Executory Contracts & Bankruptcy

• Executory contracts are unperformed contracts in bankruptcy.

Basic Bankruptcy Concepts

• Involve both property of the estate and a claim against the debtor or the estate
• Most apparent when the lessee is the debtor.
• The debtor's rights to use the leased space is an asset of the estate, but the lease involves burdens like rent payments
• The obligation to pay rent is a claim for the lessor.

Overview of Section 365

• Section 365 outlines three possible outcomes for a lease or executory contract in bankruptcy:
• Rejection: Giving up the lease.
• Assumption: Performing and keeping the lease or contract.
• Assignment: Selling the lease or contract.
• Rejection means no property of the estate can be claimed for pre-petition defaults or breaches from rejection.
• These become unsecured claims
• Assumption means the debtor retains rights under the contract, and administrative expense priority is given.
• Assignment means proceeds from the assignment go to the estate
• The non-debtor party looks solely to the assignee.

Section 365 Issues

• Debtors cannot modify unexpired leases or executory contract terms under Bankruptcy Code.
• If a lease is rejected, the lessee loses the right to use the property and has no further personal liability.
• Rejection is a breach of lease
• The lessor has an unsecured claim against the estate for back rent and future rentals.
• If a lease is assumed, the leasehold remains an asset of the estate, and the lessee can continue operating
• The estate must make all lease payments
• This becomes a first priority administrative expense.
• If a lease is assigned, the trustee and estate are relieved of liability for breaches after assignment.

Debtor and Bankruptcy Court Roles

• Court approval is required for assumption or rejection of leases/contracts
• Bankruptcy judges use a business judgment test, giving weight to the debtor's judgment.
• Debtors in possession can assume or reject leases/contracts.

Time Period for Decisions ("Gap Period")

• The "gap period" is the time between filing bankruptcy and court approval of rejection, assumption, or assignment.
• Rules for gap periods are in Section 365.
• For Chapter 7 cases involving nonresidential real property leases, automatic rejection occurs if the trustee doesn't assume the lease within 60 days after the order for relief.
• An exception exists where the court can extend the 60 days.
• this section does not apply to nonresidential real property leases
• For Chapters 11/13 cases (excluding nonresidential real property), executory contracts/leases can be assumed/rejected before plan confirmation.
• Court exception: the court can order an, earlier determination.
• The rule of a lease of nonresidential real property is deemed rejected in Ch 7, 11 & 13 if not assumed with 120 days after the order for relief.
• There are 2 exception:
• the deadline becomes the date of the entry of the order confirming the plan is earlier
• If the court extends the 120 period by 90 days & the lessor must agree

Performance During the Gap Period

• Rights and responsibilities exist for both debtors and non-debtor parties during the gap period.
• Section 365 doesn't explicitly address the non-debtor party's performance obligations.
• Non-debtor parties must still perform.
• Debtors must "timely perform" obligations under nonresidential real property leases per Section 356(d).
• Section 365(d)(5) addresses performance obligations for equipment leases

Limitations on Rejection

• Section 365 does not limit the ability to set out four situations where the effect of rejection is limited, starting with: When the debtor is the landlord.
• A trustee cannot use Section 365 to evict tenants, even if the lease is rejected.
• A trustee/lessor can reject some services (like maintenance), but the lessee can offset damages against rent.

Contract Limitations on Assumption and Assignment

• Clauses prohibiting/limiting lease assumption/assignment are ineffective in bankruptcy.
• A trustee/debtor can assume a lease despite clauses allowing termination due to bankruptcy/insolvency.
• A trustee/debtor can sell/assign a lease even if it is not assignable

Requirements for Assumption or Assignment

• Section 365(b) sets requirements for lease assumption, applying only if there's a default unrelated to bankruptcy filing/insolvency.
• Adequate assurance of future performance is always required for assignment.

Contracts That Cannot Be Assumed or Assigned

• Leases/contracts terminated before bankruptcy cannot be assumed.
• Loan commitments/financing arrangements cannot be assumed.
• Contracts not assignable under "applicable law" are not assignable.
• Debtors cannot assume leases/contracts if a legal bar to assigning exists outside bankruptcy.

Scope of Executory Contract

• Section 365 applies to leases and executory contracts.
• There is no set definition of a lease.
• An executory contract is one where unperformed obligations on both sides would constitute a material breach if not completed.