Section 365

Proposal #1: Contracts Subject to Section 365; Eliminating the "Executory" Requirement

Unlike many other types of property of the estate, contracts that come into a bankruptcy case involve both an asset and a liability. Whether contracts are tremendously valuable or a fatal drain on other estate assets depends on whether they are performed or breached in appropriate circumstances. A trustee’s potential ability to assume obligations under the contract or to decline to perform the contract under section 365 currently is triggered by the condition of "executoriness." "Executory" is a relatively meaningless modifier under common law, as it merely refers to contracts not fully performed. Under the Bankruptcy Act of 1898, courts developed a more restrictive interpretation of the term for bankruptcy purposes to try to ensure that contracts would be assumed or rejected only if economically beneficial for the estate. Yet, application of the restrictive executory requirement frequently contravenes its original purpose, and is inconsistently applied, extremely confusing, and superfluous under the Code. [ FN: See Jay Lawrence Westbrook, "A Functional Analysis of Executory Contracts, " 74 Minn. L. Rev. 227, 282 (1989).]

The Recommendation

The statute should be amended to delete all references to"executory" in section 365 and related provisions, and "executoriness" should be eliminated as a prerequisite to the trustee’s election to assume or breach a contract.

Background and Reasons for the Change

The Bankruptcy Act of 1898 offered minimal guidance for dealing with executory contracts, even after several new provisions were added in the 1930s. Gone unchecked, an estate could become obligated to perform contracts in economically improvident circumstances. By assuming a debt obligation, for example, a debtor essentially could grant a preference to one creditor to the detriment of all other creditors. To limit this possibility, courts developed their own restrictions on what constituted an executory contract, but their approaches were not cohesive. Ameliorating some of the confusion, Professor Vern Countryman proposed the following "material breach" test to identify an "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. [ FN: Vern Countryman, "Executory Contracts in Bankruptcy: Part I," 57 Minn. L. Rev. 439 (1973).]

The material breach test, gauging remaining future performance, facilitated a determination ofwhether the estate would benefit by becoming administratively obligated to perform.

While it did not endorse the adoption of a succinct statutory definition, the 1973 Report of the Commission on the Bankruptcy Laws of the United States indicated that "executory" referred to incompletely performed agreements. Congress declined to define "executory contract" when it enacted section 365 of the Bankruptcy Code. According to the legislative history, executory contracts were those in which "performance remains due on both sides," paralleling the mutual performance requirement of Professor Countryman’s material breach test.

Few would dispute the persistence of inconsistencies and difficulties in identifying an executory contract for bankruptcy purposes, with little corresponding gain. Expending valuable time and resources to identify executory contracts, courts routinely cite and analyze the material breach test, but reach varying results that frequently contravene the purpose of the restriction in the first place. The material breach test, by itself, does not identify valuable contracts and does not preclude improvident elections to perform or breach. Some very valuable contracts may be unassumable on account of this test, to the detriment of the estate and creditors. [ FN: See In re Riodizio , 204 B.R. 417, 421 (Bankr. S.D.N.Y. 1997) (option contracts, which contemplate performance from both parties but require performance from only one, demonstrate shortcomings of material breach analysis of executory requirement), citing In re America West Airlines Inc. , 179 B.R. 893, 896 (Bankr. D. Ariz. 1995) (stock option not executory); Brown v. Snellen , 96 B.R. 229, 232 (Bankr. W.D. Mo. 1989) (option contract could not be rejected).] Some courts have taken circuitous analytical routes to avoid the loss of value to the estate by a rigid application of the executory requirement. [ FN: Riodizio , 204 B.R. at 423 (citing cases that conflate contingent bilateral and option contracts to fit option contract into material breach test).] The executory requirement also has created an undefined class of contracts because the Code does not explain how non-executory contracts should be treated. [ FN: Westbrook, supra note 1, at 284.]

