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WHAT’S NEW AND DIFFERENT ABOUT EXECUTORY CONTRACTS AND UNEXPIRED LEASES IN BANKRUPTCY PROCEEDINGS Prepared for the MEETING OF THE BUSINESS BANKRUPTCY COMMITTEE, AMERICAN BAR ASSOCIATION Boston Marriott Copley Place Boston, Massachusetts April 4, 2002 10:30 a.m. – 12:00 p.m. by Samuel R. Maizel Pachulski, Stang, Ziehl, Young & Jones P.C. 10100 Santa Monica Boulevard Los Angeles, CA 90067 (310) 277-6910 FAX: (310) 201-0760 Email: smaizel@pszyj.com 68700-005\DOCS_LA:54156.1 EXECUTORY CONTRACTS AND UNEXPIRED LEASES IN BANKRUPTCY I. INTRODUCTION The Bankruptcy Code, 11 U.S.C. § 365, provides that, subject to court approval and certain limitations discussed below, debtors can assume or reject any executory contract or unexpired lease. It is an area of the law described as a “thicket . . . where . . . lurks a hopelessly convoluted and contradictory jurisprudence.” In re Drexel Burnham Lambert Group, Inc., 138 B.R. 687, 690 (Bankr. S.D.N.Y. 1992) (quoting Andrew, Executory Contracts Revisited: A Reply to Professor Westbrook, 62 U. Colo. L. Rev. 1 (1991)). “[I]n no area of bankruptcy has the law become more psychedelic than in the one titled ‘executory contracts.’“ Drexel Burnham, 138 B.R. at 690 (quoting Westbrook, A Functional Analysis of Executory Contracts, 74 Minn. L. Rev. 227, 228 (1989)). II. THRESHOLD ISSUES A. What is an executory contract? The Code does not define “executory contract”, but most courts have adopted this definition: “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 the performance of the other.” Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. R. 439, 460 (1973); In re Murexco Petroleum, Inc., 15 F.3d 60 (5th Cir. 1994); In re Texscan Corp., 976 F.2d 1269 (9th Cir. 1992); see generally Andrew, Executory Contracts In Bankruptcy: Understanding Rejection, 59 U. Colo. L. Rev. 845 (1988) (executory contract means “simply a contract under which (a) debtor and non-debtor each have unperformed obligations and (b) the debtor, if it ceases further performance, would have no right to st the other party’s continued performance”); H.R. Rep. No. 95-595, 95th Cong., 1 Sess. 347 (1977) (“[t]hough there is no precise definition of what contracts are executory, it generally includes contracts on which performance remains due to some extent on both sides.”). However, some courts have begun to move away from Countryman’s approach and have adopted a “functional approach” which works “backward from an examination of the purposes to be accomplished by rejection, and if they have already been accomplished then the contract cannot be executory.” See, e.g., In re Magness, 972 F.2d 689, 693 (6th Cir. 1992); In re Cardinal Indus., Inc., 146 B.R. 720 (Bankr. S.D. Ohio 1992) (discusses how 6th Circuit has adopted both Countryman definition and functional approach); In re General Dev. Corp., 177 B.R. 1000, 1013 (S.D. Fla. 1995); In re Drexel Burnham Lambert Group, Inc., 138 B.R. 703, 708 n.24 (Bankr. S.D.N.Y. 1992). 68700-005\DOCS_LA:54156.1 1 B. Is the contract “executory”? Is the lease “unexpired”? 1. Contracts where performance remains due on both sides are executory. See, e.g., In re Columbia Gas Sys., Inc., 50 F.3d 233 (3d Cir. 1995) (settlement agreement may be an executory contract); Matter of C & S Grain Co., 47 F.3d 233, 237 (7th Cir. 1995) (“For the purposes of the Bankruptcy Code, an executory contract is one in which the obligations of each party remain substantially unperformed. Consequently, when the debtor ... has breached the contract pre-petition with the result that the other party has no further duty to perform, ... the contract is no longer executory for purposes of section 365.”); In re Spectrum Information Technologies, Inc., 190 B.R. 741, 747 (Bankr. E.D.N.Y. 1996) (“contracts where one party has completed performance are excluded from the ambit of section 365”); Compare In re Hooker Investments, 145 B.R. 138, 144 (Bankr. S.D.N.Y. 1992) (employment contracts are executory contracts) with In re U.S. Metalsource Corp., 163 B.R. 260, 269 (Bankr. W.D. Pa. 1993) (terminable-at-will employment contracts are not executory contracts because debtor’s only legal obligation is to pay severance pay); Compare Texaco Inc. v. Louisiana Land and Exploration Co., 136 B.R. 658 (M.D. La. 1992) (state mineral lease is executory contract) with In re Philbeck, 145 B.R. 870 (Bankr. E.D. Ky. 1992) (coal lease not executory contract). Contracts in which one party has no postpetition obligation or no obligation other than the payment of money are not executory. See In re Munple, Ltd., 868 F.2d 1129 (9th Cir. 1989) (real estate brokerage commission agreement not executory even though payment of fee was conditioned upon closing of sale); Chesapeake Fiber Pkg. v. Sebro Packaging Corp., 143 B.R. 360 (D. Md. 1992) (agreements conveying patent rights are not executory contracts); In re Spectrum Information Technologies, Inc., 190 B.R. 741, 748 (Bankr. E.D.N.Y. 1996) (“where the only performance that remains is the payment of money, the contract will not be found to be executory”); In re F.B.F. Indus., Inc., 165 B.R. 544, 549 (Bankr. E.D. Pa. 1994) (promissory notes are not executory contracts). A contract substantially performed is not executory. In re Pacific Exp. Inc., 780 F.2d 1482, 1487 (9th Cir. 1986); In re Sundial Asphalt Co., 147 B.R. 72, 80 (E.D.N.Y. 1992) (contract for sale of land ceases to be executory when court issues decree of specific performance); In re Norwood Chevrolet Co., 143 B.R. 804 (Bankr. D.R.I. 1992) (substantial performance by both parties precludes rejection of contract); Compare In re Columbia Gas Sys., 146 B.R. 106 (D. Del. 1992) (court approved settlement which required only “perfunctory acts utilizing preapproved terms and conditions” is not executory contract) and Heartline Farms v. Daly, 128 B.R. 246, 250 (D. Neb. 1990) (“mere formality” remaining for performance “does not represent the kind of significant legal obligation that would render a contract executory”) with Cameron v. Pfaff Plumbing and Heating, 966 F.2d 414 (8th Cir. 1992) 2 2. 3. 68700-005\DOCS_LA:54156.1 (crediting the debtor’s account for amount of money received significant enough obligation to render contract executory) and In re Walnut Assocs., 145 B.R. 489, 496 (settlement agreement which requires only payment by one party and signing of documents by other party is executory contract). 4. A contract or lease no longer in existence is not executory and cannot be assumed. See In re Stewart Foods, Inc., 64 F.3d 141 (4th Cir. 1995) (“a debtor-in-possession does not have the option of rejecting or assuming nonexecutory contracts and remains bound by the debtor’s obligations under those contracts after the bankruptcy filing.”); In re Thompson, 186 B.R. 301, 307 (Bankr. N.D. Ga. 1995) (contract terminated prepetition “cannot be revived solely by virtue of a bankruptcy petition. Filing for bankruptcy relief does not confer new rights on a debtor in regard to [] terminated agreements and a debtor is not permitted to cure his defaults and/or assume such agreements.”); In re Interco Inc., 135 B.R. 634 (Bankr. E.D. Mo. 1992) (abandoned contract not executory); In re B & K Hydraulic Co., 106 B.R. 131 (E.D. Mich. 1989) (life insurance policy which lapsed under its own terms postpetition was not assumable by trustee). However, the termination process must be complete and not subject to reversal. See Moody v. Amoco Oil Co., 734 F.2d 1200 (7th Cir.); Ross v. Metro. Dade County, 142 B.R. 193 (S.D. Fla. 1992) (discussing test for whether contract is terminated for § 365 purposes); In re Masterworks, Inc., 100 B.R. 149 (Bankr. D. Conn. 1989) (terminated franchise agreement was executory where time for cure had not expired when bankruptcy was filed). A contract is not terminated merely because the debtor defaults or breaches the contract prepetition. In re Nemko, Inc., 163 B.R. 927, 939 (Bankr. E.D.N.Y. 1994). The case of In re Oklahoma Trash Control, Inc., 258 B.R. 461 (Bankr. N.D.Okla. 2001) discusses this principle in the context of a dispute over whether a debtor had repudiated a contract prepetition so that it could no longer be assumed. Here the Debtor’s principals had told the City that it would no longer pick up trash as required by its contract with the City. The principals then filed a chapter 7 petition and went on a cruise. Later they changed their mind, converted the case to chapter 11 and moved to assume the contract. In the meantime the City had arranged with another entity to pick up its trash. Here the court, relying on the Restatement (Second) of Contracts, held that the Debtor had repudiated the contract, which effectively terminated the City’s obligations under the contract and rendered the contract unassumable. 5. What is the correct time to determine whether a contract is executory is subject to controversy. Compare In re Columbia Gas Sys., Inc., 50 F.3d 233, 240 (3rd Cir. 1995) and In re Kong, 162 B.R. 86, 91 (Bankr. E.D.N.Y. 1993) (both look to when petition is filed) with In re Nemko, Inc., 163 B.R. 927, 935 (Bankr. E.D.N.Y. 1994); In re Broaddus Hosp. Ass’n, 159 B.R. 763, 771 (Bankr. N.D.W.V. 1993) and In re Wang Labs., Inc., 154 B.R. 389 3 68700-005\DOCS_LA:54156.1 (Bankr. D. Mass. 1993) (determination of whether contract is executory is made by looking at the contract at the time the issue is before the court). 6. Contracts as avoidable preferences under §§ 547; 548. Debtors may not avoid a prepetition termination of an executory contract; such terminations are not avoidable transfers of an interest in property. Although there are courts which have permitted such avoidances, it “would be anomalous, to say the least, to expect that the drafters of a generally thrifty codification of bankruptcy law would devote a substantial section of the Code to the subject of the assumption or rejection of executory contracts ... while at the same time allowing a portion of that subject to spill over into the section governing fraudulent transfers and obligations ....” In re Egyptian Brothers Donut, Inc., 190 B.R. 26, 28-30 (Bankr. D.N.J. 1995). Leases need only be unexpired. Courts recognize that there is a difference between “unexpired” and “terminated” under state law; the latter leases may still be assumed. Note that section 365(c)(3) provides that a terminated lease of non-residential real property cannot be assumed. In re DiCamillo, 206 B.R. 64, 67 (Bankr. D.N.J. 1997). Compare In re Huffman, 171 B.R. 649, 653 (Bankr. W.D. Mo. 1994) (lease terminated prepetition cannot be assumed) with In re Morgan, 181 B.R. 579, 584 (Bankr. N.D. Ala. 1994) (a terminated lease is not the same as an expired lease and may be assumed). 