Sandi Abdelshehed

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff

Section 365 of Title 11 of the United States Code (the “Bankruptcy Code”) allows a debtor to assume or reject an executory contract.^[1] Under section 365, a debtor may also assign an assumed contract unless restricted by another provision. Section 365(c)(1), for instance, restricts a trustee from assuming or assigning an executory contract if applicable law allows the non-debtor party to refuse performance from someone other than the original debtor.^[2] Thus, a debtor may not be able to assume a contract if it cannot be assigned as a matter of law.  In determining whether an unassignable contract may be assumed, some courts use the “hypothetical test” while others use the “actual test.” Under the “hypothetical test,” a debtor may not  assume a contract if the nondebtor counterparty can refuse to accept performance from someone else even if the debtor has no intention to assume the contract.^[3] Under the “actual test,” a debtor is precluded from assuming a contract only if the debtor actually intends to assign the contract to a third party. Thus, under the actual test, the debtor may assume a contract that is not assignable under applicable law if it has no intention to assign it to a third party.^[4]

In In re Welcome Group, the United States Bankruptcy Court for the Southern District of Ohio was asked to approve a request by Hilliard Hotels Inc. (“Hilton”) to reject a franchise agreement (“Franchise Agreement”) entered into with Hilliard Hotels, LLC (the “Debtor”). Pursuant to the Franchise Agreement, the Debtor was authorized to operate a Hampton Inn hotel and use Hilton’s trademark and operational systems.^[5] In addition, the Debtor agreed to a $1,500,000 property improvement plan (“PIP”) to meet Hilton’s brand standards.^[6] The Debtor filed for bankruptcy and Hilton sought to lift the automatic stay to terminate the contract by claiming that the Debtor breached the agreement by failing to complete renovations on time.^[7] Hilton argued that the Debtor’s failure to complete the PIP constituted an incurable default, precluding the assumption of the Franchise Agreement and requested relief from the automatic stay.^[8] Hilton argued for the “hypothetical test,” while the Debtor advocated for the “actual test” emphasizing that it had no intention of assigning the contract and would suffer a significant financial burden if it could not continue to operate the Hampton Inn according to the Franchise Agreement.^[9] In adopting the actual test, the court concluded that the Debtor could assume the Franchise Agreement because the Debtor did not intend to assign it. Moreover, preventing the Debtor from assuming the agreement would undermine the purpose of chapter 11 relief of maximizing the value of the bankruptcy estate for creditors and facilitating the debtor's reorganization.^[10]

The Court chose the “actual test” because it believed it provides a “faithful interpretation of the statutory language.”^[11] According to the Court, section 365(c)(1) protects counterparties from being forced into business with anyone other than the debtor.^[12] The Court found that the "actual test" approach aligns with this intent and supports chapter 11's goal of aiding debtor reorganization.^[13] Further, section 365(c)(1) only bars assumption when a contract is assigned to a third party, not when the debtor assumes it without assignment.^[14] In contrast, the Court found that applying the hypothetical test would render other provisions redundant such as section 365(f), which enables the assignment of executory contracts by overriding anti-assignment clauses, requiring the contract to be assumed and the assignee to provide adequate assurance of future performance, and preventing termination or modification due to assignment. Applying the "hypothetical test" renders section 365(f)(1) redundant, as section 365(f)(1) invalidates contract terms prohibiting assignment.^[15] Similarly, section 365(f)(2) allows for an executory contract to be assigned if it was assumed and there is adequate assurance of future performance.^[16] If section 365(c)(1) blocked assumption for assignment, section 365(f)(2) would be superfluous.^[17]  

Courts are divided on whether to consider a debtor's actual intent in assigning an executory contract when deciding whether an executory contract could be assumed under section 365 of the Bankruptcy Code. While some courts have adopted the “hypothetical test,” which disregards the debtor’s intent and disallows assumption of contract if there is applicable law disallowing assignment, the court in In re Welcome Group, applied the “actual test” concluding that it better serves the purpose and structure of the Bankruptcy Code.