Holding that a surety bond is not an executory contract, the Fifth Circuit also said that a triangular contract might be an executory contract in some circumstances, even if the creditor owes no further performance to the debtor.
In addition, the Fifth Circuit opened the door for courts to employ the so-called functional approach in deciding whether multiparty contracts can be executory contracts susceptible to assumption.
The Surety Bonds
The debtor was a producer of oil and gas in chapter 11. Before bankruptcy, it acquired four irrevocable performance bonds securing the debtor’s obligations for environmental liabilities and for plugging and abandoning wells. The bonds were accompanied by an indemnity agreement where the debtor agreed to indemnify the bonding company if it were called on the bonds.
The insurance company’s obligations to the third party obligees were irrevocable. That is to say, even if the debtor were to fail to pay premiums or default on its obligations to the bonding company, the bonding company would remain liable to the obligees.
The insurer was liable for a maximum of about $10.6 million on the bonds, for which the insurer held some $3.2 million in cash to secure the bonding company’s obligations were claims to be made on the bonds.
The bonding company filed a secured claim for $3.2 million and an unsecured claim for the difference, $7.4 million. In the claim, the insurer said that the bonds were financial accommodations that the debtor could not assume or assign.
The Confirmed Plan
On motion of the debtor near the outset of reorganization, the bankruptcy court authorized the debtor to “continue and maintain” the surety bonds and to pay obligations under the bonds as they came due.
The plan said that executory contracts were deemed assumed unless they were listed for rejection, but the bonds were not on the list of rejected executory contracts.
After confirmation, the debtor failed to pay a premium on the bonds. The bonding company responded by demanding $7.3 million more in collateral. The debtor refused, accusing the bonding company of violating the discharge injunction.
To resolve the dispute, the bonding company filed a motion for a declaration that the bonds were among executory contracts assumed automatically on confirmation.
Bankruptcy Judge Douglas D. Dodd of Baton Rouge, La., agreed with the debtor. He held that the bonds were not executory contracts capable of assumption. And if they were executory, he said they were financial accommodations incapable of assumption.
The surety had an allowed secured claim for $3.2 million, but Judge Dodd disallowed the surety’s unsecured claim for $7.3 million, because there had been no call on the bonds, and the claim was contingent.
The Appeal to District Court
The bonding company appealed to the district court and lost. Argonaut Ins. Co. v. Falcon V LLC, 20-00702, 2021 BL 374472 (M.D. La. Sept. 30, 2021). To read ABI’s report, click here.
Like the bankruptcy judge, District Judge Brian A. Jackson held that the contract was not executory. Judge Jackson also held that the surety bonds could not “pass through” or “ride through” bankruptcy because riding through only applies to executory contracts that were neither assumed nor rejected, and the surety bonds were not executory.
Although not recited in the Fifth Circuit affirmance on October 11, several other facts from the record are of import.
The surety has not been called on the bonds because the debtor, both before and after bankruptcy, continued to perform its obligations regarding the plugging and abandonment of wells. Similarly, the debtor had assumed leases for the wells, thus taking on post-confirmation responsibilities for obligations that would be covered by the bonds.
A finding that the surety bonds had been assumed as executory contracts would have had consequences for the debtor. Requiring the debtor to post an additional $7.3 million in favor of the surety would have resulted in a breach of the debtor’s post-confirmation financing arrangements.
The Circuit Affirms: No Executory Contract
Under the plan, the debtor would have assumed the surety bonds automatically if they indeed were executory contracts. To determine whether the bonds were executory, Circuit Judge Stephen A. Higginson said that the “vast majority of circuits have adopted” the definition of executory contracts developed by Prof. Vern Countryman of Harvard Law School.
The professor called a contract 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).
The bankruptcy and district courts both had ruled that the bonds were not executory because the bonding company owed no further obligations to the debtor, only to the obligees. The bonding company countered by arguing that the Countryman definition should be modified to take into account the surety’s unperformed obligations to the obligees.
Judge Higginson did not accept the invitation. He said:
We decline to adopt [the surety’s] proposed modification to the Countryman test. [The surety] offers no authority in support of the modification, and it makes no attempt to explain how the modification would further the test’s goal of “facilitat[ing] the debtor’s rehabilitation” by giving debtors discretion to assume or reject those contracts “where there can be uncertainty if the contract is a net asset or liability for the debtor.” In re Weinstein Co. Holdings, 997 F.3d 497, 504–05 (3d Cir. 2021).
Judge Higginson added, “[The surety’s] proposed test seems designed simply to elevate the rights of sureties above those of other creditors.”
Then, Judge Higginson added a new wrinkle to Fifth Circuit law. He said that two circuits have adopted “the ‘functional approach,’ under which ‘the question of whether a contract is executory is determined by the benefits that assumption or rejection would produce for the estate.’”
Agreeing with the surety, Judge Higginson said:
[C]ourts should apply the Countryman test to multiparty contracts in a flexible manner that accounts for the various obligations owed to all of the parties, rather than focusing exclusively on the flow of obligations between the debtor and the creditor. [Emphasis in original.]
Judge Higginson said he could “imagine . . . a tripartite agreement under which [the debtor] owes performance to a creditor, the creditor owes performance to a third party, and the third party owes performance to the debtor.” In such a case, he said, “we consider not just the obligations that [the debtor] and [the surety] owe to each other but also their respective obligations to the third-party obligees.”
Still, the modification would not avail the surety, Judge Higginson said, because the surety owed no more obligations to the debtor, since the surety had posted irrevocable bonds. Rather, the surety’s remaining obligations were to the obligees.
Even applying the Countryman test “in this flexible manner,” Judge Higginson said that bonds would fail the text “because [the debtor’s] failure to perform would not excuse [the surety] from performing.”
Judge Higginson upheld the two lower courts by ruling that the bonds were not executory contracts under the Countryman test and thus were not assumed automatically under the plan. He listed one district court and three bankruptcy courts with decisions holding that surety bonds are not executory contracts.
No Ride-Through
In one paragraph, Judge Higginson dismissed the surety’s argument that the bonds rode through bankruptcy.
Because the bonds were not executory contracts, he said they were not subject to assumption, rejection or ride-through.
Functional Approach to Triangular Agreements
Judge Higginson said that the “Countryman test, flexibly applied,” in itself was sufficient to decide that the bonds were not executory contracts. He noted that neither the bonding company nor the debtor had asked the appeals court to apply a functional analysis.
In a footnote, Judge Higginson said that “future courts should not consider foreclosed the possibility that the functional approach should be adopted for multiparty contract cases.”
Holding that a surety bond is not an executory contract, the Fifth Circuit also said that a triangular contract might be an executory contract in some circumstances, even if the creditor owes no further performance to the debtor.
In addition, the Fifth Circuit opened the door for courts to employ the so-called functional approach in deciding whether multiparty contracts can be executory contracts susceptible to assumption.