Section 365

Proposal #4: Clarifying the Option of "Assumption"

Court approval of a trustee’s request to assume a contract is a significant event: the estate becomes obligated to perform or to find an adequate replacement to perform through its right to assign. Any failure to do so will result in an administrative priority claim that must be paid in full dollars ahead of all other general creditors, as opposed to the pro rata distribution that is received by a party to a breached contract. The Code does not define assumption, but it seems clear that assumption, in the absence of assignment, merely means that the debtor-in-possession accepts the burdens and the benefits of a pre-bankruptcy contract. Due to the confusion already inherent in section 365, it may be sensible to use terms that more precisely characterize the events that they represent.

The Recommendation

"Assumption" should be replaced in with"election to perform" in section 365.

Reasons for the Proposed Change

This proposal would introduce the parallel concept to "breach" and would replace problematic language with clear language. It would not affect the obligation to cure and give adequate assurance of future performance under section 365(b), nor would it change the implications of making this election. Thus, if the court approved the trustee’s election to perform, the estate would be obligated to perform and any failure to do so would result in an administrative claim. [ FN: See In re Superior Toy & Manufacturing Co. , 78 F.3d 1169, 1172 (7th Cir. 1996); In re Klein Sleep Products , 73 F.2d 18, 25 (2d Cir. 1996) (rejecting contract after assuming it will not change administrative expense priority of resulting liabilities).] This would be the case even if an assumed contract is rejected after a chapter 11 case is converted to a chapter 7 liquidation. [ FN: Id.]

While clarifying the action being taken, this amendment would not address more specific issues inherent in the election to perform or to transfer, such as the severability of contracts and the special rules for personal services contracts. However, by distinguishing more sharply between debtor-in-possession performance and assignment (or "transfer" [ FN: It may be sensible to rename this option as well. Some commentators already have recognized that "assignment " in bankruptcy is not parallel to its state law counterparts, for the Bankruptcy Code disregards the nonbankruptcy rule prohibiting the delegation of duties if the original obligor does not remain liable. See Thomas H. Jackson & Robert E. Scott, "On the Nature of Bankruptcy: An Essay on Bankruptcy Sharing and the Creditors' Bargain," 75 Va. L. Rev. 155 (1989).] ) to another entity,implicit would be the notion that the debtor’s ability to elect performance is independent of whether the debtor could transfer its interest to another party. The postpetition debtor is not a materially different legal entity from the prepetition debtor for purposes of performance, breach or transfer of contracts. [ FN: In re Leroux , 69 F.3d 608, 613 (1st Cir. 1995), citing H.R. Rep. No. 1195, 96th Cong., 2d Sess. §27(b) (1980) and NLRB v. Bildisco & Bildisco , 465 U.S. 482 (1984). ] Consistent with the majority of case law, the debtor’s election to perform would not be contingent on a hypothetical finding that the contract would be assignable under nonbankruptcy law. [ FN: Institut Pasteur v. Cambridge Biotech Corp. , 104 F.3d 489, 493 (1st Cir. 1997) (ability to assume not dependent on whether contract is assignable); In re Cardinal Industries Inc. , 116 B.R. 964 (Bankr. S.D. Ohio 1990).] This may require a clarifying amendment to section 365(c)(1), which has elicited confusion on this point. [ FN: See In re West Electronics Inc. , 852 F.2d 79, 83 (3d Cir. 1988) (debtor cannot assume contract if applicable law precludes assignment of contract, thus section 365(c)(1) requires hypothetical assignment test).]

This proposal would not alter the economic considerations preceding a trustee’s election to perform or transfer. The trustee should elect performance or transfer only if such actions were likely to yield a net benefit to the estate, i.e., the value of the non-debtor party's remaining performance is greater than the estate's costs of taking over the debtor's remaining obligations. [ FN: Michael T. Andrew, "Executory Contracts Revisited: A Reply to Professor Westbrook," 62 U. Colo. L. Rev. 1 (1991); Jay Lawrence Westbrook, "A Functional Analysis of Executory Contracts," 74 Minn. L. Rev. 227 (1989) .]

Competing Considerations

Some might be concerned that any change in terminology will promote litigation. The concepts of "assumption" and "assignment" have been less troublesome than "rejection," and therefore a change may not be as justified in this situation. However, "perform" is a more apt analogue to "breach," and would provide a sensible and more readily comprehensible parallel structure to section 365.

The election to perform under a personal property lease in consumer cases has caused confusion and raises special problems that are not addressed in this proposal. Trustees may be reluctant to assume these types of leases if concerned about being held responsible on the leases. The Consumer Bankruptcy Working Group may opt to consider whether the statute should clearly establish that a chapter 7 consumer debtor independently can elect to continue lease performance.