7. C. A single writing may contain more than one contract for § 365 assumptionrejection purposes. In re Plum Run Serv. Corp., 159 B.R. 496, 498 (Bankr. S.D. Ohio 1993); In re Village Rathskeller, 147 B.R. 665, 671 (Bankr. S.D.N.Y. 1992) (not every provision of an assumed agreement is enforceable against the debtor-inpossession). State law determines if the contract is divisible for assumptionrejection purposes. In re Downtown Props., Inc., 162 B.R. 244, 247 (Bankr. W.D. Mo. 1993); Plum Run Serv. Corp., 159 B.R. at 498-99; In re Independent Am. Real Estate, Inc., 146 B.R. 546, 550-52 (Bankr. N.D. Tex. 1992). Whether there was separate and distinct consideration and performance under each “contract” determines if one part of a single contract is severable and enforceable on its own. In re Leslie Fay Co., Inc., 168 B.R. 294, 301 n.7 (Bankr. S.D.N.Y. 1994). Multiple contract documents may form one uniform agreement for assumptionrejection purposes. Courts have held that two or more contracts which are essentially inseparable can be, and should be, viewed as a single indivisible agreement. In re Atlantic Computer Sys., Inc., 173 B.R. 844, 849-55 (S.D.N.Y. 1994) (six agreements properly constituted one contract for § 365 purposes); In re Karfakis, 162 B.R. 719, 725 (Bankr. E.D. Pa. 1993). Postpetition, Pre-Rejection or Assumption Treatment of Executory Contracts. 4 D. E. 68700-005\DOCS_LA:54156.1 1. The status of an executory contract between filing of petition and assumption or rejection is subject to controversy. “Exactly how and when executory contracts come into the estate has been the source of continuing controversy and progressive development. One view, the exclusionary analysis, holds that executory contracts remain outside the estate prior to assumption. The competing view is that they enter the estate initially, but are thereafter subject to abandonment via rejection.” In re Drexel Burnham Lambert Group, Inc., 138 B.R. 687, 701 (Bankr. S.D.N.Y. 1992). Compare In re Albion Disposal, Inc., 152 B.R. 794, 806-07 (Bankr. W.D.N.Y. 1993); In re Alert Holdings, Inc., 148 B.R. 194, 203 (Bankr. S.D.N.Y. 1992); In re Seymour, 144 B.R. 524 ( Bankr. D. Kan. 1992); Drexel Burnham Lambert Group,, 138 B.R. at 701-02 (all holding that executory contracts are property of estate) with In re Qintex Entertainment, Inc., 950 F.2d 1492, 1495 (9th Cir. 1991) (“An executory contract does not become an asset of the estate until it is assumed pursuant to § 365.”). At least one court has held that the filing of a bankruptcy petition is the anticipatory breach of an executory contract, the consequences of which may be avoided by assumption. See In re Couture, 202 B.R. 837, 841-42 (Bankr. D. Vt. 1996). Status of Parties To The Unassumed/Unrejected Contract. During the period a contract is unassumed and unrejected, the rights, duties and obligations of the debtor are unclear. See In re Holly’s Inc., 140 B.R. 1213 ( Bankr. W.D. Mich. 1992). However, the contract is generally thought of as remaining “in effect” and the nondebtor parties are bound to honor it and perform. See In re Whitcomb & Kelly Mortgage, 715 F.2d 375 (7th Cir. 1983); In re Leslie Fay Companies, Inc., 166 B.R. 802, 808 (Bankr. S.D.N.Y. 1994); cf. In re Continental Airlines, 981 F.2d 1450, 145960 (5th Cir. 1993) (court’s discussion shows that contract continues to exist postpetition stating that “[a]n agreement cannot ‘exist’ for one purpose yet take on a ‘nonexistent’ quality which works to the advantage of one party or the other.”); In re Modern Textile, Inc., 900 F.2d 1184, 1191 (8th Cir. 1990) (executory contracts are “an existing and continuing legal obligation of the debtor” subject to rejection); In re Continental Energy Assoc. Ltd., 178 B.R. 405 (Bankr. M.D. Pa. 1995) (Bankruptcy court may compel the non-debtor party to an executory contract to continue to perform postpetition, “provided that [the court] diligently guard[s] the interests of the non-debtor party to the contract.” Although the cost of the services provided “will often times ... be measured by reference to the contract which presumably has been negotiated at arm’s length,” that is not required; court may order payment of only the “reasonable value of the material or services supplied.”); In re Thomas Co., Inc., 166 B.R. 677 (Bankr. C.D. Ill. 1994) ( xecutory contract remains in e existence until rejected). Claims based on the unassumed and unrejected contract or lease may be entitled to an administrative expense priority. In re Dant & Russell, 5 2. 3. 68700-005\DOCS_LA:54156.1 Inc., 853 F.2d 700, 707-08 (9th Cir. 1988) (Section 503(b)(1) limits administrative expense to the fair and reasonable value of the debtor’s actual use of the leased property.); In re Bridgeport Plumbing Prods., Inc., 178 B.R. 563 (Bankr. M.D. Ga. 1994) (creditor may file an administrative expense claim for the “reasonable value of the use” of the creditor’s property during the gap period). 4. However, non-residential real property leases are treated uniquely. During the period that the debtor is making the decision to assume or reject a lease, it must “timely perform all obligations” of a lease of nonresidential real property. 11 U.S.C. § 365(d)(3); In re Pacific-Atlantic Trading Co., 27 F.3d 401 (9th Cir. 1994) (Claims arising under § 365(d)(3) are entitled to administrative priority even when they exceed the reasonable value of the debtor’s actual use of the property); In re Russell Cave Co., 247 B.R. 656 (Bankr. E.D. Ky 2000) (claims arising under § 365(d)(3) are administrative expenses); In re Slim Life Weight Loss Ctrs., Corp., 182 B.R. 701, 705-06 (Bankr. D.N.J. 1995) (debtor-in-possession must pay all rents due on an unexpired lease of non-residential real estate as an administrative expense; creditor need not prove its right to an administrative expense under § 503). Compare In re All For A Dollar, Inc., 174 B.R. 358, 361 (Bankr. D. Mass. 1994) (debtor must pay only current, postpetition obligations) with In re R.H. Macy & Co., 152 B.R. 869, 872-73 (Bankr. S.D.N.Y. 1993), aff’d, 1994 WL 482948 ( S.D.N.Y. Feb. 23, 1994) (debtor must pay all postpetition obligations, even if bills cover prepetition period). The legislative history of § 365(d)(3) makes it clear that the provision was intended to protect landlords when the debtor was the lessee. In re BCE West, L.P., 257 B.R. 304 (Bankr. D. Ariz. 2000) addresses the interesting issue of “whether a debtor-lessor incurs administrative liability when it rejects an unexpired lease that contains a non-monetary objection owed to the lessee.” Here the lease had a “non-disturbance covenant” which the debtor-lessor breached by rejecting the lease. The lessee claimed § 365(d)(3) entitled its damages from that breach to administrative expense status. The court rejected the argument because of the legislative intent but conceded that “the statute suffers from many deficiencies.” In re Geonex Corp., 258 B.R. 336 (Bankr. D.Md. 2001) reviewed the limits of a creditor’s rights under § 365(d)(3). First the court discussed “the majority view” that a debtor is required to pay postpetition rent under an unexpired lease of non-residential real property and that failure to do so gives rise to an administrative expense. However, here the landlord also demanded payment of counsel fees and interest pursuant to § 365(d)(3). The court granted the motion, based on its belief that Congress “intended to protect landlords and to place them in 68700-005\DOCS_LA:54156.1 6 the same position in bankruptcy as they would be outside with respect to the enforcement of their rights under their leases.” The Ninth Circuit recently weighed in on this issue in Cukierman v. Uecker (In re Cukierman), 265 F.3d 846 (9th Cir. 2001). In this case the circuit court reviewed the situation where during a “workout” the lessor of a commercial property loaned $600,000 to the lessee of the property. In a lease agreement executed at the time of the loan, the lessee agreed to pay “further rent” monthly in an amount equal to the monthly payment required to repay the loan. The parties did not dispute that the “further rent” provision represented the repayment of the loan. The lessee filed a bankruptcy petition under chapter 11, and moved to assume the lease. The motion was denied however, and shortly thereafter the case was converted to chapter 7. The lessor filed a proof of claim asserting that the “further rent” payments which accrued during the postpetition, pre-rejection period where an administrative expense under section 365(d)(3). F. Effect of Debtor’s Failure To Act. An executory contract which is not assumed or rejected during the bankruptcy will be unaffected by the bankruptcy filing, will pass through to, and be binding upon, the reorganized debtor. In re National Gypsum Co., 208 F.3d 498, 504 n.4 (5th Cir. 2000); In re Polysat, Inc., 152 B.R. 886, 890 (Bankr. E.D. Pa. 1993). When Must the Decision Be Made. Trustee or DIP is allowed a “reasonable time” to decide whether to assume or reject. See Theater Holding Corp. v. Mauro, 681 F.2d 102, 105 (2d Cir. 1982). What constitutes “reasonable time” is left to bankruptcy court’s discretion. Id.; see also In re Beker Indus., 64 B.R. 890, 896-97 (Bankr. S.D.N.Y. 1986). Factors include: 1. 2. 3. 4. 5. 6. The nature of the interests at stake; The balance of harm to the litigants; The good to be achieved; The safeguards afforded the litigants; Whether the action to be taken is so in derogation of Congress’ scheme that the court may be said to be arbitrary; With respect to a lease: (a) whether the debtor is presently paying for the property; G. 68700-005\DOCS_LA:54156.1 7 (b) (c) the importance of the leased asset to the debtor’s plan of reorganization; and whether the debtor has taken steps to formulate a plan. If a creditor wants to force a debtor to assume or reject an executory contract before the debtor would do so voluntarily, the creditor can file a motion asking the court to compel the debtor to decide. 