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Dysfunctional Analysis Part 1

posted by Jay Lawrence Westbrook

Warning: Grumpy Alert. I am grumpy because the ABI Commission’s recent report rejected any reform of the bizarre American approach to executory contracts, which requires a quality of “executoriness” in a contract before it can be assumed or rejected. (Think of Stephen Colbert and “truthiness.”) Worse still, it recommended codifying the Countryman test, which was a great advance in its day but has been rendered hopelessly outdated by statutory changes and modern contract practices—e.g. in options and LLC memberships. Shutterstock_112522430

One reason for the Commission’s recommendation was “the perceived value in maintaining some type of gating feature to vet those contracts that a debtor in possession could assume, assign, or reject in the chapter 11 case.” A reasonable conclusion from that would be that the reason for retaining the old test was that continued confusion and inconsistency would help counterparties to maneuver in the fog. But no. The Report explains that the case law is so predictable that eliminating executoriness would just create more litigation. For those who have recently reviewed that case law, I can only assure you I am not making this up. (Please note I don’t for a moment blame this error of the Commission majority on its excellent reporter.)

Some twenty-five years ago I was guilty of an article on this subject called A Functional Analysis of Executory Contracts. Unfortunately, some cases used the phrase to mean that executoriness should depend on benefit to the debtor, while my pitch was to abolish the executoriness requirement altogether. Herewith a brief reprise of that old article and perhaps an intimation of a new one.

The relevance of benefit to the debtor relates to whether a court should approve either assumption or rejection (AorR) of a particular executory contract. In much of the case law, whether a contract is executory is an issue separate from and prior to the question of approval of AorR. For the possibility of detriment to the counterparty, which should never turn on executoriness, see below.

My understanding of the effect of section 365 of the Bankruptcy Code rests mostly on the state law of contracts, except where a bankruptcy-specific rule applies. Ignoring the timing of AorR (see below), bankruptcy treatment of contracts differs from the same state contract law that governs nonbankrupt parties in only four ways:

  • Damages are calculated under state contract law, but are paid in little Bankruptcy Dollars (BD). This value conversion provides most of the dramatic payoffs for rejection.
  • No specific performance is permitted against the trustee in bankruptcy unless the contract under state law created a property interest that cannot be taken back except through an avoiding power.
  • Ipso facto clauses are voided.
  • Occasionally bankruptcy policy overrides state law, especially as to discharge.

Any detriment to counterparties arises from four things, none of which hinge on executoriness:

  • Assumption requires the counterparty to perform despite a frequent and understandable desire to stop doing business with a bankrupt, because that counterparty detriment is inherent in the idea of permitting assumption in order to maximize estate value.
  • The timing of AorR may leave the counterparty in limbo for a considerable and expensive period of time, a legitimate concern that requires a balancing of objectives under §365(d) (2).
  • The counterparty will be undercompensated for a breach created by rejection because it will be paid damages in BD like all the other unsecured creditors who are also undercompensated.
  • The debtor may be discharged from obligations created by the contract.

Almost always the hard issues under 365 are in the obscure corners of state contract law and not in bankruptcy doctrine. The four easy steps to eliminating the heartbreak of executoriness will be in Part 2.

Graph image from Shutterstock

Comments

Rationalizing anything about executory contracts will never make sense without prioritizing first principles for why the Bankruptcy Code should and can allow for the breach of a contract in the first place, so here goes.

1. It is equitable to relieve underperformed parties to a contract because both parties win and lose something from the mutual breach (rejection) of the contract. However, it is not equitable to allow the debtor to breach a non-executory contract in which the non-debtor party to the contract is the fully performed party.

2. Regardless, the debtor’s pre-petition breach outside bankruptcy results in a claim, which is the same result for rejection inside bankruptcy.

3. The Bankruptcy Clause gives Congress the power to impair contracts in bankruptcy, but the Fifth Amendment sets limits upon the process. That is, the non-debtor party to the contract has a constitutionally protected property interest in their contract with the debtor which may not be taken for public use (bankruptcy) without just compensation.

4. 363 sales stripping claims off the assets and attaching those claims to sale proceeds, injunctions against suing the buyer of the debtor’s assets as successor to the debtor’s contracts, and any number of other complications, like Stern type challenges, change the nature, priority, and outcome of the relief owed to the non-debtor party from the debtor’s breach of the contract in bankruptcy.

Ergo, the post-petition breach of a non-executory contract in which the non-debtor party is fully performed is entitled to adequate protection attaching to sale proceeds once that breach is enjoined from prosecution against the buyer of the debtor’s assets, when the buyer is also the successor to that non-executory contract.

I count at least a dozen code sections relied upon to reach this conclusion: 365(a) & (g), 363(e) & (f), 362, 361, 1141 and 727, 507(d), 524(e), 157(c), 105, 541, etc.

It is arbitrary which code section you prioritize because we may be in for a big surprise post Wellness International that rejecting contracts raises Stern type issues. While Congress can impair contracts in bankruptcy, that impairment might need to be done by and in an Article III Court.

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