Bankruptcy Judge Michelle M. Harner of Baltimore, a law professor at the University of Maryland before ascending to the bench last year, has written a primer on executory contracts, exploring the degree of “executoriness” required before a contract can be rejected under Section 365.
Although the facts of the case easily led to the outcome, Judge Harner’s March 13 opinion is required reading with regard to some of the finer points regarding executory contracts and Section 365.
Before the chapter 11 filing, the plaintiffs in state court alleged that the debtors committed fraud in connection with the sale of a business. In a settlement conference before a judge in state court, the parties agreed to a settlement through their counsel.
The settlement called for the debtors to transfer a business and make a cash payment to the plaintiffs. In return, the plaintiffs would dismiss litigation and note that a judgment had been satisfied. The settlement included a non-disparagement agreement, or NDA.
After the settlement was reduced to writing, the debtors refused to sign, claiming that the plaintiffs had already breached the NDA. The plaintiffs returned to state court, where the judge made an oral finding that there was an enforceable settlement, albeit unsigned. When the debtors still did not sign the settlement agreement, the plaintiffs scheduled a hearing to hold the debtors in contempt. The contempt hearing never took place because the debtors filed a chapter 11 petition.
In bankruptcy court, the debtors filed a motion to reject the settlement agreement as an executory contract under Section 365. The plaintiffs opposed, contending that the agreement was not executory and thus not subject to rejection.
Judge Harner held a hearing, heard testimony from witnesses, and considered the proceedings in state court. She concluded that the settlement was executory and allowed the debtors to reject. However, she did not rule on the nature of the claim or other relief to which the plaintiffs would be entitled.
First, Judge Harner had to decide whether there was a contract that could be rejected. The oral ruling in state court could not be enforced under the rubric of claim or issue preclusion because it had not been incorporated into a judgment. Nonetheless, Judge Harner said she was unwilling to ignore the findings in state court.
Judge Harner ruled there was an enforceable contract under Maryland law because there was a general agreement negotiated by counsel and because the debtors acknowledged that the lawyer was their agent.
Next, Judge Harner dealt with the question of whether the contract was executory and therefore subject to rejection. To decide whether a contract remains executory, she said there are two tests, the so-called Countryman test and the “functional test.”
Named after a 1973 law review article by Prof. Vern Countryman, the Countryman test says that a contract is executory if the obligations of both parties are so far unperformed that a failure of either to complete performance would be a material breach excusing the other from performance.
The functional test, formulated by Prof. Jay Westbrook in a 1989 law review article, only analyzes whether assumption or rejection would benefit the estate. Judge Harner cited the report of the ABI Commission to Study the Reform of Chapter 11 for its discussion of the two theories. Judge Harner was the reporter for the ABI Commission.
Selecting between the two tests was no challenge because the Fourth Circuit has adopted the Countryman test, Judge Harner said.
Employing the Countryman test, Judge Harner turned to Maryland law. Although any breach gives rise to an action for damages in Maryland, only a material breach relieves the other of the obligation to perform.
Without much ado, Judge Harner concluded that both parties had several material unperformed obligations. Significantly, she decided that the NDA itself was a material unperformed obligation because it serves a “core purpose of the settlement agreement.”
Having decided that the settlement agreement was an executory contract susceptible to rejection, Judge Harner said that the record supported the debtor’s decision to reject the agreement as an exercise of business judgment, because performance would entail transferring a business and making a cash payment.
Judge Harner concluded her opinion by saying that rejection amounted to a breach occurring immediately before filing, under Section 365(g). However, she said she was not addressing the parties’ rights following breach, the amount of any resulting claims, or the treatment of the claims in chapter 11.
“Notably,” Judge Harner said in what may be dicta, the Fourth Circuit had ruled in Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc., 756 F.2d 1043, 1048 (4th Cir. 1985), that the consequences of breach in the context of rejection “do not include the right to request specific performance.”
The plaintiffs contended that if the agreement was not executory, they could make a claim for specific performance. Although the discussion is dicta, Judge Harner said the argument was “speculative at best” because the broad definition of “claim” encompasses claims for equitable relief. In addition, specific performance is “rare” in Maryland and is “often reserved” for transfers of real property, she said.