11 U.S.C. § 365(d)(2). Experienced bankruptcy attorneys know, however, that such motions are only infrequently granted. The decision in In re Physicians Health Corp., 262 B.R. 290 (Bankr. D. Del. 2001) (“PHC”) illustrates this principle. In PHC the court reviewed the motion of a medical group seeking an order compelling a Debtorphysician practice management entity to assume or reject the practice management agreement (“PMA”) between the Debtor and the medical group. The medical group asserted that the Debtor was (1) in default of the PMA, and (2) rejecting most other PMAs. The court, after an evidentiary hearing, rejected the medical group’s contention that the Debtor was in default under the PMA. The court also noted that, even if prepetition defaults had been established, that would be an insufficient basis to compel the Debtor to assume or reject the PMA as a matter of law. Because the court found no postpetition defaults it did not decide whether such defaults would provide sufficient legal grounds to compel the Debtor to decide but pointed out that “some courts have held that even a postpetition breach of an executory contract is not sufficient cause to compel a debtor to assume or reject a contract before confirmation.” The court also found also found insufficient arguments that the Debtors would be forced eventually to reject the PMA because there was “no possibility of a long term 68700-005\DOCS_LA:54156.1 8 relationship.” Without evidence the Debtor was being “dilatory” or that the medical group was being prejudiced, the court would not grant the motion. Some courts have suggested that, as a minimum, debtors are entitled to 120 days after the filing of the petition to make a decision. See, e.g., In re Taber Farm Associates, 115 B.R. 455, 457 (Bankr. S.D.N.Y. 1990). H. Postpetition contracts are not subject to assumption or rejection. In re MerryGo-Round Enters., Inc., 208 B.R. 637 (Bankr. D. Md. 1997); In re Lesle Fay Co., Inc., 168 B.R. 294, 300 (Bankr. S.D.N.Y. 1994). Can The Debtor Bargain Away Its Rights Prepetition? I. Many creditors seek to control a potential debtors conduct in the event of a bankruptcy by including provisions in a contract that, among other things, agree not to reject the contract. The decision in In re Trans World Airlines, Inc., 261 B.R. 103 (Bankr. D. Del. 2001) held that such provisions are unenforceable. The court held that a debtor cannot unilaterally contract away its authority to assume or reject an executory contract because it “violates public policy” in that it binds the debtor in possession without regard to the impact on the estate and limits the rights of other parties in interest. III. ASSUMPTION A. Mechanics. Assumption of an executory contract is accomplished by motion of the debtor-in-possession or trustee, subject to objection by other creditors and court approval. A motion to assume an executory contract is a summary proceeding; it is not the place for prolonged discovery or a lengthy trial with disputed issues. In re Orion Pictures Corp., 4 F.3d 1095, 1098-99 (2d Cir. 1993), cert. denied, 114 S. Ct. 1418 (1994); In re F.W. Restaurant Assocs., Inc., 190 B.R. 143, 148 (Bankr. D. Conn. 1995) (“[C]ourt reads Orion to establish a preliminary ‘likelihood of success’ standard” in deciding issues related to debtor’s motion to assume a contract. Thus, the court makes preliminary determinations concerning defaults and claims arising therefrom, but these determinations are not final, rather they are “collapsed into the ‘business judgment’ analysis.”). The debtor has the burden of persuasion that the contract is (1) subject to assumption and (2) all the requirements of § 365 have been met. Generally, courts then require the nondebtor party to prove any defaults, which then shifts the burden back to the debtor to prove adequate “cure” of those defaults. In re Diamond Mfg. Co., Inc., 164 B.R. 189, 199 (Bankr. S.D. Ga. 1994); accord In re National Gypsum, Inc., 208 F.3d 498, 513 (5th Cir. 2000) (Debtor has responsibility to assure that non-debtor party to contract was on notice of debtor’s intent to assume the contract.). Although a debtor may provide for assumption of a contract in its plan of reorganization, § 1123(b)(2), whether that assumption is sufficient is controversial. Compare In re Golden Triangle Film Labs, Inc., 176 B.R. 608, 610 (Bankr. M.D. Fla. 1994) (court was “unwilling to accept the proposition that the entry of an Order” confirming the plan satisfied § 365’s requirements) with In re Progressive Restaurant Sys., Inc., 206 B.R. 9 68700-005\DOCS_LA:54156.1 45, 48 (Bankr. W.D.N.Y. 1997) (Section 365 continues to apply to any plan provisions dealing with assumption or rejection) and In re Hall, 202 B.R. 929, 932-33 (Bankr. W.D. Tenn. 1996) (debtor’s efforts to assume contract in chapter 13 plan satisfied section 365’s requirements). Finally, some courts have held that filing of a motion to sell a contract under § 363 satisfies the requirements of § 365. In re Specialty Foods, Inc., 91 B.R. 364 (Bankr. W.D. Pa. 1988) (“[T]he Trustee filed a motion to sell which of necessity incorporates an assumption of the asset to be sold to the extent that the Trustee cannot sell an asset which he has rejected or abandoned.”); In re Zacherl Coal Co., Inc., 15 B.R. 1001 (Bankr. W.D. Pa. 1981) (same). Denial of a motion to assume does not result in rejection of the contract. In re F.W. Restaurant Assocs., Inc., 190 B.R. 143, 149 n.8 (Bankr. D. Conn. 1995). B. Standard of Review By Bankruptcy Court. A debtor’s decision to assume an executory contract is subject to review under the “business judgment standard.” See, e.g., In re Orion Pictures Corp., 4 F.3d 1095, 1099 (2d Cir. 1993); In re Gardiner, Inc., 831 F.2d 974, 975 n.2 (11th Cir. 1987); In re Health Science Products, Inc., 191 B.R. 895, 909 n.15 (Bankr. N.D. Ala. 1995) (Bankruptcy courts must approve a debtor’s decision to assume or reject an executory contract “unless there is bad faith or a gross abuse of discretion.” In other words, the court must decide “whether the decision of the debtor is so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, whim, or caprice.”). Outside of bankruptcy the business judgment rule “can be simply stated: in making a business decision, the directors are presumed to have acted independently, on an informed basis, in good faith, and in the honest belief that the decision is in the best interests of the corporation.” Thus, a business decision will normally be sustained unless the presumption is rebutted in either of two ways: (i) the process, independence, or good faith of the directors is compromised; or (ii) the decision cannot be attributed to a rational business purpose. E. Norman Veasey, The Defining Tension in Corporate Governance in America, 52 The Business Lawyer 393, 394 (Feb. 1997). However, if the assumption benefits an insider, “heightened scrutiny” may be appropriate. Westship, Inc. v. Trident Shipworks, Inc., 247 B.R. 856, 865 (M.D. Fla. 2000). Assumption Through Conduct. Whether a debtor-in-possession can assume a contract by conduct, without court approval, is subject to controversy. Compare In re University Medical Ctr., 973 F.2d 1065, 1075-79 (3d Cir. 1992); In re Whitcomb & Keller Mortg. Co., 715 F.2d 375, 380 (7th Cir. 1983); NCL Corp. v. Lone Star Bldg. Ctrs., 144 B.R. 170, 179 (S.D. Fla. 1992); In re Houbigant, 188 B.R. 347, 355 (Bankr. S.D.N.Y. 1995); In re Broaddus Hosp. Ass’n, 159 B.R. 763, 771 (Bankr. N.D.W.V. 1993); and In re Drexel Burnham Lambert Group, Inc., 138 B.R. 687, 712 (Bankr. S.D.N.Y. 1992) (all holding that assumption of an executory contract is not effective unless and until the court approves) with In re Frontier Properties, 979 F.2d 1358, 1365 (9th Cir. 1992) (court approval of stipulation that specifically provided for assumption of contract satisfies requirement for court approval under § 365(a)); In re Schleifer, 170 B.R. 283, 285 (Bankr. D.V.I. 1994) (where debtor remains employee during bankruptcy he assumes contract of employment and is bound by the statutorily 10 C. 68700-005\DOCS_LA:54156.1 defined conditions of that employment); In re Audra-John Corp., 140 B.R. 752, 755 n.7 (Bankr. D. Minn. 1992); In re Carlisle Homes, 103 B.R. 524 Bankr. D.N.J. 1988) (both holding that the debtor can assume a contract by communication of unequivocal intent to assume); In re Hodgdon, 54 B.R. 688 (Bankr. W.D. Wis. 1985) (contract may be assumed through conduct; conduct must be either express declaration of assumption or specific, unequivocal action leading to no possible conclusion other than assumption). D. Timing of Assumption [§365(d)]. 1. Chapter 7. Contracts must be assumed within 60 days after the petition is filed or it will be deemed rejected, unless an extension of time is granted within the 60 day period. See 11 U.S.C. § 365(d)(1); Cameron v. Pfaff Plumbing and Heating, 966 F.2d 414 (8th Cir. 1992); In re Annabel (Bankr. N.D.N.Y. 2001); In re Independent American Real Estate, Inc., 146 B.R. 546, 552 (Bankr. N.D. Tex. 1992). The contract will be rejected by operation of law on the 61st day even if a motion to assume or reject is filed in the court but the court has not yet acted. The order must be entered on or before the 60th day. In re Horowitz, 167 B.R. 237 (Bankr. W.D. Okla. 1994); In re Compuadd Corp., 166 B.R. 862, 866 (Bankr. W.D. Tex. 1994). Chapters 9, 11, 12 and 13. Debtor may assume or reject at any time before confirmation but, as discussed earlier in this outline, the court may order the trustee/debtor to decide sooner. 11 U.S.C. § 365(d)(2); see Theater Holding Co. v. Mauro, 681 F.2d 102 (2d Cir. 1982); In re Holly’s Inc., 140 B.R. 643 (Bankr. W.D. Mich. 1992). If a nonresidential lease is not assumed within 60 days when the debtor is the lessee, then it is deemed rejected. 11 U.S.C. § 365(d)(4); In re The Montaldo Corp., 209 B.R. 40 (Bankr. M.D.N.C. 1997) (comprehensive discussion of section 365(d)(4)); In re Lonepine Corp., 184 B.R. 370, 375 (Bankr. D. Colo. 1995) (filing a motion to assume within 60 days is sufficient, court may approve after 60 days has expired); In re Golden Triangle Film Labs, Inc., 176 B.R. 608, 610 (Bankr. M.D. Fla. 1994). Whether these provisions can be waived by the lessor are unclear. In re Progressive Restaurant Sys., Inc., 206 B.R. 45, 48 n.3 (Bankr. W.D.N.Y. 1997); In re Food Barns Stores, Inc., 174 B.R. 1010, 1013-16 (Bankr. W.D. Mo. 1994) (failure to act within 60 days results in rejection of contract, but creditor may be held to have waived the right to have the lease deemed rejected; comprehensive discussion of waiver in this context); In re Hunan Rose, Inc., 146 B.R. 313 (Bankr. D.D.C. 1992) (discusses impact of failure to act); In re 6177 Realty Assocs., 142 B.R. 1017 (Bankr. S.D. Fla. 1992) (same). The court may grant an extension if the debtor moves within the 60 day period and the court acts within the 60 day period. § 365(d)(4). Whether the court may grant an extension after the 60 day period if the debtor filed for an 11 2. 3. 68700-005\DOCS_LA:54156.1 extension within the 60 day period is subject to controversy, as is whether the court may grant a subsequent extension after the original 60 days expires. In re Channel Home Ctrs., Inc., 989 F.2d 682 (3d Cir. 1993); Compare Southwest Aircraft Servs., Inc. v. City of Long Beach, 831 F.2d 848 (9th Cir. 1987) (if debtor moves for extension within 60 days court may grant the motion even after 60 days has expired) with In re Horwitz, 167 B.R. 237 (W.D. Okla. 1994) (court bound by plain language of statute -may not grant extension if 60 days has expired). E. Impact of Assumption 1. The decision to assume a contract merely allows the contract to continue to operate and does not change the obligations of the parties, except as provided explicitly in the Code, i.e., permit the debtor to cure defaults, ignore ipso facto clauses, and resume its contractual obligations if the statutory tests are met. See In re Washington Capital Aviation & Leasing, 156 B.R. 167, 173 (Bankr. E.D. Va. 1993); In re Drexel Burnham Lambert Group, Inc., 138 B.R. 687, 706 (Bankr. S.D.N.Y. 1992); In re Allen, 135 B.R. 856, 864 ( ankr. N.D. Iowa 1992) (assuming a contract under B § 365 only allows the debtor to carry on with the contract according to its terms); In re LeRoux, 167 B.R. 318 (Bankr. D. Mass. 1994), aff’d, 1995 WL 447800 (D. Mass. Oct. 20, 1995), aff’d sub nom. Summit Inv. and Dev. Corp. v. LeRoux, 69 F.3d 608 (1st Cir. 1995) (statute and contract clause which otherwise would convert a general partner’s interest into a limited partnership interest upon the filing of a bankruptcy petition unenforceable); Jay Westbrook, A Functional Analysis of Executory Contracts, 74 Minn. L. Rev. 227, 231 (1989) (“‘Assume’ and ‘reject’ are merely bankruptcy terms for the decision to perform or to breach, an election open to any party to a contract outside of bankruptcy.”); Michael T. Andrew, Executory Contracts in Bankruptcy: Understanding “Rejection”, 59 Colo. L. Rev. 845, 847 (1988) (“Assumption permits the estate to obtain the benefits of continued performance by the nondebtor party to the contract, as would assumption by an ordinary contract assignee.”). A party who assumes an executory contract must assume it in its entirety; it may not be assumed in part and rejected in part. NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531 (1984); Department of the Air Force v. Carolina Parachute Corp., 907 F.2d 1469, 1472 (4th Cir. 1990); In re Chicago, R.I. & Pac. R.R., 860 F.2d 267, 272 (7th Cir. 1988); Richmond Leasing Co. v. Capital Bank, 762 F.2d 1303, 1311 (5th Cir. 1985); In re B & L Oil Co., 782 F.2d 155, 157 (10th Cir. 1987); Lee v. Schweiker, 739 F.2d 870, 876 (3d Cir. 1984). In other words, a debtor cannot assume the benefits of an executory contract without assuming its burdens as well. See, e.g., Covington v. Covington Land L.P., 71 F.3d 1221, 1226 (6th Cir. 1995) (“When a debtor assumes the lease or contract under § 365, it must assume both the benefits and the burdens of the contract. Neither the debtor 12 2. 