Executory Contracts and Unexpired Leases

Contributed by:
Robert S. Bernstein, Esquire
Bernstein-Burkley, P.C.

In bankruptcy cases, it can be beneficial to have an “executory contract” when your customer files a chapter 11. An executory contract is a contract which both parties have some obligation under the contract yet to perform. While leases are executory contracts, they may also enjoy some extra special protections. A trustee in bankruptcy may assume (live with) or reject (breach and terminate) an executory contract. In a reorganization case, the debtor, as debtor-in-possession, may also assume or reject an executory contract. Assumption or rejection in either case is subject to court approval.

If an executory contract is assumed, any default must be cured or adequate assurance given that the default will be promptly cured. This includes pre-petition defaults! Additionally, the non-debtor party must be compensated for any actual loss suffered as a result of the breach. The debtor or trustee assuming the lease must also give adequate assurance of future performance under the contract. If the contract is rejected, it is treated as though it were breached the day before the bankruptcy filing and the non-debtor party is entitled to damages. Unfortunately, except to the extent the contract benefited the debtor post-petition, the rejection damage claim is a pre-petition, unsecured claim.

The rule that any default must be cured prior to assumption does not apply to situations where the default was based solely on the fact that the debtor filed for protection under the Bankruptcy Code. That is, if the contract provides that any filing of a bankruptcy petition is a default, that is a default that will not have to be cured prior to the assumption of the contract.

In a chapter 7 case, the trustee must assume an executory contract within 60 days of the date of filing. Otherwise, it is automatically rejected. Except as regards non-residential real property, there is no specific time limit for assumption or rejection in a Chapter 11 or 13 case. For non-residential real property, the time limit is 120 days, with ability to get one 90-extension for cause. Beyond 210 days, the Debtor must get the landlord’s consent for any further extensions.

From a debtor’s or trustee’s point of view, an executory contract should be assumed if it is beneficial to the bankruptcy estate. Otherwise, it should be rejected. For instance, if the contract calls for the manufacture of a component which the debtor requires to complete a project for which it will earn a profit, and if the profit will be more than the cost of curing the pre-petition default, the contract should be assumed. If the project will incur a loss, the contract should be rejected. The debtor incurs very little expense in rejecting a contract, since any damage claim is treated as any other pre-petition, unsecured debt.

Any amount owing under the contract as a result of post-petition services, etc., however, could be treated as an administrative expense and would have to be paid in order to get a reorganization plan approved. Therefore, if the debtor is not benefiting from the contract, it is usually in the debtor’s best interest to reject an executory contract early, before administrative expenses accrue. Occasionally, it is in the debtor’s interest to drag out the contract and reject it at the last minute, thus benefiting from the creditor’s post-petition performance under the contract, and not having to pay the pre-petition obligations.

From a creditor’s point of view, it is often best that the contract be assumed, especially if the debtor has accrued a substantial pre-petition obligation. However, if the debtor is plainly not able to meet its obligations under the contract, a creditor is better off with the contract being rejected. This will free up the resources of the creditor by releasing it of obligations under the contract, so that the creditor’s time and money can be put to more productive uses.

If the debtor’s intentions are unclear, or if for any other reason the other party to the contract wants the debtor to either assume or reject the contract, the debtor (or the trustee) may be compelled on request of that party to either assume or reject the contract within a specified period of time.

Determining whether you have an executory contract is an important step in setting your strategy in a bankruptcy case. Having an executory contract can make the difference between full payment and not. As with so many technical bankruptcy provisions, ask your advisor.

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