Dealing with Corporate Distress 16: Overview of Bankruptcy Code § 365

The ABCs of ABCs, Business Bankruptcy, & Corporate Restructuring/Insolvency

Operating companies undoubtedly operate their businesses under a constellation of written contracts with vendors and customers alike. Additionally, companies frequently lease things like office or storage space, machinery, and equipment from third parties to operate their businesses.

So, what happens to a company’s existing contracts and leases upon a chapter 11 bankruptcy filing? Existing contracts and leases may be integral to a debtor’s ability to continue operating in bankruptcy. Conversely, some contracts and leases may represent a burden to the debtor’s future operations because of onerous terms or a lack of real benefit to the debtor’s business.

In a bankruptcy case, a debtor has an opportunity to assume (keep) or reject (get rid of) certain contracts and leases. If a contract or lease is favorable, the Bankruptcy Code allows a debtor to (a) assume the contract or lease or (b) realize the value of the contract or lease by assuming it and then assigning it to a third party (in exchange for something of value). If a contract or lease is burdensome, the debtor may reject it, regardless of what the contract or lease says about termination.

Bankruptcy Code § 365 speaks directly to these issues, stating that a debtor “subject to the court’s approval, may assume or reject any executory contract or unexpired lease. . . .” This simple statement is deceptive, however, because § 365 is lengthy and contains numerous subsections setting forth conditions for assumption and specialized treatment for various types of contracts or leases a debtor may be party to. Among other things, § 365 contains special provisions relating to:

• The conditions that must first be met to assume an executory contract or lease (§ 365(b))
• Shopping center leases (§ 365(b)(3))
• Exceptions to the assumption or assignability of certain types of contracts and leases (§ 365(c))
• The time by which a personal property contract and lease or residential real estate lease must be assumed or rejected (§ 365(d))
• The time for performing postpetition obligations under a nonresidential real estate lease (§ 365(d)(3))
• The time by which nonresidential leases must be assumed or rejected (§ 365(d)(4))
• The time by which the debtor must perform its postpetition obligations under a personal property lease (other than a lease to an individual for personal, family, or household purposes) (§ 365(d)(5))
• The conditions that must be met before an executory contract or unexpired lease may be assigned to a third party ((§ 365(f))
• Treatment of claims for parties whose contracts or leases have been rejected (§ 365(g))
• The rights of real estate lessees when the debtor, as lessor, rejects the lease (§ 365(h))
• The rights of a counterparty to a real estate sale agreement or timeshare plan (§ 365(i), (j))
• The rights of intellectual property licensors whose contracts are rejected by a debtor/licensee (§ 365(n)).

In addition to these numerous specialized provisions, what makes a contract “executory” is not always clear.

Defining “Executory” Contracts

The Bankruptcy Code does not contain a definition of the term “executory contract.” Generally speaking, courts and practitioners look to the “Countryman definition” of an executory contract, named for its proponent, the late professor Vern Countryman. Under the Countryman definition, an executory contract is:

a contract under which the obligation of both the bankrupt and the other party to the contract is so far clearly unperformed that failure of either to complete performance would constitute a material breach excusing the performance of the other. ¹

In practice, most parties interpret this definition as meaning that an executory contract has remaining unperformed duties on both sides of the agreement. It is still, however, key to look for material duties outstanding on both sides of the contract.

For example, let’s say a local brewery enters into a contract with a yeast producer under which the yeast producer will make monthly deliveries of yeast to the brewery for a year for a total contract price of $60,000 ($5,000 per month). Now, let’s assume that six months into the relationship, a breach of the agreement occurs, either by (a) the yeast producer ceasing deliveries; or (b) the brewery ceasing payments. Either breach would appear to be material enough to fit the Countryman definition, making this contract executory.

Sticking with this example, let’s assume that option (b) are our facts: the brewery stops paying its yeast producer and doesn’t make its payment in month 6 of the contract, and then files chapter 11 bankruptcy during that sixth month, leaving $5,000 unpaid to the yeast producer, and an additional $30,000 worth of contract payments outstanding to the yeast producer.

