Fifth Circuit Adopts Actual Test in Handling Exception to Ipso Facto Provisions

Journal Issue

May 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 4, p. 1, May 2006

Bankruptcy Code

365

Topic Tags

Automatic Stay

Executory Contracts/Leases

Journal HTML Content

Section 365(e)(1) of the Bankruptcy Code generally invalidates provisions of executory
contracts and unexpired leases that would otherwise allow an entity to terminate
or modify an agreement based upon ipso facto1 provisions relating
the insolvency or financial condition of a debtor/counter-party. Similarly,
§365(f) of the Code generally invalidates provisions of executory contracts
and unexpired leases that would otherwise prohibit or restrict a debtor's ability
to assign such contracts or leases. Section 365(e)(2) provides an exception
to the Code's invalidation of ipso facto provisions pursuant to §365(e)(1),
and §365(c) provides an exception to the Code's invalidation of anti-assignment
provisions pursuant to §365(f). While the language of §§365(e)(2)
and 365(c) differ in some significant respects, they both apply where "applicable
law" excuses the nondebtor from accepting performance from a third party.2
The circuit courts are split, however, on the question of whether an actual
third-party assignment must be proposed before the §365(e)(2) and 365(c)
exceptions are triggered (the "actual test"), or whether these exceptions
are triggered by the mere existence of a law that would prohibit a third-party
assignment, even where no such assignment is proposed (the "hypothetical
test").
 On Feb. 13, 2006, the U.S. Court of Appeals for the Fifth Circuit adopted
the actual test when considering the §365(e)(2) exception to the §365(e)(1)
invalidation of ipso facto provisions. The court concluded that a nondebtor
counterparty cannot terminate an executory contract on the grounds that applicable
law would prohibit a third-party assignment of the agreement where the nondebtor
counterparty concedes that there has been no assignment in fact of its agreement
and for which no motion to assume or reject has been made.3 Bonneville
Power Admin. v. Mirant Corp. (In re Mirant Corp.), 2006 WL 330121
(5th Cir. (Tex.)). The case did not address, however, whether the provisions
of §365(e)(2) would have been triggered had the debtor-in-possession (DIP)
moved to assume the subject agreement, or even whether an assignment occurred
by operation of law when the debtor's assets vested in the DIP (or, as the Fifth
Circuit put it, "as a result of the change in [the debtor's] status [from]
a pre-petition debtor to a DIP)." Id. at *12, fn. 21. Thus, the
case leaves many questions unresolved and cannot provide much comfort to debtors
in the Fifth Circuit.

Bankruptcy Court Denies Stay Relief to Terminate Energy Contract
On July 14, 2003 (the "petition date"), Mirant Corp., an international
energy company, and 82 of its direct and indirect subsidiaries, including Mirant
Americas Energy Marketing LP ("MAEM" and, together with the other
filing entities, the "debtors"), commenced bankruptcy proceedings
in the Northern District of Texas.4 The debtors' commercial activities, including
the procurement and selling of power, were (and continue to be) conducted by
MAEM.
Among myriad other third-party agreements, on the petition date MAEM was party
to an electric power agreement with Bonneville Power Administration (BPA), a
federal power marketing agency within the U.S. Department of Energy. The agreement
provided for the future purchase, sale and exchange of power and other services
between the parties, and granted BPA a one-time call option to purchase an agreed
amount of fuel for a fixed price prior to Dec. 23, 2003 (the "option termination
date"). The agreement contained an ipso facto default provision
triggered upon a bankruptcy filing by either party, prior to the option termination
date, that enabled the nondebtor party to terminate the agreement upon written
notice and entitling the nondebtor party to a termination payment.
Shortly after the petition date, BPA sent a letter to MAEM terminating the
agreement and demanding the termination payment. BPA asserted that it was entitled
to terminate the agreement without first seeking relief from the automatic stay
because the agreement qualified as a forward contract and contained a representation
that both parties were forward contract merchants. (The Code provides exceptions
to the automatic stay for certain qualifying derivative transactions between
qualifying parties. Cf. 11 U.S.C. §§362(b)(6) and 556.) Despite this
representation, however, under the Code as then in effect, a governmental unit
such as BPA clearly did not qualify as a "forward contract merchant,"5
and the court therefore ruled that the exception to the automatic stay was not
applicable.
BPA promptly filed a motion to lift the automatic stay to authorize it to terminate
the agreement in accordance with the ipso facto provisions contained
therein. BPA asserted that the ipso facto provision of the agreement
was not invalidated by §365(e)(1) because the Federal Anti-Assignment Act
was an applicable law within the meaning of §365(e)(2) that excused BPA
from accepting performance from an assignee.

