Proposal #3: Interim Protection and Obligations of Non-debtor
The trustee or debtor generally needs time to determine whether to perform, transfer, or
breach contracts. These decisions are then subject to court review. In a chapter 7 case, the trustee
automatically has sixty days in which to make this decision, and in other chapters the trustee may
make the election at any time before plan confirmation. Because of the important economic effect
that follows from performance or breach, some courts do not permit a debtor or trustee to make
an election until plan confirmation or liquidation. The non-debtor party can request that the court
order a decision be made within a certain period of time, but the court is not obliged to grant this
relief and it may not be economically reasonable to force the trustee to make a decision when it is
not yet clear what will benefit the estate. In the meantime, a non-debtor party may be expected to
continue to perform under the contract. Under current law, it is unclear what steps should or must
be taken to protect that partys interest in that interim period.
A court should be authorized to grant an order governing temporary performance and/or
providing protection of the interests of the non-debtor party until the court approves a
decision to perform or breach a contract.
Section 503(b) should include as an administrative expense losses reasonably and
unavoidably sustained by a non-debtor party to a contract pending court approval of a
decision to perform or breach a contract if such non-debtor party was acting in
accordance with a court order governing temporary performance.
Reasons for the Proposed Changes
The Bankruptcy Code does not require immediate decision making on how a trustee or
debtor will deal with a prepetition contract. The contracts value to the estate may not be
clear initially. Assuming a contract quickly, thus imposing a significant administrative burden on
the estate, may be improvident when it is not yet known whether the debtor will be able to
reorganize successfully. Moreover, any push to make an early decision leaves more power in the
hands of debtors to prefer certain contract creditors when there may be no economic benefit,
especially at a chaotic time when return performance may appear to be especially
"necessary." When cases are converted and a trustee elects to breach a contract
previously assumed, a very large portion of the debtors assets may be required to satisfy
the administrative obligation, leaving very little for pro rata distribution to other unsecured
creditors. [ FN: See , e.g. , In
re Klein Sleep Products Inc. , 78 F.3d 18 (2d Cir. 1996) (even if trustee subsequently rejected
upon conversion and gave property back to landlord and received no further benefit from lease,
assumed contract gave rise to administrative expense priority for full amount of claim and was not
subject to one-year damage cap).] At the same time, quickly electing to
breach a contract that upon greater reflection might turn out to be valuable will be damaging to
creditorsinterests as well.
However, rarely can a contract be suspended until a decision is made. Debtors, especially
chapter 11 debtors that remain in operation, must be able to rely on the return performance of a
non-debtor party. Of course, non-debtor parties should not be expected to continue to perform or
to prepare to perform without compensation and protection of their interests.
Section 365 lacks instruction on these interim obligations and entitlements. It provides some
guidance in the context of nonresidential real property and requires the trustee/lessee to perform
the debtors obligations. However, these nonresidential real estate provisions have not
guaranteed full protection for non-debtor lessors. Although many courts have held that the statute
automatically confers administrative expense priority for postpetition performance at the full lease
amount, [ FN: See , e.g. , In
re Liberty Outdoors Inc. , 95-41821-172, 1997 WL 78048 (Bankr. E.D. Mo. Feb. 4, 1997) ;
In re Ambers , 193 B.R. 819 (Bankr. N.D. Tex. 1996) . See also In re
Telesphere Communications Inc. , 148 B.R. 525 (Bankr. N.D. Ill. 1992) (lessor gets superpriority
ahead of other administrative claimants).] some courts have determined
that the debtor needs to pay the lessor only the reasonable value of the debtors actual use.
[ FN: In re Mr. Gatti's Inc. 164 B.R.
929, 946 (Bankr. W.D. Tex. 1994); In re Orvco , 95 B.R. 724 (9th Cir. Bankr. 1989).
But see In re Pacific-Atlantic Trading Co. , 27 F.3d 401 (9th Cir. 1994) (section
365(d)(3) authorizes administrative status without consideration of section
503(b)(1)).] Outside the context of nonresidential leases, there is even
more uncertainty. There is no specific authority to require a non-debtor party to perform under a
contract pending performance or breach. [ FN:
See , e.g. , In re Continental Energy Assoc. , 178 B.R. 405, 407 (Bankr. M.D. Pa.
1995) ( "it has been less common where the courts have compelled a supplier to furnish some
service or material , but there is some precedent "). The court in this case used its power under
section 105 to direct the counter party to perform.] If that counter party
must perform, there remains the question of how to determine the appropriate compensation and
what priority that compensation should receive. [
FN: In re Bridgeport Plumbing Products Inc. , 178 B.R. 563 (Bankr. M.D. Ga.
1994) (conducting section 502(b) analysis to determine postpetition/prerejection compensation
for equipment lessor); In re Mr. Gatti's Inc. 164 B.R. at 946 (notwithstanding section
365(d)(3), real estate lessor not automatically entitled to administrative expense claim for full
lease amount).] Courts are in conflict over the extent to which contract
parties are entitled to "adequate protection" payments. [ FN: See generally William H. Schorling &
Robert P. Simons, "Adequate Protection for the Nondebtor Party to Executory Contracts and
Unexpired Leases," 64 Am Bankr. L. J. 297 (1990). See also 11 U.S.C. §363(e) (amended
in 1994 to include in its scope unexpired leases of personal property).]
Even if the court permits a non-debtor party to receive full contract payments in the interim
period, the payments may be subject to later scrutiny under section 503(b), which may result in
disgorgement. [ FN: Continental Energy
Assoc. , 178 B.R. at 409.]
The non-debtor party currently has one "remedy," i.e., the right to
request the court to compel the debtor to make its election within a certain period of time.
However, as previously mentioned, many courts decline to use this blunt remedy due to the
possible negative effects of premature elections. The relief contemplated in this proposal would
compensate the counter party fairly while it minimized that partys incentive to pressure the
debtor to make a premature determination of how to handle the contract, which might have
broader economic repercussions.
This proposal seeks to fill the gap in section 365. It recognizes that the court should have
express authority to order the non-debtor party to perform while awaiting a decision from the
debtor. In conjunction, the proposal would authorize payments or other means to ensure that the
interests of the non-debtor party to a contract are not further injured or prejudiced pending the
trustees election. Compensation of the non-debtor would be based on the contract,
although the court in its discretion could fashion a more appropriate remedy in certain instances,
e.g., to include the costs to the non-debtor for preparation for performance, or to allocate
payment in a contract that provides for a lump sum payment at the conclusion of performance.
The courts are trying to develop their own remedies, perhaps obviating the need for a
statutory fix. However, the disparate approaches in the case law and the reports of many
practitioners seem to indicate that guidance would be exceedingly helpful.
This proposal would have courts take on the difficult task of fashioning interim relief.
Although the contract price would be conclusive whenever possible, the payment structure or the
nature of some contracts may require more challenging determinations of what would constitute
fair temporary compensation. Courts presently conduct some of this analysis in establishing
administrative expense priority claims, but interpreting a contract and balancing and protecting the
interests of both parties may be a more complex undertaking in many cases.
If this proposal were enacted, courts might be even less inclined to compel the trustee to
make an election within a certain period of time. To the extent that counter parties are seeking
and obtaining the imposition of time limits, these parties might get less definitive relief during the
pendency of the case. However, this proposal will provide enhanced protection to the many
counter parties that currently are required to perform with no assurance of compensation during a
protracted interim period.