The requirement of mutual remaining obligations has been de-emphasized by some courts that have used "functional"or "results-oriented" approaches, which direct one to "work backward" from the "goals rejection is expected to accomplish . . . If those purposes have already been accomplished or if they cannot be accomplished through rejection, then the contract is not executory within the meaning of the Bankruptcy Code." [ FN: In re Government Securities Corp. , 101 B.R. 343, 349 (Bankr. S.D. Fla. 1989), aff'd , 111 B.R. 1007 (S.D. Fla.1990), citing In re Jolly , 574 F.2d 349, 351 (6th Cir.), cert. denied sub nom. , Still v. Chattanooga Memorial Park , 439 U.S. 929 (1978); In re Taylor , 91 B.R. 302, 311 (Bankr. D.N.J. 1988), aff'd , 103 B.R. 511 (D.N.J. 1989), appeal dismissed , 913 F.2d 102 (3d Cir.1990).] Purposes that might be considered include: taking advantage of estate-enhancing contracts, relieving the estate of burdensome contracts, promoting the debtor's fresh start, permitting the allowance and determination ofclaims, and apprising parties of their status regarding the estate. [ FN: In re Bluman , 125 B.R. 359 (Bankr. E.D.N.Y. 1991), citing In re Monument Record Corp. , 61 B.R. 866, 868 (Bankr. M.D. Tenn.1986) (citations omitted).] Thus, contracts have been "deemed" executory if the requested election would benefit the estate/creditors; alternatively, a few courts have declined to make the threshold finding of executoriness and simply have focused on whether the estate would be benefitted by performance or breach of the contract. [ FN: See , e.g. , In re General Development Corp. , 84 F.3d 1364 (11th Cir. 1996) (affirming lower court determination that definition of executoriness has been expanded); In re The Drexel Burnham Lambert Group Inc. , 138 B.R. 687 (Bankr. S.D.N.Y. 1992); See also In re Leibinger-Roberts Inc. , 105 B.R. 208, 211 (Bankr. E.D.N.Y. 1989) (interpreting executory in broader fashion, weighing benefits and burdens). See also Jolly , 574 F.2d at 351; In re Arrow Air Inc. , 60 B.R. 117, 121 (Bankr. S.D. Fla. 1986).] However, this method has been criticized as ignoring the current statutory requirements. [ FN: See , e.g. , In re Riodizio , 204 B.R. at 421 (functional analysis is more efficient, but "ignoring executoriness rewrites statute in a fundamental way "). See also In re Child World Inc. , 147 B.R. 841, 851 (Bankr. S.D.N.Y. 1992) ( "manifestly, [functional] approach ignores statutory requirement that the contract to be assumed or rejected must be executory ").]

Courts now directly review the financial impact of the estate’s performance or breach of a contract. They must assess and approve elections to assume or reject, thus "[s]ection 365 requires a court to consider whether assumption of the contract in question will further either the rehabilitation or liquidation of the bankruptcy estate." [ FN: In re Superior Toy and Manufacturing Co. , 78 F.3d 1169, 1172 (7th Cir. 1996), citing H.R. Rep. No. 595, 95th Cong., 2nd Sess. 348 - 49 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6304 - 05.] Even using a deferential business judgment standard, a standard commonly employed by courts in reviewing motions to assume or reject, a trustee could not assume a contract if the benefits to the estate clearly would not outweigh the burdens. [ FN: In re Orion Pictures Corp. , 4 F.3d 1095, 1099 (2d Cir.1993) ("[A] bankruptcy court . . . should examine a contract and the surrounding circumstances and apply its best 'business judgment' to determine if it would be beneficial or burdensome to the estate to assume it.").] The goal to be served by the executoriness test is now met directly by court review.

The "executory" requirement no longer is necessary and actually may be running counter to the valid goal that Professor Countryman sought to attain. [ FN: "In fact, the functional approach was actually contemplated by Professor Countryman. Professor Countryman suggested that executory contracts be defined in light of the purpose for which the trustee is given the power to assume or reject: to benefit the estate. " In re Cardinal Industries , 146 B.R. 720 728 fn7 (Bankr. S.D. Ohio 1992). See also Phar-Mor Inc. v. Strouss Building Assoc. , 4:94 CV 1698, 1997 WL 16829 at *3 (N.D. Ohio Jan. 13, 1997) (material breach test helpful but not controlling), citing Jolly , 574 F.2d at 351.] As long as the term remains in the statute, this issue will continue to incite debate without an evident corresponding advantage. The ability of courts and trustees to gauge the benefits and burdens of a contract in bankruptcyvitiates the need to retain the executory requirement.

Competing Considerations

It might be argued that eliminating "executory" could have an unsettling effect on case law and encourage excessive litigation. However, this proposal would not introduce a foreign concept, but rather would streamline the analysis so that courts can focus on the critical issue of the benefit to the estate, which was the intended goal of the executoriness requirement in the first instance. Because court approval still would be required, this proposal could not eliminate litigation, for the review of the perform-or-breach-election is an assessment that necessarily is based on the facts and circumstances of each case and each contract. However, the removal of the threshold executory requirement would permit courts to focus the analysis on pertinent case-and estate-related factors.

Some have inquired whether eliminating the executory requirement would alter other parameters of section 365, thereby bringing more types of claims into the purview of the provision. However, others believe that benefits of deleting the requirement far outweigh the likelihood that this would be a significant concern. As a general matter, this proposal is not intended to alter the substantive restrictions in section 365 and, thus, for example, would have no effect on the statutory exclusion of loan and financial accommodation contracts.