HOW EXECUTORY CONTRACTS AND UNEXPIRED LEASES ARE TREATED DURING CHAPTER 7 BANKRUPTCY PROCEEDINGS ?

Executory contracts and unexpired leases occupy an important position in bankruptcy because they involve continuing obligations between the debtor and another party at the time the bankruptcy case is commenced. An executory contract is generally understood as a contract under which material performance remains due on both sides, such that significant obligations remain to be performed by both the debtor and the non-debtor party. An unexpired lease, on the other hand, is a lease of property that remains in effect and has not expired or otherwise terminated when the bankruptcy case begins. These arrangements may represent either valuable assets or significant burdens for the bankruptcy estate, depending upon the economic terms of the contract or lease and the debtor’s continuing obligations.

The Bankruptcy Code addresses executory contracts and unexpired leases principally through 11 U.S.C. § 365. Rather than automatically terminating such agreements merely because bankruptcy has been filed, § 365 generally gives the Chapter 7 trustee the authority to determine whether a particular contract or lease should be retained for the benefit of the estate or terminated through rejection.

ASSUMPTION OR REJECTION

The trustee has been empowered to accept or reject an executory contract under §  365 (a) . If the Trustee determines that   contract is beneficial for estate the Trustee can assume it subject to approval of the Court.  In such cases the Trustee continue to perform the contractual obligations of the debtor. In case the contract is burdensome, the Trustee may reject it.

For example, suppose the debtor has a contract under which it will receive $100,000 but must perform services costing only $40,000. The contract may be valuable to the estate. Conversely, if performance will cost $100,000 but the estate will receive only $50,000, the contract may be burdensome.

CONDITIONS OF ASSUMPTION

Section 365(b) sets out the conditions that must generally be satisfied before a trustee may assume an executory contract or unexpired lease that is in default. The trustee must generally cure, or provide adequate assurance of promptly curing, the existing default, compensate the other party for certain actual pecuniary losses resulting from the default, and provide adequate assurance of future performance under the contract or lease. Certain defaults, however, are subject to special treatment under the subsection. The purpose of § 365(b) is to protect the non-debtor party from being compelled to continue a contractual relationship without receiving the performance or financial assurances to which it is entitled, while still allowing the bankruptcy estate to retain contracts or leases that are economically beneficial.

LIMITATION ON ASSUMPTION OR REJECTION

Even though § 365(a) generally allows the trustee to assume or reject a contract, § 365(c) prevents assumption or assignment in certain circumstances. Section 365(c)(1) generally prevents the trustee from assuming or assigning an executory contract or unexpired lease if:

(i) Applicable law excuses the non-debtor party from accepting performance from, or rendering performance to, an entity other than the debtor, and

(ii) The non-debtor party does not consent to the assumption or assignment.

This is particularly relevant where the identity, qualifications, or personal performance of the debtor is important to the contract.

For example,  a debtor is a professional architect who has entered into a contract with a client to personally design a specialized and highly customized building. The contract was entered into specifically because of the debtor’s professional reputation, qualifications, and personal expertise. After the debtor files for Chapter 7 bankruptcy, the trustee considers assuming the contract and having another architect perform the debtor’s obligations. If applicable non-bankruptcy law provides that the client is not required to accept performance from an architect other than the one with whom the client originally contracted, and the client does not consent to the trustee’s proposed assumption or assignment, § 365(c)(1) may prevent the trustee from assuming or assigning the contract. The reason is that the contract depends substantially upon the debtor’s personal qualifications and performance, and the non-debtor party cannot be compelled to accept a substitute performer whom it did not agree to engage.

TIME LIMIT

11 U.S.C. § 365(d) deals primarily with the time limits within which a Chapter 7 trustee must decide whether to assume or reject an executory contract or unexpired lease, and with certain post-petition obligations to make payments. For a Chapter 7 case, if the trustee does not assume or reject an executory contract or an applicable unexpired lease within 60 days after the order for relief, the contract or lease is deemed rejected, unless the court extends the period for cause within that 60-day period.

11 U.S.C § 365(d)(3)  concerns a non-residential real-property lease where the debtor is the tenant. Until the lease is assumed or rejected, the trustee generally must timely perform the obligations of the debtor under the lease, subject to the statutory provisions.

11 U.S.C. §365(d)(4) establishes the 120-day rule for non-residential real-property leases, with limited extensions. For a debtor that is a tenant under a non-residential real-property lease, the trustee generally has 120 days after the order for relief to assume or reject the lease. The court may grant a 90-day extension for cause. Any further extension requires the lessor’s written consent.

BANKRUPTCY RELATED TERMINATION CLAUSES

11 U.S.C. § 365(e) deals with “ipso facto” clauses—contractual provisions that allow a party to terminate or modify an executory contract or unexpired lease because the debtor has filed bankruptcy, become insolvent, or had a trustee appointed.

