Third Circuit Judge Thomas L. Ambro found an exception to the general rule that a debtor must cure defaults before selling a contract.
If the non-debtor counterparty has no remaining material obligations, the debtor may sell or assign the contract without curing monetary defaults owing to the counterparty, and the non-debtor cannot require the buyer to cure pre-petition monetary defaults.
The counterparty only has a pre-petition unsecured claim against the debtor, according to Judge Ambro.
In his May 21 opinion, Judge Ambro has identified an aspect of the so-called Countryman definition of executory contracts that undercuts the general notion that debtors must cure defaults before selling or assigning contracts.
As Judge Ambro said, “This pill is bitter to swallow, but bankruptcy inevitably creates harsh results for some players.” However, Judge Ambro explained how parties can draft their contracts to avoid the result.
The Movie Producer’s Contract
An individual, whom we shall call the producer, had a contract to produce a movie for a movie company. In the movie business, it’s called a work-made-for-hire contract where the producer produces the movie, but the movie company owns all of the intellectual property.
In this case, the producer was paid $250,000 for producing the movie, plus contingent future payments equal to some 5% of the movie’s net profits. The movie was a success. A cast member won the Academy Award for Best Actress.
By the time the movie company filed a chapter 11 petition years later, the movie company owed the producer an additional $400,000.
In chapter 11, a purchaser bought the movie company’s assets along with the right to designate executory contracts for assumption and assignment. The buyer filed a declaratory judgment action asking Bankruptcy Judge Mary F. Walrath in Delaware to rule that the contract was not executory and had already been sold.
Bankruptcy Judge Walrath granted summary judgment in favor of the purchaser. The district court affirmed, prompting an appeal to the Third Circuit.
The Countryman Definition
The outcome turned on an extrapolation from the definition of “executory contracts” proposed by Harvard Law Professor Vern Countryman. See Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439 (1973). The Third Circuit adopted the Countryman definition.
Prof. Countryman defined an executory contract as “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 performance of the other.” Id. at 460.
In turn, Judge Ambro said that a “material unperformed obligation” is determined by state law, in this case New York law chosen by the parties to govern the contract. Combining the Countryman definition with state law, Judge Ambro said there is an executory contract if “each side has at least one material unperformed obligation as of the bankruptcy petition date.”
Judge Ambro described an executory contract as a bundle of assets and liabilities. From the point of view of the debtor, the performance owed by the debtor is a liability, while the performance due from the contract party is an asset. When the contract party has fully performed but the debtor has not, he said that the contract is “not executory because it is only a liability for the estate.”
If the contract is not executory, Judge Ambro said that it can be sold without curing defaults under Section 363 just “like any other liability or asset.” On the other hand, the “buyer must typically fulfill obligations under the contract it bought after the sale closes, just as it would with any other asset or liability.”
Should there be no buyer, the counterparty would be left with only an unsecured claim, Judge Ambro said.
Judge Ambro saw “no fairness concerns” when the counterparty has fully performed and retains only an unsecured claim, even when the contract is sold without cure. He said that the counterparty “should simply be grateful that someone agreed to buy its contract and assume obligations after the sale’s closing.”
Did the Non-Debtor Fully Perform?
Having laid out the law, Judge Ambro applied the law to the facts, first to determine whether there were material unperformed obligations making the contract executory.
The debtor’s obligations to make contingent payments were “clearly material,” Judge Ambro said. The same could not be said for the obligations of the producer.
The contract called for the producer “to produce the Picture in exchange for money. Thus, he contributed almost all his value when he produced the movie,” Judge Ambro said. In the movie industry, Judge Ambro cited the Ninth Circuit for the notion that “the employee in a work-made-for-hire contract usually does not have material obligations after the work is completed despite ancillary negative covenants or indemnification obligations.”
In the case on appeal, Judge Ambro said that the producer’s remaining obligations were not material because they were “all ancillary after-thoughts in a production agreement.”
Because the producer had no remaining material unperformed obligations, the contract was not executory, and the debtor could sell the contract without curing the $400,000 default.
Parties May Change the Outcome by Contract
Judge Ambro said that the parties “can contract around” the substantial performance rule and thereby “override the Bankruptcy Code’s intended protections for the debtor.”
The producer argued that the contract indeed altered the substantial performance rule by declaring that the unperformed obligations by the producer were material. Judge Ambro rejected the argument, because the contract “did not clearly and unambiguously avoid the substantial performance rule for evaluating executory contracts.”
Observations
In the view of Prof. Stephen J. Lubben, it’s “a nicely written opinion, although it does not take up the suggestion of Tempnology that we might analyze contracts and leases in a more straightforward way, with a bit less emphasis on the late Professor Countryman’s notion of executoryness. Indeed, Judge Ambro even suggests that the parties might be able to control, by contract, whether or not their agreement is subject to Section 365, which itself suggests to me that we are asking the concept of executoryness to do too much work.”
Prof. Lubben is the Harvey Washington Wiley Chair in Corporate Governance & Business Ethics at Seton Hall University School of Law.
The professor is on the right track. For example, consider the implications of the opinion with regard to sales of intellectual property.
Assume that a writer sold a book and all its intellectual property to a publisher in return for a small payment up front and a percentage of sales thereafter. Applying the Third Circuit’s analysis, the publisher could file bankruptcy and either retain or sell the intellectual property without curing defaults.
Presumably, the publisher or the buyer must pay royalties on later sales, but the most lucrative royalties might have been produced before bankruptcy. Under general notions of contract law, why doesn’t the publisher’s default and breach of contract mean that the intellectual property reverted to the writer?
Assuming Prof. Countryman pronounced the correct definition for executory contracts to apply in all circumstances, and also assuming that Judge Ambro reached the proper conclusion that the producer’s remaining obligations were not material, the result seems correct. But what about the effect of the debtor’s breach of contract? Why didn’t ownership of the intellectual property revert to the producer following the debtor’s breach?
Because the Countryman definition has been adopted as a matter of judge-made law, courts have the power to make exceptions to the definition if the outcome seems at odds with the general notions about intellectual property and curing defaults before selling contracts in bankruptcy.
The opinion leaves open an interesting question. The movie company debtor had a right of first refusal covering sequels. Can the buyer enforce the first-refusal right without curing the pre-bankruptcy defaults, or were those claims cut off by the sale “free and clear”?
If the producer can never require the purchaser to pay $400,000 to enforce the right of first refusal, it seems as though the right of first refusal was a material, unperformed, bilateral provision in the contract.
In that regard, Judge Ambro said that the “buyer must typically fulfill obligations under the contract it bought after the sale closes, just as it would with any other asset or liability.” Does that language imply that the producer can or cannot enforce the right of first refusal (or perhaps other rights under the contract) without paying $400,000?
Third Circuit Judge Thomas L. Ambro found an exception to the general rule that a debtor must cure defaults before selling a contract.
If the non-debtor counterparty has no remaining material obligations, the debtor may sell or assign the contract without curing monetary defaults owing to the counterparty, and the non-debtor cannot require the buyer to cure pre-petition monetary defaults.
The counterparty only has a pre-petition unsecured claim against the debtor, according to Judge Ambro.
In his May 21 opinion, Judge Ambro has identified an aspect of the so-called Countryman definition of executory contracts that undercuts the general notion that debtors must cure defaults before selling or assigning contracts.
As Judge Ambro said, “This pill is bitter to swallow, but bankruptcy inevitably creates harsh results for some players.” However, Judge Ambro explained how parties can draft their contracts to avoid the result.