68700-005\DOCS_LA:54156.1 nor the bankruptcy court may excise material obligations owing to the nondebtor contracting party.”). In re Godwin Bevers Co., Inc., 575 F.2d 805, 807 (10th Cir. 1978) (trustee who accepts executory contract takes burdens with benefits); In re Fitch, 174 B.R. 96, 101 (Bankr. S.D. Ill. 1994) (“debtor cannot change the nature of a contract merely by ... assum[ing] it ... debtor may not ‘conditionally’ assume such a contract, and ... must assume its burdens as well as its benefits”); In re Monroeville Dodge, Ltd., 166 B.R. 264, 267 (E.D. Pa. 1994) (debtor-in-possession takes contract cum onere). The debtor must perform “in full, just as if the bankruptcy had not intervened.” In re Frontier Properties, 979 F.2d 1358, 1367 (9th Cir. 1992); In re Airlift Int’l, 761 F.2d 1503 (11th Cir. 1985); In re Steelship Corp., 576 F.2d 128, 132 (8th Cir. 1978). 3. The assumption of an executory contract results in an administrative expense status for all obligations under the contract, regardless of whether the expenses arose pre- or postpetition. In re Coast Trading, Inc., 744 F.2d 686, 692 (9th Cir. 1984); In re U.S. Metalsource Corp., 163 B.R. 260, 269 (Bankr. W.D. Pa. 1993). F. Limits On The Debtor’s Ability To Assume 1. Contracts In Default. § 365(b). A contract in default may only be assumed if the debtor meets certain Code requirements: (a) Cure pre- and postpetition defaults or provide adequate assurance of prompt cure. Courts define “cure” as “taking care of the triggering event and returning to predefault conditions.” In re Johnson, 184 B.R. 570, 574 (Bankr. D. Minn. 1995). In other words, “a cure returns the parties to the status quo ante by paying all arrearages on the debt and reinstating the debt’s original payment terms.” Id.; see In re Claremont Acquisition Corp., 113 F.3d 1029 (9th Cir. 1997) (default which is an “historical event” and can no longer be cured results in debtor’s inability to assume contract or lease); In re Embers 86th Street, Inc., 184 B.R. 892 (Bankr. S.D.N.Y. 1995) (“[a]dequate assurance of a prompt cure requires that there be a firm commitment to make all payments and at least a reasonably demonstrable capability to do so”); In re Washington Capital Aviation & Leasing, 156 B.R. 167, 173 (Bankr. E.D. Va. 1993) (discussing general requirements for cure). Compare In re Diamond Mfg. Co., Inc., 164 B.R. 189, 197-99 (Bankr. S.D. Ga. 1994) and NCL Corp. v. Lone Star Bldg. Ctrs., 144 B.R. 170 (S.D. Fla. 1992) (both holding that when bankruptcy court approves assumption of contract it necessarily finds that no uncured default exists) with In re National Gypsum Co., 208 F.3d 498 (5th Cir. 2000) 13 68700-005\DOCS_LA:54156.1 (Section 1114(d) (discharge does not provide for discharge of amounts in default of assumed contract in a manner which nullifies the cure requirements of Section 365(b)(1)) and In re Peters, 101 F.3d 618 (9th Cir. 1996) (when bankruptcy court confirms plan of reorganization it does not result in cure of existing defaults). Compare In re Coors, Inc., 27 B.R. 918 (Bankr. N.D. Miss. 1983) (cure need not be made by immediate cash payment; can be “adequately assured” by future business prospects) with In re DiCamillo, 206 B.R. 64, 67 (Bankr. D.N.J. 1997) (36 months not prompt) and In re Liggins, 145 B.R. 227, 231 (Bankr. E.D. Va. 1992) (deferred plan payments over a period of years do not constitute prompt cure); The decision in In re RVP, Inc., 269 B.R. 851 (Bankr. D. Idaho 2001) raises an interesting question about the obligation of a debtor to disclose defaults prior to assumption. The debtor filed a motion to assume an executory contract with MICROS. No opposition was received and the court granted the motion. Almost one year later MICROS filed a motion to amend the order allowing the assumption, asserting the debtor had been in default of the contract at the time it was assumed. The court noted that the debtor had failed to serve the motion in the manner required by the contract. It then held that the debtor had an affirmative obligation to (1) disclose defaults; and (2) explain how those defaults would be cured. The debtor having failed to do so, the court set aside the order allowing the assumption. In In re Bankvest Capital Corporation, 270 B.R. 541 (Bankr. D. Mass. 2001) the court reviewed a limitation on a debtor’s obligation to cure existing defaults. Section 365(b)(2)(D) exempts defaults relating to “the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations.” The court noted a disagreement exists among courts interpreting this Code provision as to “whether the word ‘penalty’ defines both the word ‘rate’ and the phrase ‘provision relating to a default arising from any failure of the debtor to perform nonmonetary obligations.’ In other words, must the nonmonetary default arise from a penalty provision” to be exempt from cure? Compare In re GP Express Airlines, Inc., 200 B.R. 222 (Bankr. D. Neb. 1996) (holding § 365(b)(2)(D) addresses two separate issues) with In re 68700-005\DOCS_LA:54156.1 14 Claremont Acquisition Corp., 113 F.3d 1029 (9th Cir. 1997) (holding that “penalty” modifies both “rate” and “provision”). The court here agreed with the court in GP Express Airlines and held that failure to deliver certain items as required under the contract was a nonmonetary default which need not be cured. AND (b) Compensate for pecuniary loss caused by defaults (or provide adequate assurance of compensation), which may include interest on the amount of the default and attorney’s fees and expenses if provided for in the contract or by law. See 11 U.S.C. § 365(b)(1)(B); In re Ryan’s Subs, Inc., 165 B.R. 465, 467-69 (Bankr. W.D. Mo. 1994); In re Eagle Bus Mfg., Inc., 148 B.R. 481 (Bankr. S.D. Tex. 1992); AND (c) Provide adequate assurance of future performance, i.e., provide adequate assurance of ability to satisfy outstanding and upcoming financial obligations. See 11 U.S.C. § 365(b)(1)(c). While the term adequate assurance is not defined in the Code, they are generally considered to require a “practical pragmatic construction” to be “defined by commercial rather than legal standards.” An absolute guaranty of performance is not required. Cinicola v. Scharffenberger, 248 F.3d 110, 120 n.10 (3d Cir. 2001); accord In re Washington Capital Aviation & Leasing, 156 B.R. 167, 173 (Bankr. E.D. Va. 1993) (while an absolute guarantee is not required, more than speculative plans are needed); Defaults constituting breach of contract provisions which do not require cure include: (1) insolvency or financial condition; (2) commencement of a case; or (3) appointment of a trustee. § 365(e)(1). (d) 2. Contracts which, under non-bankruptcy law, are not assumable or assignable. § 365(c)(1). (a) General rule: contract may not be assumed if: 68700-005\DOCS_LA:54156.1 15 (1) Applicable non-bankruptcy law excuses the nondebtor party from accepting performance from a third party; and That nondebtor party does not consent. (2) (b) The scope of this exception is subject to controversy. Compare In re Catapult Entertainment, Inc., 165 F.3d 747, 749-50 (9th Cir.), cert. dismissed, 528 U.S. 924 (1999); In re Catron, 158 B.R. 629 (E.D. Va. 1993) (adopts hypothetical test; state statute which excuses partners from rendering or accepting performance from assignee of partnership interest satisfies as “applicable nonbankruptcy law” making contract unassumable without consent of nondebtor party), aff’d, 25 F.3d 1038 (4th Cir. 1994); In re Midway Airlines, Inc., 6 F.3d 492, 495 (7th Cir. 1993) (§ 365 not limited to personal services contracts); In re West Elecs., 852 F.2d 79, 83 (3d Cir. 1988) (§ 365 applies to all contracts and even if debtor-in-possession is party assuming the contract); In re Pioneer Ford Sales, 729 F.2d 27, 29 (1st Cir. 1984); In re Braniff Airlines, 700 F.2d 935, 943 (5th Cir. 1983) (§ 365 applies to all executory contracts); In re Claremont Acquisition Corp., Inc., 186 B.R. 977, 981-84 (C.D. Cal. 1995) (reconciling confusion over § 365(c)(1) and § 365(f)(1) by holding that the latter applies only “to state laws that validate contractual anti-assignment provisions, regardless of state law. However, where federal or state statutory or common law prohibits assignment of certain types of agreements ... it is appropriate to apply those laws in a bankruptcy proceeding.”) and 2 Collier on Bankruptcy, § 365.05 (15th ed. 1991) (“the wording of [§ 365(c)] is such that considerably more contracts than those which one would normally consider personal service contracts are affected.... The reference to applicable law in section 365(c) includes situations in which state or federal law can be said to bar assignment.”) with Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493-94 (1st Cir.) cert. denied 521 U.S. 1120 (1997) (rejecting hypothetical test); Summit Inv. and Dev. Corp. v. Leroux, 69 F.3d 608, 610 (1st Cir. 1995) (The court rejects the hypothetical test and holds instead that courts must “undertake a fact ‘sensitive’ inquiry to determine whether or not, in the circumstances of the particular case,” the debtors can provide the nondebtor party to the contract with the “full benefit of their bargain.” Only if they cannot is the contract not assumable as of right in bankruptcy proceedings.); In re James Cable Partners, L.P., 154 B.R. 813 (M.D. Ga. 1993), aff’d, 27 F.3d 534 (11th Cir. 1994) (district court rejects West Elecs. 