. v. Potomac Electric
Power Co., 378 F.3d 511 (5th Cir. 2004).
Interestingly enough, the issue in Mirant was not the applicable standard for rejecting
executory contracts, but whether a bankruptcy court has jurisdiction to
approve a motion to reject an executory contract governed by Federal Energy
Regulatory Commission (FERC)-approved rates. While this is a
groundbreaking opinion on the jurisdictional issue alone, it may also
result in additional considerations when rejecting an executory contract,
as well as increased litigation as to when this new standard should apply.

<h4>The Time-honored Standard</h4>

As stated above, the Bankruptcy Code allows a DIP to
freely reject an executory contract subject to few exceptions. See 11 U.S.C. §365(a). In
fact, "the authority to reject an executory contract is vital to the
basic purpose of a chapter 11 reorganization, because rejection can release
the debtors' estate from burdensome obligations that can impede a
successful reorganization." See In re
National Gypsum Co., 208 F.3d 498, 504 (5th
Cir. 2000). As such, courts have widely applied the business-judgment rule
in determining whether to approve the proposed rejection of an executory
contract. See Group of Institutional Investors
v. Chicago, Milwaukee, St. Paul & Pac. R.R. Co., 318 U.S. 523, 550, 63 S.Ct. 727, 742, 87 L.Ed. 959 (1943).

The business-judgment rule provides that "[a]s long as assumption [or rejection] of a lease appears to
enhance a debtor's estate, court approval of a DIP's decision
to assume the lease should only be withheld if the debtor's judgment
is clearly erroneous, too speculative or contrary to the provisions of the
Bankruptcy Code." Richmond Leasing Co. v.
CapitalBank N.A., 762 F.2d 1303, 1309 (5th Cir.
1985) (citing Allied Technology Inc. v. R.B.
Brunemann & Sons, 25 B.R. 484, 495 (Bankr.
S.D. Ohio 1982)). The business-judgment rule, therefore, focuses on the
interests of the bankruptcy estate without any real consideration of the
interests of the non-debtor party to the executory contract or other
third-party interests. Since certain executory contracts may raise issues
that affect public interest, the Supreme Court once created a "more
rigorous standard." See NLRB v. Bildisco
and Bildisco, 465 U.S. 513, 526-27, 104 S.Ct.
1188, 1196, 79 L.Ed.2d 482 (1984), superceded
by statute.

In Bildisco, the Court held that due to the special nature of a
collective-bargaining agreement, Congress must have intended for a higher
standard than that of the business-judgment rule. Bildisco, 465 U.S. at 526. Thus, the
Supreme Court mandated careful scrutiny of the equities in rejecting a
labor contract—while also directing bankruptcy courts to examine
whether the parties negotiated—to ensure that the national labor
policies of avoiding labor strife and encouraging collective bargaining
were adequately served. Id.

Though subsequent legislation superceded Bildisco, its holding
demonstrates the Court's thoughts on reconciling Congress's
intent to allow an effective reorganization under the Bankruptcy Code with
conflicting federal law that seeks to protect the public interest. Based on
the Court's willingness to create a new standard where the public
interest is involved, and the otherwise limited consideration given thereto
under the business-judgment rule, the Fifth Circuit recently revisited Bildisco's public
interest scrutiny. See Mirant Corp. v. Potomac
Electric Power Co., 378 F.3d 511 (5th Cir.
2004).<a href="#1" name="1a">1</a>

<h4>The Mirant Opinion</h4>

During the course of its bankruptcy, Mirant sought to
reject an ancillary schedule (the contract) to an asset-purchase agreement
(APA). The contract was executed because of the contractual inability of the seller, Potomac Electric Power Co. (PEPCO), to assign certain power
purchase agreements. The rates charged in the contract were approved by
FERC. Though beneficial upon execution, the contract's FERC-approved
rates were higher than market rates.

Mirant, therefore, sought authority from the
bankruptcy court to reject the contract, but not the APA itself.
Mirant's motion received strong opposition from both PEPCO and FERC
alleging, inter alia, that Mirant could not reject the contract without rejecting the
entire APA and that the bankruptcy court was not the proper forum for a
challenge to a FERC order. Following a preliminary hearing, the bankruptcy
court held that it had the power to authorize the rejection of the
contract, but did not decide the merits of the motion to reject.

Prior to ruling on the merits of the motion to
reject, the district court withdrew the reference, set a new hearing on the
matter and held that FERC has "exclusive" authority to
determine whether wholesale rates charged for electricity sold in
interstate commerce are reasonable and that any challenge to approved rates
must occur in a FERC proceeding. As a result, the district court found that
Mirant's motion to reject was an improper attempt to avoid
FERC-approved contractual rates.

On appeal, the Fifth Circuit held that although the
Federal Power Act (FPA) gives FERC the exclusive responsibility of
approving rates charged in wholesale contracts for the interstate sale of
electricity as being "just and reasonable," Mirant's
attempt to reject the schedule was not a challenge to FERC-approved rates. Mirant, 378 F.3d at 519-20.
Instead, the rejection of the contract was akin to a breach of contract,
which a district court could consider without a separate FERC proceeding so
long as the breach of contract was not related to a FERC-approved rate. Id. Thus, rejection only has an
"indirect" impact on rates, as the FERC-approved rates would
determine PEPCO's unsecured rejection damage claim. Id. at 520. In this regard, the
Fifth Circuit specifically stated:

The FPA does not preempt a district court's
jurisdiction to authorize the rejection of an executory contract subject to
FERC regulation as part of a bankruptcy proceeding. A motion to reject an
executory power contract is not a collateral attack upon that
contract's filed rate because that rate is given full effect when
determining the breach-of-contract damages resulting from the rejection.
Further, there is nothing within the Bankruptcy Code itself that limits a
public utility's ability to choose to reject an executory contract
subject to FERC regulation as part of its reorganization process. Id. at 522.
</blockquote>

The Fifth Circuit did not clarify, however, the
relevance of a debtor's intentions in seeking to reject a power
contract. Specifically, FERC asserted, and the district court held, that
Mirant's reason for seeking to reject the contract was that its rates
were higher than the current market rate. Mirant asserted, however, that it
did not need the electricity provided under the contract to meet its supply
requirements.

