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Executory Contracts & Puzzles of the Code

posted by Stephen Lubben

Tomorrow I'm going to be busy at the law school's graduation, so I think I'll make this my last post.  I really appreciate the chance to post here at Credit Slips.  I'll end with my musing about one of many puzzles I see in the Bankruptcy Code.

Courts and academics often proclaim, with little analysis, that the Bankruptcy Code prohibits non-debtor termination of contracts. Specifically, because section 362(b) of the Bankruptcy Code does not mention termination of contracts with the debtor, several courts have held that non-debtor parties are precluded from unilaterally terminating a contract or lease with the debtor, absent relief from the automatic stay. Why this should be so, especially in cases where the contract would be terminable outside of bankruptcy, is unclear. Arguably the automatic stay should not give the debtor greater contractual rights than it enjoys outside of bankruptcy.

Instead, I argue that careful reading of sections 362 and 365 shows that the Bankruptcy Code simply ensures that the non-debtor party will have to pay full breach damages if it terminates a contract solely because of the debtor’s bankruptcy filing. In most cases paying damages is an unattractive option, since the debtor will likely incur substantial costs to cover. In short, the Code often effectively precludes termination by the non-debtor party, by making it prohibitively expensive, but there may be instances in which a party could advance sufficient “cause” to lift the automatic stay for purposes of breaching a contract.

Am I wrong? What are some other puzzles you see in the Code?

Some that I wonder about are: (a) where does it say in the Code that administrative expenses come after secured claims (it was the other way around in receiverships with regard to "six month" claims) and (b) where exactly does it say that a chapter 11 debtor can’t pay prepetition debts in the ordinary course of business?

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Comments

I don't understand Professor Lubben's interpretation of 362 / 365 that results in damages for termination of a contract in bankruptcy at least where the contract clearly provides for termination in that event; in such a case, I do not see how there could be a breach or resulting damages.

I agree with Professor Lubben that the Code does not bar payment of prepetition claims outside a plan. Rather the language of 363 clearly enables it; the only difference between ordinary course and nonordinary course is the need for a motion, notice and opportunity to be heard in the latter case. The only limitations have been judge-made, mainly at the appellate level by non-specialists. Persons with substantial experience in reorganizations see the payment of prepetition claims incurred in the ordinary course as a nonevent, in an 11 anyway. Even as to prepetition claims incurred in the nonordinary course, the matter should be seen as one left to the sound discretion of the bankruptcy judge.

Where to begin -- with Prof. Lubben's nifty conundrums, or with MarkT's response? I'll go with Mark first.

I think I'm on safe ground stating that a party to a contract is free to breach a contract at any time -- but must also be prepared to pay the damages that result from breach. That has to be the point of Prof. Lubben's comment that the automatic stay shouldn't bar a nondebtor party from exercising freedom of contract, though the NDP must still be prepared to bear the consequences. Easy enough to see, I think.

If the contract terminates by its own terms post-petition, that raises a different question. But there has always been a distinction between breach (whether anticipatory or not) -- which gives rise to damages, and termination -- which might simply occur as part of the terms of the contract (e.g., a lease for a period of years). The latter would not give rise to damages. But a premature termination would count as a breach. Prof. Lubben, if you're still reading this thread, tell me if I'm off the mark here.

Where indeed does the Code say that you can't pay ordinary course claims post-petition? I always thought that section 549 functioned as the necessary brake on that option, though that section doesn't actually prohibit the payment. It simply says that the resulting transfer is vulnerable to a snapback, unless first sprinkled with judicial holy water. Hence the genesis of critical vendor motions.

The automatic stay question relating to 365 is fascinating. The 5th Cir says that 362 applies -- but what's the theory? That the debtor's interest in the contract partakes of an interest in property that cannot be "taken" without first obtaining stay relief? I guess so. Some contracts might be better fits for that analysis than others -- a take-or-pay contract, or a franchise agreement, or a licensing agreement come to mind as closer to "property rights" than, say, a contract to clean the offices in the debtor's building.

I think Judge Clark has got it exactly right -- I'm arguing that contracts in bankruptcy should be analyzed as contracts, and sections 365/362 should not be the source of new property rights.

Perhaps an example will illustrate my difficulty with comprehending the 362/365 point. If I make a classic personal services contract for X to render services to me at an outrageous price, and provide that it is completely nonassignable and that I may terminate it if X files bankruptcy. If then X does file before rendering performance, I think I can terminate that contract post-petition without damages for breach, and the only issue is do I need relief from stay as a technical matter. Are you saying something different, Professor Lubben, when you write "sections 362 and 365 show ...that the non-debtor party will have to pay full breach damages if it terminates a contract solely because of the debtor’s bankruptcy filing." Because that proposition does not make sense as applied to my hypothetical, in which I terminate solely because of X's bankruptcy filing.

Mark, your hypo only works with personal service contracts because of the exception in section 365(e)(2). It's a poor argument for a broader policy, as termination is otherwise barred if triggered by an ipso facto clause. Maybe it would be better to examine the problem with an example that relied on neither 365(e)(2) or 365(e)(1).

Great questions!

1) For me, the issue is whether the termination is causally shown to be an attempt to induce payment. I see no problem with a contractual party terminating a contract post-bankruptcy. Nor do I see a problem with such a party breaching (Holmesian bad man that he is). But if the breach, or the "natural termination", or even the "passive non-renewal" can be shown to be linked to the debtor's non-payment of past claims, THAT'S where I think the stay comes into play and serves a blocking function.

2) Oh please. Where does it say a secured creditor doesn't get paid first? Are you suggesting that on the text of the Code, there is nothing left for the secured creditor until all priority claims have been paid? How about this: why does 506(c) "tax" costs to the secured creditor -- wouldn't they have come out in 503(b), per 507(a)(2) already, under the "puzzling" read?

3) The constraints on the DIP's conduct in the OCB (or out of the OCB) are found nowhere textually (with the exception of cash collateral, and perhaps that one that says you can't break laws), so you have to derive any contraints from fiduciary duty and the policies and principles of the Code. This kind of collapses into the whole s. 105 debate. I'm agnostic as to the answer on this. I'm not so sure it's as "offensive" to the Code as the K-Mart appeal implies. So take that, Prof. Easterbrook! (I accord him the higher titular honor in this blog entry.)

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