Section 365

Proposal #2: Clarifying the Meaning of "Rejection"


Section 365 of the Bankruptcy Code governs the "assumption" and "rejection" of executory contracts and leases in bankruptcy. One area of great confusion in section 365 has been the meaning of "rejection," a term with no obvious state contract law counterpart. Although the Bankruptcy Code provides that rejection should be treated as a breach for some purposes, [ FN: 11 U.S.C. §§365(g), 502(g).] the Code does not state expressly that rejection is synonymous with breach, nor does it fully delineate the consequences of a trustee’s decision to reject. Does rejection "nullify" or "rescind" the contract and terminate the rights of the parties? Does rejection serve as an avoiding power separate and apart from the avoiding powers already provided in the Bankruptcy Code? In answering these questions, the concept of rejection has been applied inconsistently by the courts.

The Recommendations

The concept of "rejection" in section 365 should be replaced with "election to breach."

Section 365 should provide that a trustee’s ability to elect to breach a contract of the debtor is not an avoiding power.

Section 502(g) should be amended to provide that a claim arising from the election to breach shall be allowed or disallowed the same as if such claim had arisen before the date of the filing of the petition.

Reasons for the Proposed Changes

These suggested amendments would clarify further that the trustee’s election not to perform a contract is to be treated like a prepetition breach. Under most circumstances, this means that the non-debtor party would be entitled to damages, and the contract obligations themselves would be discharged. Damages would be paid in pro rata bankruptcy dollars along with unsecured creditors. Although federal courts generally should defer to state law in the substantive interpretation of contracts in bankruptcy, the remedies portion of a contract should remain a federal law question. Thus, bankruptcy law should determine the extent to which a non-debtor party is entitled to specific performance; [ FN: "Rejection avoids specific performance, but the debtor assumes a financial obligation equivalent to damages for breach of contract. " Midway Motor Lodge of Elk Grove v. Innkeepers ’ Telemanagement & Equipment Corp. , 54 F.3d 406, 407 (7th Cir. 1995), citing NLRB v. Bildisco & Bildisco , 465 U.S. 513, 531 (1984), and Douglas G. Baird, The Elements of Bankruptcy 117 - 27 (rev. ed. 1993). Cf. In re Udell , 18 F.3d 403 (7th Cir. 1994) (reversing district court that held that covenant not to compete was "claim " entitled to pro rata distribution and dischargeable in bankruptcy).] otherwise, state laws providing very broad rights to specific performance would have the inequitable effect of granting preferential treatment tocertain contract creditors, to the detriment of all other general unsecured creditors in bankruptcy.

At the same time, it is imperative to resolve any doubts that a breach in bankruptcy does not constitute repudiation, termination, or an avoiding power, contrary to the views expressed by some courts. [ FN: See , e.g. , Lubrizol Enterprises Inc. v. Richmond Finishers , 756 F.2d 1043 (4th Cir. 1985), cert. denied 475 U.S. 1057 (1986); In re Gillis , 92 B.R. 461 (Bankr. D. Haw. 1988) (effect of rejection is to terminate lease and extinguish corresponding security interest in leasehold), citing In re Southwest Aircraft Services Inc. , 66 B.R. 121 (9th Cir. Bankr.), rev'd on other grounds , 831 F.2d 848 (9th Cir. 1988); In re Giles Assoc. , Ltd., 92 B.R. 695 (Bankr. W.D. Tex. 1988) (section 365(d)(4) terminates lease as to all parties, including creditors); Chatlos Sys. Inc. v. Kaplan , 147 B.R. 96 (D. Del. 1992), aff ’d without opinion , 998 F.2d 1005 (3d Cir. 1993). "[I]f the . . . Agreement is a real property lease, then upon rejection, the lessee [ ] may be able to retain possession pursuant to section 365(h), a protection that is not available in the event of a rejection of any other type of executory contract such as a management agreement. " In re Dunes Hotel Assoc. , 194 B.R. 967, 987 (Bankr. D. S.C. 1995). See also In re Firstcorp Inc. , 973 F.2d 243, 246 (4th Cir. 1992) ( "section 365(o ) . . . prevent[s] the trustee from rejecting any such commitment as an executory contract under his usual 'avoidance' powers" pursuant to 11 U.S.C. §365(a)).] If a debtor had conferred rights in the asset itself to a non debtor party, for example, a trustee would not be entitled to repudiate the contract and retrieve the property. Clarifying that a breach in bankruptcy is not an avoidance power and does not "vaporize" the contract would prevent the contrary results reached by some courts without enactment of additional special interest legislation in response to each individual case. [ FN: The result in Lubrizol lead to the enactment of the special interest provision for patents, section 365(n). The Report of the House Judiciary Committee indicated the treatment of executory contracts and leases "should be revisited as a whole and fashioned so as to apply consistently in all situations. The Committee believes that continued creation of special interest exceptions to section 365 is not desirable, and intends to revisit section 365 so that it is, in [George] Hahn ’s words, a ‘total cohesive section. ’ " H.R. Rep. No. 1012, 100th Cong., 2d Sess. 3 (1988).] Of course, otherwise-applicable bankruptcy avoiding powers might provide a basis for avoiding the contract.