The court denied BPA's motion on the grounds that BPA had failed to make a
sufficient showing of cause to lift the stay as required by the Code. The court
concluded that "even if the ipso facto clause could be enforced
to trigger a default, BPA failed to demonstrate cause for relief where BPA would
suffer no harm by the continued enforcement of the stay." Id. at
*4. The district court affirmed the ruling of the bankruptcy court and BPA appealed
to the Fifth Circuit.
 Arguments on Appeal 
On appeal to the Fifth Circuit, BPA urged the court to adopt the hypothetical
test and rule that the §365(e)(2) exception to the Code's invalidation
of ipso facto clauses applied because the federal Anti-Assignment Act
excused BPA from accepting performance from an assignee of the debtor.6
BPA argued that the event triggering the applicability of the§365(e)(2)
exception was the fact that the Anti-Assignment Act precluded the assignment
of the agreement to a third party and that it did not matter that MAEM had not
actually moved to assign the agreement (or even assume it). As a result of the
applicability of the exception, BPA asserted that it was entitled to either
automatically terminate the agreement "prior to judicial review and prior
to the entry of the automatic stay," or alternatively, that the court was
compelled to lift the stay to permit BPA to enforce the ipso facto clause.
Id. at *5.

Conversely, MAEM urged the court to adopt the actual test and rule that the
§365(e)(2) exception was not yet applicable because MAEM had not sought
to assign the agreement in violation of the Anti-Assignment Act. MAEM further
argued that even if the exception was applicable, the court had not abused its
discretion by declining to lift the stay because BPA had failed to show "cause"
for lifting the stay as required by the Code.
Hypothetical vs. Actual Test
Under the hypothetical test, a court will look only at whether the nondebtor
party could refuse to accept performance from any assignee as a matter of law,
even where the DIP has no intention of assigning the contract in question to
a third party. The hypothetical approach was first adopted by the Third Circuit
in In re West Electronics Inc., 852 F.2d 79, 83 (3d Cir. 1988), and has
subsequently been adopted by the Fourth, Ninth and Eleventh Circuits. The issue
in West Electronics was whether a court had abused its discretion when
it denied the government's request to lift the automatic stay to terminate an
executory contract with a debtor (military contractor) based on alleged irregularities
in the debtor's accounting procedures and other deficiencies.
 In West Electronics, which was a §365(c) rather than a §365(e)(2)
case, the Third Circuit held that the court had abused its discretion by refusing
to lift the stay. The Third Circuit held that the language of §365(c) precluded
the assumption of an agreement where applicable law barred its assignment without
the consent of the nondebtor, and that the Anti-Assignment Act constituted an
applicable law precluding assignment. Although the case did not deal with the
validity of an ipso facto default provision relating to the debtor's
filing, the Third Circuit reasoned that because the language of §365(c)
provided that the debtor could neither assume nor assign an agreement if applicable
law prohibited assignment, the agreement would ultimately have to be rejected.
Therefore, the court concluded that it had no choice but to permit the government
to terminate the agreement.7 The essence of the hypothetical test is that the
exceptions to §§365(e)(1) and 365(f) are triggered anytime there exists
a law that would entitle the nondebtor party to the agreement to refuse performance
of the agreement from an assignee, notwithstanding the fact that no such assignment
has yet been (or may ever be) proposed.

