In COR Route 5 Co. v. Penn Traffic Co.1 (In re Penn Traffic Co), the United States Court of Appeals for the Second Circuit held that a non-debtor party to an executory contract may not, by fulfilling its contractual obligations post-petition, deprive the debtor of its ability to reject an executory contract. The Court held that, because the contract was executory when the debtor commenced its Chapter 11 bankruptcy proceeding, the non-debtor’s unilateral, post-petition performance under the contract did not change the contract’s executory status and prevent the debtor from exercising its section 365(a) rights to reject the contract.

COR and Penn Traffic’s Agreement and Post-Petition Activity

The Penn Traffic Company (“Penn Traffic”), the debtor-in-possession and a leading U.S. food retailer, and COR Route 5 Company, LLC (“COR”), a commercial real estate developer, entered into a project agreement. The agreement provided for an exchange of certain real property between the parties, construction of a supermarket, reimbursement of the cost of construction by COR to Penn Traffic, transfer of the certain property to COR, and a leaseback of the property to Penn Traffic. Midway through the contract, Penn Traffic filed for chapter 11 in the United States Bankruptcy Court for the Southern District of New York. At that time, each party had substantial obligations under the contract that remained unperformed. Several months later, COR tendered performance of its contractual obligations by paying certain construction costs and delivering a signed lease. Penn Traffic refused to accept COR’s tender and filed a motion under section 365 of the Bankruptcy Code to reject the contract.

The Bankruptcy Court originally found that the project agreement was not executory. The Bankruptcy Court based this finding on its view that the operative date for determining the status of the contract was the date of Penn Traffic’s motion. Because COR had tendered performance of its contractual obligations by that date, the Bankruptcy Court concluded that the contract was no longer executory. The United States District Court for the Southern District of New York reversed in part and remanded, ruling that post-petition performance cannot change the executory status of a contract. Following the District Court’s holding, on remand, the Bankruptcy Court permitted Penn Traffic to reject the contract, and COR appealed. The District Court affirmed the rejection order, and COR appealed to the Second Circuit Court of Appeals.

Post-Petition Performance by Non-Debtor Alone Does Not Render Contract Non- Executory

COR first argued that the provisions of section 365 were not implicated because the project agreement was not, at any time, an executory contract. Instead COR claimed that it was a simple financing lease, prepaid option or real estate transaction. The Second Circuit rejected this argument. The Court found that the agreement was too complex to be considered a simple purchase of property. Further, the Court found that because COR clearly had unperformed contractual obligations, the project agreement was executory when Penn Traffic commenced its chapter 11 case.

COR then argued that, while the project agreement had been an executory contract on the petition date, it was no longer executory on the motion date when Penn Traffic sought to reject it. COR contended that a contract which is executory on the petition date becomes non-executory when the non-debtor party tenders performance of its remaining obligations under the contract.2 COR thus maintained that the debtor could not reject the project agreement.

Pursuant to section 365(a) of the Bankruptcy Code, a debtor has the right, with court approval, to assume or reject executory contracts. Assumption of an executory contract binds the debtor to the contract going forward; rejection gives rise to a deemed prepetition breach of the contract and a resulting claim for damages.3 In determining what constitutes an “executory contract,” most jurisdictions, including the Second Circuit, apply the so-called “Countryman test,” which says an executory contract is 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.”4

The Court of Appeals rejected COR’s argument that the project agreement had changed from an executory contract to a non-executory contract based on COR’s post-petition tender of performance. The Court explained 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.”5 Neither the Court nor the parties had identified any case in which a non-debtor’s unilateral post-petition actions changed a contract that was executory at the petition date to one that was non-executory, and thus, incapable of being rejected by the debtor.6 The Court explained that the only recognized circumstances in which a contract’s executory status is altered during bankruptcy are “where the contract expired post-petition by its terms, such that there were no longer any obligations to assume or reject, or where the debtor itself has taken affirmative action under a contract that affected the existence of outstanding performance obligations.”7 Thus, although certain post-petition events can alter a contract’s status, the Court held that these circumstances were not present in Penn Traffic.8

Moreover, the Court reasoned that it was contrary to the goals underlying section 365 to allow a non-debtor to deprive a debtor of the right to determine whether to assume or reject the contract by performing post-petition.9 The Court explained that section 365 of the Bankruptcy Code was designed to give the debtor “breathing space” in which to evaluate its condition and assess its various contracts. Regardless of how long it takes for the debtor to review its executory contracts and decide whether to assume or reject them, the power to make that decision lies with the debtor alone and cannot be exercised by another party.10 The Second Circuit thus concluded that “[t]he 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 . . . inconsistent with both the plain language and the policy of the Code.”11

Conclusion

Penn Traffic stands for the proposition that a debtor-in-possession does not lose the right to assume or reject an executory contract when the non-debtor party tenders performance or otherwise satisfies its outstanding contractual obligation post-petition. This rule, however, seems to require that the debtor not take “affirmative action under the contract,” and accepting such performance may arguably well constitute such action.

The debtor in Penn Traffic clearly rejected the post-petition tender of performance extended by the non-debtor, and thus, no “affirmative action” issue was present. Under a different scenario, a court might be forced to make a more difficult decision. For example, if a debtor receives periodic performance (payment, deliveries, etc.) from the non-debtor, but refuses only the last of the series to preserve the executory nature of the contract, would the Court’s ruling change? Although the limits of the Second Circuit’s decision in Penn Traffic remain to be developed, debtors should derive some comfort from the Court’s conclusion that the right to assume or reject contracts under section 365 cannot be eliminated by the nondebtor party’s post-petition performance.