Generally, a contractual provision is unenforceable under 11 U.S.C. § 365(e) (1)  if it provides for termination or modification of the contract or lease merely because the debtor has filed a bankruptcy case. Section 365(e) generally prevents the landlord from relying on that bankruptcy filing alone to terminate the lease.

Section 365(e)(2) creates important exceptions. The anti-termination rule does not apply in certain circumstances where:

(i) Applicable law excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the debtor or debtor-in-possession; or

(ii) The contract is one where the material obligation is based on the financial condition, financial responsibility, or operating condition of the debtor.

These exceptions are particularly important for certain personal-service contracts and specialized financial arrangements.

For example, a professional singer has a contract requiring the singer personally to perform at a series of concerts. The singer files Chapter 7. The trustee cannot simply assume the contract and substitute another singer if applicable law gives the promoter the right to insist on the singer’s personal performance. Section 365(e)(2) recognizes an exception to the general protection against termination based on bankruptcy.

ASSIGNMENT

11 U.S.C. § 365(f) deals with the assignment of an executory contract or unexpired lease after it has been assumed by the trustee. A trustee who assumes an executory contract or unexpired lease can generally assign it to another party, even if the contract contains a provision restricting assignment, subject to the requirements and exceptions in § 365. Section 365(f)(1) generally makes such anti-assignment provisions unenforceable when the trustee is permitted to assign the contract under §365.

For example, suppose a debtor has a valuable supply contract under which the customer has agreed to pay $500,000, while the debtor’s remaining cost of performance is $300,000. The contract therefore has an approximate value of $200,000 to the bankruptcy estate. After the debtor files a Chapter 7 petition, the trustee determines that although the contract is valuable, the estate does not want to undertake the remaining performance itself. The trustee therefore finds another company willing to take over the contract. Subject to the requirements of § 365, the trustee may first assume the contract under § 365(a) and then assign it to the third party under § 365(f). The trustee may receive consideration for the assignment, thereby realizing the value of the contract for the benefit of the bankruptcy estate.

Section 365(f)(2) imposes important requirements before assignment. The trustee generally must assume the contract under §365; and  provide adequate assurance of future performance by the assignee.

For example, if the original debtor was supposed to pay $50,000 per month, the counterparty should have reasonable assurance that the new party will be capable of performing that obligation.

EFFECT OF REJECTION OF EXECUTORY CONTRACT

11 U.S.C. § 365(g) deals with the effect of rejection of an executory contract or unexpired lease. When the trustee rejects an executory contract or unexpired lease, the rejection generally constitutes a breach of that contract or lease.

Suppose a debtor has an executory supply contract under which it agreed to supply goods worth $500,000. After the debtor files Chapter 7, the trustee determines that continuing the contract would be burdensome and therefore rejects it under §365(a).

The rejection does not mean that the contract simply disappears. Instead, under §365(g), the rejection generally constitutes a breach of the contract, treated as having occurred immediately before the date of the filing of the bankruptcy petition.

If the customer suffers damages because of the breach, the customer may have a claim against the bankruptcy estate for those damages, subject to the applicable provisions governing claims and distribution.

RIGHTS OF LESSE

11 U.S.C. § 365(h) deals with the rights of a lessee when the trustee rejects an unexpired lease of real property in which the debtor is the landlord. If the debtor is the landlord and the trustee rejects the lease, the tenant may, in certain circumstances, choose to remain in possession for the remaining lease term.

Suppose a debtor owns a commercial building and has leased a shop in that building to a tenant for 10 years. The debtor later files Chapter 7.

The trustee examines the lease and decides that the lease is burdensome or otherwise not beneficial to the estate. The trustee therefore rejects the lease under §365(a).

Ordinarily, rejection constitutes a breach under §365(g). However, §365(h) gives the tenant special protection. The tenant may generally elect to treat the lease as terminated and assert its resulting claim; or remain in possession and continue to exercise its rights under the lease for the remaining term, subject to the conditions of §365(h).

RIGHTS OF PURCHASER IN POSSESSION

11 U.S.C. § 365(i) deals with the rights of a purchaser when the debtor is the seller of real property and the trustee rejects the executory contract for the sale of that property. If the debtor has agreed to sell real property to a purchaser, and the trustee rejects the sale contract, §365(i) gives the purchaser certain rights to complete the purchase, if purchaser is in possession of the property.

For example, suppose the debtor agrees to sell a house to a buyer for $400,000. The buyer has already paid $50,000 as a deposit and is entitled under the contract to obtain the property after completing the purchase. Before the sale is completed, the debtor files Chapter 7. The trustee determines that the executory sale contract should be rejected.

