Can the nondebtor party to an executory contract withhold services to the debtor postpetition if the debtor breached the contract prepetition?

Many view this as a settled area of bankruptcy law, and believe that the answer is “no” as long as the debtor is performing postpetition. Commentators of this view question how a debtor could ever reorganize if nondebtors did not have to perform under contracts postpetition, particularly if the debtor’s business is entirely dependant upon the contract at issue.

In In re Lucre, 339 B.R. 648 (Bankr. W.D. Mich. 2006), the debtor was a telecommunications provider that relied exclusively on a supply contract with Michigan Bell Telephone Company (MBTC). Without MBTC’s performance under the supply contract postpetition, the debtor was out of business. The debtor claimed that as long as it performed under the contract postpetition, MBTC had to perform postpetition until the debtor decided at plan confirmation whether to assume or reject the contract.

The Lucre court disagreed. It held that:

(a) Section 541 of the Bankruptcy Code does not transfer the entire supply agreement to the debtor’s estate. It transfers the debtor’s rights under the contract thus, MBTC’s right to cease performance under the contract is not property of the estate and therefore is not stayed.

(b) Section 365 of the Bankruptcy Code does not compel MBTC to continue to perform under the contract. All Section 365 does is create a series of rules on assumption or rejection of the contract.

(c) Section 362 of the Bankruptcy Code does not stay MBTC from ceasing services postpetition. According to the court, Section 362 stays certain “acts,” and MBTC’s desire to do nothing is not an “act.”

(d) Section 361 of the Bankruptcy Code is not relevant. The fact that the debtor will perform postpetition is not “adequate protection” for MBTC’s performance because MBTC’s property rights under the contract are not property of the estate and therefore are not impacted by the bankruptcy filing or the adequate protection provisions.

The debtor argued that this was an extreme result and one that dooms any reorganization for a debtor in this predicament. The court was sensitive to this, yet said that Congress does not guaranty all debtors success under chapter 11. The court also acknowledged that its holding may be at odds with other rulings (See, In re Pittsburgh-Canfield Corp., 283 B.R. 231 (Bankr. N.D. Ohio 2002) – gas supplier must continue to supply debtor postpetition until contract is rejected), yet it was of the view that those courts misinterpreted the postpetition operation of executory contracts.