Imagine that Hal Steinbrenner agreed to purchase the Boston Red Sox from John Henry, Tom Werner and Larry Lucchino. All three signed non-compete agreements promising to buy no interest in an MLB team for the next five years. Steinbrenner made a $1 billion down payment, and MLB Commissioner Rob Manfred signed off on everything. But shortly after all the parties signed the final contract, Steinbrenner filed a bankruptcy petition.
Now you have an executory contract. Many courts follow Prof. Vern Countryman’s definition of an executory contract: “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.”[1] The definition is difficult to apply, but this is an executory contract because “nonperformance by either party would excuse the other.”[2] Here, Steinbrenner would excuse performance by the sellers if he failed to pay the remaining billions of dollars to buy the Boston Red Sox in a timely manner. And the sellers would excuse performance by Steinbrenner if they bought a controlling interest in the New York Mets the next season.
What would happen if the parties modified their agreement following Steinbrenner’s chapter 11 filing? In a recent decision by the U.S. Bankruptcy Court for the Eastern District of North Carolina, Judge Callaway addressed such a scenario, finding that a modified agreement “was authorized and effective without necessity of notice or hearing” because it “occurred in the [d]ebtor’s ordinary course of business.”[3]
Agreement with Stiletto to Manufacture a Custom Catamaran
Stiletto Manufacturing Inc. manufactured and sold custom catamaran boats in Columbia, N.C.[4] Before commencing its bankruptcy proceeding, Stiletto agreed to build a 30-foot custom catamaran in its XC model line for John Enderle.[5] In return, Mr. Enderle made a down payment and agreed to make subsequent periodic progress payments.[6] This was the “Original Agreement.”[7] Less than one year later, Stiletto filed for bankruptcy.[8] In its schedules, Stiletto identified an agreement with Mr. Enderle as an executory contract.[9]
Nearly two months after filing its bankruptcy petition, Stiletto agreed with Mr. Enderle to modify the Original Agreement in writing.[10] This was the “Modified Agreement.”[11] By agreeing to buy a catamaran with fewer custom features and different materials for some parts of the boat, Mr. Enderle obtained a significant price reduction and a promised expedited completion date.[12] This is when specific dates became important. The parties entered into the Modified Agreement on April 27.[13] Stiletto agreed to complete construction of the boat by June 15.[14] But Mr. Enderle filed a motion for relief from the automatic stay in late May — in between those two dates — and visited Stiletto’s facility several times up to around the time of the promised completion in mid-June.[15] He wanted relief from the automatic stay to get the boat that he paid for.[16] A creditor named CapitalNexus responded, however, in opposition to Mr. Enderle’s motion.[17]
The Boat Builder and the Buyer Acted in the Ordinary Course of Business
Stiletto was authorized to operate its business as a debtor in possession under §§ 1107 and 1108.[18] As a debtor in possession, Stiletto could enter into transactions without court approval under § 363(c)(1) if those transactions occurred within Stiletto’s ordinary course of business.[19] To analyze whether a transaction occurs within the ordinary course of a debtor’s business, courts examine two dimensions of the transaction: horizontal and vertical.[20] The horizontal dimension test considers the perspective of other companies in the same industry as the debtor; the vertical dimension test considers that of creditors in a similar situation.[21]
The court found that Stiletto’s transactions — entering into the Original and Modified Agreements — met both tests.[22] First, the transactions met the horizontal-dimension test because custom boat builders often make contract adjustments for payment and completion dates.[23] Second, the transactions met the vertical-dimension test because creditors such as CapitalNexus had no appreciably different kind of risk with the Modified Agreement as they had with the Original Agreement.[24] Stiletto’s transactions fell within the reasonable expectations of its creditors and other interested parties.[25]
The Buyer Can Take Possession of the Catamaran
When Stiletto commenced its bankruptcy proceeding, the Original Agreement was an executory contract.[26] The parties disputed, however, whether Stiletto and Mr. Enderle could rescind the executory contract post-petition in the ordinary course of business without court approval.[27] Mr. Enderle wanted the rescission — by way of the Modified Agreement — to require no court approval so that it could quickly receive possession and delivery of the boat that it paid for.[28] CapitalNexus wanted the court to review the Modified Agreement and reject it as an executory contract so that it could be paid more upon the liquidation of Stiletto’s estate.[29] After a hearing, the court concluded that the Modified Agreement required no court approval because the agreement was made in the ordinary course of Stiletto’s business.[30] In sum, the court authorized Mr. Enderle to take possession of the boat once he paid all sums due under the contract.[31]
The court primarily relied on Biggs to rule in favor of Mr. Enderle.[32] In Biggs, a debtor in possession and a licenser executed a modified licensing agreement post-petition.[33] As in this case, the court in Biggs held that the mutual modification of an executory contract post-petition required no court approval because the parties acted in the ordinary course of business.[34] Under § 365, however, a debtor in possession needs court approval to assume or reject any executory contract of the debtor. To resolve the conflict, the court in Biggs differentiated mutual modification of an executory contract (under § 363(c), possible without court approval) from unilateral rejection of an executory contract (under § 365, impossible without court approval).[35] And the court in Stiletto found that this conclusion was consistent with the policy goals of the statute.[36] If a debtor in possession acts in the ordinary course of business, it deserves the right to quickly modify or rescind an executory contract without seeking court approval.[37] The court observed in Stiletto that such a result encourages efficient reorganizations of struggling bus
[1] 10 William L. Norton Jr. & William L. Norton III, Norton Bankruptcy Law and Practice § 365 (3d ed. 2018) (quoting Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973)).
[2] 3 Richard Levin & Henry J. Sommer, Collier on Bankruptcy § 365.02 (16th ed. 2018).
[3] In re Stiletto Mfg. Inc., 588 B.R. 762, 772 (Bankr. E.D.N.C. 2018).
[4] Id. at 764.
[5] Id.
[6] Id.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] Id.
[12] Id.
[13] Id.
[14] Id.
[15] Id. at 764-65.
[16] Id. at 765.
[17] Id.
[18] Id. at 769.
[19] Id. at 768.
[20] Id. at 769.
[21] Id. (citing In re Roth Am. Inc., 975 F.2d 949, 953 (3d Cir. 1992)).
[22] Id. at 770-71.
[23] Id. at 770.
[24] Id. at 771.
[25] Id.
[26] Id. at 765.
[27] Id.
[28] Id.
[29] Id.
[30] Id.
[31] Id. at 772.
[32] Id. at 766-68 (citing Biggs, Inc. v. Glosser Bros. Inc. (In re Glosser Bros. Inc.), 124 B.R. 664 (Bankr. W.D. Pa. 1991)).
[33] Id. at 766.
[34] Id. at 767.
[35] Id.
[36] Id.
[37] Id.