In this simple example, what are the brewery’s (now debtor’s) options in chapter 11? Under § 365, it can assume the contract, but it is important to note that when a contract or lease is assumed in bankruptcy, it must be assumed on its terms, and (pursuant to § 365(b)(1)) any outstanding obligations under the agreement must be cured by the debtor at the time of assumption (i.e., the debtor must catch up on unpaid prepetition amounts or perform its unperformed prepetition obligations). Another option is to assume and assign the contract to another party (often an asset purchaser), which requires not only that the agreement be cured, but that the agreement itself may be assigned by the debtor, compelling the counterparty to accept performance from a third party (subject to certain requirements). Finally, the debtor can reject the agreement, resulting in a termination of the agreement as of the petition date and leaving the counterparty with a mere unsecured claim for its damages (colloquially referred to as a “rejection damages claim”). We discuss these options, along with several nuances applicable to various specific types of parties in greater detail in Installment 17.

To assume or reject an executory contract or unexpired lease, debtors must seek approval of the bankruptcy court. Courts apply a deferential “business judgment” standard to assessing whether the debtor’s assumption or rejection of an agreement should be permitted and don’t often second-guess the debtor’s decision to assume or reject an agreement, as long as the debtor has met the other requirements for assumption or rejection.

Distinguishing True Leases from Disguised Financings

One issue that arises (albeit infrequently) when dealing with leases in bankruptcy is determining whether an unexpired lease is actually a “true lease” or a disguised financing transaction. A true lease is an arrangement in which the lessor bears both the risks and benefits of ownership of the property being leased and generally speaking, the lessee only holds the right to use the property during the term of the agreement. In some cases, an agreement that may be titled a “lease” is actually a secured financing transaction in disguise. Where this is the case, bankruptcy courts may recharacterize the transaction according to its actual substance.

Courts analyzing whether a transaction is a true lease or disguised financing apply a bright line test, asking whether the debtor/lessee is able to terminate the agreement during its term. If so, the transaction is a true lease. If not, courts look to “residual value factors” set forth in § 1-203(b). If the debtor/lessee does not have the right to terminate the agreement during its term and one or more of these residual value factors is present, courts typically find that the transaction was a disguised financing. The residual value factors considered are whether (1) the original term of the agreement is equal to or greater than the remaining economic life of the goods; (2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods; (3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement; or (4) the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement.

So why does this distinction matter? For creditors, the characterization of a transaction as a lease versus a secured financing transaction impacts ownership status of property, as well as the creditor’s recovery options in a bankruptcy case. If a transaction is characterized as a true lease, the leased property belongs to the creditor, not the debtor’s bankruptcy estate. Additionally, debtors must honor their postpetition obligations to lessors after the first 60 days of their case, meaning that the creditor will either see future payments from the debtor or the lease will be rejected, and the property returned to the creditor. Furthermore, a debtor cannot unilaterally modify its lease obligations to a lessor upon assuming a true lease and will have to cure its unfulfilled obligations at the time of assumption, essentially making the lessor whole.

By contrast, if a lease is recharacterized as a disguised financing arrangement, the subject property belongs to the debtor’s bankruptcy estate, meaning that the debtor can be subject to the terms of Bankruptcy Code § 363. And when addressing secured claims in a chapter 11 plan, the debtor can propose treatment of the creditor’s claim on terms differing from those initially agreed to with the secured creditor. Finally, risk exists where a lease is characterized as a secured transaction because the lessor may not have perfected its security interest by filing a UCC-1 financing statement, believing it to be the owner of the subject property. In that case, the creditor’s lien is subject to potential avoidance under Bankruptcy Code § 544.

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[Editors’ Note: This article, while written to be read and understood on a standalone basis, is part of a series. To read Installment 1, which includes a table of contents and links to every article in the series, click here.

The authors are corporate restructuring and insolvency attorneys with Much Shelist, P.C. and Levenfeld Pearlstein, LLP. Read more in their bios below.

Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy.

To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

• Commercial Leases, Their Provisions, and Pitfalls to Avoid
• Procurement & Government Contracting Compliance
• The Nuts & Bolts of DIP Financing]

©2022. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. Countryman, Executory Contracts in Bankruptcy: Part I., 57 Minn. L. Rev. 439, 469 (1973)