Section 365

Proposal #3: Interim Protection and Obligations of Non-debtor Parties

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 party’s interest in that interim period.

The Recommendations

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 contract’s 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 debtor’s 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 creditors’interests 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 debtor’s 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 debtor’s 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 party’s 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 trustee’s 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.

Competing Considerations

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.