Chapter VI Executory Contracts and Unexpired Leases

• Jurisdiction: United States

VI. Executory Contracts and Unexpired Leases

A. Introduction

Always keep in mind that the trustee in bankruptcy (or debtor in possession, usually, in a chapter 11 case) has the duty to maximize the estate for the benefit of the unsecured creditors. Contracts that the debtor entered into before bankruptcy are estate assets, but the estate cannot obtain the property rights embodied in the contract without performing the contractual promise that the debtor made before filing for bankruptcy.

Sometimes, the cost of performing that promise will be more than the value of the asset. If that's the case, performing the contractual promise might harm the creditors. For example, suppose that the debtor is an airline that entered into a long-term fuel contract before filing for bankruptcy. If the price of fuel has increased, the contract is a good deal for the estate. If the price of fuel has decreased, it might make more sense for the trustee to break the contract and find a new fuel supplier. Such a decision is governed by § 365 of the Bankruptcy Code, which says:

The trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor.

This is a rule that looks easy on the surface but is in fact trickier than it first appears to be. To begin with, consider what it means to "assume or reject." Start with "assume." If the trustee "assumes" an executory contract, the estate takes on all the burdens as if the bankruptcy had never occurred. If the pre-bankruptcy contract required that the debtor pay $100 a month on the contract, the trustee (or the reorganized debtor) must pay the same $100 a month as if the bankruptcy had never happened. If the trustee "rejects," the estate must give back whatever property it holds that came to it via the contract.

On the surface, this seems unobjectionable. The trustee is supposed to maximize the value of estate assets. If the contract or lease is profitable to the estate — a below-market lease on real estate in a gentrifying neighborhood, say — then the trustee ought to assume it so as to maximize the value. On the other hand, if the contract is burdensome to the estate, he ought to get out of it as best he can. The trustee has a lot of leeway in making the decision here: As long as he exercises "business judgment," the court is not going to second-guess him.

Determining the types of contracts subject to § 365 can be tricky. Let's take as an example the debtor's contract to buy 1,000 widgets. The debtor and the seller agreed that the debtor would pay in installments. If the seller transferred all of the widgets to the debtor before bankruptcy, then the seller merely has a claim for payment of the unpaid balance in the debtor's bankruptcy. On the date of bankruptcy, the debtor owes $10,000 as the balance on the contract. The widgets are worth $6,000. What are the rights of the parties?

If the transfer is a simple unsecured installment sale, then the trustee gets to retain the property for sale or use in the estate. The transferor has a claim on which he gets paid in little tiny bankruptcy dollars. If the seller retained a perfected security interest in the widgets, then the seller has the right to the value of the widgets, with an unsecured claim for the $4,000 shortfall. The trustee may be able to retain the widget and rewrite the contract under the "cramdown" rule, so long as he gives the creditor the full value of the collateral, in this case the widgets.

Suppose, however, that the debtor and seller structured the deal as a lease. If the deal is truly a lease, then the trustee must either assume in toto, agreeing to make all the payments according to the contract terms, or reject in toto, in which case he must give the widgets back.

Sometimes it is hard to determine whether a deal that is structured as a lease is a true lease or a secured sale disguised as a lease. Here is another place where you go to state law for guidance. The Uniform Commercial Code has a test for distinguishing leases from secured sales. It does not work perfectly for every transaction, but it helps.³⁶ In...