Executory Contracts under 365

<b>Editor's Note:</b> <i>We addressed bankruptcy issues of
concern to real estate landlords and tenants last month. That
necessitated us to talk about §365, but only those parts that deal
with real property leases of nonresidential real property. Section 365,
however, covers a great deal more than that. This month, we discuss
executory contracts and the way in which Bankruptcy Code §365 deals
with them. </i> </blockquote>

<p>Bankruptcy Code §365(a) provides that
"the trustee, subject to the court's approval, may assume or reject any
executory contract or unexpired lease of the debtor." You would think
these words are simple and straightforward. You would be wrong. This
section is long. It is rifled with special-interest legislation. Case
law is mixed in interpreting its various subsections. Even the term
"executory contract" is more complicated than it appears at first blush.

</p><p>The term "executory contract" is not defined in the Code. It may seem
intuitive—but on a moment's reflection, we can see that it cannot
mean what it means outside of bankruptcy. That is this: In state law, an
"executory contract" is any contract unperformed on either side. Apply
this to bankruptcy, and every creditor's claim becomes an executory
contract. This would suggest that the trustee may pick and choose which
claims to assume and which to reject. The whole idea of bankruptcy,
however, is that we deal with claims <i>pro rata.</i> Picking and
choosing is so far from <i>pro rata</i> that the drafters must have been
thinking of something else. Faced with this perplexity, a lot of courts
have fallen back on a definition that we associate with the late, great
Prof. Vern Countryman—the so-called "Countryman definition," which
holds that an "executory contract" is </p><blockquote>[A] contract which the
obligation of both the bankrupt and the other party to the contract is
so far clearly unperformed that failure of either to complete
performance would constitute a material breach excusing the performance
of the other. </blockquote> Countryman, "Executory Contracts in
Bankruptcy: Part I.," 57 Minn.L.Rev. 439, 469 (1973).

<p>Consider a deal in which the seller agrees to deliver a load of
widgets every month for a year, the buyer to pay 10 days after delivery.
Suppose the seller suspends delivery after three months, or suppose the
buyer stops paying. Breach by either would seem to excuse the other from
his obligation. This case, at least, seems to fit the Countryman
definition. It seems reasonably clear what Countryman was up to. He
wanted to distinguish "executory contract" on one side from "security
interest" on the other. To see why this is important, consider the case
of a transferor who transfers a widget to a transferee in exchange for a
promise to pay $1 million. The buyer takes possession, but then files
bankruptcy without paying. Suppose also that the widget, at the time of
filing, is worth only $600,000. What are the rights of the parties? If
the deal is a security agreement, the rights are tolerably clear. The
transferor/seller has first dibs on the widget, and retains a deficiency
claim for $400,000.

</p><p>If the debtor is in chapter 11, then the trustee (or, more likely,
debtor-in-possession (DIP), acting as a trustee) may do more: He may
"rewrite the contract" and impose a new deal on the secured creditor,
binding so long as it has a present value of $600,000. For example,
suppose the debtor offers 10 payments of $81,500, discounted at six
percent. The present value of this payment stream is $600,000. If six
percent is the "right" rate, then the court can impose the plan on the
secured creditor. However, the court can't do anything of the sort if
the deal is an executory contract, even though the economics may be the
same.

</p><p>If the deal is an executory contract, the rights are equally clear
and dramatically different. The DIP may assume or reject. But assume
means "assume in tote"—assume the contract with all its attendant
obligations, and no nonsense about scaling down or rewriting. Or he must
"reject in tote," which means he must give back the property (for any
shortfall there remains an unsecured claim). Which should the DIP do?
The answer to that question ought to depend on the value of the deal. If
the contract is burdensome to the estate, he ought to reject (Countryman
taught us to think of it as an analog to abandoning worthless property).
If it is a benefit to the estate, he ought to assume or even (as we
shall see below) assign it to a third party.

