HOW EXECUTORY CONTRACTS AND UNEXPIRED LEASES ARE TREATED UNDER CHAPTER 11 BANKRUPTCY ?
A corporate debtor ordinarily has numerous contractual relationships at the time it commences a Chapter 11 case. These may include supply agreements, distribution agreements, employment and service contracts, construction agreements, intellectual property licences, franchise agreements, real estate leases and equipment leases. Many of these agreements remain partly unperformed by both parties when the bankruptcy case begins.
The Bankruptcy Code provides a special mechanism for dealing with such agreements through Section 365. The debtor in possession (“DIP”), subject to court approval, may generally assume, reject or, where legally permissible, assign an executory contract or unexpired lease.
This mechanism is important because a financially distressed company may have both valuable and burdensome contractual relationships. Contracts that are essential to the continued operation of the business may need to be preserved, while contracts requiring substantial future expenditure without corresponding economic benefit may need to be terminated. Section 365 allows the debtor to make these adjustments as part of the reorganization process.
EXECUTORY CONTRACTS
The Bankruptcy Code does not expressly define the term “executory contract.” Courts have generally adopted a formulation under which a contract is executory when material performance remains due from both the debtor and the counterparty and the failure of either party to perform would constitute a material breach.
The determination is therefore based upon the substance of the parties’ remaining obligations rather than merely the formal status of the agreement. A contract may remain executory even though substantial performance has already occurred if significant obligations continue on both sides.
For example, a long-term supply agreement requiring the debtor to purchase specified quantities of goods and the supplier to continue making deliveries may constitute an executory contract. Similarly, certain service agreements, licensing arrangements, distribution agreements and construction contracts may fall within Section 365.
The classification is important because Section 365 applies specifically to executory contracts and unexpired leases. A contract that has already been fully performed, or one under which no material obligations remain on one or both sides, may instead be treated as an ordinary claim or property right under other provisions of the Bankruptcy Code.
UNEXPIRED LEASES
Section 365 separately addresses unexpired leases of the debtor. A corporate debtor may, for example, be the tenant under leases relating to factories, warehouses, offices, retail premises, vehicles or equipment.
The commencement of Chapter 11 does not automatically terminate these leases. The debtor must determine whether each lease is economically beneficial to the estate and whether it should be retained, rejected or, where permitted, assigned.
The treatment of an unexpired lease under Section 365 should be distinguished from the debtor’s authority under Section 363 to lease property belonging to the estate. Section 363 concerns the use, sale or leasing of estate property, whereas Section 365 concerns contractual leases under which the debtor is the lessee.
ASSUMPTION OF EXECUTORY CONTRACTS AND LEASES
Under Section 365(a), the DIP may, subject to court approval, assume an executory contract or unexpired lease. Assumption represents the debtor’s decision to retain the contractual relationship and continue performing its obligations.
Where the debtor is in default, Section 365(b)(1) generally requires the debtor to address that default before assumption. The debtor must generally – (i) cure, or provide adequate assurance of prompt cure of, the default; (ii) compensate, or provide adequate assurance of prompt compensation for, the counterparty’s actual pecuniary loss resulting from the default; and (iii) provide adequate assurance of future performance under the contract or lease.
These requirements are intended to prevent the debtor from retaining the benefits of a contract while leaving the non-debtor party exposed to prepetition defaults and an uncertain prospect of future performance.
The requirement of adequate assurance of future performance does not ordinarily mean that the debtor must establish absolute certainty that it will perform. Rather, the court considers whether the circumstances reasonably demonstrate that the debtor or proposed assignee will be able to perform its future obligations.
Assumption may therefore be particularly important where a contract is essential to the debtor’s continued operation, such as a critical supply agreement, licence or premises lease.
REJECTION OF EXECUTORY CONTRACTS AND LEASES
Section 365(a) also permits the DIP, subject to court approval, to reject an executory contract or unexpired lease. Rejection is generally appropriate where continued performance would impose an undue economic burden on the estate or where the contract is inconsistent with the debtor’s restructuring strategy.
In NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984), the Supreme Court recognised that §365 permits a debtor in possession, subject to court approval, to reject an executory contract where the requirements of bankruptcy law are satisfied. The Court described an executory contract as one under which performance remains due to some extent on both sides. The decision illustrates the special treatment accorded to executory contracts in Chapter 11, where the debtor is permitted to determine whether continued performance is beneficial to the estate.
Under Section 365(g), rejection is generally treated as a breach occurring immediately before the date of the filing of the bankruptcy petition. The counterparty may consequently assert a claim for damages arising from the rejection, subject to the Bankruptcy Code and any applicable statutory limitations.
The Supreme Court substantially clarified the effect of rejection in Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. 370 (2019). The Court held that rejection of an executory contract under §365 constitutes a breach of the contract and does not ordinarily rescind rights that the counterparty had already obtained under the agreement. Consequently, rejection and termination are conceptually distinct: rejection relieves the estate from future performance but does not necessarily extinguish contractual rights that would survive an ordinary breach outside bankruptcy.
Rejection does not necessarily operate as a traditional contractual termination for every purpose. Its principal bankruptcy consequence is that the estate is relieved from the obligation of continuing performance under the rejected agreement, while the counterparty is generally left with a bankruptcy claim arising from the breach.
The debtor must therefore evaluate both the economic cost of continuing a contract and the potential rejection damages before seeking rejection.
