Puerto Rico Case and the Efficacy of Prof. Westbrook’s Definition of ‘Executoriness’

A decision by the district court in restructuring Puerto Rico’s debt demonstrates the gyrations a court must sometimes undertake to conclude that a contract is capable of assumption under the “Countryman” definition of an executory contract.

Rather than decide whether a contract is executory under the dueling “Countryman” and “functional” definitions of executoriness, this writer instead recommends adoption of the “Modern Contract Analysis” proposed by Prof. Jay L. Westbrook and Kelsi S. White in “The Demystification of Contracts in Bankruptcy,” 91 Am. Bankr. L.J. 481 (Summer 2017). Prof. Westbrook occupies the Benno C. Schmidt Chair of Business Law at the University of Texas School of Law.

The Class Action Insurance Settlements

When auto owners in Puerto Rico register their vehicles, they pay auto insurance premiums to the commonwealth government. If an owner has private insurance, the owner is entitled to a refund of the premium paid to the government.

Two class actions were filed seeking refunds for auto owners who had private insurance but paid for duplicate insurance between 1998 and 2010. One suit was in a commonwealth court, and the other was in federal district court in Puerto Rico.

The suits were settled at least in principle before Puerto Rico and its instrumentalities initiated their debt adjustments in district court in Puerto Rico in 2017 under the Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA (48 U.S.C. §§ 2161 et. seq.). PROMESA incorporates large parts of the Bankruptcy Code, including Section 365 and law on assuming executory contracts.

Acting as the representative of the commonwealth in the debt-adjustment cases, the Financial Oversight and Management Board for Puerto Rico filed a motion to assume the settlements as executory contracts under Section 365. The official creditors’ committee objected, contending that the settlements were not executory, and if they were, that assumption did not satisfy the business judgment standard.

District Judge Laura Taylor Swain overruled the objections in an opinion on June 29. She concluded that the settlements were executory and that the Oversight Board exercised sound business judgment in deciding to assume the settlements as executory contracts. Judge Swain ordinarily sits in the Southern District of New York but was tapped by the Chief Justice to preside over the PROMESA proceedings.

The Two Definitions of ‘Executory’

Under Section 365(a), a trustee may assume or reject a contract if it is “executory.” The term is not defined in the Bankruptcy Code.

Judge Swain laid out two competing definitions of executory contracts:

(1) The so-called Countryman definition, where Prof. Vern Countryman of Harvard Law School proposed that a contract is executory if it is “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.” Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973); and

(2) The so-called functional approach, which, as explained by Judge Swain, works backward from the purposes to be accomplished by rejection. The contract is no longer executory if the purposes have been accomplished already.

Judge Swain said that “some courts” have moved away from the Countryman definition to the functional approach, believing that courts should not be bound by a static definition not appearing in the language of the statute.

Judge Swain first applied the Countryman test and found one narrow (if not contorted) basis for concluding that the contract remained executory because the plaintiffs had remaining obligations that would amount to breach if not performed.

Without much in the way of explanation, Judge Swain also decided that the contract was executory under the functional approach.

Having decided that the contract was available for assumption, Judge Swain asked whether the Oversight Board had properly exercised its business judgment.

Settlement would resolve a lawsuit kicking around for 20 years and end the commonwealth’s expenditures on counsel fees. The settlement would also avoid paying interest on the monies withheld from auto owners for so long.

Judge Swain authorized assumption of the settlements.

The Westbrook Approach

Prof. Westbrook told ABI that the result reached by Judge Swain was correct, but he went on to say that “the so-called ‘functional’ cases are a dead end, with the name taken from my first executoriness article but ignoring its analysis.”

In that regard, we have written several times in recent months about the sometimes baffling analysis and results that courts reach in applying the Countryman analysis or avoiding it. To read ABI discussions of recent cases on the Countryman definition, click here, here, here, and here.

To provide a more solid foundation for analysis, this writer recommends that courts embrace Prof. Westbrook’s Modern Contract Analysis.

Prof. Westbrook told ABI that he provides a “simple analysis and relates it to all the major lines of modern cases to show how it can light the way out of the labyrinth.”

The approach in the professor’s 2017 article “ensures that pre-bankruptcy bargains and entitlements will be changed in Chapter 11 only insofar as bankruptcy policies, like equality of treatment and rehabilitation of debtors, require alteration. Properly understood, the very process of acceptance or rejection is simply the trustee’s exercise of the opportunity every contract party has to perform or breach with whatever consequences non-bankruptcy law proscribes.” Westbrook, supra, 91 Am. Bankr. L.J. at 535.