Business Reorganization Committee

Volume 7, Number 2 / June 2008

In This Issue:

• Committee Co-Chairs and New Leadership Positions Announced
• The Imposition Of Constructive Trusts In Bankruptcy Proceedings
• Timing Is Everything: Assumption and Rejection of Executory Contracts after Penn Traffic
• Materials From The Annual Spring Meeting

• Committee Officers
• Upcoming Events
• Contribute to the Newsletter
• ABI World
• Newsletter Archives

Timing Is Everything: Assumption and Rejection of Executory Contracts after Penn Traffic

Written by: Jay Teitelbaum [1]

Teitelbaum & Baskin, LLP; White Plains, N.Y.

On April 29, 2008, the Second Circuit Court of Appeals in In re The Penn Traffic Co., 2008 WL 1885328, held that under Bankruptcy Code §365, a nondebtor party to a contract that is executory at the time a bankruptcy case is commenced cannot, by post-petition tender or performance of its own outstanding obligations under the contract, deprive the debtor party of the ability to exercise its statutory right to reject the contract as disadvantageous to the estate.[2]

Summary 

The petition date is the relevant date for determining whether a contract may be assumed or rejected as executory unless (1) the contract expired post-petition by its terms (other than ipso facto clauses), such that there were no longer any obligations to assume or reject; or (2) the debtor had taken affirmative action post-petition that affected the existence of outstanding performance obligations.

Code §365 

Section 365 of the Code gives the debtor the unilateral right to exercise its business judgment to select which exectuory contracts it will continue to perform and which it will not.  As demonstrated in the trilogy of decisions in The Penn Traffic bankruptcy cases, notwithstanding the integral role this right often plays commercial bankruptcy cases, determining threshold requirements for the applicability of Code §365 is left to case-by-case interpretation rather than explicit statutory provisions. 

Discussion

On May 30, 2003, The Penn Traffic Co. and various affiliates commenced voluntary chapter 11 bankruptcy cases in the Southern District of New York. The debtors operated approximately 211 supermarkets located throughout six states.  In addition, the debtors served as a wholesaler of products, operated distribution facilities, and owned and operated a bakery processing plant.

Prior to the commencement of the bankruptcy cases, COR Route 5 Co. LLC (COR) and Penn Traffic entered into a project agreement providing for, inter alia, the exchange of certain parcels of land, the site preparation and construction of a modern supermarket, reimbursement by COR to Penn Traffic of a specified portion of the construction costs, Penn Traffic's conveyance to COR of the parcel of land on which the supermarket is situated and Penn Traffic's leaseback of the improved supermarket parcel from COR.  At the time of Penn Traffic's bankruptcy filing, COR had performed all of its obligations under the project agreement except for the reimbursement of the construction costs (amounting to approximately $3.5 million) and the tender of a lease to Penn Traffic. Penn Traffic had not conveyed the supermarket parcel to COR.  Several months post-petition, COR tendered to the debtor reimbursement of the $3.5 million in construction costs, as well as a signed lease, as called for by the project agreement. Penn Traffic declined to accept COR's tender and several months later, moved to reject the project agreement pursuant to Code §365.  As discussed below, the bankruptcy court denied the motion to reject.

As a preliminary matter, COR’s attempt to recharacterize the project agreement as a lease financing was rejected by the bankruptcy court.  This ruling was affirmed on all appeals. In re Penn Traffic, 322 B.R. 62, 69 (Bankr S.D.N.Y 2005), rev’d in part and remanded, In re Penn Traffic, 2005 WL 2276879 at *3-5 (S.D.N.Y 2005), aff’d, In re Penn Traffic, 2008 WL 1885328 at *8 (2d Cir. 2008). 

