Executory Contracts: Assumption and Assignment

Key Background Facts:

From Executory Contracts and Unexpired Leases:

Key Facts:

The bankruptcy estate does not automatically assume the contracts of the debtor; therefore the contracts are not enforceable against the bankruptcy estate until they are assumed. The trustee or the debtor in possession (DIP) under Chapter 11 either assumes the contract, or rejects it. Under Chapter 7, the trustee has 60 days after the order for relief (which, for voluntary petitions, is the bankruptcy filing date) to assume an executory contract. Under Chapter 13, 12, and 11, contracts have to be assumed by the confirmation of the debtor's payment plan. In any case, the court can grant more time, if necessary. However, if the trustee does not assume a contract in the required time, then the contract is deemed rejected.

A contract will only be assumed if it has a net benefit to the bankruptcy estate and only with court approval. If the contract is assumed, then the bankruptcy estate takes the place of the debtor as a party to the contract. Consequentially, the bankruptcy estate must perform the obligations of the contract, but also receives its benefits.

However, the contract must be assumed cum onere, as they say—with all of the burdens. The contract must be accepted in its totality except for ipso facto clauses (aka bankruptcy termination clauses), which are clauses that are conditional on the party's financial status or bankruptcy. Most of these ipso facto clauses stipulate that the contract will be terminated if the party becomes either insolvent or files for bankruptcy. Ipso facto clauses are not enforced under bankruptcy, so the trustee still has the option of assuming a contract with an ipso facto clause.

Because the non-debtor party of an assumed contract has priority over other unsecured creditors of the estate, the decision to assume is generally postponed as long as possible, especially since the non-debtor party is required to perform until the decision to assume or reject is made. Postponing the decision allows the trustee to better assess whether assuming the contract will have a net benefit to the bankruptcy estate. However, the non-debtor party can petition the court to force an earlier decision.

Hence, another element of contracts that is modified are clauses requiring specific performance by a deadline. Bankruptcy extends some deadlines so that the trustee is given more time to evaluate the contracts. The non-debtor party cannot terminate the contract as a result of the delay.

Contracts in Default

A requirement for the assumption of contracts that are in default is that the bankruptcy estate must cure any defaults of the contract. In most cases, this would involve making up for any missed payments by the debtor.

The estate must also compensate the non-debtor party for any damages that have resulted from the debtor's default. Any payments for damages or for performance under the contract have administrative priority. There is no limit on the amount of the claim except for real estate commercial leases for which a claim is limited to 2 years rent. Moreover, any payments received by the non-debtor party prior to the bankruptcy will not be treated as preferences.

To assume a contract in default, §365(b)(1) of the Bankruptcy Code requires that the trustee cure the default, remunerate the non-debtor party for any losses suffered because of the default, and provide adequate assurance of future performance under the contract.

However, §365(b)(2) stipulates that there are 2 types of default that do not have to be cured:

  1. ipso facto clauses discussed above.
  2. the failure to pay penalties that arose because the debtor failed to perform nonmonetary obligations under the contract, such as maintaining certain store hours.

Except for shopping centers, there is little guidance in the Bankruptcy Code about what constitutes adequate assurance of future performance. Generally, the courts will decide if the trustee has presented enough evidence of such assurance. However, the trustee does not have to provide adequate assurance if there is no default.

Non-Assumable Contracts

There are 3 types of contracts, specified by §365(c), that are not assumable:

  1. contracts that are not assignable under nonbankruptcy law,
  2. contracts for loans or other extensions of credit,
  3. and commercial leases that were terminated under nonbankruptcy law before the order for relief.

If a contract cannot be assigned, then it is not assumable. This provision does not depend on the terms of the contract but rather on its nature. For instance, if the contract called for the debtor to sing at a wedding, then obviously, the trustee cannot assume such a contract, since such a contract was agreed to because of the debtor's singing ability and not the trustee's.

But what if the bankruptcy administrator is a debtor in possession rather than a trustee? The courts have divided over the issue. Some courts stressed that the debtor in possession is a different legal entity than the debtor, hence, the contract was not assumable. The courts' reasoning has rested on a hypothetical test that asks not whether the debtor in possession can perform under the contract, but whether nonbankruptcy law would allow the assignment of the contract to a hypothetical 3rd party. If not, then these courts have ruled that the contract is not assumable. Other courts have adopted the commonsensical approach that since the debtor and the debtor in possession are the same actual entity, then there should be no problem in allowing the contract to be assumed if it would benefit the estate.

To protect the unsecured creditors of the bankruptcy estate, the trustee or the DIP cannot assume any loans or other financing contracts for the debtor, even if the lender agrees to it. However, certain contracts whose primary purpose is other than giving a loan, such as leases or credit sales of goods or services, are assumable even though there is some extension of credit.

Assignment

Sometimes the trustee wants to assume a valuable contract, but does not want to perform under it. In this case, the trustee may assume the contract, but then assign it to a 3rd party for a fee. The assigned party acquires both the rights of the debtor under the contract and the delegation of its duties.

Because the trustee must assume the contract before assigning it, any limitation that applies to assumption also applies to assignment. In many cases, the trustee will be able to assign the contract even if there are provisions in the contract against assignment unless it is clear that the contract requires something that only the debtor could uniquely supply, as noted above.

Furthermore, the trustee must provide adequate assurance that the assigned party is reasonably likely to be able to perform under the contract. This requirement is to reduce the likelihood that the assigned party will breach the contract, since, once assigned, §365(k) relieves the bankruptcy estate of all liability for any breaches by the assigned party.