This recommendation reflects a trend in the case law, [ FN: "Three circuits, including this one, have held that this language does not mean that the executory contract or lease has been terminated, but only that a breach has been deemed to occur. " In re Austin Development Co. , 19 F.3d 1077, 1081 (5th Cir.), cert. denied , 115 S. Ct. 201 (1994), citing In re Continental Airlines , 981 F.2d 1450, 1459 (5th Cir.1993) ("to assert that a contract effectively does not exist as of the date of rejection is inconsistent with deeming the same contract breached"), In re Modern Textile Inc. , 900 F.2d 1184, 1191 (8th Cir. 1990); Leasing Service Corp. v. First Tennessee Bank, Nat'l Ass'n , 826 F.2d 434, 436 - 37 (6th Cir. 1987).] and is quite consistent with the scholarly literature on this subject. [ FN: See , e.g. , Michael T. Andrew, "Executory Contracts in Bankruptcy, Understanding 'Rejection,'" 59 U. Colo. L. Rev. 845 (1988); Jay Lawrence Westbrook, "A Functional Analysis of Executory Contracts," 74 Minn. L. Rev. 227 (1989); Morris Shanker, "A Proposed New Executory Contract Statute," 1993 Annual Survey of Bankruptcy Law, 129; Thomas H. Jackson, The Logic and Limits of Bankruptcy Law (1986).] However, there has been sufficient misunderstanding of the term "rejection" to make this reasonable change necessary and desirable.

Competing Considerations

Some argue that a trustee or debtor should be able to repudiate or avoid a contract in bankruptcy when such avoidance is in the best interest of the estate and would increase the likelihood of a successful reorganization. To the extent that one believes that section 365 was intended to be another avoiding power, this proposal would curtail that power.

Another concern is that adjusting the lexicon of section 365 might encourage additional litigation. However, this type of change has been endorsed overwhelmingly. The special interest amendments reflect an underlying support for the clarifications suggested herein. Using the word "breach" incorporates a term that derives its meaning from state law contract principles, with which courts already are familiar, and is unlikely to cause undue confusion.

Finally, this proposal might be criticized as being inadequately remedial. The proposal stops short of dismantling the special interest provisions that presently pervade section 365. Some might take issue with this more conservative approach because section 365 will remain too complicated even after the implementation of these changes. More importantly, another problem arises regarding the relation between these sections and the amendments suggested here. By negative implication, legislation devoted to only one type of contract undercuts the general applicability of the principles expressed therein. For example, delineating specific results for one type of intellectual property to the exclusion of others leads courts to distinguish between the special rule and a default rule, when in fact the special rule may reflect a principle that should be broadly applicable and articulated generically. By the same token, establishing a general rule that is consistent with the principles of the special interest legislation without eliminating the special interest legislation may exacerbate the undesirable results that the special interest provisions were designed to foreclose in the first place, perhaps indicating that those provisions may be doing more harm than good. The Commission may wish to consider whether this package of amendments vitiates the need for several of the subsections of section 365 that apply only to one type of contract.