Arbitration Agreements as Executory Contracts in Bankruptcy After Mission Prod. Holdings, Inc. v. Tempnology, LLC.

• Author: Ware, Stephen J.

Introduction I. Arbitration Agreements as Executory Contracts in Bankruptcy A. Basics of Bankruptcy Code [section] 365 1. The Bankruptcy Estate May Assume or Reject an Executory Contract 2. Consequences of Assumption and Rejection B. Tempnology and Rights that Survive a Contract Breach 1. Rejection is Breach, not Rescission 2. Money Damages v. Equitable Remedies 3. Specific Performance Against the Bankruptcy Estate. C. The Right to Arbitrate Survives Breach 1. Arbitration Enforced Only with Specific Performance 2. Nearly All Courts Before and After Tempnology Enforce Arbitration Agreements, Notwithstanding Rejection II. Arbitration Law's Separability Doctrine Meets Bankruptcy Code [section] 365 A. Overview B. The Separability Doctrine Increases Enforcement of Arbitration Agreements 1. The Separability Doctrine Enforces Executory Arbitration Agreements, Notwithstanding Challenges to the Validity of the Contracts Containing Them 2. Expanding the Pre-Arbitration Separability Doctrine to State Courts, Adhesion Contracts, and a Wide Range of Contract Defenses . 3. Both Sides of Debates About the Separability Doctrine Agree that it Makes Arbitration Agreements More Enforceable 4. Rent-A-Center's "Super-Separability" Sacrifices Still More to Enforce Still More Arbitration Agreements C. Bankruptcy's All-or-Nothing Rule for Assumption or Rejection 1. Assume or Reject all Executory Portions of Contract 2. Comparing Rare Exceptions to Bankruptcy's All-or Nothing Rule with Arbitration Law's Separability Doctrine D. Integrating the Separability Doctrine with [section] 365 1. Arbitration Agreements are Separable Executory Contracts 2. Tempnology Defeats Arguments that Separability Enables Rejection of an Arbitration Agreement to Prevent its Enforcement III. Conclusion INTRODUCTION

In 2021, a bankruptcy court refused to enforce an arbitration agreement because, among other reasons, the debtor rejected the contract containing the arbitration agreement under Bankruptcy Code [section] 365. (1) In concluding that rejection meant the debtor was "no longer bound by the [contract]'s provisions that impose specific performance obligations on it--provisions such as the Arbitration Clause," (2) the bankruptcy court rightly found "support in" a 2014 federal district court decision refusing to enforce an arbitration agreement against a receiver who had rejected that agreement under receivership law similar to [section] 365. (3) These two decisions conflict with a long line of cases enforcing executory arbitration agreements notwithstanding rejection under [section] 365. Moreover, the Supreme Court's Mission Prod. Holdings, Inc. v. Tempnology (4) decision supports this long line of cases, as another bankruptcy court recognized by citing Tempnology in holding that "the bankruptcy code does not render arbitration clauses in rejected executory contracts inoperative." (5)

Bankruptcy Code [section] 365 gives the trustee or debtor-in-possession representing a bankruptcy estate the power to choose whether the estate will assume or reject many of the executory contracts formed by the pre-bankruptcy debtor. Section 365 instructs courts to treat the estate's rejection of an executory contract as though the pre-petition debtor had breached that contract. This treatment typically means that the non-debtor party to the rejected contract will collect no money from the estate or merely a small portion of the money damages a non-bankruptcy court would have awarded for the debtor's breach of contract had the debtor stayed out of bankruptcy. In this sense, rejection of an executory contract typically weakens enforcement of that contract by the non-debtor party seeking money damages.

In contrast, the rejection of an executory arbitration agreement formed by the pre-bankruptcy debtor does not--except in the two outlier cases noted above--weaken the non-debtor party's enforcement of that arbitration agreement. Notwithstanding rejection under [section] 365, nearly all courts enforce executory arbitration agreements against the estate with the remedy of specific performance that compels the estate to arbitrate. However, [section] 365 cases have been uneven in their handling of arbitration law's separability doctrine, (6) which holds that "arbitration clauses as a matter of federal law are 'separable' from the contracts in which they are embedded." (7) The separability doctrine may, at least initially, seem to conflict with [section] 365 cases stating that an executory contract must be assumed or rejected in its entirety under the "all-ornothing rule." Difficulties combining the separability doctrine with [section] 365 have produced erroneous statements by several courts, including the Third Circuit's oft-cited decision in Hays and Company v. Merrill Lynch, Pierce, Fenner, & Smith, Inc. (8)

