Section 365 of the Bankruptcy Code allows a debtor in bankruptcy to assume, assign, or reject executory contracts and unexpired leases. What is an executory contract? An executory contract is interpreted by courts to mean a contract where there remain unperformed obligations by both parties at the time the bankruptcy is filed. For example, a supply contract is an executory contract because the supplier has a continuing obligation to supply the goods, while the debtor has a continuing obligation to pay for those goods; on the other hand, a promissory note is a non-executory contract because only the borrower has a continuing obligation to pay. Moreover, only true, unexpired leases can be assumed or rejected in bankruptcy; for example, lease of personal property may actually be a security agreement as opposed to a true lease.
In assessing whether to grant or deny a debtor's motion to assume, reject, or assign its executory contract or unexpired lease, the bankruptcy judge defers to the bankrupt's business judgment, and will usually grant the motion unless it was made in bad faith or was a gross abuse of the debtor's business discretion. The debtor's ability to reject burdensome contracts or leases and retain those that are vital to the reorganization process align with the bankruptcy policy goal of rehabilitating struggling businesses, but not at the expense of creditors. Instead, the freedom and flexibility afforded to debtors in the process of deciding whether to assume or reject their contracts is a decision between abandoning burdensome assets and retaining favorable ones, which maximizes the value of the estate and benefits creditors.
What happens if a debtor does not file a motion to assume or reject its lease? If a debtor does not assume or reject a lease within 120 days of its bankruptcy filing, the lease is deemed rejected. If a debtor decides to assume its lease of which it is in default, the debtor must satisfy three requirements:
- The debtor must cure all defaults, or provide adequate assurance that the default will be timely cured.
- Secondly, the debtor must compensate, or provide adequate assurance that it will timely compensate the non-debtor for any actual monetary loss caused by the default.
- Finally, the debtor must provide adequate assurance of future performance under the lease. *Adequate assurance is not required if the debtor is not in default.
If you are a non-debtor on the opposite end of the contract or lease, you may be curious about the consequences of a debtor's assumption of your agreement. Specifically, you as a non-debtor cannot attempt to terminate the agreement despite provisions that deem a bankruptcy filing an event of default. These provisions are known as ipso facto clauses and are generally invalidated in bankruptcy. However, ipso facto clauses are enforceable in contracts to loan money, issue securities, or make other financial contracts. Non-debtors may also terminate contracts like personal service contracts and franchise agreements, i.e., contracts which are non-assignable without consent. In order to exercise the right to end these contracts, non-debtors must obtain relief from the automatic stay (see our recent article on what the automatic stay is – https://kilegal.com/automatic-stay-101/ – for more information).
Some types of executory contracts receive heightened judicial scrutiny and special treatment under the Bankruptcy Code due to their implications. For example, the decision to grant or deny a debtor's assumption or rejection of a collective bargaining agreement, ("CBA") (see our recent article on collective bargaining agreements in bankruptcy reorganizations – https://kilegal.com/collective-bargaining-agreements-in-bankruptcy-reorganizations/ – for more information) is subject to the provisions of section 1113 of the Bankruptcy Code. Section 1113 prescribes strict procedural and substantive requirements before a court can approve the modifications or rejection of a CBA. Moreover, it is presumed that a debtor's contractual obligations to pay retiree benefits must be enforced.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.