Leases and Executory Contracts in Chapter 11

• DOI: http://doi.org/10.1111/jels.12087
• Author: Kenneth Ayotte
• Published date: 01 December 2015
• Date: 01 December 2015

Leases and Executory Contracts

in Chapter 11

Kenneth Ayotte*

This article offers the first empirical analysis of the timing and disposition decisions large

Chapter 11 debtors make with respect to their leases and other bilateral (“executory”)

contracts in bankruptcy, with an emphasis on commercial real estate leases. Section 365,

which governs these contracts, allows debtors to choose whether to keep (“assume”),

abandon (“reject”), or transfer (“assign”) their contracts, with time limits provided by the

Bankruptcy Code. The main goal of the article is to analyze a controversial change to the

Code in 2005 (BAPCPA) that shortens the time to expiration of a debtor’s option to reject,

requiring tenant-debtors to make decisions on their real estate leases within seven months

unless a landlord grants an extension. I find that the seven-month limit strongly accelerated

real estate lease disposition decisions, suggesting that bankruptcy bargaining is far from a

frictionless, Coasean world. Further, I find that BAPCPA is associated with a significantly

lower probability of reorganization for the most lease-intensive firms. I also test a simple

theory of real options, and I find that debtors do not behave as the simple theory suggests.

In particular, many executory contracts are assumed before expiration. I present suggestive

evidence of implicit contracting motives: debtors often assume early in order to secure

performance from their counterparties that cannot be guaranteed by the contract alone.

I. Introduction

The theory of real options has proven fruitful in understanding bankruptcy dynamics.

1

The firm owns a pool of assets that may be worth more as a going concern than liqui-

dated, or vice versa. Because the firm’s claimholders occupy different layers in the firm’s

capital structure, they may have different preferences over the reorganization/liquida-

tion decision, and the timing of this decision. Senior creditors—conceived as holding

risk-free debt, less a put option on the firm’s assets—generally prefer a quick resolution

*Professor of Law, U.C. Berkeley School of Law, 891 Simon Hall, Berkeley, CA 94720; email: kayotte@law.berke-

ley.edu.

Thanks to Robert Bartlett, Anthony Casey, Gen Goto, Edward Morrison, David Skeel, Eric Talley, two anony-

mous referees, and seminar participants at Western University, the American Bankruptcy Institute—Illinois Sym-

posium, U.C. Berkeley, U.C. Hastings, and the ALEA and CELS annual meetings for helpful comments. Nate

Anderson, Young Moon, Justin Morgan, John Reinert, Ben Spulber, and Sam Winters provided excellent research

assistance. Special thanks to David C. Smith, and to Lynn LoPucki for sharing data.

1

Other work taking a real options approach to corporate bankruptcy decisions includes Baird and Morrison

(2001), Morrison (2007), and Casey (2011).

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Journal of Empirical Legal Studies

Volume 12, Issue 4, 637–663, December 2015

to minimize the value of the put. This creates incentives for senior creditors to push for

a fire sale or a premature shutdown. Junior claims, long a call option on the assets, gen-

erally prefer delay. This may result in the inefficient preservation of a nonviable firm

and the incurrence of deadweight costs. Empirical evidence is consistent with these

incentives (Ayotte & Morrison 2009; Jenkins & Smith 2014).

In some instances, however, a different set of real options are crucial drivers of

the case. Consider Movie Gallery, a retail movie rental chain that filed for Chapter 11 in

2007. There was little debate between the debtor and its major lenders about whether

Movie Gallery would reorganize; indeed, a plan supported by its major constituents was

negotiated before the filing and proposed early in the case. Instead, the main dynamics

in the case were about managing and reducing its portfolio of over 4,000 leases (Kurich-

ety et al. 2009). Movie Gallery knew that many of its store locations were unprofitable,

but it did not know how many were unprofitable at the outset. Some locations required

time and more information to evaluate; moreover, a third-party investor providing new

equity financing wanted input into the decision-making process. These decisions were

accelerated by an important change to the Bankruptcy Code in 2005, which required

Movie Gallery to decide on these leases within 210 days. Ultimately, Movie Gallery shed

about 1,000 leases in the first seven months, and committed to retaining the remainder

close to the 210-day deadline. This restructuring ultimately proved insufficient, as the

company filed again for bankruptcy in 2010.

This article is the first in-depth study of the timing and disposition decisions that

debtors make on their leases and executory contracts inside Chapter 11. Executory con-

tracts are defined under bankruptcy law as those contracts that are, simultaneously,

both assets and liabilities to the bankrupt debtor at the time of filing. Examples of exec-

utory contracts include intellectual property licenses, supply contracts, employment con-

tracts, service contracts, customer contracts, and many others. The Bankruptcy Code’s

rules regarding leases and executory contracts create a real options problem with a rich

set of strategic choices available to the debtor, and these choices have not yet been stud-

ied in detail empirically.

This project has three main contributions. The first is descriptive. Using a hand-

collected, detailed sample of nearly 1,500 debtor motions in 91 large Chapter 11 cases

between 2003 and 2007, I catalog the total number of contracts disposed of during the

case, the disposition decision made by the debtor—assumption, assignment, or rejec-

tion—and the timing of these dispositions. I supplement these detailed findings by con-

structing a dollar-valued measure of the lease-intensiveness of large Chapter 11 debtors

to get a sense of the economic importance of leases to these Chapter 11 debtors.

The second goal of the project is to examine the effect of important changes to

the Code (BAPCPA) on lease disposition decisions. In particular, the revised Section

365(d)(4) requires a tenant-debtor to make a disposition decision on its commercial

real estate leases within seven months (210 days), unless the landlord consents to an

extension. Prior to the change, courts could extend this deadline without limit. Under-

standing the effect of this change is an important policy issue in its own right. Some

bankruptcy professionals claim that this change has affected bankruptcies of retailers

and other lease-intensive debtors, making it more difficult for viable firms to reorganize

638 Ayotte