Contract Assumption – A Potent Defense to Preferences and Fraudulent Transfers

Bankruptcy attorneys are familiar with the statutory defenses to preferences and fraudulent transfers. Less familiar is the so-called “contract assumption defense.” Courts have employed that non-statutory defense to bar preferences and fraudulent transfers based on three primary arguments:

1. The debtor is judicially or equitably estopped from arguing that pre-petition payments under an executory contract or unexpired lease were improper and must be avoided when, during the bankruptcy case, the debtor successfully argued that assumption of the contract or lease cum onere is in the best interests of the estate;
2. The requirement of § 365(b) that all defaults must be cured for an executory contract or an unexpired lease to be assumed is irreconcilable with preferences and fraudulent transfers seeking to reverse pre-petition payments that, had they not been made pre-petition, would have been required by § 365(b) to be made;[1] and
3. Assumption of executory contracts and unexpired leases in and of itself and as a matter of law is proof that the contract or lease counterparty receiving the challenged pre-petition payments provided reasonably equivalent value for those payments.

The contract assumption defense is powerful as it can be successfully raised by a motion to dismiss.[2] The defense, however, only applies to payments under the assumed contract, not those outside of it.[3]

Preferences

The contract assumption defense to preferences is well-established. For example, in In re Superior Toy & Manufacturing Co.,[4] the Seventh Circuit invoked it to bar a preference action relating to a pre-petition payment under an assumed contract: “We believe Congress passed § 365 to ensure that a contracting party is made whole before a court can force the party to continue performing with a bankrupt debtor. Permitting a preference suit after an assumption order would undermine that purpose…. Section 365 was clearly intended to ensure that the contracting parties receive the full benefit of their bargain if they are forced to continue performance.”[5] Based on this reasoning, the Seventh Circuit held that “[a]n assumption order divests the trustee of subsequent claims to monies paid under the contract whether they were paid prepetition or postpetition.”[6] Numerous cases are in accord.[7]

Fraudulent Transfers

The contract assumption defense has also been extended to fraudulent transfers in six bankruptcy court cases and one district court case.[8] To date, no U.S. court of appeals has spoken on the subject.

Constructive Fraudulent Transfers

Courts most frequently extend the contract assumption defense to constructive fraudulent transfers. For instance, last year, in In re HH Liquidation LLC,[9] the Delaware Bankruptcy Court rejected the committee’s attempt to recover lease payments under assumed leases as constructive fraudulent transfers where the debtors had successfully argued that assumption of the leases was in the best interest of the debtors: “It would not have been a ‘sound exercise of [debtors’] business judgment to assume the [leases] if it was not receiving equivalent value for the payments it was making under the agreements.’….”[10] This ruling was nothing new in Delaware. In a 2005 case, In re Vision Metals Inc.,[11] the bankruptcy court likewise held that judicial estoppel barred the debtor from asserting that certain contracts (and payments made under them) should be voided as constructively fraudulent.[12]

Non-Delaware Bankruptcy Court cases likewise have long applied the contract assumption defense to constructive fraudulent transfers. In In re Centrix Financial LLC,[13] for instance, the Colorado bankruptcy court barred a constructive fraudulent transfer claim based on that defense: “In this case, the Trustee alleges that the Debtor received less than reasonably equivalent value in exchange for the payments on the contract. The Court fails to comprehend, however, how the Trustee can now claim that the estate did not receive reasonably equivalent value for making payments under a contract that, presumably, was valuable enough to the estate to merit assumption and assignment.”[14]

Actual-Intent Fraudulent Transfers

Three bankruptcy courts have further extended the defense to actual-intent fraudulent transfer claims.[15] The Delaware bankruptcy court in Network Access Solutions, for instance, reasoned that “[a]n agreement cannot be in a debtor’s sound business judgment if the transfers under the agreement were made with the actual intent to hinder, delay and defraud creditors. Good faith — the foundation of the business judgment test — cannot co-exist with actual fraud.”[16] The Greater Southeast Community Hospital bankruptcy court reached the same result, albeit on different grounds: “Once a trustee … obtains an order assuming an executory contract, the trustee’s avoidance powers may not be brought to bear. This follows because assumption of an executory contract carries with it all of the benefits and burdens of the contract…. Under § 365(b)(1), a debtor is required to cure all defaults … as a condition to assuming the contract. Treating payments made under such an assumed contract as subject to a trustee’s avoidance powers would be inconsistent with having accepted the burdens of the assumed contract, and the obligation fully to perform under the contract.”[17] “Once the assumption power is exercised … pursuit of a trustee’s … avoidance power is barred as inconsistent with such assumption.”[18]

Conclusion

Before deciding to assume an executory contract or unexpired lease, debtors and creditors’ committees should carefully consider whether assumption will result in the loss of any valuable avoidance actions that they might later want to bring. Conversely, when landlords and contract counterparties find themselves defending against preference and fraudulent transfer actions, they should promptly evaluate whether the transfers sought to be avoided are pursuant to assumed executory contracts or unexpired leases, and if so, they should consider an early motion to dismiss to defeat those claims.