As a recent number of bankruptcy cases have illustrated,
contract integration clauses can have profound and unintended
effects when, upon the bankruptcy of a counterparty, the contract
becomes subject to section 365 of the Bankruptcy Code. Typically,
integration clauses in contracts provide that all the terms of the
parties' agreements are captured within one or more referenced
written contracts. The primary purpose of these clauses is to
define clearly the "four corners" of the parties'
written contract and prevent the parties from later claiming that
there are oral or other agreements outside the four corners of the
referenced written contract. But, as indicated by the recent Eighth
Circuit decision in Interstate Bakeries/Hostess,
integration clauses can take on additional importance in the
bankruptcy context.
A debtor in bankruptcy has the right to assume or reject executory
contracts and unexpired leases pursuant to section 365 of the
Bankruptcy Code. This right allows a debtor to keep valuable
contracts and jettison burdensome ones. As a general rule, however,
a debtor must assume or reject the entire agreement and cannot
"cherry pick" the best provisions or carve out those that
are burdensome. As a result, bankruptcy courts have a unique task
in contract interpretation, for they must determine the precise
contours of a single contract for purposes of determining what can
be assumed or rejected. This can be particularly difficult when
agreements among parties are contained in a number of related,
written contracts. Bankruptcy courts regularly turn to integration
clauses to evaluate whether a set of agreements should be
considered single or multiple contracts for purposes of
section 365 of the Bankruptcy Code.
The recent decision from the Eighth Circuit emphasizes the
relationship between contract "integration" and the
treatment of contracts in bankruptcy under section 365. In
Lewis Brothers Bakeries Inc. v. Interstate Brands Corp. (In re
Interstate Bakeries Corp.), No. 11-1850, (8th Cir. June 6,
2014), the en banc Eighth Circuit concluded that a license
agreement was not an executory contract based substantially on the
court's determination that the agreement was merely one part of
a larger, integrated contract governing the transaction between the
parties. As a result, the license was not subject to rejection by
the bankruptcy estate, and the rights of the licensee were
protected from the effects of rejection.
The Context: Asset Sale Pursuant to an Antitrust
Judgment
In 1995, Interstate Bakeries announced its acquisition of
Continental Baking Company, the owner of the Wonder and Hostess
brands and trademarks. The US Department of Justice challenged that
transaction on antitrust grounds. The final judgment entered in the
antitrust litigation required Interstate Bakeries to divest itself
of certain of its brands in certain territories. In accordance with
that judgment, in 1996 Interstate Brands Corporation (IBC), a
subsidiary of Interstate Bakeries, entered into two agreements with
Lewis Brothers Bakeries, Inc. (LBB): (a) an Asset Purchase
Agreement, under which IBC agreed to sell its Butternut and Sunbeam
bread operations and assets in certain territories to LBB in
exchange for $20 million, and (b) a License Agreement, under which
IBC granted to LBB a "perpetual, royalty-free, assignable,
transferable, exclusive" license to use the brands and
trademarks in the respective areas. The parties allocated $11.88
million of the $20 million purchase price to various tangible
assets, with the remaining $8.12 million allocated to intangible
assets, including the license. Of note, the License Agreement also
provided mutual duties of notification regarding infringement,
required that the goods sold under the marks be of a certain
character and quality, and provided that LBB's failure to
maintain such quality would constitute a material breach of the
agreement.
In 2004, Interstate Bakeries and certain of its affiliates,
including IBC (collectively, the Debtors), filed chapter 11
petitions. In 2008, LBB filed a complaint seeking a declaratory
judgment that the License Agreement was not an executory contract
and therefore, was not subject to assumption or rejection by the
debtor under section 365 of the Bankruptcy Code (which generally
permits debtors in bankruptcy to assume or rejects contracts that
are "executory"). The bankruptcy court found that the
License Agreement was an executory contract because both IBC and
LBB had material, unperformed (or continuing) obligations under
that agreement. The district court affirmed on appeal, reasoning
the License Agreement was executory because LBB's failure to
maintain the character and quality of goods sold under the
trademarks would constitute a material breach of the agreement. On
appeal to the Eighth Circuit, a divided panel affirmed. The
majority found that the License Agreement was executory because
both LBB and IBC had at least one remaining material obligation
under the agreement.
