Here, at the Bankruptcy Blog, we are committed to keeping you up to speed on the current state of bankruptcy law. Today’s post provides readers with an update to a decision by the United States Bankruptcy Court for the District of Delaware, which considered whether the debtors were required to assume a bundle of related agreements as one executory contract, or whether the debtors could assume only those agreements that contained provisions most favorable to their ongoing operations. We discussed the Bankruptcy Court’s decision here and, today, we are following up with a discussion of the District Court’s recent decision to reverse and remand.
Here’s a recap of the facts: Prepetition, the debtors, who operated an outpatient physical therapy clinic, hired a consulting firm. The debtors entered into a number of related agreements with the consulting firm, including a master agreement and a software license agreement that granted the debtors the right to use the consulting firm’s accounting software. Approximately two years later, the debtors filed petitions under chapter 11 accompanied by a prepackaged plan that sought to assume the software license agreement, while at the same time reject the remaining agreements, including the master agreement. The debtors needed the licensed accounting software for a period of time post-emergence because it was critical to the operation of their business. The debtors did not, however, want to assume the master agreement and its associated burdens, which included a broad indemnity provision requiring the debtors to indemnify the consulting firm for any liability, loss, and expense related to claims by third parties arising out of the services rendered to the debtors by the consulting firm. This indemnity provision was particularly concerning to the debtors because a lawsuit had recently been commenced against the consulting firm for alleged problems relating to the software. By contrast, the indemnity provision in the related software license agreement provided the consulting firm with much narrower rights. The debtors argued that if they assumed the terms of the master agreement, they would risk exposing themselves to greater indemnity liability that would threaten their reorganization. The consulting firm objected to the proposed assumption and rejection, arguing that the agreements were integrated and should be treated as one agreement.
The Bankruptcy Court and the District Court each considered the following issues in determining whether the debtors were entitled to assume only one of the agreements in the bundle of related agreements:
- Is the license agreement assumable under section 365(c) of the Bankruptcy Code?
- Do the related agreements constitute a single integrated contract such that the debtors must assume or reject the agreements as a whole, or, do these agreements constitute separate agreements that could be independently assumed, assigned, or rejected?
Issue 1: Is the license agreement assumable?
As a preliminary matter, both the Bankruptcy Court and the District Court considered whether the license agreement was “assumable” under section 365(c) of the Bankruptcy Code. Section 365(c) prohibits a debtor from assuming or assigning an executory contract — without the consent of the nondebtor party — if applicable nonbankruptcy law would exclude the nondebtor party from accepting or rendering performance from or to a party other than the original contracting party. The Third Circuit has adopted the so-called “hypothetical test” for interpreting and applying section 365(c)(1). Under this test, if non-bankruptcy law prohibits the assignment of the executory contract, the debtor in possession may not assume that contract.
The Bankruptcy Court reasoned that the express terms of the agreements permitted the assignment of the debtors’ rights under the agreement and, although the consulting firm retained a right to terminate the license agreement upon a “change in status” of the debtors, the consulting firm had not elected to do so. On appeal, the consulting firm argued that the Bankruptcy Court erred in reaching this conclusion because the firm had not consented to the assumption and, although it had not terminated the agreements, it nonetheless retained the right to do so. The District Court acknowledged that this was a “close call,” but ultimately agreed with the Bankruptcy Court, finding that the consulting firm did not appropriately exercise its right to terminate the agreements upon the debtors’ change in status (a right that could not survive indefinitely) and, consequently, section 365(c) would not prevent the assignment and, accordingly, assumption of the license agreement.
Issue 2: Do the Related Agreements Constitute One Contract?
As discussed in our previous post, the Bankruptcy Code affords debtors a broad right to assume, assign, or reject their executory contracts; however, the decision must apply to the entire contract. Accordingly, whether the debtors’ related agreements constituted one contract or separate contracts was crucial: if the debtors’ related agreements formed a single integrated contract, the debtors would be required to either reject the agreements wholesale and lose access to the critical accounting software program or else assume all of the agreements and take on the unknown cost of indemnifying the consulting firm under the master agreement.
The Bankruptcy Court, over the objection of the consulting firm, determined that the agreements did not form a single contract and allowed the debtors to assume the license agreement while simultaneously rejecting the master agreement. In particular, the Bankruptcy Court found that the agreements could not be a single integrated contract because the agreements had not been executed at the same time and, in the event of a contradiction in the terms between the license agreement and the master agreement, the master agreement “took the back seat.” Furthermore, the Bankruptcy Court was not persuaded by the consulting firm’s argument that the integration clauses contained in each of the agreements demonstrated the parties’ intent to create one contract, concluding that such clauses, which stated that the agreements “constitute[d] the entire agreement of the parties” were intended solely to exclude parole evidence. The District Court reversed on each of these three conclusions.
First, the District Court held that simultaneous execution of multiple agreements is not required to establish a single contract. Second, the District Court found that the inclusion of a “conflict clause” (that is, a clause that determines which agreement should govern in the event of a conflict) reinforces the notion that the parties intended for the terms of all agreements to interact as one agreement. Lastly, although the District Court agreed that the integration clauses were likely intended to bar parole evidence, the District Court found that such clauses also evinced a more robust intent to treat the agreements as a single contract. Notably, the District Court stated that where separate agreements “refer to each other and import each other’s terms, without countervailing restrictive language,” this provides a clear indication that the parties intended for those agreements to constitute one complete agreement. For these reasons, the District Court reversed and remanded for further proceedings, directing the debtors to choose between rejecting or assuming the agreements in their entirety.
As we noted in our previous post, the Bankruptcy Court’s decision was particularly favorable to the debtors, enabling them to avoid the difficult decision of rejecting the agreements wholesale and losing access to the critical accounting software program or, in the alternative, assuming all of the agreements and taking on the unknown cost of indemnifying the consulting firm. Following the appeal from the Bankruptcy Court’s decision, the debtors are now faced with the difficult decision that they were so hopeful (and, in the first instance, fortunate) to avoid. So, we’ll say it again –– although parties are loathe to consider the possibility of a bankruptcy filing while negotiating the terms of their prepetition contracts, these two diverging decisions may be reason enough for parties to consider whether a bundle of related agreements constitutes a single agreement or whether such agreements are intended to stand on their own, and to explicitly negotiate terms to reflect the consequences that flow from each configuration.