The ability of a chapter 11 debtor-in-possession (“DIP”) or bankruptcy trustee to assume or reject unexpired leases or contracts that are “executory” as of the bankruptcy filing date is one of the most important entitlements created by the Bankruptcy Code. It allows a DIP to rid itself of onerous contracts and to preserve contracts that can either benefit its reorganized business or be assigned to generate value for the bankruptcy estate and/or fund distributions to creditors under a chapter 11 plan. The fundamental importance of affording the DIP or trustee adequate time to decide whether a given contract should be assumed or rejected, even when the attendant delay and uncertainty may subject nondebtor contracting parties to considerable prejudice, is deeply rooted in the fabric of U.S. bankruptcy jurisprudence. As demonstrated by a ruling recently handed down by the Second Circuit Court of Appeals, courts only rarely find that the right to assume or reject can be compromised or abridged under circumstances not expressly spelled out in the Bankruptcy Code. In COR Route 5 Co. v. The Penn Traffic Co. (In re The Penn Traffic Co.), the court of appeals held that post-petition completion of performance by a nondebtor party to a contract that was executory as of the chapter 11 petition date cannot strip the DIP of the right to assume or reject the contract.

Assumption and Rejection of Executory Contracts and Unexpired Leases

Section 365(a) of the Bankruptcy Code provides that, with certain exceptions delineated elsewhere in the statute, “the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.” The trustee’s power to assume or reject is conferred upon a DIP under section 1107(a) of the Bankruptcy Code. Rejection results in breach of the contract, with any claim for damages treated as a pre-petition claim against the estate on a par with the claims of other unsecured creditors (unless the debtor has posted security). Assumption of a contract requires, among other things, that the DIP cure all existing monetary defaults and provide adequate assurance of its future performance.

Bankruptcy courts will generally approve assumption or rejection of a contract if presented with evidence that either course of action is a good business decision. Upon assumption, most kinds of executory contracts may also be assigned by the DIP or trustee to third parties under the circumstances specified in section 365. Except with respect to certain kinds of contracts, such as nonresidential real property leases and aircraft and parts lease agreements, the DIP or trustee may decide to assume or reject at any time up to confirmation of a chapter 11 plan. However, any nondebtor party to a contract may seek to compel the DIP or trustee to assume or reject the contract prior to confirmation, in which case the bankruptcy court must decide what period of time is reasonable to make the decision. Pending the decision to assume or reject, the trustee or DIP is generally obligated to keep current on obligations that become due under the contract post-petition.

The Bankruptcy Code does not define “executory.” The legislative history of section 365 refers with approval to the definition articulated by the famous commentator and scholar Professor Vern Countryman, who in 1973 defined an “executory” contract 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 complete performance would constitute a material breach excusing performance of the other.” Most courts accept this or a substantially similar definition of the term. If a contract or agreement is not executory, it may be neither assumed nor rejected (although the contract may give rise to either an estate asset or obligation).

As a general rule, whether a contract is executory (and may be assumed or rejected) is determined as of the bankruptcy petition date. Some courts, however, have ruled that even though a contract was executory on the petition date, post-petition events can alter the contract’s status, so that it can no longer be assumed or rejected. This is sometimes referred to as the “post-petition evaluation principle.” Courts have invoked it in cases where, for example: (i) the contract expired post-petition by its terms, such that there were no longer any obligations to assume or reject; or (ii) the DIP affirmatively acted in a way that affected the existence of outstanding performance obligations (e.g., by ceasing to operate or discharging an employee covered by an employment agreement). In Penn Traffic, the Second Circuit, without categorically rejecting the idea that such a principle might apply under certain circumstances, ruled that the nondebtor’s completion of performance post-petition could not strip the DIP of the right to reject a construction agreement that was executory as of the bankruptcy petition date.

Penn Traffic

The Penn Traffic Company (“PTC”), a leading food retailer in the U.S., owned a parcel of land and certain improvements adjacent to the Towne Center shopping mall in Fayetteville, New York. COR Route 5 Company, LLC (“COR”), a commercial real estate developer, also owned land near the shopping mall. PTC’s real property could not have been developed into a modern suburban supermarket as part of the mall without the inclusion of COR’s contiguous and connecting real property. PTC accordingly entered into a “project agreement” with COR providing for the exchange of land, site preparation and construction of a supermarket, reimbursement by COR of construction costs incurred by PTC, and PTC’s conveyance to COR of the land on which the supermarket is situated, after which the facility would be leased back to and operated by PTC.