16 68700-005\DOCS_LA:54156.1 and holds that § 365 only applies when third party rather than debtor-in-possession assumes the contract; the circuit court applies the hypothetical test but holds that “applicable law” in § 365 means laws other than general prohibitions against assignment); In re Optimum Merchants Servs., 163 B.R. 546, 554-55 (Bankr. D. Neb. 1994) (rejects West Elecs.’s hypothetical test; holds that § 365 (c) only applies to personal services contracts); In re Terrace Apartments, 107 B.R. 382 (Bankr. N.D. Ga. 1989) (§ 365(c)(1) applies only to nondelegable personal service contracts). See In re Magness, 972 F.2d 689 (6th Cir. 1992) (country club membership which was subject to detailed rules and procedures for selection was not assignable); In re Antonelli, 148 B.R. 443 (D. Md. 1992) (analysis of conflict as to assumption of partnership executory contract). 3. Contracts to make a loan or extend other d financing or financial ebt accommodations. § 365(c)(2); see In re Hamilton Co., 969 F.2d 1013 (11th Cir. 1992) (court reviews meaning of term “financial accommodation;” collects cases discussing definition thereof); Watts v. Pennsylvania Hous. Fin. Co., 876 F.2d 1090 (3d Cir. 1989) (suspension of mortgage assistance payments upon filing did not violate automatic stay because housing authority’s commitments were executory contracts to “make a loan or extend other debt financing” which are terminable by housing authority under § 365(e)(2)(B)); In re Boutiette, 168 B.R. 474, 481 (Bankr. D. Mass. 1994) (“Congress undoubtedly envisioned a more expansive meaning of ‘financial accommodations’ than the extension of credit or the making of loans.”); In re Cardinal Indus., Inc., 146 B.R. 720, 730-31 (Bankr. S.D. Ohio 1992) (revolving line of credit is contract for financial accommodation); In re United Press Int’l, 55 B.R. 63, 66 (Bankr. D.D.C. 1985) (“[T]he intent of Congress was to prohibit the assumption of any contract wherein the Debtor is extended, directly or indirectly, cash or a line of credit.”); In re Adana Mortgage Bankers, 12 B.R. 977, 987 (Bankr. N.D. Ga. 1980) (Guaranty Agreements issued by Gov’t Nat’l Mortgage Assoc. deemed executory contracts to make financial accommodations for the benefit of the debtor and therefore not assumable.) But cf. In re TS Indus., 117 B.R. 682 (Bankr. D. Utah 1990) (a creditor plan could provide for the recalcitrant debtor’s assumption of a prepetition “workout” executed in anticipation of debtor’s bankruptcy even though it is a contract to extend financial accommodations). Whether this prohibition applies to contracts with “incidental financial accommodations” is subject to controversy. In re Cole Bros., Inc., 154 B.R. 689 (W.D. Mich. 1992). The case of Westship, Inc. v. Trident Shipworks, Inc., 247 B.R. 856 (M.D. Fla. 2000), has an illustrative discussion of this prohibition. One of the most common issues is whether a purported lease of property is a 68700-005\DOCS_LA:54156.1 17 “true” lease or a disguised financing arrangement for a sale. The court in Westship initially held that determination of whether a lease is a true lease is a matter of state law. The court reviewed the lease to decide the “economic substance” of the transaction and stated that the “most significant factor” was “whether the lessor has retained a residual interest at the end of the lease term.” The court rejected the idea that if an insider was involved the court should apply “strict scrutiny” to the motion to assume. In In re Mandrell, 246 B.R. 528 (Bankr. D.S.C. 1999) the court also discussed whether a purported lease was a true lease or a disguised financing agreement. The court listed the following factors to decide this issue: 1. Whether the debtor has acquired sufficient equity in the property by making payments under the agreement so that at the end of the contractual terms it can reasonably be anticipated that the debtor will exercise the option to pay the nominal consideration necessary to purchase the property; Whether the lessee may terminate the agreement without paying a sum certain or without any further obligation; Whether the lessee is obligated to maintain and repair the property; Whether the total amount of the payments under the agreement exceeds the value of the property; Whether the property has a useful life in excess of the economic value to the lessor; Whether the debtor acquires any equity in the property by making payments under the agreement; Whether the agreement requires the lessee to be responsible for the payment of any taxes, insurance, maintenance, repairs and other charges normally associated with ownership; Whether the lessor is in the business of leasing such equipment; and Whether the lessee assumes the risk of any loss. 2. 3. 4. 5. 6. 7. 8. 9. The Court’s decision in In re Pro Page Partners, LLC, 270 B.R. 221 (Bankr. E.D. Tenn. 2001) also discusses what is a “financing agreement” in the context of an agreement for the purchase of personalty. In this case the debtor assumed an agreement between it and a company called Message Express Paging Company (“Message 68700-005\DOCS_LA:54156.1 18 Express”). Later, however, the debtor moved to amend the order, asserting that the agreement was “nothing more than a financing arrangement for the purchase of assets.” The agreement provided for (1) the debtor to manage Message Express in exchange for the profits generated by the business less a $4,000 monthly fee to Message Express; and (2) an option for the debtor to purchase the assets of Message Express in which case the fee would be credited towards the purchase price. The debtor asserted that the agreement was a financing agreement because (1) Message Express had no substantial obligations under the agreement; (2) the debtor’s only remaining obligation was the payments; (3) the option agreements were a disguised payment of the purchase price; and (4) the agreement had the “ear markings” of a financing agreement. The debtor noted that all the assets of Message Express had been turned over to it upon signing of the agreement. The court noted that under applicable non-bankruptcy law legal title to personal property or goods is transferred upon delivery of the goods and that any retention or reservation of title thereafter is nothing more than a security interest in the property. The court held that title in the computers and paging and office equipment, as goods, transferred when those goods were conveyed to the debtor. The remaining provisions of the agreement were merely the financing arrangements for the sale of that personal property. G. Assignment of The Debtor’s Interests To A Third Party. Once an executory contract is assumed, it may also be assigned to a third party regardless of applicable laws or contractual provisions restricting assignment. § 365(f)(1); A.R.S.C. Co. v. Rickel Home Centers (In re Rickel Home Centers, Inc.), 209 F.3d 291, 29899 (3d Cir. 2000). Before assignment the debtor must provide adequate assurance of future performance. Once assigned, the debtor’s estate is shielded from liability for breaches arising after the assignment. § 365(k). H. The Interrelationship Between Assumption/Assignment under Section 365 and Sales Under Section 363. Section 363 allows a debtor to sell property of the bankruptcy estate. Once the debtor sells its property § 363(m) prohibits reversing a sale when a party fails to obtain a stay pending appeal, unless vacating or modifying the sale would not affect its viability. While these protections do not expressly apply to assignments under § 365, in a series of opinions the Third Circuit has held that the assignment of a contract under § 365 is also the sale of property of the estate under § 363. The recent decision of the Third Circuit in Cinicola v. Scharffenberger, 248 F.3d 110 (3d Cir. 2001) illustrates this in the context of the challenge by a group of doctors to the attempted assumption and assignment of their contracts by the trustee of the Allegheny Health, Education and Research Foundation (“AHERF”) to Allegheny General Hospital. The doctors did not obtain a stay pending appeal and the trustee moved to have their appeal held moot. The Third Circuit stated that there is a “nexus” 68700-005\DOCS_LA:54156.1 19 between the two sections because the policy concerns represented by the two sections are “equally applicable” and the definitions of assignment and sale are “synonymous.” The Third Circuit affirmed its prior holdings and remanded the case for review as to whether § 363(m)’s limits could be satisfied. IV. REJECTION. A. Mechanics. 1. The debtor may reject an executory contract through a motion to reject under § 365(a) or through a provision in the plan of reorganization pursuant to § 1123(b)(2). In re Parkwood Realty Corp., 157 B.R. 687, 690 (Bankr. W.D. Wash. 1993). However, boilerplate terms in a plan which reject all contracts not assumed, without further specificity, may not always be effective. Parkwood, 157 B.R. at 690-91. As with assumption, there is controversy over whether court approval is required for an effective rejection of a contract. Compare In re Thinking Machines Corp., 67 F.3d 1021 (1st Cir. 1995); Paul Harris Stores v. Mabel L. Salter Realty Trust, 148 B.R. 307 (S.D. Ind. 1992) (both holding that court approval necessary for effective rejection of contract); In re 1 Potato 2, Inc., 182 B.R. 540, 542 (Bankr. D. Minn. 1995) (“rejection ... is only effective upon court approval”); In re Compuadd Corp., 166 B.R. 862, 866 (Bankr. W.D. Tex. 1994) (same); In re Four Star Pizza, 135 B.R. 498, 501 (Bankr. W.D. Pa. 1992) (same) and In re Worths Stores Corp., 130 B.R. 531 (Bankr. E.D. Mo. 1991) (finds court approval required for rejection of contract, distinguishing between assumption and rejection) with In re Joseph C. Spiess Co., 145 B.R. 597, 600-06 (Bankr. N.D. Ill. 1992) (court approval of assumption or rejection is not a condition precedent to its effectiveness, rather it makes it subject to review and possible reversal) and In re 1 Potato 2, Inc., 58 B.R. 752 ( Bankr. D. Minn 1986) (rejection effective with unequivocal conduct). In an effort to avoid postpetition liabilities, debtors frequently seek to have the rejection made effective on an earlier date. One circuit court has approved a retroactive rejection, effective on the day the motion was filed. In re Thinking Machines Corp., 67 F.3d 1021 (1st Cir. 1995). At least one court has allowed a lease rejection retroactive to the petition date, where the debtor had turned over the keys and vacated the premises prepetition. See In re Ambers Stores, Inc., 193 B.R. 819 (Bankr. N.D.Tex. 1996). While the court in In re O’Neil Theatres, Inc., 257 B.R. 806 (Bankr. E.D. La. 2000) recognized the “majority position” as not allowing retroactive rejection, it allowed a rejection retroactive to the petition date where the debtor had been locked out of the premises by the landlord prepetition. 68700-005\DOCS_LA:54156.1 2. 