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.
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