Chapter 11 Executory Contracts

• Jurisdiction: United States

Chapter 11 Executory Contracts

§ 11.1 ~ it's Not Easy

On the face of things, the topic of executory contracts seems simple enough. Section 365(a) says that "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." But a quick skim over the next several pages of statutory language is enough to show that the scope and meaning of § 365(a) is more complex than it appears.

Part of the problem is that § 365 has become the repository of at least as many "special situation" or, if you will, "special interest" rules as any section in the Code. But the deeper problems are conceptual. No one has ever come up with a precise, definitive definition of what an executory contract is, nor is it entirely clear why the Code singles out executory contracts and leases from other forms of legal obligations between debtors and creditors.

We begin with a word on procedure and a form of pleading. Then we plunge into a discussion of what it means to be an executory contract and what it can do for and to you.

§ 11.2 ~ Procedure

A proceeding to assume, reject, or assume and assign an executory contract or unexpired lease is a contested matter governed by Rule 9014 (unless it is done in the plan).¹ Notice must be given to the other party to the contract and "to other parties in interest as the court may direct" (and to the U.S. Trustee).² Note that there is no general requirement to send notice to all creditors (although the court may require it in a particular case, or it may be required by local rule). Contrast this with the procedure for sale of property outside the ordinary course of business, where notice to all creditors is required by the Bankruptcy Rules.³

A single motion may include requests to assume or reject multiple executory contracts or unexpired leases with different counterparties. There are some limits on how many contracts and leases may be bundled into a single motion, as well as some procedural requirements that must be followed when seeking to reject, assume, or assume and assign multiple contracts. ⁴

Complicating this further is the fact that the debtor's books and records may not always correspond with those of its counterparties, leading to situations in which it may not be clear to creditors which contracts the debtor is seeking to assume. Finally, when the debtor is pursuing a going-concern sale of substantially all of its assets, it is common to see requests to assume, reject, or assume and assign contracts and leases included with a motion to approve the sale.

§ ìì.3 ~ Form: motion to reject Executory contract

Here's what a motion to reject an executory contract might look like:

DEBTOR'S MOTION TO REJECT UNEXPIRED LEASES FOR CERTAIN WAREHOUSE FACILITIES

The Debtor and Debtor-in-Possession, Insolvent Supply Corporation ("Debtor"), by its counsel, hereby moves for authority to reject the unexpired leases for the seven warehouse facilities listed on Schedule A to this motion (the "Florida Facilities"). This motion is filed pursuant to 11 U.S.C. § 365(a) and Federal Rule of Bankruptcy Procedure 6006.

In support of its motion to reject the leases on the Florida Facilities, the Debtor represents as follows:

A. FACTUAL BACKGROUND

1. The Debtor filed its voluntary chapter 11 Petition on February 23, 2014. Since that date, the Debtor has remained in possession of its assets and has operated its business as a debtor-in-possession pursuant to Sections 1107(a) and 1108 of the Bankruptcy Code.

2. On March 12, 2014, the United States Trustee appointed an Official Committee of Unsecured Creditors (the "Committee") in this case. No other committees have been appointed.

B. REASONS FOR REJECTING THE FLORIDA LEASES

1. Over the past several years, the Debtor has purchased wiring almost exclusively from Asian manufacturers and has re-sold over 85% of its wiring in states that are west of the Rocky Mountains. The Debtor's East Coast business has diminished considerably. Under these circumstances, it is not profitable to maintain Florida warehouse space.

2. An integral part of the Debtor's reorganization strategy will be to focus its business exclusively on those western states in which it does the most business. The Debtor intends to file a plan of reorganization implementing this strategy as soon as possible. However, the Debtor is not in a position to file such a plan at this time because it is still negotiating the plan terms with the Committee, its secured lenders and potential sources of exit financing.

3. The Debtor currently pays a total of approximately $650,000 per year in rent (and related charges) for the Florida Facilities.

4. The Debtor has looked into the possibility of selling its leasehold interests in the Florida Facilities and has consulted Kone Realty, a real estate advisory firm, concerning this possibility. However, the Debtor has determined that each of the Florida Facility leases is at an above-market rent and there is substantial vacant warehouse space in the regions of Florida in which the Florida Facilities are located. Accordingly, there is no market for the Debtor's Florida leasehold interests.