20 B. Standards for Rejection of a Contract. An executory contract may only be rejected if the proponent satisfies the business judgment test. In re Chi-Feng Huang, 23 B.R. 798, 800 (B.A.P. 9th Cir. 1982); In re Trans World Airlines, Inc., 261 B.R. 103, 120-21 (Bankr. D. Del. 2001). The primary issue is whether the rejection of the contract would benefit general unsecured creditors. E.g., In re Orion Pictures Corp., 4 F.3d 1095, 1098 (2d Cir. 1993), cert. dismissed, 114 S. Ct. 1418 (1994); In re Kong, 162 B.R. 86, 94 (Bankr. E.D.N.Y. 1993); In re Lawson, 146 B.R. 663, 664-65 (Bankr. E.D. Va. 1992); In re Audra-John Corp., 140 B.R. 752, 755 (Bankr. D. Minn. 1992). However, other factors courts may consider include whether (a) the contract burdens the estate financially; (b) rejection would result in a large claim against the estate; (c) the debtor showed real economic benefit resulting from the rejection; and (d) upon balancing the equities, rejection will do more harm to the other party to the contract than to the debtor if not rejected. “Generally, absent a showing of bad faith, or an abuse of business discretion, the debtor’s business judgment will not be altered.” In re G Survivor Corp., 171 B.R. 755, 757-58 (Bankr. S.D.N.Y. 1994); accord Trans World Airlines, 261 B.R. at 121 (“A debtor’s decision to reject an executory contract must be summarily affirmed unless it is the product of ‘bad faith, or whim or caprice.’”). Effect of Rejection. 1. Rejection of a contract not assumed constitutes a breach immediately before the date of filing of the petition. Aslan v. Sycamore Inv. Co., 909 F.2d 367 (9th Cir. 1990); In re Continental Airlines, Inc., 146 B.R. 520, 531 (Bankr. D. Del. 1992) (rejection of lease). Rejection makes other party to the contract simply an unsecured creditor. NLRB v. Bildisco and Bildisco, 465 U.S. 513 (1984). The nondebtor party has (1) a claim against the debtor for damages for breach of contract, which claim is deemed to have arisen immediately before the filing of the petition and is a prepetition claim, and (2) an expense of administration claim for any benefits received by the debtor in possession prior to rejection. In re Bridgeport Plumbing Prods., Inc., 178 B.R. 563 (Bankr. M.D. Ga. 1994) (creditor may file administrative expense claim for the “reasonable value of the use” of the creditor’s property prior to rejection); In re Hooker Inv., 145 B.R. 138, 144 (Bankr. S.D.N.Y. 1992); see also Texaco Inc. v. Louisiana Land and Exploration Co., 136 B.R. 658, 663 (M.D. La. 1992) (rejection of the prepetition contract does not cancel the contract; it constitutes a breach of the contract and grants the other party a claim against the estate as an unsecured creditor). The rejection claim should be filed by the general bar date or the court may set a separate date for rejection claims to be filed. In re The Montaldo Corp., 209 B.R. 40 (Bankr. M.D.N.C. 1997). The amount of the damages may be controlled by state law or the remedies specified in the contract. In re Yasin, 179 B.R. 43, 49-50 (Bankr. S.D.N.Y. 1995) (After rejection parties 21 C. 2. 68700-005\DOCS_LA:54156.1 must resort to state law to determine their rights as a result of the breach.); In re Independent American Real Estate, Inc., 146 B.R. 546, 553 (Bankr. N.D. Tex. 1992) (state law specifies the remedies of a non-breaching party to a contract, to the extent state law does not contravene the Code); In re Audra-John Corp., 140 B.R. 752, 757 (Bankr. D. Minn. 1992) (state law, not federal bankruptcy law, controls remedies available to non-rejecting party upon a breach). But see In re Hamilton Roe Int’l, Inc., 162 B.R. 590, 596 (Bankr. M.D. Fla. 1993) (contract damages provisions do not control after rejection). 3. Rejection does not extinguish the contract. It merely constitutes a breach of the contract, and the terms of the contract still control the relationship of the parties. In re Flagstaff Realty Assocs., 60 F.3d 1031 (3d Cir. 1995) (Rejection of a lease does not alter the substantive rights of the parties to the lease. Hence, creditor-lessee could rely on lease provision permitting it to make repairs to leased property and deduct the cost of those repairs from its rent payments to the debtor-landlord.); In re Austin Development Co., 19 F.3d 1077, 1082 (5th Cir. 1994) (rejection breaches rather than terminates the contract), cert. denied, 115 S. Ct. 201 (1994); In re Continental Airlines, 981 F.2d 1450, 1459-61 (5th Cir. 1993) (rejection does not invalidate or extinguish contract); In re Printronics, Inc., 189 B.R. 995, 1000 (Bankr. N.D. Fla. 1995) (Rejection of an executory contract does not terminate the contract, it merely breaches the contract.); In re Yasin, 179 B.R. 43, 49-50 (Bankr. S.D.N.Y. 1995) (Rejection constitutes a breach of the contract or lease, it does not terminate it.); In re Fitch, 174 B.R. 96, 100 (Bankr. S.D. Ill. 1994) (“rejection ... neither adds to nor detracts from a claim for payment under the contract or the estate’s liability for such payment”); In re Old Electralloy Corp., 167 B.R. 786, 791 ( ankr. W.D. Pa. 1994) (“The B Trustee’s rejection of the contract ... does not render the contract non-existent. ... [nor does] the Trustee’s rejection extinguish the Debtor’s obligations under the ... provisions of the contract or render the [contract’s] provisions inapplicable as of the date of rejection. ... [Finally], the rejection does not relieve the Trustee of his obligations which arise from the period of time during which the Trustee operated the business [postpetition but prior to rejection]”); In re South Motor Co. of Dade County, 161 B.R. 532, 545-46 (Bankr. S.D. Fla. 1993) (“rejection has no effect on a contract’s continued existence ... Accordingly, rejection of an executory contract does not ipso facto terminate rights and obligations that arise from rejected contracts.”); In re Walnut Assocs., 145 B.R. 489, 494 (Bankr. E.D. Pa. 1992) (rejection of contract does not “invalidate, rejudicate, repeal, or avoid” an executory contract; it merely means that contract is not assumed and nondebtor party cannot make an administrative claim against debtor’s estate if debtor fails to perform). These cases’ discussion of the effect of rejection is interesting with regard to exploring how much relief a debtor can obtain by rejecting a contract. In In re Annabel, 263 B.R. 19 (Bankr. N.D.N.Y. 2001) the Debtor bought a chiropractic practice from the Seller. The sale 68700-005\DOCS_LA:54156.1 22 agreement contained a covenant not to compete, inter alia, prohibiting the Seller from practicing within 20 miles of the sold practice for at least one year after the purchase price was fully paid and, in the event of a default by the Debtor, that the Debtor could not practice within 20 miles of the office for 2 years. The Debtor filed a chapter 7 petition and the Seller bought a motion to lift the stay so he could sue the Debtor in state court for injunctive relief compelling compliance with the covenant not to compete. The Seller argued that a covenant not to compete was enforceable postrejection. The Debtor argued that the covenant did not survive rejection. The court first addressed the Seller’s arguments that a covenant not to compete was severable from a rejected contract, citing In re Noco, Inc., 76 B.R. 839 (Bankr. N.D.Fla. 1987). However, in Noco the court had found the contract was not executory and, therefore, not subject to rejection. Here the court held the contract had mutual substantial obligations remaining to be performed on both sides and was, therefore, executory. The court then discussed a line of cases holding that covenants not to compete could be rejected as part of an executory contract if the covenant was “intimately bound” to the rest of the contract. Here the court held that was the situation. The court then discussed the effect of rejection, noting that rejection only breached the contract and was “not tantamount to the termination of all of the rights of the parties under the contract.” Rather, the court framed the inquiry as whether the breach of the covenant resulted in a claim dischargeable in bankruptcy. In deciding this issue the court discussed the seminal case of Ohio v. Kovacs, 469 U.S. 274 (1985). In Kovacs the Supreme Court had held that a state court injunction compelling a debtor to clean up a hazardous waste disposal site created a dischargeable claim where the state had eventually appointed a receiver to perform the clean up, reducing Kovacs’ sole remaining method of performance as repayment of the receivers’ clean up costs. The court in Annabel stated that most courts had reduced Kovacs’ holding to: “a claim on a chapter 7 debtor’s breach of a covenant not to compete is dischargeable where compliance requires the expenditure of money but if, on the other hand, compliance with the covenant requires nothing more of the debtor than to refrain from conduct, then the covenant is not a debt or claim subject to discharge.” The court here granted relief from the stay for the Seller to seek a state court injunction compelling compliance with the covenant finding it was not dischargeable. In In re G.I. Industries, Inc., 204 F.3d 1276 (9th Cir. 2000), the court of appeals dealt with the argument that the court’s approval of a motion to 68700-005\DOCS_LA:54156.1 23 reject an executory contract made a subsequent ruling that the contract was invalid (in the context of a claim objection) improper. The Circuit Court held that (1) the bankruptcy court retained jurisdiction to consider the validity of the rejected contract despite the prior rejection; (2) the trustee had standing to contest the proof of claim; and (3) the court’s approval of the rejection of the contract was not the equivalent of a ruling that the contract is valid at the time of rejection, nor does it create a separate and independent cause of action supporting a claim. In Foothill Capital Corp. v. Midcom Communications, 246 B.R. 296 (E.D. Mich. 2000), the court reviewed Foothill’s argument that because its loan agreement was not assumable, rejection of the agreement was inevitable, and, therefore, rejection was the equivalent of an immediate termination which would entitle Foothill to an early termination premium. The court disagreed, holding that rejection is merely a breach and that filing a petition was not the equivalent of termination. Hence, Foothill was not entitled to a premium for early termination. 3. Despite the apparently limited impact of rejection, one court has held that claims arising from rejection of an executory contract are not available for recoupment. United States v. Dewey Freight Sys., Inc., 31 F.3d 620 (8th Cir. 1994) (claims arising from rejection may only be recovered through proof of claim). But see In re Hirschorn, 156 B.R. 379, 388 (Bankr. E.D.N.Y. 1993); In re Don & Lin Trucking Co., 110 B.R. 562, 568 (Bankr. N.D. Ala. 1990)) (both holding that rejection does not limit the nondebtor party to filing a proof of claim for damages) and Howard Johnson, Inc. v. Tucker, 157 F.2d 959, 961 (5th Cir. 1946) (claims for damages arising on rejection of an executory lease in bankruptcy are properly subject to recoupment where the obligations both arise out of the same transaction); In re Chestnut Ridge Plaza Assocs., 156 B.R. 477, 485 (Bankr. W.D. Pa. 1993) (creditor can offset losses incurred from rejection of lease against rents due the debtor under the rejected lease); In re Express Freight Lines, Inc., 130 B.R. 288, 291-92 (Bankr. E.D. Wis. 1991) (court allows setoff of claims resulting from rejection of an unexpired lease); cf. In re Columbia Gas Sys., Inc., 50 F.3d 233, 239 n.8 (3rd Cir. 1995) (“Rejection ... is equivalent to a nonbankruptcy breach. Rejection leaves the nonbankrupt with a claim against the estate ... and unless the nonbankrupt’s claim is somehow secured, he will be a general unsecured creditor of the estate.”) (emphasis added); In re Klein Sleep Prods., Inc., 173 B.R. 296, 299 (S.D.N.Y. 1994) (“Section 365 merely establishes the method for determining the date upon which a breach of an [executory contract] is deemed to occur. It does not purport to assign the priority awarded to damages flowing from the rejection of a[n executory contract].”). Leases of Personal Property. To compensate and protect the nondebtor lessor while a debtor is deciding whether to reject an unexpired lease of personal property, the Code allows the lessor to : (1) claim an 24 4. 