Based in part on Mirant's assertions, the Fifth
Circuit held that a debtor's use of the filed rate as a criterion to
select contracts for rejection under §365(a) does not convert that
decision into a prohibited collateral attack on the filed rate when the electricity purchased
under the rejected contract is not necessary to fulfill a debtor's
supply obligations. Id. at 520. This leaves the unanswered question of whether the
district court would have jurisdiction to authorize the rejection of the
contract if Mirant's basis for rejection were the unprofitable rates
charged therein. Nonetheless, the Fifth Circuit concluded that nothing in
the Bankruptcy Code itself limited a DIP's ability to reject
executory contracts that are subject to FERC regulation. Id. at 521-22.

Since neither court had ruled on the merits of
rejection, the Fifth Circuit remanded the matter to the district court.
Upon remand, the Fifth Circuit made certain "suggestions" to
the district court. This dicta may create more controversy than the
bankruptcy/FERC jurisdictional issue.

<h4>The Fifth Circuit's Suggestive Language: The New Standard?</h4>

In remanding the case to the district court for
determination of whether grounds for rejection exist, the Fifth Circuit
noted that the bankruptcy court had previously indicated that it might
choose to apply a more "rigorous" standard than the usual
business judgment standard in evaluating Mirant's rejection motion. See Mirant, 378 F.3d at 524. The
Fifth Circuit noted that because FERC can only approve a rate change if it
is in the public's interest, the district court "should"
consider applying more stringent standards to Mirant's motion to
reject than the typical business judgment test. Id. at 525.

Further, the Fifth Circuit "suggested"
the adoption of a standard whereby Mirant bore the burden of showing that
(a) the contract "burdens the estate," (b) the
"equities" are in favor of rejecting the contract and (c)
rejection would further Mirant's reorganization. Id. at 525. In doing so, the Fifth
Circuit instructed the district court to "carefully scrutinize the
impact upon the public interest" and to "ensure that rejection
does not cause any disruption in the supply of electricity to other public
utilities or to consumers," reminiscent of the Supreme Court's Bildisco opinion. Id. In fact, the Fifth Circuit
relied on Bildisco
as authority for "suggesting" a different standard. Id. at 524-25.

While couched as "suggestions," the Fifth
Circuit made clear its expectation that the district court apply a more
stringent standard to the rejection of executory contracts like the
contract at hand. Although the Fifth Circuit did not specifically state
what this higher standard entails, "public interest" is the
stated factor to consider. Since public interest is a broad and potentially
all-encompassing term, application of this new standard could alter a
DIP's ability to reject an executory contract in more than just
energy-related bankruptcies.

<h4>Conclusion</h4>

Mirant is an important decision for two reasons. First, it
addresses what some argue is a lack of bankruptcy court jurisdiction. In
the only circuit court opinion addressing the authority of a bankruptcy
court over FERC-approved contracts, the Fifth Circuit has swung a blow for
bankruptcy.

Second, and what could conceivably result in much
litigation, is the "suggestion" that a stricter standard should
apply to the executory contract rejection analysis when the contract in
issue affects the public interest. The potential for additional litigation
is the notion of "public interest" and the varying contracts
that affect public interest outside the power generation industry.

Interestingly enough, the Fifth Circuit declined to
create an exception for contracts regulated by FERC because of the express
language in §365, while creating an exception for analyzing the
propriety of the actual rejection of the executory contract based on
superceded case law. Yet just as Congress sought to supercede Bildisco by enacting 11
U.S.C. §1113, it could have created a subsection in §365 that
addresses such matters. It did not.

On a practical note, one might argue that public
interests, though not plead, are already taken into account under the
business judgment standard. After all, if the public interest is affected,
it naturally follows that the rejection damage claim against the bankruptcy
estate could increase, thereby decreasing the return to other unsecured
creditors—making rejection not in the best interest of the bankruptcy
estate.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> While this
Fifth Circuit opinion appears to be the First Circuit Court of
Appeal's decision directly addressing this issue, a similar situation
arose recently in the NRG Energy Inc. bankruptcy. In NRG, the bankruptcy court determined that the
business-judgment standard had been satisfied, yet refused to vacate an
existing FERC order requiring NRG to continue providing energy under the
contract. In re NRG Energy Inc., 2003 WL 21507685, *2 (S.D.N.Y. 2003). NRG then filed a
motion with the U.S. District Court for the Southern District of New York
requesting authority to cease performance under the contract and for
injunctive relief. That court, much like the district court in Mirant, held that it did not
have subject-matter jurisdiction to make a decision on these issues. See Id. at 4. This issue
was settled prior to a ruling by the Second Circuit. <a href="#1a">Return to article</a>

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Friday, October 1, 2004 - 12:00

Bankruptcy Rule

2004