PTC and certain affiliates filed for chapter 11 protection in May 2003 in New York. At the time of the filing, COR had performed all of its obligations under the project agreement except for reimbursement of PTC construction costs (approximately $3.5 million) and the tender of a lease to PTC, which had not yet conveyed the supermarket property to COR. The property was subsequently appraised at nearly $10 million.

In March 2004, COR tendered the reimbursement costs due under the project agreement as well as a signed lease. PTC declined to accept the tender. Instead, it sought court authority in November 2004 to reject the project agreement. The bankruptcy court denied the motion, ruling that the project agreement was no longer executory, and could not be assumed or rejected, after COR tendered its performance. PTC appealed to the district court, which reversed the court’s ruling that executory status should be assessed at the time of assumption or rejection and take into account post-petition performance. On remand, the bankruptcy court ultimately granted PTC’s motion to reject the project agreement, finding that rejection was in PTC’s best interests. COR appealed the rejection order all the way to the Second Circuit.

The Second Circuit’s Ruling

The court of appeals affirmed, ruling that the nondebtor party to a contract that is executory on the petition date cannot, by post-petition tender or performance of its own outstanding obligations, “deprive the debtor of the ability to exercise its statutory right to reject the contract as disadvantageous to the estate.” The plain language of section 365, the court explained, permits a DIP or trustee to assume or reject an executory contract “at any time before the confirmation of a plan.” Counterparties seeking an earlier determination, the court emphasized, may seek a court order requiring the debtor to assume or reject a contract by a specified deadline.

According to the Second Circuit, it need not determine “the precise contours of the test for executoriness” because the bankruptcy court determined that the parties’ unperformed obligations under the project agreement satisfied the “Countryman standard” as of the bankruptcy petition date. It rejected COR’s contentions that the agreement should not be treated as an executory contract because the agreement is actually a “financing lease,” a “prepaid option,” or a form of secured real estate transaction that is not subject to the rules governing executory contracts in section 365 of the Bankruptcy Code. The facts of this case, the court concluded, do not support the legal conclusion that the project agreement was anything other than an executory contract.

Emphasizing that “[e]xecutoriness and the debtor’s rights with respect to assumption or rejection of an executory contract are normally assessed as of the petition date,” the Second Circuit distinguished the facts in this case from those considered by courts that have invoked the “post-petition evaluation principle.” In this case, the court explained, the project agreement had not expired prior to PTC’s decision to reject it, nor had PTC acted affirmatively in any way that affected the existence of outstanding performance obligations. The court acknowledged that the Bankruptcy Code creates an uneven playing field when it comes to executory contracts, but for important reasons:

Sympathy for the non-debtor that may, through no fault of its own, bear some significant burden from the debtor’s rejection of an executory contract due to the happenstance of an unforeseen bankruptcy proceeding is understandable. The notion that a non-debtor could prevent the exercise of § 365 rights with regards to an executory contract through post-petition performance of the non-debtor’s contractual obligations is, however, inconsistent with both the plain language and the policy of the Code. . . . The Code does not condition the right to assume or reject on lack of prejudice to the non-debtor party, and the satisfaction of claims at less than their full non-bankruptcy value is common in bankruptcy proceedings, as is the disruption of non-debtors’ expectations of profitable business arrangements.

In keeping with the policy considerations underlying section 365, the court emphasized, the power to elect whether to assume or reject an executory contract is “that of the debtor alone,” regardless of the “onerous dilemmas” faced by a nondebtor contracting party forced to languish in statutory limbo while the DIP or trustee deliberates on the question. The debtor’s interests, the Second Circuit concluded, “are paramount in the balance of control.” 

Outlook

Penn Traffic could have squelched any further debate (at least in the Second Circuit) concerning the right of a DIP or trustee to assume or reject contracts that are executory as of the bankruptcy petition date, but it does not. The Second Circuit avoided adopting a bright-line rule on the issue, opting instead to leave open the possibility that, under certain circumstances, post-petition events can strip a DIP of its rights under section 365 by revoking a contract’s “executory” status on the petition date. This approach was characterized by the court as a “deviation from the general rule.” The Bankruptcy Code generally establishes the bankruptcy petition date as the point of reference for determining the legal status of various rights, claims, and interests, unless it expressly provides otherwise. Under the Second Circuit’s ruling, a DIP in some cases may still face the risk of forfeiting its right to assume or reject a contract under the “post-petition evaluation principle.”