68700-005\DOCS_LA:54156.1 administrative expense of the actual, necessary costs and expenses of preserving the estate; (2) seek relief from the automatic stay; (3) request adequate protection payments; or (4) move for the court to set a date by which the lease must be assumed or rejected. In re Continental Airlines, Inc., 146 B.R. 520 (Bankr. D. Del. 1992). Section 365(d)(10) requires debtors to timely perform obligations arising from a lease of personal property arising 60 days or more after the petition date. Thus, while a creditor may only be entitled to administrative expense status for rents due in the first 60 days of the case if they can satisfy § 503, thereafter the debtor must perform. In In re P.M. Kaye & Sons Transport, Inc., 259 B.R. 114 (Bankr. D.S.C. 2001) the court reviewed a demand for such payments on the rejected lease of some tractors. On the § 503 issue the court noted that to qualify as an administrative expense the obligation had to prove that (1) the claim arose out of a postpetition transaction, and (2) the claim directly and substantially benefited the estate. The court pointed out that mere performance under a prepetition contract does not create an administrative expense. However, where the debtor induces (or “actively bargains” for) the non-debtor party to continue to perform postpetition there is a postopetition “transaction” between the estate and the Creditor. Here that was the case. That a benefit was provided to the estate was satisfied by the debtor’s continued use of the tractors postpetition. Without discussion the court held obligations arising after the 60th day until the tractors were returned were administrative expenses. Query whether this latter result is correct: the Code merely requires “timely” performance and does not specify a remedy for a failure to do so. 5. Rejection of a contract previously assumed constitutes a breach as of date of rejection unless conversion from 11 or 13 to 7, in which case breach deemed to occur immediately before conversion. Whether damages resulting from rejection of a previously assumed contract are always entitled to administrative expense status is subject to controversy. Compare In re Frontier Properties, 979 F.2d 1358, 1367 (9th Cir. 1992) (damages from rejection of previously assumed contract are administrative expenses) with In re Klein Sleep Products, Inc., 173 B.R. 296, 298-99 (S.D.N.Y. 1994) (damages arising from rejection of previously assumed contract are only entitled to administrative expense status if they meet the requirements of § 503) and In re Chugiak Boat Works, Inc., 18 B.R. 292 (Bankr. D. Alaska 1982) (damages from rejection of previously assumed contract are administrative expenses but not entitled to superpriority under § 726(b)). Note: “The rules are more complicated when a case converts from one chapter to another. If the executory contract or lease is assumed prior to conversion, then rejected post-conversion, the 25 68700-005\DOCS_LA:54156.1 damages are deemed to have arisen immediately prior to the conversion. § 365(g)(2)(B)(i). However, where assumption occurs postconversion and then there is a rejection in the converted case, any damages are deemed to have arisen at the time of rejection. § 365(g)(2)(B)(ii).” In re Wright, 256 B.R. 858, 859 n. 1 (Bankr. W.D.N.C. 2001). The decision in In re Wright, 256 B.R. 858 ( Bankr. W.D.N.C. 2001) illustrates this point. In Wright the Debtor’s chapter 13 plan assumed the lease for a trailer. Post confirmation problems compelled the Debtors to abandon the trailer and request that payments under the assumed lease to general unsecured claims. As one would expect, the lessor objected, asserting its claims must be treated as administrative expenses. The court agreed with the lessor rejecting the Debtor’s argument that the obligations status should be evaluated under the standards established by § 503 (“Actual necessary costs or expe nses of preserving the estate”). While the court mentioned that this result was “at odds with the general premise . . . that one creditor should not enjoy a windfall at the expense of other creditors” it reached its conclusion based on considerations of the intent of Congress and precedent. An interesting twist on this is the effort by the Debtor in In re Trans World Airlines, Case No. 01-00056 (PJW). Here the Debtor obtained an order allowing it to assume a contract with Kuwait Airlines. Approximately two months later the Debtor filed a motion to vacate the earlier order, relying on Rule 60 of the Federal Rules of Civil Procedure. This motion asserted that the earlier order was based on the “mistaken belief” that the contract was essential. Query whether a debtor should be allowed to avoid the liability imposed by an assumption if it inadvertently assumes a contract as part of an omnibus motion and order or through a blanket provision assuming all contracts not expressly rejected. The status of claims based on future rents when the lease is assumed and then subsequently rejected is subject to controversy. See In re Johnston, Inc., 164 B.R. 551, 553-56 (Bankr. E.D. Tenn. 1994) (loss of future rents from lease which is assumed and then rejected is not an administrative expense). 6. Rejection Of Leases. (a) Whether the rejection by the debtor-lessor always terminates the lease is subject to controversy. Compare In re Carlton Restaurant, Inc., 151 B.R. 353 (Bankr. E.D. Pa. 1993) (rejection always terminates lease and lessor’s obligations thereunder; lessee is entitled to only those rights provided under § 365(h)) with In re Chestnut Ridge 26 68700-005\DOCS_LA:54156.1 Plaza Assocs., L.P., 156 B.R. 477 (Bankr. W.D. Pa. 1993) (§§ 365(g), (h), read together, do not mandate automatic termination where debtor-lessor rejects lease); In re Kong, 162 B.R. 86, 95-96 (Bankr. E.D.N.Y. 1993) (rejection of lease by debtor-lessor only results in termination of covenants that require future performance by debtor); and In re Mr. Gatti’s, Inc., 162 B.R. 1004, 1011-12 (Bankr. W.D. Tex. 1994) (collecting cases). Whether rejection by the debtor-lessee always terminates the lease is also subject to controversy. In re Austin Development Co., 19 F.3d 1077 (5th Cir. 1994) (rejection by debtor-lessee does not terminate lease). (b) Whether the lessor-nondebtor’s claim for the postpetition, prerejection rents is limited by § 503 and/or are entitled to an administrative priority is subject to controversy. Compare In re Templeton, 154 B.R. 930, 932 (W.D. Tex. 1993) (collecting cases and holding that such claims are not entitled to administrative expense status); In re Mr. Gatti’s, Inc., 164 B.R. 929, 1007-1011 ( ankr. B W.D. Tex. 1994) (exhaustive discussion of history and present treatment of postpetition, prerejection claims for lease-related obligations as administrative expenses; court holds that such claims are not automatically entitled to administrative expense status) with In re Compuadd Corp., 166 B.R. 862, 864-66 (Bankr. W.D. Tex. 1994) (rejecting conclusion of court in Mr. Gatti’s). Section 502(b)(6) of the Bankruptcy Code provides that if a claim is filed by a lessor for damages resulting from termination of a lease of real property, such claim may not exceed – (A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease following the earlier of – (i) the date of the filing of the petition; and (ii) the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus (B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates. In other words, § 502(b)(6) caps a landlord’s claim arising from lease rejection. The method of calculating the capped damages is subject to controversy. Most courts have held that a security deposit held by the lessor must be applied to reduce the capped claim for damages. In other words, first the claim is reduced to its capped amount and then the security deposit is offset against the resulting claim. In re PPI Enterprises, Inc., 228 B.R. 339, 349 (Bankr. D. Del. 1998). However, where a lessor can mitigate its damages, courts have allowed those proceeds to be applied to the total, uncapped claim. In re Handy 68700-005\DOCS_LA:54156.1 27 Andy Home Improvement Centers, Inc., 222 B.R. 571 (Bankr. N.D. Ill. 1998). In In re Andover Togs, Inc., 231 B.R. 521 (Bankr. S.D.N.Y. 1999) the court analyzed what constitutes “rent” to which the §502(b)(6) limitation applied. The court found that an expense term in a lease may be considered “rent’ if (1) it is designated as rent or additional rent in the lease; (2) it is an obligation of the tenant in the lease; (3) it is related to the property or lease; and (4) it is a fixed, regular or periodic change. Thus, charges for electricity usage did not qualify as rent but common area maintenance charges did qualify as rent. In In re Arden, 176 F.3d 1226 (9th Cir. 1999) the court of appeals held that the damage cap in § 502(b)(6) applied even where the debtor was a lease guarantor, rather than a lessee. (c) Tenant’s options if the Debtor-lessor rejects: (1) Treat lease as terminated; or (2) Remain in possession. § 365(h)(1); In re Kong, 162 B.R. 86, 95-96 (Bankr. E.D.N.Y. 1993). If remain in possession: May offset against rent any damages caused by debtorlessor’s non-performance BUT (2) 7. No further, independent claim against estate for further damages. § 365(h)(2). What About Cross Default Provisions in Leases? Many cases hold that cross-default provisions are not generally enforceable in bankruptcy. However, it is axiomatic that rejection of a lease has a limited effect. Rejection does not extinguish a lease; it merely constitutes a breach of the lease, and the terms of the lease still controls the relationship of the parties. See, e.g., In re Flagstaff Realty Assocs., 60 F.3d 1031 (3d Cir. 1995). Thus, because rejection is merely a breach of a (1) 68700-005\DOCS_LA:54156.1 28 lease, whether it should impact on the enforceability of cross-default provisions is unclear. Cases holding that cross-default provisions are not generally enforceable are based on general principles of bankruptcy law; such general principles should not be used to create substantive rights for debtors that Congress did not grant. To the contrary, “Congress has suggested that the modification of a contracting party’s rights are not to be taken lightly.” In re Joshua Slocum Ltd., 922 F.2d 