Conversely, courts applying the actual test have generally ruled that the exceptions
to §§365(e)(1) and 365(f) are triggered only if the debtor formally
compels the nondebtor party to accept performance from, or render performance
to, a third party. Thus, where no assignment has taken place and no intent to
assign can be shown, the exceptions in §§365(e)(2)(A) and 365(c) would
not apply. This approach was first adopted by the First Circuit in Summit
Inv. & Dev. Corp. v. Leroux, 69 F.3d 608 (1st Cir. 1995). In Summit
Inv., the First Circuit fashioned a test to be applied on a case-by-case
basis and requiring a showing that the contract at issue would actually be assigned
or that the nondebtor party would actually be asked to accept performance from,
or render performance to, a party other than the party with whom it actually
contracted.
Narrow Ruling Favors Debtor
After considering cases construing both §§365(c) and 365(e)(2), the
Fifth Circuit adopted the actual test based on its analysis of the structure
of the statute. The court noted that the §365(e)(2) exception was comprised
of a two-part test, the first part of which requires there to be an applicable
law that would excuse the nondebtor party from accepting performance from an
assignee, and the second part of which requires a finding that the nondebtor
party "does not consent to such assumption or assignment". (See
§365(e)(2)(A)(ii), emphasis added). The court concluded that the reference
to the nondebtor's consent to "such assumption or assignment" in the
second part of the test required that a particular assignment be proposed by
the debtor and rejected by the nondebtor party before the exception to the Code's
general invalidation of ipso facto provisions could be triggered. Therefore,
in the Fifth Circuit's view, even where an applicable law existed, the exception
would only apply if a specific assignment had been proposed by the debtor and
rejected by the nondebtor party.8

Moreover, the court also concluded that it was premature to determine whether
the Anti-Assignment Act constituted an "applicable law" precluding
assignment, since the act itself contained exceptions to its general prohibition
on the assignment of federal contracts.9 Thus, the court ruled that by its own
terms, the Anti-Assignment Act could not be considered an applicable law until
an actual assignment was proposed that did not fall within the exception to
the general rule prohibiting assignment.
Unanswered Questions
While the Fifth Circuit technically adopted the actual test in relation to
the applicability of §365(e)(2), it did not address certain critical questions
due to the particular facts before it on appeal.
First, because BPA had conceded on the record that there was no assignment
in fact of the agreement, the court expressly left open the question of whether
the mere change in status from a debtor to a DIP constituted an actual assignment
in violation of the Anti-Assignment Act. If a filing did result in such an assignment,
there would be no real distinction between the actual test and the hypothetical
test in the Fifth Circuit, as the Anti-Assignment Act would trigger §365(e)(2)
under either test immediately upon a bankruptcy filing.
Second, because MAEM had not moved to assume the agreement, the court did not
consider whether the mere assumption of a federal contract by a DIP constituted
an assignment from debtor to a DIP in violation of the Anti-Assignment Act.
As such, even if an impermissible assignment did not automatically occur upon
the filing, it remains an unsettled question in the Fifth Circuit whether the
attempted assumption of a federal contract (or other nonassignable contract)
by a DIP triggers the §365(e)(2) exception entitling the government counterparty
to seek relief to terminate the agreement.
Finally, while the Fifth Circuit did acknowledge that it had previously recognized
the ride-through doctrine under which an agreement may pass through a bankruptcy
case without being either assumed or rejected, Id. at *12, fn. 1911,
it did not address the question of whether, and to what extent, the provisions
of §365(e)(2) invalidating ipso facto clauses would apply to a contract
that has ridden through a bankruptcy case. This is a particularly critical question
because some courts that have applied the doctrine have held that ride-through
differs from formal assumption in that, unlike a formal assumption, the debtor
must fully comply with the agreement and cannot, for example, rely on the exceptions
to cure contained in §365(b)(2). These courts conclude that with ride-through,
a debtor may not ignore an ipso facto default or a penalty rate, as the
doctrine demands complete fidelity with the contractual terms of the agreement.11

