Contracts and Leases in Bankruptcy
| Publication year | 1984 |
| Pages | 1153 |
1984, July, Pg. 1153. Contracts and Leases in Bankruptcy
The effect of a skyrocketing number of bankruptcies since the Bankruptcy Reform Act of 1978 ("Bankruptcy Code") became effective in October 1979 has been that attorneys who practice in the areas of commercial and real estate law know that they now must understand at least the basics of bankruptcy law. An insolvency or Chapter 11 proceeding can adversely affect any party who has a contractual or lease arrangement with the debtor in bankruptcy.
While more sophisticated problems may necessitate associating with an experienced bankruptcy specialist, all commercial and real estate lawyers need a working knowledge of how to draft contracts and leases to meet possible bankruptcy problems and of how clients may be affected should a bankruptcy occur.
The purpose of this article is to give the practitioner a basic outline of the law in this area and to suggest how best to protect the client. A first step is to define the concepts of "executory contract" and "unexpired lease" as used in Bankruptcy Code § 365.
The term "executory contract" is undefined by the Bankruptcy Code, but the legislative history states that "it generally includes contracts on which performance remains due to some extent on both sides."(fn1)
According to Professor Vern Countryman of Harvard, executory contracts should be defined as an agreement where
the obligations 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.(fn2)
This definition has been upheld in the Ninth Circuit,(fn3) but other courts and authors have differed with it.(fn4)
In the Rocky Mountain area, an executory contract was defined in a pre-Code case by the Tenth Circuit as one where further performance is required by each party.(fn5) The definitions used by the Tenth Circuit and that of Professor Countryman would yield different results with respect to limited partnership agreements. Professor Countryman's definition would not make such agreements executory, whereas the Tenth Circuit's definition would.(fn6)
Obviously, a lease which has expired according to its own terms and thus terminated is not an unexpired lease. More often, a dispute arises as to whether the lease or contract has actually terminated. The leading Tenth Circuit opinion, Trigg v. United States,(fn7) found that a contract effectively terminated before the filing of a petition in bankruptcy cannot be later assumed or rejected by the trustee. Trigg was a pre-Bankruptcy Code case where oil and gas leases stated that they automatically terminated for nonpayment of annual rent. The court found that the leases could not be reinstated by the Bankruptcy Court in a Chapter XI case. Other circuits in pre-Code cases have similarly held that a terminated lease or contract cannot be reinstated or somehow revived.(fn8)
Cases decided under the Bankruptcy Code have upheld these rules regarding termination. For example, in Omni International, Ltd. v. Mimi's of Atlanta, Inc.,(fn9) the court held notification of termination for failure to cure prepetition default within ten days to be effective. Likewise, the Oregon Bankruptcy Court in Hazen v. Hospitality Assoc., Inc.,(fn10) held a sublease to be effectively terminated by a prepetition nonpayment of rent, notwithstanding subsequent acceptance of late rental payments.
Under Trigg, whether a contract or lease has actually terminated is determined by looking to state law. However, state law can give the bankruptcy judge a reason to find there has been no termination---in most states, common law provides that the "law dislikes forfeiture." As to what act of law constitutes a termination of a lease which does not terminate by its own terms, the leading authority is Kearny Mesa Crossroads v. Acorn Investments.(fn11) In this case, the court found that a prepetition default judgment entered in an unlawful detainer action terminated the lease.
Under various state laws, it might be asked whether it is expiration of the time specified in a notice to quit, the entering of a judgment in a forcible entry and detainer action or the service of the order of possession which would constitute the last act necessary to cause termination of the lease. In Colorado, the expiration of the time specified in a notice to quit because of the lessee's default may constitute termination.(fn12)
The lease of personal property for purposes of security is not actually a "lease," but is subject to the Bankruptcy Code provisions regarding security interests.(fn13)
If counsel is unfortunate enough to be in a position where the court determines that the lease actually is a secured transaction, the allowable amount of the secured claim will be determined by the court. The lessor would be entitled to accelerated maturity of installments remaining due after default, but not including unearned interest on the secured debt accruing after the filing of a petition.(fn14)
Often in the "unreal" lease situation, the lessor treating the transaction as a true lease has failed to file a financing statement as required by the Uniform Commercial Code ("UCC"). Such a "lease" becomes voidable by the trustee and the"lessor" is treated as an unsecured creditor.(fn15) Indeed, even belated perfection of filing of a financing statement within ninety days before the filing of a petition, or for one year for an insider, may subject the lessor's interest in the leased property to the trustee's avoiding powers. The payments which the lessor received within the preference period, in turn, may be subject to being turned over to the trustee. In addition, post-petition proceeds, products, offspring, rents and profits accruing to the lessor under a lease intended as a security interest would be terminated pursuant to § 522(b).
Some of the considerations given by the Bankruptcy Court as to whether a lease is a true lease or a financing transaction are: (1) the useful life of equipment; (2) costs of removal and return; (3) comparative values; and (4) purchase options and at what price.(fn16)
The court in In re Booth(fn17) found that the following policy considerations should be used: (1) benefit to the estate; (2) harm to the creditor; and (3) whether the form should really be controlling. In this case, Judge Mabey determined that despite the land contract looking as though it was an executory contract, it was in fact, by analogy to the UCC, a purchase money security interest and thus could not be assumed or rejected.
Generally, the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor under § 365(a). However, the trustee may not assume or assign a contract or lease if the law excuses the other party to such a contract or lease from accepting or rendering performance to the trustee. An example of this would be a personal performance contract if such party does not consent to an assumption.(fn18)
This provision has been strictly construed and does not incorporate common law which is restrictive of assignment of leases not involving an element of personal service, trust or confidence.(fn19) However, it is not only personal performance contracts which are nonassumable. If any applicable statutory or regulatory law excuses the party from performing, that party need not perform.
In Pension Benefit Guaranty Corp. v. Braniff Airways, Inc.,(fn20) the district court had authorized Braniff to assume its lease and agreements with the United States for the use of facilities and space at Washington National Airport. However, the Fifth Circuit, based on its reading of § 365(c), held that this statute is not restricted to application of personal service contracts. Since Braniff's assignee had not obtained approval of the FAA for operations at the Washington airport, the FAA was excused from accepting performance by an assignee.
Under any equity theory, this would appear to be an erroneous result. There was no objection by the United States that the assignee to be would do a less credible job than Braniff had done, but only that technical approval had not been obtained.
A trustee cannot assume a commitment letter or contract to make a loan or extend financial accommodations for the benefit of a debtor or to issue a security of the debtor.(fn21) With regard to loans, it is immaterial whether the other party consents or whether the contract or lease restricts assignment of rights or delegations of duty.
Although it is not entirely clear, it seems from the legislative history that this provision does not prevent the trustee from assuming contracts requiring delivery of goods, equipment or services on the credit of the buyer.(fn22)
Special problems may exist where a bank has issued a letter of credit for benefit of a debtor and the holder of the letter of credit demands the bank make payment after the debtor has filed a bankruptcy petition. If the bank was defrauded in some way in the inception, the bank should seek an injunction under § 105to stop the...
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