ASSIGNMENT OF CONTRACTS AND LEASES
Assignment can be particularly valuable where an executory contract or lease has significant economic value. Under Section 365(f), an executory contract or unexpired lease that has been properly assumed may, subject to statutory requirements, be assigned to another party.
Assignment frequently arises in connection with the sale of a debtor’s business under Section 363. A purchaser may be willing to acquire the debtor’s business only if it can obtain important contracts, licences or leases necessary for continuing the business.
Where the debtor has defaulted, the applicable cure requirements generally must be satisfied before assumption and assignment. The debtor must also provide adequate assurance of future performance by the assignee.
Section 365(f) generally limits the ability of a contracting party to prevent assignment solely through contractual restrictions. However, this principle is subject to important statutory exceptions. In particular, Section 365(c) may restrict assignment where applicable law excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the debtor.
The interaction between Sections 365(c) and 365(f) can therefore become significant in contracts involving personal performance, special qualifications, government licences or other circumstances in which the identity of the contracting party is material.
TIMING OF ASSUMPTION OR REJECTION
The debtor does not ordinarily have to decide immediately whether every executory contract should be assumed or rejected. The Bankruptcy Code allows the debtor some time to evaluate its contractual relationships and determine which agreements are necessary for the reorganization.
The timing rules become particularly important in relation to unexpired leases of nonresidential real property. Under Section 365(d)(4), if the applicable deadline for assumption is not met, the lease may be deemed rejected and the debtor may be required to surrender the leased premises, subject to the extensions permitted by the statute.
The court may also establish procedures and deadlines for the debtor to identify and address its contractual obligations. These provisions prevent the debtor from indefinitely retaining the benefits of contracts and leases without determining whether it intends to perform them.
SPECIAL RULES RELATING TO LEASES
Section 365 contains special provisions dealing with different categories of leases and contractual arrangements. These provisions recognize that the consequences of rejection may vary depending upon the nature of the property and the parties’ respective rights.
For example, the Bankruptcy Code contains specific provisions concerning residential and nonresidential real property leases, aircraft and certain other specialized arrangements. Consequently, the general principles governing assumption and rejection must sometimes be considered together with the specific statutory provisions applicable to the particular contract or lease.
A corporate debtor must therefore examine not only Section 365(a), but also the specific provisions governing the type of agreement involved.
IPSO FACTO PROVISIONS
A significant protection afforded to a debtor under Section 365 concerns ipso facto provisions. Commercial contracts sometimes contain clauses providing that the agreement may be terminated, accelerated or modified merely because the counterparty becomes insolvent or files for bankruptcy.
Section 365(e) generally restricts enforcement of provisions that terminate or modify an executory contract or unexpired lease, or otherwise give the counterparty a right or power because of the debtor’s insolvency, bankruptcy filing or appointment of a trustee.
There are, however, statutory exceptions, particularly where applicable law excuses the non-debtor party from accepting performance from an entity other than the debtor or where other requirements of the Bankruptcy Code are satisfied.
The provision prevents bankruptcy itself from automatically destroying valuable contractual relationships, while preserving certain legitimate contractual and regulatory interests recognized by Congress.
POSTPETITION PERFORMANCE AND ADMINISTRATIVE EXPENSES
While the debtor evaluates whether to assume or reject a contract, issues may arise concerning obligations accruing after commencement of the bankruptcy case. Where the debtor continues to receive benefits from a contract or lease, the counterparty may seek payment for the value of post-petition goods or services in accordance with the applicable provisions of the Bankruptcy Code.
Section 503(b)(1) may provide administrative-expense treatment for the actual, necessary costs and expenses of preserving the estate, subject to the statutory requirements. In the case of certain non-residential real property leases, Section 365(d)(3) imposes specific obligations concerning timely performance of the debtor’s lease obligations pending assumption or rejection.
These provisions help ensure that counterparties are not required to continue providing valuable post-petition performance indefinitely without appropriate payment.
EXECUTORY CONTRACTS AND THE CHAPTER 11 PLAN
The treatment of executory contracts and unexpired leases is closely connected with the debtor’s plan of reorganization.
Contracts essential to the reorganized business may be assumed and, where permitted, assigned to a purchaser or reorganized debtor. Burdensome contracts may be rejected, with the resulting damages claim treated through the bankruptcy process.
The debtor’s contractual decisions may therefore materially affect the feasibility and economic structure of the Chapter 11 plan. A plan may depend upon retaining key suppliers, licences, leases and customer agreements while eliminating contracts that impose excessive costs.
In a sale-oriented Chapter 11 case, the ability to assume and assign valuable contracts and leases may also substantially influence the value of the assets offered to a purchaser.
COURT APPROVAL
Although Section 365 gives the DIP substantial flexibility, assumption, rejection and assignment generally require court approval. The court’s role is to ensure compliance with the Bankruptcy Code and to protect the interests of the bankruptcy estate and affected parties.
Parties to the contract or lease are ordinarily given notice and an opportunity to object. The court may consider the nature of the agreement, the debtor’s business requirements, the consequences of assumption or rejection and the statutory requirements applicable to the proposed transaction.
The court does not necessarily decide which contract would be most advantageous from a purely commercial perspective. Rather, it applies the statutory framework while giving appropriate consideration to the debtor’s legitimate reorganization objectives.
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Mukesh Suman is a lawyer based at Delhi, India. He also provides bankruptcy paralegal services to clients based in USA. He may be contacted at mukesh_suman@outlook.com or +91 9717864570.
