Today, in the latest installment of our series reviewing the Final Report and Recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, we explore the Commission’s recommendations on executory contracts and leases – discussed in section V.A.  The Commissioners were of the consensus that section 365 of the Bankruptcy Code, which “generally allows a debtor in possession to assume, assign, or reject executory contracts and unexpired leases in [a] chapter 11 case,” is working relatively well, and, thus, their recommendation with regard to unexpired leases and executory contracts can be summed up (for the most part) as: maintain the status quo.  Indeed, even in the one instance where the Commissioners recommended a change to section 365 of the Bankruptcy Code, it was to codify the status quo definition of executory contracts – the “Countryman” definition.   

The introduction to the Final Report states:

Whether by design or chance, efforts to review and assess U.S. business reorganization laws are undertaken approximately every 40 years. Such efforts have led to federal legislation effecting meaningful revisions to business reorganization laws in 1898, 1938, and 1978.  It may be that four decades is the maximum amount of time that any financially driven regulation can remain relevant.

This four decade rule may be true generally (the Final Report itself is evidence of that), but the relevance of the rules governing executory contracts and unexpired leases appear to have a bit more staying power.  Although the Commissioners spent a great deal of ink discussing the need to balance the interest of debtors against nondebtors in the context of executory contracts and unexpired leases, they consistently concluded that the current (largely pro debtor) language of section 365 of the Bankruptcy Code, and the body of case law that has developed from it, strikes the right balance of protecting debtors while permitting nondebtors to seek relief from the court in extraordinary circumstances where a nondebtor can demonstrate that the harm to the nondebtor outweighs the potential benefits to a debtor.  The Commission’s review of executory contracts and unexpired leases was divided into three subtopics: (i) the definition of executory contract; (ii) the rights of parties prior to a decision by the debtor to assume, reject, or assign; and (iii) rights of parties post rejection.

What Is an Executory Contract Anyway?

As noted, the one thing the Commissioners found lacking from section 365 of the Bankruptcy Code was a specific definition for the term “executory contract.”  Thus, the Commissioners recommended that the so-called “Countryman” definition of executory contracts be incorporated into the Bankruptcy Code.  The Countryman definition, which was developed by Professor Vern Countryman, “defines an executory contract for bankruptcy purposes as ‘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 compete performance would constitute a material breach excusing the performance of the other.’”  The Commissioners noted that although the Countryman test is not perfect and has its flaws, including being ill-suited to certain types of contracts (such as, among others, oil and gas agreements, licenses, warranties, severance agreements, and trademark agreements), the Countryman definition is fair and reasonable and “strikes an appropriate balance between the rights of debtors in possession and nondebtor counterparties to a contract.”  Additionally, the Commissioners noted that “many of the potentially challenging issues under the Countryman test have been resolved by the courts,” and, thus, there is a large body of law to “guide the implementation of the codified standard.”

Rights of Parties Prior to Debtor’s Decision to Assume or Reject

After settling on a definition for executory contracts, the Commission turned its attention to the rights of parties under section 365 of the Bankruptcy Code in the period between the petition date and when the debtor ultimately makes a decision to assume, reject, or assign the executory contract or unexpired lease, a period that in many cases is a considerable amount of time.  The Commission recommended that prior to the rejection or assumption of an executory contract or unexpired lease, (i) the executory contract or unexpired lease should continue to be “enforceable by the debtor in possession, but not enforceable against the debtor in possession” (however, the debtor must continue to pay for goods and services delivered after the petition date), (ii) the debtor should be absolved of its contractual obligation to cure defaults prior to assumption of a executory contract, and (iii) a nondebtor should be able to seek to compel the debtor to provide postpetition performance, but “that the standard of proof should be stringent [recommending a high evidentiary burden] and the nondebtor party should bear the burden of proof” in seeking such relief.  Notably, all three recommendations are consistent with the current majority view of the law and do not require any alteration to the existing language of the Bankruptcy Code.  The Commissioners further recommended that in the event the debtor chooses to assume an executory contract or unexpired lease, the debtor should not be required to cure any nonmonetary defaults that are impossible to cure at the time of such assumption.

Rights of Parties When Debtor Rejects

With regard to the consequence of rejection of executory contracts and unexpired leases, the Commission again essentially advocated that the status quo be maintained.  Although ultimately making recommendations in line with the current language of section 365 of the Bankruptcy Code and the case law that has developed out of it, the Commissioners engaged in intense debate regarding the consequences of rejection.  Indeed, the report notes that:

The Commission focused a substantial amount of time on the concept of rejection and whether a debtor in possession’s decision to reject an executory contract or unexpired lease should trigger a breach or termination of such contract or ease.  The Commissioners discussed the language of section 365 and specifically contrasted it with chapter 5 avoiding powers of the debtor in possession.  Congress did not intend section 365 to operate as an avoiding power that would allow a debtor in possession to terminate or unwind prepetition agreements or completely extinguish the rights of the nondebtor counterparty to an agreement.  Such a result would be contrary to the language and structure of the Bankruptcy Code and well-settled federal policy that state law generally determines property rights in bankruptcy.

In light of the above, the Commission recommended that the rejection of an executory contract or an unexpired lease continue to be considered a breach of contract, as opposed to the termination of the contract, as of the time immediately preceding the filing of the chapter 11 petition.  The commission than undertook a review of the consequences of “equating rejection with breach” and determined (i) that such breach shall not entitle the non-debtor party to any specific performance remedies it would be entitled to outside of chapter 11 because to do so “would elevate the rights of such counterparty beyond those of other similarly situated prepetition creditors,” (ii) that if a nondebtor party breaches prior to the debtor’s assumption or rejection, the debtor may treat the executory contract or unexpired lease as breached and immediately exercise remedies, and (iii) that a nondebtor party to a rejected contract or lease should be required to immediately return the debtor’s property upon rejection except where the Bankruptcy Code specifically authorizes a nonbreaching nondebtor party to retain possession of or continue its use of such property.

Take-Away

A chapter 11 filing unquestionably has an impact on the debtor, but, as the Bankruptcy Code and the Commission both recognize, it also has an impact on nondebtor parties in interest – sometimes a significant impact.  Thus, the Bankruptcy Code and in turn the Commission in its review, attempt to strike a balance between these competing interests.  In the case of executory contracts and unexpired leases, the balance is tipped in favor of the debtor “emphasizing the importance of the breathing spell created by the automatic stay” (after all, the entire purpose of the statute is to rehabilitate the debtor), but the Bankruptcy Code includes release valves for nondebtors who face significant negative consequences as a result of the debtor’s filing.  As time passes and business conditions and standard conventions shift, the balance needs to be revisited and reevaluated, and, if necessary, rebalanced to reflect the business environment of today.  The Commission undertook such review and determined that the 40 year old statute (and the case law that has grown out of it) on executory contracts and unexpired leases still strikes the right balance. Check back in another 40 years to see if the law on executory contract and unexpired leases continues to be impervious to the march of time.