1081, 1091 (3d Cir. 1990). Moreover, “overwhelming case authority [holds] that a bankruptcy court is not free to re-write an executory contract upon either its assumption or its rejection.” In re Gunter Hotel Assocs., 96 B.R. 696, 698 ( Bankr. W.D. Tex. 1988). There are no express provisions in the Bankruptcy Code invalidating cross-default provisions. Moreover, only by ignoring the plain language of section 365(f) and expanding its reach beyond its terms have courts concluded that, because a debtor may assign a lease not withstanding a provision in the lease “prohibiting, restricting or conditioning” the assignment of that lease, it necessarily follows that any provision that hampers a debtor’s opportunity to assume a lease—such as the cross-default provisions--must be excised from the lease. Needless to say, cross-default provisions in leases do not expressly “prohibit, restrict or condition” the assignment of such leases. That debtors may not be able to subsequently assume a lease because they have previously breached a provision of the lease should not shield the debtors from the implications of their choices. Where Congress has not excused a debtor from complying with the terms of a contract or lease (i.e., an ipso facto clause) courts should not create such an exception. See generally United States v. Wells Fargo Bank, 485 U.S. 351, 357 (1988) (a maxim of statutory interpretation is espressio unis est exclusio alterious, the expression of one thing implies the exclusion of another). If a court could excuse compliance with any provision of a lease or contract because, based on a debtors’ business judgment, the debtor, for economic reasons thought it better not to comply with that provision, no lease or contract provision would be safe. Debtors could simply argue that the lease or contract would be easier to assume and assign without the offending provision and, 68700-005\DOCS_LA:54156.1 29 thus, the provision “restricts” the debtors’ ability to assume and assign the lease or contract. A debtor could argue that a lease provision requiring an increase in rent “restricts” its ability to assume and assign the lease, so that provision should be excised. Excising a cross-default provision because it may have the result of “restricting” a debtor’s ability to assume and assign a lease simply bends the language of section 365(f) out of all proportion to the plain language of the statute. Some courts will enforce cross default provisions if the “facts and circumstances” indicate that those provisions are an “essential part” of the bargain between the parties. In re Kopel, 232 B.R. 57, 64-65 (Bankr. E.D.N.Y. 1999). Among the factors to be considered are (1) whether the non-debtor party would have entered into the contract or lease absent the cross-default provisions; (2) whether legally separate entities are parties to the various contracts or leases; (3) whether the documents with the cross-default provisions are “contemporaneously executed as necessary elements of the same transaction;” (4) whether the separate leases or contracts “formed one indivisible agreement” constituting a single contract for purposes of state law; and (5) whether enforcement of the cross-default provisions would “impermissibly hamper” the Debtor’s reorganization. See, e.g., Kopel, 232 B.R. at 64-67. V. TERMINATING EXECUTORY CONTRACTS A. Mechanics. Request for determination that automatic stay does not apply coupled with request for relief from the stay. A request for relief from the stay is a contested matter commenced by a motion and governed by Fed. R. Bankr. P. 9014. The stay expires 30 days after filing of the motion unless the court, after notice and hearing, continues it. § 362(e). The hearing is generally held on an expedited basis, and the scope of these hearings is generally limited. § 362(e); see In re Transamerican Natural Gas Corp., 978 F.2d 1409, 1416 (5th Cir. 1992); In re Midway Airlines, Inc., 167 B.R. 880, 883 (Bankr. N.D. Ill. 1994) (“hearings to determine whether to lift the stay are meant to be summary in character. ... limited strictly to adequacy of protection, equity, and necessity to an effective reorganization.”); In re Grand Traverse Dev. Co. L.P., 150 B.R. 176, 187-89 (Bankr. W.D. Mich. 1993) (same); In re Orfa Corp. of Philadelphia, 170 B.R. 257, 267 (E.D. Pa. 1994) (even “inadvertent failure to hold preliminary hearing” results in termination of stay; however, creditor’s acts can waive this result). Compare In re Vitreous Steel, 911 F.2d 1223 (7th Cir. 1990) with In re Shehu, 30 68700-005\DOCS_LA:54156.1 128 B.R. 26 (Bankr. D. Conn. 1991) (cases representing divergent views on scope of hearing). B. Is termination of an executory contract subject to the automatic stay. A prepetition termination for default that has become final is not stayed. Cf. Moody v. Amoco Oil Co., 734 F.2d 1200 (7th Cir. 1984). Postpetition terminations for convenience probably are stayed because the termination action deprives the estate of an asset the might adversely impact the debtor in possession’s ability to formulate a viable reorganization plan. Compare In re West Elecs., 852 F.2d 79 (3d Cir. 1988) (relief from the stay is mandated because of Anti-Assignment Act) with In re Computer Communications, 824 F.2d 725, 728-31 (9th Cir. 1987) (dicta) (termination of even non-assumable personal services contract subject to automatic stay). Some courts have also held that terminations for default are similarly stayed. In re Corporacion de Servicios Medicos Hospitalarios de Fajardo, 805 F.2d 440 (1st Cir. 1986); Harris Prods., Inc., ASBCA No. 30426, 87-2 BCA ¶ 19,807 (both finding that pending default terminations based on prepetition facts are stayed); Communications Technology Applications, Inc., ASBCA No. 41573, 92-3 BCA ¶ 25,211 (board holds that the automatic stay provisions nullify termination for default received two days after the petition was filed); see generally In re National Environmental Waste Corp., 191 B.R. 832, 834 (Bankr. E.D. Cal. 1996) (Executory contracts are property of the bankruptcy estate and termination of an executory contract requires relief from the automatic stay; termination of a contract without relief from the stay is an act to exercise control over property of the estate which violates § 362(a)(3).). However, the automatic stay does not apply to contracts entered into by the debtor postpetition. Such contracts may be terminated by the non-bankrupt party in accordance with the terms of the contract without relief from the stay. In re New England Marine Servs., Inc., 174 B.R. 391, 397 (Bankr. E.D.N.Y. 1994). That contract is non-assumable/non-assignable is “cause” for relief from stay under § 362(d)(1). In re West Elecs., 852 F.2d 79 (3d Cir. 1988); In re Adana Mortgage Bankers, 12 B.R. 977, 988 (Bankr. N.D. Ga. 1980); see also In re Pennsylvania Peer Review Org., 50 B.R. 640 (Bankr. M.D. Pa. 1985). C. 68700-005\DOCS_LA:54156.1 31 TABLE OF CONTENTS Page I. II. A. B. C. D. E. F. G. H. I. III. A. B. C. D. E. F. G. H. IV. A. B. C. V. A. B. C. INTRODUCTION .............................................................................................................. 1 THRESHOLD ISSUES ....................................................................................................... 1 What is an executory contract? ............................................................................................. 1 Is the contract “executory”? Is the lease “unexpired”? ........................................................... 2 A single writing may contain more than one contract for §365 assumption-rejection purposes. ............................................................................................................................. 4 Multiple contract documents may form one uniform agreement for assumption-rejection purposes .............................................................................................................................. 5 Postpetition, Pre-Rejection or Assumption Treatment of Executory Contracts........................ 5 Effect of Debtor’s Failure To Act. ........................................................................................ 7 When Must the Decision Be Made. ...................................................................................... 8 Postpetition contracts are not subject to assumption or rejection. ......................................... 10 Can The Debtor Bargain Away Its Rights Prepetition? ........................................................ 10 ASSUMPTION ................................................................................................................ 10 Mechanics. ........................................................................................................................ 10 Standard of Review By Bankruptcy Court. ......................................................................... 11 Assumption Through Conduct. ........................................................................................... 11 Timing of Assumption [§365(d)]......................................................................................... 12 Impact of Assumption ........................................................................................................ 14 Limits On The Debtor’s Ability To Assume......................................................................... 15 Assignment of The Debtor’s Interests To A Third Party. ..................................................... 21 The Interrelationship Between Assumption/Assignment under Section365 and Sales Under Section363. ............................................................................................................. 22 REJECTION. .................................................................................................................... 22 Mechanics. ........................................................................................................................ 22 Standards for Rejection of a Contract. ................................................................................ 23 Effect of Rejection.............................................................................................................. 24 TERMINATING EXECUTORY CONTRACTS .............................................................. 33 Mechanics. ........................................................................................................................ 33 Is termination of an executory contract subject to the automatic stay. ................................... 34 That contract is non-assumable/non-assignable is “cause” for relief from stay under §362(d)(1)......................................................................................................................... 34 -i- An extra section break has been inserted above this paragraph. Do not delete this section break if you plan to add text after the Table of Contents/Authorities. Deleting this break will cause Table of Contents/Authorities headers and footers to appear on any pages following the Table of Contents/Authorities.