Executory Contracts: Rejection
Key Background Facts:
- An executory contract is one in which neither party to the contract has fulfilled its obligations.
- Either the trustee or the debtor in possession (DIP) can either assume or reject an executory contract.
- An executory contract not assumed is deemed rejected.
- An executory contract will be assumed if it has a net benefit for the bankruptcy estate; otherwise, it will be rejected.
- A business judgment standard is used in evaluating whether to assume or reject the contract. Little consideration is given to the effects of rejection to the non-debtor party.
- The rejection of an executory contract is considered a breach of the contract rather than a termination or cancellation.
- As a result, the non-debtor party can either terminate the contract or continue using any property interest granted by the rejected contract as long as the non-debtor party continues paying for the property interest, such as a leasehold or the right to use intellectual property. Whatever the non-debtor party chooses to do, the debtor or the bankruptcy estate has no more liability for the contract.
- Likewise, the non-debtor party has no additional obligation under the contract to either the debtor or the bankruptcy estate.
- The non-debtor party can file an unsecured claim for any damages resulting from the rejection.
- If the contract is a collective bargaining agreement or provides retirement benefits, then a balance-of-the-equities standard must be used in which the consequences of assumption or rejection must be weighed in its harm to the debtor, its creditors and employees, and other parties in interest.
If the trustee decides not to assume a contract, then she rejects it. This is not the same as canceling or terminating the contract—the bankruptcy estate does not assume the contract at all, it never becomes a party to it. Since the bankruptcy estate takes the place of the debtor for the debtor's liabilities and contractual obligations that arose before bankruptcy, rejection of an executory contract removes both the debtor and the estate as a party to the contract.
Hence, neither the bankruptcy estate nor the debtor becomes legally liable for a rejected contract, nor will they benefit from it. Rejection also removes any obligation to the debtor or the estate from the non-debtor party. Because §365(g) specifies that rejection of a contract is equivalent to a breach of the contract, the non-debtor party is entitled to an unsecured claim for damages as a result of the breach. The non-debtor party will be paid pro rata along with the debtor's other creditors, and the remaining liability for the debt will be discharged.
Because only prepetition claims become claims against the bankruptcy estate, the breach is considered to have occurred right before the bankruptcy filing date, even if the debtor had not actually breached the contract at that time. However, for calculating damages, the date of the actual rejection of the contract is used, although some courts have used the filing date as the date of the breach. However, a special rule, §562(a), requires that the actual date of rejection be used for swap agreements, securities contracts, forward contracts, commodity contracts, repurchase agreements, and master netting agreements.
A trustee is not going to assume a residential lease that a debtor is paying for his residence, and since executory contracts, such as residential leases, are deemed rejected, if not assumed, most renters, if they are not behind in their rent, can continue paying the rent and remain in their home. Although technically, the lease is breached, in most states, the landlord can only evict for the nonpayment of rent and not generally for other breaches of the lease, and certainly not for the technical breach implied by the trustee not assuming the lease.
Hence, the debtor can continue living at his rented place, but the debtor's liability for the rest of the rent payments is discharged. So a renter would be free to leave before the termination of the lease without incurring liability for the remaining payments.
Special Cases where the Debtor is the Lessor, Vendor, or Licensor
Because some courts have treated rejection of executory contracts as terminations rather than breaches, Congress added some rules to §365 to clarify its objectives. If the courts had consistently treated rejected contracts as breaches rather than terminations, these special rules would have been unnecessary. In these cases, the non-debtor party may retain its property interest by continuing to make payments or it can terminate the contract and file a claim for damages. If the non-debtor party continues paying, then it can offset its payments for any damages resulting from the non-performance of the debtor of its contractual obligations.
Under §365(h), if the debtor is the lessor of a real estate lease, then, even if the lease is rejected, the lessee can continue occupying the property for the duration of the lease, including any elected extensions. The debtor does not have to perform anything further under the lease, but the lessee is entitled to a claim for damages for the debtor's nonperformance, such as providing electricity or water, or maintaining the common areas.
Section 365(i) applies similar rules to real estate or timeshare sales contracts where the debtor is the vendor and the non-debtor party is the vendee, and the non-debtor party already has possession of the property. If the vendee has already paid part of the purchase price, then it will have a lien on the property; if the property is paid for in full, then the trustee will have to deliver good title.
Under §365(n), if the debtor is the licensor of intellectual property and the non-debtor party is the licensee, then the licensee may choose to either terminate the contract and file a claim for damages, or continue using the intellectual property by continuing to make royalty payments.
Collective Bargaining Agreements
When deciding on rejecting a collective bargaining agreement under Chapter 11, the trustee or the debtor-in-possession must use the balance-of-the-equities standard in which the consequences of assumption or rejection must be weighed in its harm to the debtor, its creditors and employees, and other parties in interest.
Congress added §1113 to the 1984 Amendments that also prevented the trustee or debtor in possession (DIP) from unilaterally modifying a collective bargaining agreement before its rejection is approved by the bankruptcy court. Interim changes can only be made if approved by the court, and if it is demonstrated that such modifications are necessary for the continuation of the debtor's business or to prevent irreparable damage to the bankruptcy estate. However, the granting of an interim modification does not indicate whether the court will approve of the ultimate rejection of the contract. Furthermore, the union retains the right to strike under all circumstances.
Section 1113 specifies the negotiation procedures that must be followed before rejection, the standard for approving or denying rejection, and the hearing schedule.
A considerable financial hardship for many businesses is retirement packages for its employees. Employers often retain the right in their contracts to terminate or modify the package, and nothing in the Bankruptcy Code prevents the employer from exercising its contractual rights.
Absent such rights, the employer's ability to modify or terminate its retirement benefits requires the approval of the retirees' representatives or court approval. Under Chapter 11, §1114 and §1129(a)(13) were added in 1988 to prevent a trustee or a DIP from modifying or dropping benefits for its retirees nor unilaterally modifying any union contract for benefits. Moreover, a section was added by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) that extends the protection against unilateral modification of retirement benefits to 180 days before bankruptcy, so that if the debtor made such unilateral changes while it was insolvent during this time, then the debtor may have to reinstate benefits for that time period if so ordered by the court.
Interim changes can be made to retiree's benefits with approval of the court, but such approval will only be granted if they are necessary for the business's survival or to prevent irreparable harm to the bankruptcy estate.
To obtain a permanent modification of retiree's benefits, the debtor must negotiate with the union or other representative of the retirees. If the representatives reject any proposals without good cause, then the court may order a modification if "such modification is necessary to permit the reorganization of the debtor and assures that all creditors, the debtor, and all of the affected parties are treated fairly and equitably, and is clearly favored by the balance of the equities."
The payment for the retiree's benefits is treated as an administrative expense, which has the highest priority for a business. Furthermore, a debtor cannot get confirmation of a payment plan unless the plan provides for the current and continued payment for retiree benefits.