Conclusion
 In the abstract, the Fifth Circuit's adoption of the actual test when considering
the applicability of the §365(e)(2) exception to the court's general invalidation
of ipso facto provisions is certainly welcome news for debtors. However,
the narrowness of the language of the ruling leaves many questions unanswered,
including whether the test as applied in the Fifth Circuit will ultimately lead
to a different result than the application of the hypothetical test. For these
reasons, debtors in the Fifth Circuit will need to tread carefully around these
issues for the foreseeable future.
<h3>Footnotes</h3>
 1 The term ipso facto refers to a provision in an agreement that is
triggered merely upon the happening of an event rather than upon an action or
failure to act on the part of a party to the agreement.
2 Section 365(c) provides, inter alia, that a debtor may not "assume
or assign an executory contract or unexpired lease...if applicable law excuses
the [nondebtor party]...from accepting performance from or rendering performance
to an entity other than the debtor or the DIP...." Section 365(e)(2) provides,
inter alia, that the court may not invalidate an ipso facto provision
"if applicable law excuses [the nondebtor party]...from accepting performance
from or rendering performance to the trustee or to an assignee of such contract
or lease...." (emphasis added).

3 The Fifth Circuit did not address the applicability of the actual test or
the hypothetical test in the context of §365(c).
4 White & Case LLP acted as lead counsel to Mirant and its subsidiaries
in the bankruptcy cases.
5 Unfortunately for BPA, the debtors commenced their cases prior to the adoption
of BAPCPA. Prior to the adoption of BAPCPA, in order to fall within the definition
of a "forward contract merchant" (11 U.S.C. 101(26)), an entity was
required to be a "person" as defined in §101(41) of the Code,
which, except in very limited circumstances not applicable to BPA, does not
include a governmental unit such as BPA. Under BAPCPA, the definition of "forward
contract merchant" was amended, inter alia, to delete the term "person"
and to replace it with the term "entity." The term "entity"
includes governmental units. Therefore, had the debtors' bankruptcy cases been
commenced after the effective date of BAPCPA (generally, Oct. 17, 2005) the
court might have ruled that BPA was entitled to terminate the agreement without
first seeking relief from the automatic stay.
6 The Anti-Assignment Act provides that: No contract or order, or any interest
therein, shall be transferred by the party to whom such contract or order is
given to any other party, and any such transfer shall cause the annulment of
the contract or order transferred, so far as the United States is concerned.
41 U.S.C. §15(a).
7 Apparently, the Third Circuit did not consider the applicability of the "ride-through
doctrine" when considering the debtor's options after ruling that the contract
was not capable of being either assumed or assigned. Under the ride-through
doctrine, an executory contract or unexpired lease may pass through a chapter
11 case without being either assumed or rejected and remain an obligation of
the reorganized debtor. The theory is based on the view that nothing in the
Code requires a debtor in a chapter 11 case to assume or reject an executory
contract or unexpired lease during the case. Most courts that have applied the
theory have concluded that an executory contract that has neither been assumed
nor rejected will simply "ride through" the chapter 11 case unaffected
and the reorganized debtor will be required to perform as though the bankruptcy
had not happened.
8 Having adopted the actual test, the Fifth Circuit naturally concluded that
the automatic stay must take precedence over a nondebtor's right to enforce
an ipso facto provision. The court ruled that MAEM's interest in the
agreement, even if ultimately terminable, became property of the estate on the
petition date subject to court review.
9 The Anti-Assignment Act contains an exception to the rule prohibiting assignment
were "the moneys due or to become due from the United States...under a
contract providing for payments aggregating $1,000 or more, are assigned to
a bank, trust company or other financing institution." 41 U.S.C. §15(b).
10 Citing Century Indem. Co. v. NGC Settlement Trust (In re Nat'l.
Gypsum Co.), 208 F. 3d 498, 504 n. 4 (5th Cir. 2000).

11 In re Hernandez, 287 B.R. 795, 800 (Bankr. D. Ariz 2002) ("a
contract that is not assumed is not entitled to the benefits afforded by 11
U.S.C. §365 such as insulation from ipso facto provisions or the
right to cure arrearages within a reasonable period of time notwithstanding
what the payment terms of the contract might be").

Journal Authors

Evan C. Hollander

Journal Date

Monday, May 1, 2006 - 12:00

Bankruptcy Rule

2006

362

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