The En Banc Decision: Court Unanimously Finds One
Integrated Agreement; Majority and Dissent Disagree on Whether
Agreement is Executory
The en banc Eight Circuit reversed, holding that the
License Agreement and Asset Purchase Agreement constituted a
single, integrated agreement and that the agreement was
non-executory. Judge Colloston, the author of the dissenting panel
opinion, wrote for the en banc majority.
The court explained that before addressing whether the agreement
was executory, it had to first "identify what constitutes the
agreement at issue." Slip. Op. at 8. The bankruptcy court,
district court and panel majority had all considered the License
Agreement alone, but the en banc court found that the
Asset Purchase Agreement and License Agreement should be considered
together as one contract. The court explained that under Illinois
law, whether a contract is a separate agreement depends on the
intent of the parties; in the absence of contrary intent,
instruments executed by the same parties in the course of the same
transaction will be considered together; and "[a] contract
should be treated as entire when, by a consideration of its terms,
nature, and purposes, each and all of the parts appear to be
interdependent and common to one another and to the
consideration." Slip. Op. at 9. Applying these principles, the
court examined the language of the relevant agreements, noting,
among other things, that (a) the Asset Purchase Agreement listed
the license as one of the assets sold to LBB as part of the
transaction; (b) the Asset Purchase Agreement directed the parties
to enter into the License Agreement "[u]pon the terms and
subject to the conditions contained in [the Asset Purchase
Agreement]"; (c) a model for the License Agreement was
included as an exhibit to the Asset Purchase Agreement; (d) the
integration clause in both the Asset Purchase Agreement and License
Agreement provided that the "entire agreement between the
parties" included both agreements; and (e) the License
Agreement provided that "as consideration for the license, LBB
'has paid to IBC a fee of ten dollars ($10.00), and other good
and valuable consideration, set forth in the Allocation Agreement
described in Section 2.3 of the Purchase Agreement.'"
Id. The court concluded that treating the Licensee
Agreement as a standalone agreement would run counter to the plain
language of the two agreements.
The court then addressed whether the integrated agreement was
executory, concluding that it was not. In reaching that conclusion,
the court relied on Professor Countryman's widely adopted
definition of "executory contract": "[A] contract
under which the obligation of both the bankrupt and the other party
to the contract are so far unperformed that the failure of either
to complete performance would constitute a material breach excusing
the performance of the other." Slip. Op. at 10. The court
found IBC's failure to perform its outstanding obligations
would not constitute a material breach. The court explained that
"the essence of the agreement" was the sale of IBC's
Butternut and Sunbeam bread operations and assets to LBB in certain
territories, of which the license of IBC's trademarks was
merely one part. IBC had already transferred all of the tangible
assets and inventory to LBB, executed the License Agreement, and
received the full $20 million purchase price from LBB. IBC's
only remaining obligations—to refrain from using its
trademarks in the territories, control the quality of goods
produced with the trademarks, provide notice of and defend against
infringement—all pertained exclusively to the license.
Considered in the context of the overall agreement, the court
reasoned, those obligations were relatively minor and did not
relate to the central purpose of the agreement—the sale
of certain IBC operations and assets. As a result, the failure to
perform those obligations would not constitute a material
breach.1
The dissent agreed that the Asset Purchase Agreement and License
Agreement constituted a single, integrated contract but concluded
that the integrated agreement was executory.
Like the majority, the dissent reasoned that "the materiality
of a contractual obligation depends on whether the obligation goes
to the essence of the contract." Slip. Op. at 15. But the
dissent found that the essence or purpose of the integrated
contract was the sale of IBC's bread business to comply
with the antitrust final judgment. And that judgment directed
IBC to divest itself of the tangible assets reasonably necessary to
allow the purchaser to make effective use of the license. Thus, the
dissent reasoned, the "multitude of tangible assets listed in
the Asset Purchase Agreement were there for the purpose of allowing
LBB to make effective ongoing use of the license."