</p><p>The DIP has to act within the realm of "business judgment" in
deciding whether to assume or reject, but the courts aren't eager to
second-guess him. Even within "business judgment," though, the DIP
cannot assume on a whim. He must "cure and assure." That is, he must
follow the dictate of Bankruptcy Code §365(b):

</p><blockquote> (1) If there has been a default in an executory contract or
unexpired lease of the debtor, the trustee may not assume such contract
or lease unless, at the time of assumption of such contract or lease,
the trustee—

<blockquote> (A) cures, or provides adequate assurance that the trustee
will promptly cure, such default;

<br>(B) compensates, or provides adequate assurance that the trustee
will promptly compensate, a party other than the debtor to such contract
or lease, for any actual pecuniary loss to such party resulting from
such default; and

<br>(C) provides adequate assurance of future performance under such
contract or lease.</blockquote></blockquote>

The devil is in the details: A fair amount of bankruptcy litigation, and
a great deal of knuckle-crunching negotiation, occurs in the realm of
"cure and assure."

<p>How soon must the DIP decide whether to assume or reject? Code
§365(d) says that in chapter 11, "the trustee may assume or reject
an executory [contract]...at any time before the confirmation of a
plan." But it also says, "the court, on the request of any party to such
contract...may orde r the trustee to determine within a specified period
of time whether to assume or reject such contract or lease." (Don't
confuse this rule with the time limits on real estate leases, which are
trickier.)

</p><p>The practical effect of this rule is to put the ball in the
non-debtor's court. If he is tired of waiting for a decision, it is he
who must ask the court to make a determination—and the court may
choose not to make a determination if it thinks the issue is best left
to the plan.

</p><p>It is one thing to assume the executory contract, but quite another
to assign it to a third party. Remarkably, the Code provides both.
<i>See</i> Bankruptcy Code §365(f). To assign, the DIP must first
assume (recall "cure and assure"). Then he must provide "adequate
assurance of future performance <i>by the assignee.</i>" Once again,
there is plenty of contention over the nature of "adequate assurance."

</p><p>Not every contract is eligible for assumption and assignment.
Bankruptcy Code §365(c), for example, prohibits assignment where
"applicable law" excuses a party "from accepting performance from or
rendering performance to an entity other than the debtor." Think
personal service contracts. If Metallica were to go into bankruptcy, you
wouldn't want Ozzfest to have to accept a performance from Barbra
Streisand.

</p><p>The Code seems also to say that if the contract cannot be assigned,
it cannot be assumed. In chapter 7, perhaps this makes sense: you
wouldn't want the trustee striding onstage. But suppose Metallica files
for relief under chapter 11 and remains as DIP. You might not think that
the Code should prohibit its assumption of its own deal, but it may: In
an important case, the Code used just such reasoning to prevent the
assumption of an intellectual property agreement. <i>In re Catapult
Entertainment,</i> 165 F.3d 747 (9th Cir. 1999).

</p><p>One notable fact of executory contract law is that courts seem to
assume that if something is an executory contract when the debtor is the
transferee, then it must be also when the debtor is the transferor. It
isn't obvious that this must be so. But in a much-noticed case, the
Fourth Circuit held that a technology licensing agreement was an
executory contract when the debtor was the licensor. <i>Lubrizol
Enterprises Inc. v. Richmond Metal Finishers Inc.,</i> 756 F.2d 1043
(4th Cir. 1985), <i>cert denied,</i> 475 U.S. 1057 (1986).

</p><p>The decision touched off a rumpus in the Intellectual Property (IP)
bar. Consider the case of a non-debtor licensee who had poured a big
investment into developing a factory to deploy the IP. It risked losing
the value of its investment with nothing but (at best) an unsecured
claim against the estate. Responding to the concerns of the industry,
Congress adopted present §365(n), designed to secure the rights of
the nondebtor licensee, notwithstanding the rejection by the licensor.
Congress could, of course, have simply redefined "executory contract" to
specify that it did not cover IP rights where the debtor was the
transferor—but it did not.

</p><p>If the DIP assumes an executory contract, the counterparty has all
the rights he had before bankruptcy, and a bit more: The counterparty
has a first-priority administrative claim against the estate, or a
post-discharge claim against the reorganized debtor.

</p><p>Note that assumption or rejection must be done "subject to the
court's approval." The purpose of this was to make sure that the DIP
didn't assume "by accident" (or perhaps better, "by ambush"). It hasn't
quite worked that way: There remains the question of contracts that are
neither assumed nor rejected before the confirmation of the plan. Do we
assume that they are implicitly rejected? Or implicitly assumed? There
is no compelling answer to this question. Prudent counsel sidesteps it
by language in the Code, as, for example "all executory contracts not
explicitly assumed are deemed rejected."

</p>