§ 28.03 Leases and Contracts: The Effect of Bankruptcy

• Jurisdiction: United States
• Publication year: 2022

§ 28.03 Leases and Contracts: The Effect of Bankruptcy

[1]—Options Available to the Trustee/Debtor-in-Possession

The power of a bankruptcy trustee to "assume" (keep or affirm) or "reject" (disavow) executory contracts and unexpired leases entered into prior to bankruptcy is set forth in Section 365(a).¹ A debtor-in-possession, in a Chapter 11 case, standing in the shoes of the bankruptcy trustee, is vested with this power.²

The concept of rejection has its roots in the principle that the bankruptcy trustee should be able to abandon burdensome property.³ Debtors-in possession and trustees have two additional powerful tools to use to modify obligations existing under executory contracts and unexpired leases for real and personal property,: (1) the right to assume a contract or lease by curing defaults, notwithstanding a provision in the affected contract or lease providing for termination due to a bankruptcy filing or other insolvency event, and (2) the right to assign such contract or lease, notwithstanding a provision restricting assignment.⁴ However, the benefits of assumption and of assumption and assignment come at the cost of meeting the requirements for assumption and assignment to occur imposed by Section 365. -Additionally, the non-debtor party, such as a lessee of personal or real property is entitled to "adequate assurance of future performance" of the debtor's ongoing obligations under the subject contract or lease. Also, a debtor-in-possession or trustee must cure existing defaults and pay damages arising from a breach under the contract or lease being assumed and then "live in accordance with the remaining provisions. . . ."⁵

Landlords of commercial real estate have certain protections under the Bankruptcy Code not generally availavleavailable to other non-debtor counterparties.⁶ Principally, commercial leases of non-residential real property must be assumed or rejected before the earlier of 120 days from the entry of an order for relief or confirmation of a Chapter 11 plan.⁷ -In December 2020, in response to the economic dislocation engendered by the COVID-19 pandemic, Congress enacted the CAA,⁸ which in part, amends Section 365(d)(4)(A) of the Bankruptcy Code to give the debtor-in possession or the trustee 210 days after the order for relief to assume an unexpired non-residential real property lease, thereby extending the period under prior law by an additional 90 days. This change applies to cases under all chapters, and it sunsets in two years on December 27, 2022.⁹ Subject to the temporary change included in CCA, such 120-day period (now 210) may be extended for a period not to exceed 90 days for "good cause."¹⁰ No further extensions beyond 210 days are permitted without the landlord's written consent.

Prior to assumption or rejection and after the filing of a bankruptcy case, executory contracts and unexpired leases entered into by a debtor prior to the filing of a bankruptcy case remain in existence and enforceable by the debtor-in-possession or trustee, but generally are not enforceable against the debtor-in possession or trustee.¹¹ Section 365 does impose certain performance oblivions on debtors-in-possession and trustees during this interim period. For example, with respect to leases for nonresidential real property, section 365(d)(3) provides that the trustee "shall timely perform all the obligations of the debtor" arising after the petition is filed and before the lease is assumed or rejected. Moreover, the Bankruptcy Code provides debtors-in-possession and trustees with the means to compel third parties to continue doing business with them when a bankruptcy filing might otherwise cause a non-debtor party to be reluctant to do so.¹²

[2]—Underlying Disputed Contract Issues

Any underlying disputed issue regarding the validity of a commercial lease, or whether a party has breached, at least in the Second Circuit, is not to be resolved in the context of a motion to assume or reject, since such motions are to be dealt with expeditiously.¹³

[3]—Is a Certain Lease or Contract "Executory" or "Unexpired" for the Purposes of Bankruptcy Code Section 365?