Id. Accordingly, "the mere fact that the license was
one asset listed among many does not indicate it plays a minor role
in the transaction." Id. Furthermore, the dissent
explained, the language of the agreement demonstrated that
"the parties regarded the ongoing ligations associated with
the license as more likely to be material than those regarding the
asset purchase." Id. Judge Bye pointed to the
severability provisions in each document: those in the Asset
Purchase Agreement provided that, to the extent any provision was
deemed invalid, it would be severed and the remainder of the
agreement would remain in effect; by contrast, the License
Agreement provided that, to the extent any provision was deemed
invalid, either party could request renegotiation of the agreement
if it deemed the invalidated provision to be material.
The dissent concluded that both IBC and LBB had ongoing obligations
that would result in a material breach if not performed. LBB had
such an obligation—a section of the License Agreement
expressly provided that LBB's failure to maintain the quality
and character of goods sold under the trademark would constitute a
material breach. Judge Bye found that IBC did as well: "[a]s
the purpose of the integrated agreement was to transfer IBC's
bread business in the specified territories to comply with the
antitrust Final Judgment, it cannot seriously be argued IBC would
not materially breach the integrated agreement if it breached its
duty to forbear from using the trademarks in those
territories." Because each party had ongoing obligations that
would result in a material breach if not performed, the integrated
agreement was executory under the Countryman test.
The Bottom Line
Defining which agreements constitute the contract at issue is key
to determining whether the contract may be assumed or rejected by a
debtor in bankruptcy. In In re Physiotherapy Holdings,
Inc., No. 13-12965 (Bankr. D. Del. Mar. 19, 2014) (see WilmerHale Client Alert, April
11, 2014), the bankruptcy court allowed a debtor to assume a
license agreement while simultaneously rejecting other related
agreements with the licensor because the court found that the
license agreement was an agreement separate and distinct from the
other related agreements between the parties. And in Interstate
Bakeries, by finding the License Agreement and Asset Purchase
Agreement to be one integrated agreement, the majority essentially
"diluted" the materiality of the outstanding obligations
in the License Agreement and, as a result, found the integrated
agreement to be non-executory. The rights of the licensee were
therefore protected from the effects of potential
rejection—for example, the potential termination of the
licensee's rights to use the trademarks.
When parties entering into a transaction governed by multiple
agreements fail to clearly express their intent on whether the
various agreements constitute a single integrated contract for
purposes of rejection or assumption under section 365 of the
Bankruptcy Code, courts may resolve the issue by relying on clauses
many attorneys consider to be boilerplate—e.g., severability
and integration clauses. In Interstate Bakeries, for
example, the court relied in part on the boilerplate integration
language in both the License Agreement and Asset Purchase Agreement
to conclude that they were one agreement. And while in
Physiotherapy Holdings the court rejected the argument
that the integration clause provided evidence that one of the
agreements at issue was a mere component of
another—explaining that "the integration clause simply
means all of the Agreements between the parties are reflected in
the Agreements as written, thereby eliminating parol
evidence"—it did rely on (a) language providing which of
the agreements would govern in the event of contradiction between
the two and (b) the fact that indemnity provisions in the two
agreements differed in scope as evidence that the agreements should
not be considered a single contract. The contractual clauses relied
on by the courts in these cases are typically included in
agreements for other purposes and without a view to section
365.
In sum, courts may differ in which clauses they find relevant and
how they interpret the clauses for section 365 purposes. Parties
entering into multi-agreement transactions—including asset
purchase and other acquisition transactions—should consider
carefully whether the agreements are to be read as an integrated
contract or distinct agreements for purposes of section 365 of the
Bankruptcy Code, and should draft contracts clearly to leave no
ambiguity on the issue. Even transactions like these among
seemingly healthy companies could otherwise create unexpected
results if one of the parties later becomes financially
distressed.
1 In so concluding, the court relied in part on the Third Circuit's decision in In re Exide Techs., 607 F.3d 957 (3d Cir. 2010).
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