Bankruptcy Litigation Committee

ABI Committee News

Fleming: Executory Contract Assignment Not Approved When Proposed Assignee Could Not Comply with aTerm Deemed Integral to the Bargained-for Exchange

Section 365(f) of the Bankruptcy Code permits a debtor to assume and assign an executory contract so long as adequate assurance of future performance is provided to the nondebtor party. However, the phrase “adequate assurance of future performance” is not defined in the Bankruptcy Code, and thus courts must interpret its meaning. In 1990, the Third Circuit set forth a material and economically significant standard to differentiate between the terms of a contract where adequate assurance must be provided from those terms that may be modified by a bankruptcy court. In re Joshua Slocum Ltd., 922 F.2d 1081, 1092 (3d Cir. 1990). Although the material and economically significant standard provided some guidance to bankruptcy practitioners, it was unclear whether a contract term must be economically material, or whether materiality alone would suffice to bring a contract term within the protections afforded by §365(f). That issue was recently clarified by the Third Circuit in In re Fleming Cos., 48 Bankr. Ct. Dec. 188 (3d Cir. 2007).

In Fleming, the debtor was a wholesale supplier of grocery products to supermarkets. In 2002, Fleming purchased a warehouse distribution center in Tulsa, Okla. (the Tulsa facility), from Albertson’s, one of Fleming’s supermarket customers. The parties executed a supply contract that included a provision whereby the products Fleming would deliver to Albertson’s for its Oklahoma stores would come “from the Tulsa facility” (the supply agreement). The parties operated under the supply agreement for less than one year before Fleming filed for bankruptcy in April 2003. In Fleming’s bankruptcy case, the bankruptcy court entered an order approving the sale of Fleming’s assets to C&S Wholesale Grocers Inc. and C&S Acquisition LLC (collectively, C&S). The order authorized C&S to designate third-party purchasers for certain assets, including Fleming’s executory contracts with Albertson’s. C&S designated AWG, a cooperative of independent grocery wholesalers with distribution centers, as the entity that had the right to acquire Fleming’s executory contracts with Albertson’s. AWG sought to assume the supply agreement but not the lease for the Tulsa facility. Accordingly, Fleming closed the Tulsa facility and rejected its lease for the Tulsa facility.

As for the supply agreement, AWG’s representatives testified that AWG was capable of fully performing under that agreement and would provide products to Albertson’s under the same price and terms as Fleming, including freight charges. Albertson’s objected to the proposed assumption and assignment because AWG could not deliver the products from the Tulsa facility, which was designed by and employed many former Albertson’s employees. AWG contended that under Joshua Slocum, adequate assurance of future performance need only be given for “economically material” terms of a contract. AWG argued that shipment from the Tulsa facility was not an economically material term of the supply agreement and could be disregarded by the court.

The Third Circuit disagreed with AWG, finding that whether or not adequate assurance of future performance must be provided does not depend on whether a term is “economically material,” but rather on the importance of the term within the overall bargained-for exchange. In other words, the focus should be on whether the contract term is integral to the bargain (material) and whether performance of the term gives the party the full benefit of its bargain (economic significance). The Third Circuit compared the provision that required that delivery be made from the Tulsa facility to a time-is-of-the-essence clause. Although neither requirement is inherently material or obviously economic, such terms can be integral terms of a contract. Regarding the delivery from the Tulsa facility requirement, the court noted that the parties expressly included the requirement in the agreement. Albertson’s included the provision to reap the benefits of a trained staff, a consistent supply of products and a proven electronic system of record-keeping that furthered Albertson’s marketing efforts. Although the court weighed the rights of Fleming’s creditors to get a benefit from the supply agreement, the court held that in favor of Albertson’s because AWG could not provide the same benefits to Albertson’s as were available from Fleming (Fleming had rejected the lease for the Tulsa facility at the direction of AWG).

AWG also argued that designating “from the Tulsa facility” a material term of the supply agreement transformed that term into a de facto anti-assignment provision. Pursuant to §365(f)(1) of the Bankruptcy Code, assignments of executory contracts are permitted even when contracts expressly prohibit such assignments. Courts have consistently held that provisions that are so restrictive that they constitute a de facto anti-assignment provision are rendered unenforceable.

In rejecting AWG’s anti-assignment argument, the court first announced the general rule that §365(f) requires a debtor to assume a contract subject to the benefits and burdens thereunder. While the court recognized that a fine line exists between a contractual term that is a burden and a de facto restriction on assignment, the court decided to draw the line where a party refuses to accept part of the contract’s obligations but cannot perform a material term of the contract. The court noted that because AWG directed Fleming to reject the Tulsa facility lease, it cannot avail itself of the argument that the term requiring shipment from the Tulsa facility is an anti-assignment provision.

In sum, the Fleming court clarified the “material and economically significant” standard set forth in Joshua Slocum. The Fleming court held that when a proposed assignee cannot comply with a term of a proposed assigned contract, the court should focus on whether the contract term is integral to the bargain (material) and whether performance of the term gives the party the full benefit of its bargain (economic significance). In light of the Fleming decision, counsel for a debtor and proposed assignee should be prepared to show that any term not being complied with was not important to the overall bargained-for exchange. If the term was integral, then the debtor and proposed assignee must evaluate whether there is any way to comply with the provision, and if not, accept the risk that the assignment will not be approved. For example, in Fleming, it appears as though AWG would have been successful in obtaining the assignment of the supply agreement if AWG had also sought assumption of the lease for the Tulsa facility. For those representing non debtor parties, Fleming teaches that counsel should carefully analyze the terms of the contract and endeavor to understand the negotiating history behind the contract. Integral non economic terms may not be readily apparent from the contract itself. Additionally, if a contract term has not been complied with and the nondebtor party seeks to defeat the proposed assignment, counsel should present evidence establishing that the contract term was integral to the bargained-for exchange, and that the assignment should be denied.