[a]?quot;Executory Contracts" and "Unexpired Leases"—No Statutory Definitions

The Bankruptcy Code neither defines nor attempts to define "executory contract" and "unexpired lease." However, the House report on Section 365 indicates that the term "generally includes contracts on which performance remains due to some extent on both sides."¹⁴ The Supreme Court, citing the legislative history, has characterized an executory contract as one "on which performance is due to some extent on both sides."¹⁵

[b]—The Countryman Definition

The following definition, which has been adopted by many courts, is the most widely cited definition of "executory contract" for purposes of the Bankruptcy Code.¹⁶ An executory contract is?/span>

"a contract under which the obligation of both the bankrupt and other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other."¹⁷

Many courts have adopted the "Countryman" definition and have held various types of contracts to be executory, thereby allowing a debtor-in-possession or trustee to assume, assign or reject such contracts and leases.¹⁸

[c]—The Functional Approach

A number of courts have eschewed the Countryman definition as too rigid and have followed a more result-oriented approach.¹⁹ Taking this approach, courts focus on whether the estate will benefit from the assumption or rejection.²⁰ Courts employing the "functional" approach consider the purpose behind permitting a debtor-in-possession or trustee to assume or reject a contract or lease, and, rather than focusing on the dictionary definition of "executory contract," analyze whether rejection or assumption will benefit the estate.²¹ In addition to criticizing the rigidity of the Countryman definition, several courts have criticized its failure to further the goals of the Bankruptcy Code of maximizing the value of the estate assets.²²

Employing this type of benefit/burden analysis, in many cases, will result in the same outcome as applying the Countryman analysis. For example, when rejecting an employment agreement would benefit the estate by avoiding the debtor's obligation to make a large severance payment, such a contract would be considered executory under the benefit/burden approach.²³

However, in contrast to the application of the Countryman Definition, the use of the benefit/burden approach, may result in a finding that a contract is executory, even if one party has fully performed. Thus, when the buyer fully performed his obligations under a land sale contract, a court still found the contract capable of rejection, when the contract called for a $300,000 parcel of realty to be sold for $251,750.²⁴

Similarly, a contract probably would not be executory using a benefit/burden analysis when parties to a land sale contract have significant obligations that would render the contract executory, since the estate would benefit from having the claim of the non-debtor treated as a lien against the estate rather than forcing the debtor to assume or reject the agreement.²⁵

The Second Circuit, by way of example, has never expressly adopted the Countryman test; rather, the court has referred instead to the legislative history for the proper standard, stating that:²⁶

"A test less exclusive than Countryman's that takes into account the mutual performance requirement embodied in the legislative history should be substituted. Under this test, a contract is executory if each side must render performance, on account of an existing legal duty or to fulfill a condition, to obtain the benefit of the other party's performance. Weighing the relative benefits and burdens to the debtor is the essence of the decision to assume or reject; if each party must still give something to get something, the contract is executory, and the debtor must demonstrate whether assumption or rejection confers a net benefit on the estate. If the debtor has done everything it needs to do to obtain the benefit of its bargain, assumption serves no purpose, and the debtor may simply sue to enforce its rights. Similarly, if the other party has done everything necessary to require the debtor to perform, the debtor's performance adds nothing to the estate, the debtor will not assume the contract, and the other party can file a prepetition claim."²⁷

The Fourth and Sixth Circuits, by way of a further example, have held that an executory contract is one that requires performance on both sides.²⁸

[d]—Application of Section 365—Only to Contracts and Leases in Effect upon a Bankruptcy Filing

Section 365 of the Bankruptcy Code pertains only to executory contracts and unexpired leases in effect on the bankruptcy filing date.²⁹ If there is no term remaining on a commercial lease when a bankruptcy is filed, then such lease has expired by its own terms and cannot be said to be "unexpired" within the meaning of section 365. Similarly, if a contract was terminated prior to the commencement of a bankruptcy case, then the contract, by definition has been fully executed and there is nothing left to be assumed or rejected post-bankruptcy.³⁰

The character of an agreement as either an executory contract or unexpired lease for real or personal propertyordinarilyproperty ordinarily is determined as of the bankruptcy filing date.³¹

For purposes of assumption or rejection, the legal status of a lease agreement as one that is executory or unexpired is governed by applicable state law.³² However, where bankruptcy filing date events alter the nature of the contract, e.g., expiration of the term by the passage of time, the bankruptcy court may review such facts and act or refuse to do so.³³

Stated differently, whether there are continuing obligations under a contract is something that is determined based on the...