This Article has two main parts. Part I begins with [section] 365 and the consequences of assumption and rejection, before exploring the implications of the United States Supreme Court's statement in Mission Prod. Holdings, Inc. v. Tempnology, that "[a] rejection breaches a contract but does not rescind it. And that means all the rights that would ordinarily survive a contract breach ... remain in place" after rejection. (9) Consistent with this statement and its likely implications, Part I shows, many courts before, and one after, Tempnology have specifically enforced arbitration agreements against the estate, notwithstanding rejection of those arbitration agreements. Part I argues that these many cases are right rather than the two outlier cases identified at the start of this Article.

Part II of this Article explains arbitration law's separability doctrine and integrates it with bankruptcy law. This analysis shows, contrary to the outlier cases and some commentators, that the separability doctrine is compatible with, and even further supports, courts' conclusions that rejection under [section] 365 does not prevent specific enforcement of an arbitration agreement. The Article concludes that a pre'bankruptcy debtor's arbitration agreement is specifically enforceable by or against the estate, regardless of whether the rest of the contract containing the arbitration agreement is executory. And either party is entitled to specific performance of the arbitration agreement regardless of whether the estate has rejected it and the broader contract containing it or rejected only the arbitration agreement while assuming the broader contract containing it.

1. ARBITRATION AGREEMENTS AS EXECUTORY CONTRACTS IN BANKRUPTCY

   1. BASICS OF BANKRUPTCY CODE [section] 365

      1. The Bankruptcy Estate May Assume or Reject an Executory Contract

         The commencement of a bankruptcy case creates a new legal person, the bankruptcy estate, represented by a trustee or debtor-in possession (DIP), (10) and automatically transfers much or all the pre-bankruptcy debtor's property to the estate. (11) Largely following earlier bankruptcy law, (12) Bankruptcy Code [section] 365(a) gives the trustee or DIP the power to choose whether the estate will assume or reject many of the executory contracts formed by the prebankruptcy debtor. (13)

         While the Bankruptcy Code does not define "executory contract," courts have overwhelmingly adopted the so-called Countryman definition, (14) which defines an executory contract as "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." (15)

         To see what an executory contract under [section] 365 is and is not, consider a pre-petition contract obligating Seller to deliver goods and Buyer to pay for those goods. Suppose Seller delivers conforming goods, but Buyer fails to pay, and then enters bankruptcy. This contract is not executory for [section] 365 purposes because one party (Seller) substantially performed its contractual duties before Buyer's bankruptcy. So, [section] 365 does not apply, and Buyer's bankruptcy estate has no right to reject this contract. The pre-bankruptcy debtor received Seller's performance under this contract, and Seller has a claim against the debtor's bankruptcy estate for payment. (16)

         Now suppose, instead, that before its bankruptcy Buyer paid for the goods but Seller failed to deliver or tender delivery of those goods. This contract is also not executory and [section] 365 does not apply for the same reason that one party substantially performed its contractual duties before bankruptcy. But because the party that performed (Buyer) is now in bankruptcy, its breach of contract claim against Seller passes (along with Buyer's other property) to the bankruptcy estate. (17)

         In contrast, [section] 365 does apply to a third version of this hypothetical. Suppose before Buyer's bankruptcy neither party performed its contractual duties. That is, Seller did not deliver or tender goods, and Buyer did not pay for them, perhaps because the contractually specified time for each party's performance had not yet occurred when Buyer entered bankruptcy. This is an executory contract for [section] 365 purposes because each party still owes material duties to the other. So, [section] 365 empowers the bankruptcy estate (represented by a trustee or DIP) to choose whether to assume or reject this contract formed by the pre'bankruptcy debtor.

      2. Consequences of Assumption and Rejection

         If the estate assumes an executory contract the estate acquires the rights and duties of the pre-bankruptcy debtor with respect to that contract and thus is fully liable if the estate later breaches the contract. (18) In contrast, an estate's rejection of an executory contract constitutes breach of that contract, and Bankruptcy Code [section] 365(g)(1) treats the non-debtor party's claim for breach as though it arose before bankruptcy. (19) Consequently, the non-debtor party becomes just another general...