Executory Contracts and Leases Under US Bankruptcy Law

Under the U.S. Bankruptcy Code, Section 365, debtors and trustees are vested with the power to assume or reject executory contracts and unexpired leases.

Policy.

This power is grounded in the principle that debtors should have the ability to abandon burdensome property and retain beneficial property.

Definitions.

The phrase “unexpired lease” does not need defining. The phrase “executory contract” does. Unfortunately, however, there is no definition of an executory contract in the Bankruptcy Code. Executory contracts have been characterized by the Supreme Court as contracts “on which performance is due to some extent on both sides.” Other, but not all, courts define an executory contract as one in which the obligations of both parties are so extensively unperformed that the failure of either to complete performance would constitute a material breach excusing performance by the other. The types of contracts that have been held to be executory include insurance contracts, partnership agreements, franchise agreements, repurchase options, software licenses, collective bargaining agreements, joint venture agreements, and settlement agreements. Contracts are also held to be non-executory based on one side’s full performance. Examples include loan agreements, trust indentures, royalty agreements, escrow agreements and purchase agreements. A few courts rely on a benefit/burden approach.

Applicability of State Law.

Notwithstanding the bankruptcy, state law principles of contract interpretation and construction continue to apply in deciding whether a group of agreements are severable for assumption/rejection purposes or are part of one integrated contract.

Terminated or Expired Agreements.

Executory contracts and leases that have expired by their own terms, or have been validly terminated by one or all of the parties before bankruptcy are no longer subject to assumption or rejection, since there is nothing left to assume or reject.

Timing.

In Chapter 7, trustees must assume or will be deemed to have rejected executory contracts and residential leases within 60 days of filing, unless the deadline is extended by the court before its expiration. In Chapters 9, 11, and 13, such agreements may be assumed or rejected at any time before confirmation. However, non-residential leases must be assumed within 60 days or any extension deadline granted before expiration. In the case of leases of non personal, household, or family personal property, the debtor or trustee must perform beginning 60 days after filing, unless the court orders otherwise. The court, on motion of a party for good cause shown, may set an earlier date, which the debtor or trustee must assume or reject.

Procedure.

Assumption and rejection both require authorizing orders from the Bankruptcy Court after notice and a hearing.

Assumption.

Generally, the assumption of a contract involves its reaffirmation by the debtor or trustee. The entire contract must be assumed or rejected. Its provisions cannot be “cherry picked.” Following assumption, it becomes a post-bankruptcy obligation that can be enforced against the bankruptcy estate and damages for breach are accorded priority status.

Requirements for Assumption. A debtor or trustee may assume an executory contract or an unexpired lease that is in default (other than a default due to financial condition or the bankruptcy filing) only if the debtor or trustee “cures, compensates, and assures,” meaning that it:

cures, or provides adequate assurance it will promptly cure defaults,
compensates, or provides adequate assurance it will promptly compensate, the counterparty for actual pecuniary loss resulting from default, and
provides adequate assurance of future performance.

Standards for Assumption. Generally, the decision to assume an executory contract or lease will be governed by the business judgment rule using a benefit/burden approach. Because damages for breach of an assumed contract or lease have priority, creditors will generally want assumption (where no assignment is contemplated) to be deferred until confirmation.

Assumption and Assignment. Upon assumption of an executory contract or lease, a debtor or trustee may assign it on the condition the counterparty is provided with adequate assurance of future performance by the assignee, whether or not there has been a default. Generally, adequate assurance of future performance by a proposed assignee requires a showing that the assignee’s general financial circumstances and ability to satisfy its obligations under the contract or lease are no less than that of the debtor on the date the petition was filed.

Effect of Assignment. Assignment by the debtor or trustee of an assumed executory contract or unexpired lease relieves the trustee and the estate of any liability for any breach of such contract or lease occurring after the assignment.

Anti-Assignment Clauses. Provisions in an executory contract or unexpired lease that prohibit, restrict, or condition assignment are not enforceable and may not be used to prevent assumption and assignment.

Contracts Exempt from Assumption and Assignment. The Bankruptcy Code prohibits assumption of contracts to make loans or extend financial accommodations such as letters of credit. Also prohibited is assignment of executory contracts in cases in which applicable non-bankruptcy law would excuse the other party from accepting performance from someone other than the debtor, unless the other party consents. Non-assignable contracts include personal service contracts.

Rejection.

Rejection of an executory contract or unexpired lease terminates both parties’ obligations going forward, but does not result in an unraveling of the executed portion of the contract.

Standards for Rejection. Most courts follow a business judgment rule in deciding whether to permit rejection. The issue is whether the debtor’s business judgment indicates rejection will benefit the bankruptcy estate. Other courts examine the impact of rejection on the debtor and on the recovery that maybe available to the creditors. Some courts permit rejection only when assumption would be onerous or burdensome to the estate. A few courts “balance the equities.” Some courts have refused to authorize rejection and, in fact, have dismissed the bankruptcy case when the debtor is determined to have filed its petition for the sole purpose of rejecting an executory contract. Other courts have refused to consider motives.

Effect of Rejection. Rejected executory contracts and leases are treated as if they were breached immediately prior to filing the bankruptcy case. The counterparty has a general unsecured claim for its breach of contract damages.

Rejection of Leases by Landlords. While rejection of an unexpired lease by a tenant terminates the tenancy, rejection by a landlord does not terminate an electing, non-debtor tenant’s right to continue to occupy the leased premises. While all other obligations of the landlord (such as maintenance and other service obligations) are terminated, the tenant has the right to treat the lease as terminated, or remain in possession and offset against its rent obligation any damages caused by rejection.

Rejection of Intellectual Property Licensing Agreements. Such agreements can be fully assumed or rejected by the debtor licensee. However, where the debtor is the licensor, the non-debtor licensee may elect to retain its rights under to license and must continue to make its royalty payments. Rejection, however, relieves the debtor licensor of all other obligations, including service and update obligations. Unlike the electing, non-debtor tenant, the electing, non-debtor licensee cannot offset its damages against its royalty payments.

Rejection of Collective Bargaining and Self Insured Pension Obligations. The Bankruptcy Code severely restricts rejection of these types of contracts and sets forth elaborate procedures that must be followed by the debtor that desires to attempt to do so.

Status of Agreements Prior to Assumption or Rejection.

After commencement of the case, but prior to assumption or rejection, executory contracts and unexpired leases remain in existence and enforceable by the debtor or the trustee, but are not enforceable against the debtor or the trustee. In other words, performance can be compelled by the debtor or trustee, but cannot be compelled by the counterparty.

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