Executory Contracts and Unexpired Leases

Key Facts:

A primary goal of bankruptcy is to give the debtor a fresh start, which is achieved by paying its creditors what can be paid, either from a liquidation of the debtor's nonexempt assets, or from a payment plan where the debtor pays its creditors what it can over a specific amount of time. One method used to give the debtor a fresh start is §365(a) of the Bankruptcy Code that allows the trustee or the debtor in possession (DIP), with court approval, to reject or assume executory contracts, of which, one common type is unexpired leases.

An executory contract is one where the debtor is a party but neither party has fulfilled its obligations under the contract. An unexpired lease is a common example of an executory contract — the lessor has not given its leasehold for the full term of the lease yet, nor has the debtor paid for the full term. If the lease is rejected, then the debtor is relieved of its obligation to pay, but also loses its leasehold. Likewise for any rejected executory contract — the bankruptcy estate does not gain from the contract nor is it burdened by its liability.

The bankruptcy estate does not automatically assume the contracts of the debtor, and the contract cannot be enforced against the bankruptcy estate unless and until it is assumed. The trustee, or the debtor in possession as the case may be, 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.

The assumption or rejection of executory contracts is most important to business debtors, since businesses have many more outstanding contracts than individual debtors, and often, such contracts become more onerous over time, especially collective bargaining agreements, as recently evinced by the bankruptcy of General Motors. However, even for individuals, the inability to reject contracts may also prevent or diminish the debtor's fresh start.

If an executory contract is beneficial, then the bankruptcy estate may assume the contract either to require that the other party perform for the estate or to assign the valuable contract to a 3rd party for cash, which can be distributed to the debtor's unsecured creditors.

If the contract is considered a net liability to the debtor or the estate, then it will be rejected, which is treated as a breach of the contract. Then the debtor and the non-debtor party are no longer required to perform under the contract and any claim for damages by the non-debtor party will be paid pro rata along with the other debtor's creditors by the bankruptcy estate. However, if the non-debtor party has a property interest, such as a lease or an intellectual property license, that was conveyed by the contract, then it can continue to use the property as long as it continues to pay for its use.

Except for collective bargaining agreements, there is no standard specified by the Bankruptcy Code by which an executory contract is assumed or rejected. Instead, how much the contract profits or burdens the bankruptcy estate will determine whether it is assumed or rejected. If there is a net benefit, then it will be assumed; otherwise, it will be rejected. Most courts accept this standard, but a few courts take into consideration the effect of the rejection on the non-debtor party.

For most contracts, the trustee relies on the business judgment standard, which weighs the benefits and liabilities of the contract to the bankruptcy estate with little regard to the non-debtor party, and most courts support this standard. Only if the trustee is wrong about the consequences of rejection, will the courts disapprove. There is 1 important exception to the non-consideration of the non-debtor party and that is for 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.

Under the balance-of-the-equities standard, only if the liabilities of the contracts are great enough to prevent the debtor from getting a fresh start will the court approve of the rejection of the contract.

The Non-Debtor Party Must Continue Performance Until Assumption or Rejection

While the trustee is given time to decide whether to assume or reject the contract, the non-debtor party must continue to perform under it. As a result, the non-debtor party is entitled to compensation for any losses suffered as the result of the performance. This compensation, which has priority over other unsecured creditors as an administrative expense, is for actual pecuniary losses, not for rates specified in the contract.

As a result of its required continued performance, the non-debtor party may ask the court to force the trustee or DIP to assume or reject the contract earlier than required by law.