Under §365(g), rejection generally constitutes a breach. However, §365(i) provides special protection to the purchaser. If the purchaser elects to remain in the property, the purchaser may have the right to remain in possession of the property; and   complete the purchase, subject to the conditions specified in §365(i).

PURCHASER’S LIEN

§ 365(j) deals with the rights of a purchaser when the debtor-seller rejects an executory contract for the sale of real property and the purchaser does not elect the protection provided by § 365(i). If the purchaser is entitled to specific performance but does not remain in possession under §365(i), §365(j) gives the purchaser a lien on the debtor’s interest in the property for the recovery of certain payments made under the contract.

For example, suppose a debtor agrees to sell a house to a purchaser for $400,000. The purchaser pays the debtor $50,000 toward the purchase price, but the sale has not been completed. The debtor files Chapter 7, and the trustee rejects the sale contract.

If the purchaser does not elect to remain in possession and complete the purchase under §365(i), the purchaser may have a lien on the debtor’s interest in the property for the recovery of the amount paid toward the purchase price.

RELEASE OF TRUSTEE AFTER ASSIGNMENT

11 U.S.C. § 365(k) deals with the liability of the trustee and the bankruptcy estate after the trustee assigns an executory contract or unexpired lease. Once the trustee properly assumes and assigns an executory contract or unexpired lease, the trustee and the estate are generally relieved from liability for obligations arising after the assignment.

Suppose the debtor has a valuable supply contract with a customer. The trustee assumes the contract under §365(a) and assigns it to another company under §365(f); and  the other company takes over the debtor’s obligations under the contract.

After the assignment, the new company fails to perform the contract. Under §365(k), the customer generally cannot hold the trustee or the bankruptcy estate liable for the assignee’s post-assignment failure to perform.

LESSOR’S INDEMNIFICATION

11 U.S.C. § 365(l) deals with the effect of rejection of a lease on the debtor’s obligations to indemnify the lessor. More specifically, it provides protection to the lessor (landlord) where the debtor is the lessee (tenant) and the lease has been rejected. It prevents rejection of the lease from automatically eliminating certain contractual rights that the lessor may have against the debtor concerning indemnification.

For example, suppose a company leases a warehouse and agrees to indemnify the landlord for certain liabilities arising from the tenant’s use of the premises. The company later files Chapter 7, and the trustee rejects the lease. The rejection constitutes a breach under §365(g), but §365(l) addresses the continuing effect of the tenant’s indemnification obligations toward the landlord.

Section 365(m) provides that, for purposes of §365, §541(b)(2), and §362(b)(10), the expression “leases of real property” includes any rental agreement to use real property. Suppose a debtor occupies an office under a document called a “rental agreement” rather than a formal “lease.” If the agreement gives the debtor the right to use real property, §365(m) says that, for the specified Bankruptcy Code provisions, it is treated as a lease of real property.

§365(n) provides that rejection of a contract under §365 does not terminate or modify certain rights of a licensee to use intellectual property if those rights are protected under the relevant provisions of the Bankruptcy Code.

PROTECTION OF INTELLECTUAL PROPERTY LICENSES

Suppose a debtor grants another company a license to use its intellectual property under a long-term agreement. The debtor later files Chapter 7, and the trustee rejects the license agreement under §365.

Ordinarily, rejection constitutes a breach under §365(g). However, §365(m) can protect the licensee’s existing rights, so that the rejection does not automatically destroy those rights.

PERSONAL PROPERTY LEASES

365(p) deals with what happens to a lease of personal property when the debtor files bankruptcy, particularly when the lease is not assumed by the Chapter 7 trustee.

365(p)(1) provides that if a personal-property lease is rejected or is not timely assumed by the trustee under §365(d), then the leased property ceases to be property of the bankruptcy estate; and  the automatic stay under §362(a) terminates with respect to that property.

365(p)(2) provides that if the debtor is an individual, the debtor may notify the lessor in writing that the debtor wants to assume the personal-property lease.

The lessor may agree to the assumption and may require the debtor to cure outstanding defaults according to the contract. If the lessor agrees and the debtor gives the required written notice of assumption within 30 days, the lease liability becomes the debtor’s liability, not the bankruptcy estate’s liability.

For example, suppose an individual debtor files Chapter 7 while leasing a car. The Chapter 7 trustee does not assume the car lease within the applicable period. Under §365(p)(1), the car is no longer property of the bankruptcy estate and the automatic stay terminates with respect to the car. However, under §365(p)(2), the debtor can notify the car-leasing company that the debtor wants to assume the lease. If the lessor agrees, the debtor can assume the lease, potentially after curing any required default. The lease then becomes the debtor’s obligation rather than an obligation of the bankruptcy estate.

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Mukesh Suman is a lawyer based at Delhi, India. He also provides bankruptcy paralegal services to clients based at USA. He can be approached at mukesh_suman@outlook.com.