Everyone Has Rejection Issues

March 21, 2018

Authored by: James Maloney

Rejected

In the typical day-to-day experience in bankruptcy proceedings, the debtor’s ability to assume or reject executory contracts and leases under Section 365 of the Bankruptcy Code is seen from the sometimes-unfortunate perspective of the creditor.  To the creditor’s perspective, the prohibitions of the automatic stay, periods of time during which treatment of the contract is uncertain, struggling to acquire adequate protection, a loss of control over who the contract may be assumed and assigned to, and the alternative of being rejected and left with a deemed prepetition claim, all combine to an undesirable scenario.

As misery loves company, two recent cases have illustrated that the requirements and operations of Section 365 can also result in disappointment to a debtor estate seeking contract damages and to a civil action plaintiff seeking compensation for appropriation of its intellectual property.

In Lauter v CITGO Petroleum Corp.[1] a United States District Court dismissed a claim based upon a post-petition breach of contract because the debtor’s rejection of such contract also ended the debtor’s ability to bring claims for post-petition breach.  In Stanley Jacobs Production, Ltd. v. 9472541 Canada, Inc.[2] a Delaware Bankruptcy Court determined that a defendant who had utilized the plaintiff production company’s infomercials after purchasing assets of a debtor could not be liable to plaintiff for royalties under the debtor’s contract because the debtor had not assumed and assigned the agreement, nor could there be an implied assumption and assignment of a debtor’s executory contract.

Treatment of executory contracts and leases under Section 365 is a broad topic.  In general terms:

  • Section 365 allows the bankruptcy estate, through the trustee or debtor in possession, to do three things with an executory contract: (i) reject it, (ii) assume it or (iii) assume and assign it.
  • If the estate rejects the contract, the rejection is deemed to constitute a material breach of the contract occurring the day before the filing of the bankruptcy petition, Section 365(g)(1), and the non-debtor party receives pre-petition claim for damages arising from such breach. So, rejection converts the non-debtor contract party into an unsecured creditor. Sections 365(g), 502(g).
  • If the estate assumes the contract, the estate is required to cure all defaults or to provide “adequate assurance” that such defaults will be promptly cured, and is committed to perform on a going-forward basis. Section 365(b)(1)(A).
  • Assumption of the contract is a prerequisite to the estate’s ability to assign the contract. Section 365(f)(2)(a).
  • Procedurally, a party must submit a motion for court approval to properly assume or reject an executory contract. Fed. R. Bankr. P. 6006, 9014 (procedures for filing a motion to approve or reject an executory contract).

Because the essential purposes of the Bankruptcy Code include giving the debtor “breathing room,” and a “fresh start” or opportunity to reorganize its debts, it should come as no surprise that the above-stated factors of Section 365 are all unpleasant for creditors.  Creditors can end up compelled to perform an agreement that is later rejected in exchange for an unsecured claim of dubious value, or having to perform under an assumed contract with dubious “adequate assurance,” or having their contract assigned to a party they would not have chosen to do business with.

But the recent Lauter and Stanley Jacobs cases illustrate that Section 365 is truly a gift that keeps on giving, and the same substantive and procedural factors can also reach out to work to the detriment of legal parties other than typical creditors of the estate.

The Lauter case involved a corporate Chapter 11 debtor that operated a service station and a contract with the debtor’s petroleum supplier.  In the underlying bankruptcy case, the debtor sold substantially all its assets, rejected many executory contracts including the supplier’s agreement, then confirmed a Chapter 11 Plan that specifically preserved and transferred claims for breach of contract against the supplier to the post-confirmation trust. In due course, the post-confirmation trust sued the supplier on claims including material post-petition breaches of the supply contract.

However, the trust’s claim for post-petition breaches of the supply contract were dismissed by the court because the debtor’s rejection of the supply contract effectively divested the debtor and the trust from standing to sue for post-petition breach.  The Court reasoned that the debtor’s rejection of the supply contract constituted a material breach entitling the supplier to a dischargeable, unsecured, pre-petition claim and “relieved both the [debtor] and [supplier] from post-petition performance.”  Therefore, the rejection “not only relieved the estate of its post-petition performance obligations, but also relieved the estate of its ability to assert claims for post-petition breaches thereof.”

The Stanley Jacobs case involved a corporate Chapter 15 debtor that used television ads in that sale of consumer products and a “Production Agreement” contract with a producer that created infomercials for such products.  The contract included an obligation of the debtor to pay royalties for use of the infomercials.  In the course of the bankruptcy case, the debtor sold substantially all of its assets.  While the debtor had the explicit right to assign the contract, the debtor did not include the contract as one being assumed and assigned in the sale. The debtor also did not advise the producer of the sale, and the producer was unaware of the bankruptcy until after the sale.

However, the sale purchaser did use one of the infomercials, and the producer responded by filing a district court lawsuit to recover royalties from the purchaser under the contract.  The district case was transferred from its California venue and referred to the Delaware bankruptcy court. The plaintiff producer asserted that the contract royalties were binding upon the purchaser because the purchaser’s course of conduct and continued actual use of the infomercial yielded an implied assumption of this executory contract.

The Delaware court addressed the proposition of implied assumption with significant criticism and authority.  While acknowledging the existence of cases supporting the doctrine of implied assumption, the court characterized the issue as “unsettled” and “hazy” and one that would “force courts to meddle in the fact-laden intricacies of transactions.”  The court expressed the concern that the use of implied assumption brings undesirable uncertainty to the parties, and relied on authorities treating Section 365 and Fed. R. Bankr. P. 6006 as (i) requiring the formalities of assumption and rejection, and (ii) effectively overruling cases that may have recognized implied assumption and rejection.  The Court specifically held that “continued use does not obviate the need for a formal motion to assume,” further stating, “there simply cannot be an assumption without providing the necessary cure or adequate assurance of one.”

There are two postscripts of note regarding these cases.  The loss of standing via rejection set out in the Lauter case is not plenary, and clearly would not apply to any prepetition breach.  As for the plaintiff in Stanley Jacobs, beyond the contract royalties claim here discussed, there are other theories of recovery that do not require contractual privity available against a person is unjustly enriched by appropriation of another’s property without compensation.

[1]          Lauter v. Citgo Petroleum Corp., Case No. 17-2028 (S.D. Tex. Feb. 8, 2018).

[2]          Stanley Jacobs Production Ltd. v. 9472541 Canada Inc. (In re Thane International Inc.), Adv. Proc. No. 17-50476 (Bankr. D. Del. Feb. 21, 2018).