5. The Debtor is current on all of its post-petition obligations under all leases, including those related to the Florida Facilities. However, the Debtor is not fully utilizing the warehouse space at the Florida Facilities, and they are therefore a substantial cash drain. The Debtor seeks to stop this cash drain by rejecting the Florida Facility leases immediately.

C. LEGAL BASIS FOR RELIEF SOUGHT

1. Section 365 of the Bankruptcy Code permits a debtor-in-possession to assume or reject leases, with court approval. A debtor's decision to assume or reject a lease is evaluated under the "business judgment test." In re Penn Traffic Co., 524 F.3d 373, 383 (2d Cir. 2008). The court should ordinarily defer to a debtor's decision to reject a lease, so long as the decision is a rational one. In re Old Carco LLC, 406 B.R. 180, 188 (Bankr. S.D.N.Y. 2009). Rejecting a lease for real estate that is not utilized by the debtor and constitutes a cash drain on the estate is consistent with the debtor's obligations as a fiduciary and should be permitted under the business judgment test.

2. For the reasons described above, rejection of the Florida Facility leases is in the best interests of the estate and its creditors, and is consistent with sound business judgment. Failure to reject these leases would result in a continued cash drain, with no corresponding benefit, and would impair the Debtor's prospects for a successful reorganization.

3. The Debtor has discussed the rejection of the Florida Facility leases with the Committee, and the Committee has authorized the Debtor to represent to the Court that the Committee supports the Debtor's decision to reject these leases.

D. CONCLUSION

WHEREFORE, the Debtor requests that the Court grant this motion, authorize rejection of the Florida Facility leases as of April 1, 2014, and grant such other and further relief as the Court deems appropriate.

§ 11.4 ~ Why it can't mean what you Think it means

Start with the problem of definition. Broadly speaking, under non-bankruptcy law an "executory contract" is any contract that has not been fully "executed" or performed. Thus, if the debtor owes $10 to the creditor and has not yet paid, then the contract is "executory" in the broadest sense. But this is not what the phrase means in bankruptcy. Consider a simple case. Daniel owes $10 each to Charlie, Carla, and Kermit, pursuant to written contracts. He has $10. He files for bankruptcy, and his $10 passes to the trustee.

Give "executory contract" its broad meaning, and it would seem that the trustee has the power to pick and choose — for example, to "assume" the contract with Carla, pay her $10, and leave Charlie and Kermit high and dry. But this is flatly contrary to a basic principle of bankruptcy law: the principle of pro rata distribution among similarly situated creditors. Pro rata distribution is so fundamental to bankruptcy law that it is inconceivable that the Bankruptcy Code would dispense with it by simply allowing a debtor to decide to satisfy one obligation and not others. So "executory contract" in bankruptcy must have a narrower meaning than it does under non-bankruptcy law. ⁵

Here is a second problem. Suppose Daniel owes $10 to Kermit, secured by Daniel's widget, worth $10. Under a broad reading, this secured obligation might also qualify as an executory contract under non-bankruptcy law. But the Bankruptcy Code contains special provisions dealing with secured claims. So again, we are compelled to conclude that the drafters meant the category of "executory contract" to include less than it would include at the state law level.

§ 11.5 ~ Why it matters

So much for what the term cannot mean. We will return later to the question of what it does mean when we discuss Professor Vern Countryman's attempt at a definition.⁶ The next job is to understand why it matters. To consider this question, observe that so far we have identified three separate classes of transactions that the Code seems to recognize.

First, we have ordinary unsecured claims (call them simple contracts); second, we have claims secured by interests in property of the debtor (call them security interests); and third, we have executory contracts. Suppose Donald accepted the transfer of a widget from Tess under a "contract for transfer" and then filed for bankruptcy. The trustee has taken possession of the widget, and the transferor remains unpaid. Donald still owes Tess $10,000; the widget is worth only $6,000. There are $20,000 worth of other assets and $50,000 worth of other claims (all unsecured).

What are the rights of Tess (and the obligations of the trustee) if we characterize the transferor's deal as (1) a simple contract; (2) a security interest; or (3) an executory contract? Let's consider each of the three in turn.

First, if the deal is a simple...