The bankruptcy court then turned to the issue of whether the project agreement was an executory contract. Because the Code does not define an executory contract, the court applied the generally accepted definition of Prof. Vern Countryman that an executory contract “is 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 performance of the other.”  Countryman, Executory Contract in Bankruptcy, Part I, 57 Minn. L. Rev. 439, 460 (1973).  The use of the Countryman definition was affirmed on all appeals.  Applying the Countryman definition, the bankruptcy court held that:

the project agreement was an executory contract upon the date of filing of the Penn Traffic, chapter 11 petition, because on that date . . . COR had not paid or tendered reimbursement of the $3.5 million required of it under . . . the project agreement as a precondition of its right to conveyance to it [by the debtor] of title to the Penn Traffic Supermarket Parcel. 

Penn Traffic, 322 B.R. at 69 (emphasis added).

Again, the appellate courts agreed that, as of the petition date, the project agreement was an executory contract.  See Penn Traffic, 2008 WL 1885328 at *5 (2d Cir.).  However, the bankruptcy court noted that the Code did not specifically provide that the determination of whether a contract was executory is to be made as of the petition date and found:

Once again, the statute is silent as to the date for determining the executory status of a contract under §365(a), which necessarily leaves it to the courts to establish a rule or to make the determination on a case-by-case basis. And again, not surprisingly, the courts have given differing answers to the question in differing circumstances.

* * *

Lacking any controlling authority from the Court of Appeals for the Second Circuit, I conclude that post-petition events should be considered among the other facts hearing on the question of executoriness when a motion to assume or reject is filed.

 

In this case there is no principled reason for declaring retrospectively that the date of Penn Traffic's bankruptcy filing was the deadline for COR to have fulfilled the balance of its obligations under the project agreement if it wanted to preserve its rights thereunder. There is no such deadline in the project agreement itself. Nor is there any statutory basis for the court to create such a limitation. Penn Traffic's bankruptcy filing did not terminate the project agreement, or [the respective rights and obligations of the parties to perform]. COR was never in default under the project agreement, although Penn Traffic clearly breached the agreement by refusing to [accept the post petition tender] and to perform.

Penn Traffic, 332 B.R. at 70-72. (emphasis added). Accordingly, the bankruptcy court held that (1) nothing in the Bankruptcy Code or the contract terminated the agreement as of the petition date or thereafter and (2) as a result of the post-petition tender of full performance by COR prior to filing of the motion to reject under Code §365, the contract was no longer executory and the debtor could not rely upon Code §365 to unilaterally deprive COR of its contractual rights.  Id. at 73-74.  The bankruptcy court therefore denied the debtor’s motion to reject on the ground that the contract was not executory at the time the motion was filed. The district court reversed and remanded [3] on this issue, holding:

We reject this determination and hold that the project agreement's executoriness should be measured as of the petition date. Our reasons for doing so are two-fold. First, we find that considering post-petition performance diminishes the rights of the estate under §365. Second, our reading of the relevant case law on post-petition performance convinces us that as a general rule such performance should not be considered.

 

Section 365(d)(2) allows a debtor until the confirmation of its reorganization plan to decide to assume or reject executory contracts. 11 U.S.C. §365(d)(2). As noted earlier, this provision “provide[s] the debtor with breathing space following the filing of a bankruptcy petition”. . .. In that time, the debtor can decide which contracts are beneficial to the estate and should be assumed, and which are detrimental and therefore should be rejected. . . .  Rejection of an executory contract relieves the debtor of the duty to perform its obligations under the contract, and is “vital to the basic purpose [of] a chapter 11 reorganization. . . ”

* * *

We find that consideration of post-petition performance in determining a contract's executoriness runs contrary to the policy behind this provision. . . .   The bankruptcy court's ruling permits a non-debtor party to circumvent this right by tendering post-petition performance of its remaining obligations under an executory contract. Since a contract that is burdensome to the estate is ordinarily beneficial to the non-debtor counterparty, a non-debtor party would have much to gain from such performance.  Rather than facing the potential rejection of its executory contract, the non-debtor could perform its remaining obligations, as COR did here, thereby eliminating the estate's right to reject the burdensome contract.  Accordingly, considering post-petition performance diminishes the statutory protection offered to the estate by section 365. 

 

Penn Traffic, 2005 WL 2276879 at * 3-5 (S.D.N.Y) (citations omitted) (emphasis added).

The Second Circuit affirmed the rejection of the project agreement.  The court distinguished the line of cases that considered post-petition events in determining whether a contract could be assumed or rejected, holding that such cases are limited to contracts that had expired on their own terms prior to the filing of the motion, or where the debtor took affirmative action affecting the existence of outstanding performance obligations (e.g., debtor terminated an employee prior to filing motion to reject employment agreement; debtor ceased operations prior to filing motion to reject a collective bargaining agreement). Penn Traffic, 2008 WL 1885328 at *6 (2d Cir.).  The Second Circuit specifically noted:

The Code provisions permitting a debtor to accept or reject an executory contract do not alter the parties' contractual rights. The terms of the contract are unchanged and thus . . . where the contract expires by its own terms in the course of the bankruptcy, or the debtor takes action in the course of the bankruptcy to terminate the outstanding obligations, the contract's mere executory nature as of the commencement of the proceeding—without more—will not guarantee the debtor the availability of §365's assumption and rejection provisions. Where, however, the parties' rights under the terms of their pre-petition agreement have not been altered or extinguished by operation of nonbankruptcy law, both parties remain subject to the contractual obligations, and rejection of the contract constitutes a breach. In the event of rejection of such an executory contract, the Code governs the treatment of the non-debtor party's resulting claim within the bankruptcy proceeding.

Id. at *8. Indeed, on this issue, the district court had previously held:

In contrast, those cases that do address a non-debtor's post-petition performance have not found that this performance alters the executoriness of the contract. Instead, post-petition performance, if accepted by the estate, merely gives rise to an elevated claim for that performance. “If the debtor-in-possession elects to continue to receive benefits from the other party to an executory contract pending a decision to reject or assume the contract, the debtor-in-possession is obligated to pay for the reasonable value of those services, which, depending on the circumstances of a particular contract, may be what is specified in the contract.”

Penn Traffic, 2005 WL 2276879 at *6 (S.D.N.Y).

The Second Circuit recognized that Code §365 was not designed for a level playing field and that the Code gives the debtor the exclusive right to determine whether to assume or reject an executory contract as in the best interests of the estate: 

Sympathy for the non-debtor that may, through no fault of its own, bear some significant burden from the debtor's rejection of an executory contract due to the happenstance of an unforeseen bankruptcy proceeding is understandable. The notion that a non-debtor could prevent the exercise of §365 rights with regards to an executory contract through post-petition performance of the non-debtor's contractual obligations is, however, inconsistent with both the plain language and the policy of the Code. . . . The Code does not condition the right to assume or reject on lack of prejudice to the non-debtor party. . .
 

As for policy, we have noted that “[t]he main purpose of §365 is to allow a debtor to reject executory contracts in order to relieve the estate of burdensome obligations while at the same time providing ‘a means whereby a debtor can force others to continue to do business with it when the bankruptcy filing might otherwise make them reluctant to do so.”

* * *

However long this process may take, however onerous the dilemmas faced by the non-debtor party to an executory contract may be while the non-debtor awaits the debtor's decision . . . to assume or reject, the power to make that election is [solely with the debtor], not with its business partners. To disturb this mechanism would unbalance the Code's overriding policy favoring debtor reorganization and rehabilitation.

 

That the debtor's interests are paramount in the balance of control is underscored by the business judgment standard employed by courts in determining whether to permit the debtor to assume or reject the contract.  Penn Traffic, 2008 WL 1885328 at *6-8 (2d Cir.)

(emphasis added). Accordingly, the Second Circuit has now set forth the general rule that, absent applicable principles of nonbankruptcy law, determining whether a contract is executory for purposes of Code §365 will be made as of the commencement of the bankruptcy proceeding. Id. at *8.